Welfare Economics and
the Environment
(Lecture 2)
MSc Sustainable Resources: BENV0070
Introduction to Resource Economics and Policy
Dr Álvaro Calzadilla
Senior Lecturer in Macro-economic Modelling
UCL Institute for Sustainable Resources
([email protected])
London, 9th October 2018
Aims of lecture
• Learn concepts of efficiency and optimality in allocation
• Identify conditions for an efficient and optimal allocation of resources
• Learn about social welfare function
Contents
Chapter 4. Perman R. et al. (2011). Natural Resource and Environmental
Economics
• Efficiency and optimality
– Efficiency in consumption
– Efficiency in production
– Product-mix efficiency
• The social welfare function
2
Circular flow of the economy
Ecosystem services:
- Recreation
- Pollination
Environment Environment
Natural resources: Waste:
- Energy - Emissions
- Materials - Materials
Recycling:
- Natural
- Industrial
3
Efficiency and optimality
4
Key assumptions
For simplicity we assume that the economy consist of:
• Two person: A and B
• Two goods: X and Y are produced
• Two productive resources: Capital and labour, each available in a fixed
quantity
For the moment we assume that:
• No externalities exist in either consumption or production
• All produced goods and services are private (not public) goods
Individuals have preferences about the various goods that it is feasible to
produce using the available resources
Allocation of resources describes what goods are produced and in what
quantities they are produced, which combinations of resource inputs are used
in producing those goods and how the outputs of those goods are distributed
between persons
Y
Utility functions
UA
The utility functions for A and B:
Ya .
U
A A A
= U ( X ,Y ) A a
.
U
B
= U B( X B,Y B) Yb b
0 Xa Xb X
Marginal utility that A derives from the consumption of good X is defined by
U XA =
∂U A /∂X A
with equivalent notation for the other three marginal utilities
K
Production functions
Y
The production functions for goods X and Y:
Ka .
a
X = X (K ,L ) X X
.
Kb b
Y = Y (K ,L )
Y Y
0 La Lb L
Marginal product of the input L in the production of good Y is defined by:
MPLY = ∂Y/∂LY
with equivalent notation for the other three marginal products
Key concepts
Marginal rate of utility substitution for A (MRUSA):
• The rate at which X can be substituted for Y at the margin, or vice versa, while
holding the level of A's utility constant
• It varies with the levels of consumption of X and Y and is given by the slope of
the indifference curve
• Similarly for B
The marginal rate of technical substitution in the production of X (MRTSX):
• The rate at which K can be substituted for L at the margin, or vice versa, while
holding the level output of X constant
• It varies with the input levels for K and L and is given by the slope of the
isoquant
• Similarly for Y
The marginal rates of transformation for the commodities X and Y (MRTL):
• The rates at which the output of one can be transformed into the other by
marginally shifting capital or labour from one line of production to the other
• MRTL is the increase in the output of Y obtained by shifting a small amount of
labour from use in the production of X to use in the production of Y, or vice
versa
• Similarly for capital
Economic efficiency
• An allocation of resources is efficient if it is not possible to make one or
more persons better off without making at least one other person worse off
• A gain by one or more persons without anyone else suffering is a Pareto
improvement
• When all such gains have been made, the resulting allocation is Pareto
optimal (or Pareto efficient).
• Efficiency in allocation requires that three efficiency conditions are fulfilled
1. efficiency in consumption
2. efficiency in production
3. product-mix efficiency
1) Efficiency in consumption
Y
Indifference curves
IB1 • IB0IB0 and IB1IB1 are
IB0 indifference curves for
individual B
c
Ya . • Moving from a towards b
a gives the same utility
.
Yb • Point c gives a higher
b
IB1 utility to consumer B
IB0
B0 Xa Xb X • The slope of the
indifference curve is the
UB = UB (XB , YB) MRUSB
1) Efficiency in consumption
BY
IB1
IB0
BYa .a
BYb .b
IB1
IA IB0
B0 BXa BXb BX
Efficiency in consumption
(Fig 4.1, Perman et al (2011))
1) Efficiency in consumption
BY
Allocation of fixed amounts
S AXa AXb A0 of X and Y between A and B
AX
IB1
IB0
IA
BYa .a AYa
BYb .b AYb
IB1
IA IB0
B0 BXa BXb T BX
AY
Efficiency in consumption
(Fig 4.1, Perman et al (2011))
1) Efficiency in consumption
BY
Consumption efficiency
S AXa AXb A0 requires that the marginal
AX rates of utility substitution for
IB1
the two individuals are equal:
IB0
MRUSA = MRUSB
IA
BYa .a AYa If this condition is not
BYb .b AYb
satisfied, it would be possible
to re-arrange the allocation of
goods between A and B to
IB1
IA IB0
make one better-off without
making the other worse-off
B0 BXa BXb T BX
AY
Efficiency in consumption
(Fig 4.1, Perman et al (2011))
2) Efficiency in production
K
Isoquant curves
IY1 • IY0IY0 and IY10IY1 are
IY0 isoquant curves for the
production of good Y
c • Moving from a towards b
Ka . gives the same
a production
.
