Applied Welfare Economics Part IIB: Paper 1

1. Applied Welfare EconomicsPart IIB: Paper 1 Dr Toke Aidt Lecture 1 Office hour: Monday 1-2 in room 31.

2. What (should) set economists apart? Understanding deadweight cost Understanding concept of externality Understanding opportunity cost Understanding comparative advantage

3. Opportunity cost You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost �40. On any given day, you would be willing to pay up to �50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) �0, (b) �10, (c) �40, or (d) �50.

4. Overview of the Course onSecond Best Theory and Social Cost-benefit Analysis Optimal (second-best) tax policy Deadweight cost. Efficiency equity trade offs. Externalities The Coase theorem Piguvian taxes Social cost-benefit analysis Expenditure programmes and public investments (opportunity cost).

5. What do these individuals have in common?

6. Outline of lecture 1 The two Fundamental Welfare Theorems and the three Pareto conditions. Social Welfare Functions. The first best and the Principle of Targeting.

7. The Fundamental Welfare Theorems A competitive equilibrium will be Pareto efficient under the following conditions: Perfect competition in all markets Complete set of markets (=no externalities or public goods) Perfect and symmetric information. Any Pareto efficient allocation can be achieved by a competitive equilibrium after an appropriate redistribution of resources through lump sum taxation.

8. Baseline model and notation Produced goods: xi (i=1,�,n; often with n = 2). Factor of production (labour) in variable supply: l0 Total time (T0) = labour (l0) + leisure (L0). Factor of production (capital) in fixed supply: k. Many consumers (h=1,..,H; sometimes only two, h=A or h=B) with concave utility functions Uk(x;l0). Many producers (j=1,�.,J) with production technology fj(l0,k).

9. The Three Pareto Conditions

10. The First Welfare Theorem A competitive equilibrium will be Pareto Efficient, i.e., at equilibrium the three Pareto conditions are satisfied.

11. Relative prices and the three Pareto conditions Producer prices p are the prices on commodities and factors of production (demanded) that producers face. Consumer prices q are the prices on commodities and factors of production (supplied) that consumers face. They may differ because of taxes and subsidies (or for other reasons).

13. The Second Welfare Theorem Any Pareto efficient allocation can be achieved by a competitive equilibrium after an appropriate redistribution of resources through lump sum taxation.

14. The Role of the government in a �Perfect World� Make sure that markets are competitive and complete so that the market allocation of resources is Pareto efficient. the right set of LUMP SUM taxes are employed to achieve the desired distribution of welfare.

15. Foundations of Social Welfare Functions Which of the many Pareto efficient allocations should the government aim at?

16. The Collective Choice Problem

17. Bergson-Samuelson SWFs Based on some notion of inter-personal comparability of cardinal utilities. The social welfare function embodies some ethical objective of society.

18. Two examples social welfare functions Utilitarian principle Rawlsian principle

21. What is needed for the world to be �perfect�? Conditions for the First Welfare Theorem: Perfect competition and price taking behavior in all markets. Complete set of markets (or the absence of externalities and public goods). Complete and symmetric information. Second Welfare Theorem in addition requires that optimal lump sum taxes are feasible (and convexity).

22. Two types of distortions Endogenous distortions arise because of market imperfections. Examples include natural monopoly, externalities in production and consumption, power in international trade, information asymmetries. Policy-imposed distortions arise because of government intervention in the economy. Examples include taxes on and subsidies to outputs and inputs, tariffs, regulation of entry, public production of goods, etc.

23. First best versus second best worlds The first best is achieved when all Pareto conditions are satisfied. A first best world is one in which the government has the capacity to correct all distortions and therefore insure that all the Pareto conditions are satisfied simultaneously. A second best world is one in which the government only has the capacity to correct some distortions and therefore cannot insure that all the Pareto conditions are satisfied simultanously.

24. The Principle of Targeting: Policy in a first best world. To correct a distortion (whether endogenous or policy-imposed) in a first best world, use the instrument that most directly offsets the source of the distortion. Why? Indirect instruments create unwarranted deadweight costs that could be avoided!

25. Some implications of the principle Use competition policy to regulate a natural monopoly; not the tax system. Use an optimal tariff to exploit terms of trade effects in a large open economy; not a production subsidy. Correct an externality with a tax on the externality; not with a commodity tax.

26. Conclusion When one or more of the three Pareto conditions fail, the government should intervene, but how it should do this depends on whether the world is first or second best. The principle of targeting works in a first best world, but, as we shall see, not in a second best world. Government intervention may in itself create distortions so it is important to carefully consider how it should intervene.

27. What is next? Lump sum taxes and the Second Welfare Theorem. Taxation and tax incidence. Tax equivalence results.