Kb • Point c yields to higher
b
IY1 production of good Y
IY0
Y0 La Lb L • The slope of the
isoquant curve is the
MRTSY
Y = Y (KY , LY)
2) Efficiency in production
KY
IY1
IY0
KYa .a KXa
KYb .b KXb
IY1
IY0
LY
Y0 LYa LYb
Efficiency in production
(Fig 4.2, Perman et al (2011))
2) Efficiency in production
KY
Allocation of fixed amounts
LXa LXb X0 of L and K between X and Y
LX
IY1
IY0
IX
KYa .a KXa
KYb .b KXb
IY1
IX IY0
LY
Y0 LYa LYb
KX
Efficiency in production
(Fig 4.2, Perman et al (2011))
2) Efficiency in production
KY
Efficiency in production
LXa LXb X0 requires that the marginal
LX rate of technical substitution
IY1 be the same in the
IY0 production of both
commodities:
IX MRTSX = MRTSY
KYa .a KXa
KYb .b KXb
If this condition is not
satisfied, it will be possible to
re-allocate inputs to
IY1 production so as to produce
IX IY0
LY more of one of the
Y0 LYa LYb commodities without
producing less of the other
KX
Efficiency in production
(Fig 4.2, Perman et al (2011))
3) Product-mix efficiency
Production Possibility Frontier
(PPF)
• There are many combinations of K
and L that satisfy efficiency in
production MRTSX = MRTSY
• All these combinations are
represented by the contract curve
0X0Y . All points are Pareto efficient
allocations (only in production)
• The production possibility
frontier shows the output
combinations that the economy
could produce using all of its
available resources
3) Product-mix efficiency
Y The final condition necessary
for economic efficiency is
product-mix efficiency. This
I requires that
YM
a MRTL = MRTK =
Ya •
MRUSA = MRUSB
Yb • b
The production possibility
frontier, YMXM, showing the
output combinations that the
Yc • c economy could produce
I
using all of its available
XM X resources.
0 Xa Xb XC
Product mix efficiency
The slope of YMXM is MRT
(Fig 4.3, Perman et al (2011))
Fully efficient static allocation of resources
• An economy attains a fully efficient static allocation of resources if the
conditions given by
– Efficiency in consumption
– Efficiency in production
– Product-mix efficiency
are satisfied simultaneously
• The results readily generalise to economies with many inputs, many goods
and many individuals
– The only difference will be that the three efficiency conditions will have
to hold for each possible pairwise comparison that one could make
But, an efficient allocation of resources is not unique
BY • For an economy with
S A0 given quantities of
AX available resources, and
A B
B C given production functions
B A and utility functions, there
A will be many efficient
B allocations of resources
A
B
B A • At any point along CC,
A . A B the consumption
B
A efficiency condition is
B satisfied
C A
A B
B0 B
T X
AY
The set of allocations for consumption efficiency
(Fig 4.4, Perman et al (2011))
So, there are many combinations of X and Y output levels that are
consistent with allocative efficiency ...
... and for any particular combination there are many allocations as between
A and B that are consistent with allocative efficiency.
UB
Utility Possibility Frontier (UPF)
U Bmax T
• There are many combinations of X
and Y that satisfy efficiency in
consumption MRUSA = MRUSB
Z
•
• The shape of the UPF depends on
U B
S the particular forms on the utility
R
R and production functions
• The utility possibility frontier
shows the all possible
UA combinations of UA and UB that
0 U AR U Amax correspond to efficiency in
allocation (both production and
Utility possibility frontier consumption)
(Fig 4.5, Perman et al (2011))
The utility possibility frontier
• The utility possibility frontier shows the UA/UB combinations that
correspond to efficiency in allocation, situations where there is no scope for
a Pareto Improvement
• There are many such combinations
• Is it possible, using the information available, to say which of the points on
the frontier is best (optimal) from the point of view of society?
The utility possibility frontier
• The utility possibility frontier shows the UA/UB combinations that
correspond to efficiency in allocation, situations where there is no scope for
a Pareto Improvement
• There are many such combinations
• Is it possible, using the information available, to say which of the points on
the frontier is best (optimal) from the point of view of society?
• It is not possible for the simple reason that the criterion of economic
efficiency does not provide any basis for making interpersonal
comparisons
• Efficiency does not give us a criterion for judging which allocation is best
(optimal) from a social point of view
• Choosing a point along the utility possibility frontier is about making moves
that must involve making one individual worse off in order to make the other
better off. Efficiency criteria do not cover such choices.
The social welfare function
25
The social welfare function and optimality
• In order to consider such choices we need the concept of a social welfare
function
• A social welfare function (SWF) associates numbers for social welfare
with combinations of utility levels UA and UB
• A SWF can be used to rank alternative allocations
• For a two person economy, the SWF could be defined by:
W = W (U A, U B)
• The only assumption that we make here regarding the form of the SWF is
that welfare is non-decreasing in UA and UB.
• SWF is formally of same nature as a utility function, so we can depict a
SWF in terms of social welfare indifference curves
The social welfare function and optimality
UB
At point b, social welfare indifference
curve WW has the same slope as the
W utility possibility frontier. This point
identifies the combination of UA and UB
that maximises the SWF
a
U aB •
b The fact that the optimum lies on the
U Bb •
utility possibility frontier means that all
of the necessary conditions for
efficiency must hold at the optimum.
U cB •c
W
Efficiency in consumption, production
and product-mix must be satisfied for
A
Uthe
0 U aA U Ab U cA maximisation of welfare
Maximised social welfare
(Fig 4.6, Perman et al (2011))
The social welfare function and optimality
UB
The slopes of the social indifference curve
W
and the utility possibility frontier must
satisfied the following condition:
a B B
U aB • WA U X UY
= = A A
WB U X UY
U Bb •
b
The left-hand side is the slope of the
social welfare indifference curve
U cB •c
W
The two right-hand side terms are
0 U aA U Ab U cA alternative
UA expressions for the slope of
Maximised social welfare the utility possibility frontier
(Fig 4.6, Perman et al (2011))
The social welfare function and optimality
UB
Allocative efficiency is a necessary
condition for optimality
D It is not generally true that moving from
• an allocation that is not efficient (C) to
one that is efficient (D) must represent
a welfare improvement
•
E Such a move might result in a lower
•
C level of social welfare.
W2
W1
0 UA
Welfare and efficiency
(Fig 4.7, Perman et al (2011))
The social welfare function and optimality
UB
Whenever there is an inefficient
allocation (C), there is always some
other allocation (E) which is both
D efficient and superior in welfare terms.
•
E is allocatively efficient while C is not
E is on a higher social welfare
•
E indifference curve
•
C
The move from C to E is a Pareto
W2 improvement where both A and B gain,
and hence involves higher social
W1 welfare
0 UA
Welfare and efficiency
(Fig 4.7, Perman et al (2011))
The social welfare function and optimality
UB
On the other hand, going from C to D
replaces an inefficient allocation with
an efficient one
D
• … but the change is not a Pareto
improvement – B gains but A suffers –
and involves a reduction in social
welfare.
•
E
•
C
W2
W1
0 UA
Welfare and efficiency
(Fig 4.7, Perman et al (2011))
The social welfare function and optimality
UB
Clearly, any change which is a
Pareto improvement must increase
social welfare. Given that the SWF is
D non-decreasing in UA and UB
•
For the kind of SWF employed here, a
Pareto improvement is an un-
ambiguously good thing
•
E
•
C
W2
W1
0 UA
Welfare and efficiency
(Fig 4.7, Perman et al (2011))
Summary
• Allocative efficiency is a good thing if it involves an allocation of goods
between individuals that can be regarded as fair
• Judgements about fairness, or equity, are embodied in the SWF in the
analysis
• If these are acceptable, then optimality is an un-ambiguously good thing
• But how do we proceed if there is not a generally accepted SWF?
Compensation Tests (section 4.4)
Part II: Allocation in a market economy
Part III: Market failure, public policy and the
environment
34
