Professional Documents
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CH 20
CH 20
Economics
Chapter 20
Slides by Pamela L. Hall
Western Washington University
2005, Southwestern
Introduction
Introduction
Introduction
Social-Welfare Function
Such a measurement for determining how well off agents are in a society requires
a set of welfare criteria
Since no one agent is made worse off and at least one agent is made better off
It is assumed, given independence of utility functions, that all agents would
support Pareto criterion
Social-Welfare Function
Pure-exchange Economy
Pure-exchange Economy
Utility combinations associated with P1, P2, and P3 are same for both
figures
Pure-exchange Economy
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Changing this level of utility for Friday will result in alternative combinations of q 1 and
q2 produced and allocated between Robinson and Friday
As illustrated in Figure 20.4, maximizing Robinsons utility given UFas Fridays level of
satisfaction results in Pareto-efficient allocation of (qR1, qR2, qF1, qF2) with q*1 and q*2
efficiently produced
With an alternative level of satisfaction for Friday, say UF' maximizing Robins utility will result
in an alternative Pareto-efficient allocation, (qR'1, qR'2, qF'1, qF'2) with q*1 and q*2 produced
We obtain a collection of Pareto-efficient utility levels for both Robinson and Friday
By varying Fridays utility from zero to level where Robinsons utility would be zero
Plotting these Pareto-efficient utility combinations yields utility possibilities frontier in Figure 20.2
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At P1 utility combination and any other utility bundle on frontier are Pareto optimal
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Government would then maximize social welfare subject to utility possibilities frontier
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As illustrated in Figure 20.5, tangency between a social indifference curve and utility
possibilities frontier results in maximum level of social welfare
Point P2 is only point on utility possibilities frontier where there is no other point preferred to it
For example, point P3 is Pareto efficient but there are points that are preferred to P 3
Even though point A is Pareto inefficient, society prefers it over Pareto-efficient point P 3
Using maximum level of social welfare, point P2, we determine optimal allocation of
commodities in Edgeworth box (Figure 20.1) for a pure-exchange economy
Or in production possibilities frontier (Figure 20.3) for a production and exchange economy
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These shapes (and thus social preferences) are generally based on some
equitable allocation among Pareto-efficient allocations
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Egalitarian
Unless Robinson and Friday have identical utility functions, level of utility
achieved by them will not be the same
But their utility levels are not a factor in this egalitarian equity
In terms of a social-welfare function, social preferences for Robinsons
or Fridays utilities are identical
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Egalitarian
society
For Robinson and Friday, Rawlsian criterion is
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Utilitarian
Only total utility is relevant, so utilitarian criterion does not consider distribution of
utility
As long as social gain is greater than social loss, it makes no difference that consumer who
gains in utility may already be happier than the other consumer
Although ethics teaches that virtue is its own reward, classical utilitarian function
teaches that reward is its own virtue
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Utilitarian
For example, utility of an individual such as Mother Teresa will be weighted higher than that
of a child sex offender
The more egalitarian a society is, the more its social indifference curves will
approach right angles
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as to their desirability
To derive a social-welfare function, there must exist a ranking of these
states on a society-wide scale that fairly considers these individual
preferences
For example, these states could be sending a human to Mars, building and
equipping a new aircraft carrier, or curing cancer
Arrows Impossibility Theorem says a reasonable social ranking of these
three states cannot exist based only on how individual agents ordinally rank
these states
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A reasonable social ranking may be stated with the following axioms relating
individual consumers preferences
This also holds for the other two pairs (A, C) and (B, C)
No agent paternalism
Axiom 5: Pairwise IndependenceSocietys social ranking between A and B should
depend only on individual preferences between A and B
Not on individual preferences for some other social state, say state C
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Majority Voting
Treats all agents the same and all agents have just one vote
However, majority rule can lead to a pattern of social choices that is not
transitive
Majority Voting
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Majority Voting
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Majority Voting
However, intensity of desires is a utility measure that can only be measured on at least a
cardinal scale
Magnitude or intensity of an individual voters desires is not known when she votes
Called instantaneous voting, procedure has not yet been widely adopted
But offers potential of further revealing voters preferences and mitigating any strategic
voting
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Strategic Voting
A problem with allowing ordinal ranking of candidates (or any other choices) is
possibility of strategic voting
Where an agent does not reveal her true preferences but instead votes to enhance outcome
in her favor
A game-theory strategy
One form of strategic voting is for an agent, say Friday, to rank her first choice highest
Strategic voting is illustrated in Table 20.3 for determining social ranking of four
alternatives
In panel (a), alternative A, which was not Fridays top choice, comes out on top
However, as illustrated in panel (b), Friday can change outcome by ranking alternative A low
(strategic voting)
Now Fridays top choice, alternative B, comes out on top as the social choice
Judges in Olympic games have been accused of practicing this type of strategic voting
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Strategic Voting
From panel (b), alternative A is still selected even given strategic voting by
Friday
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Strategic Voting
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Strategic Voting
Market Failure
Market Failure
In general, conditions causing market failure are classified into four categories
Monopoly power
Exists when one or a number of agents (suppliers or demanders of a commodity) exert some market
power in determining prices
Externalities
An interaction among agents that are not adequately reflected in market priceseffects on agents
are external to market
Public goods
One individuals consumption of a commodity does not decrease ability of another individual to
consume it
Asymmetric information
When perfectly competitive assumption of all agents having complete information about
commodities offered in market does not hold
Incomplete information can exist when cost of verifying information about a commodity may not be universal
across all buyers and sellers
For example, sellers of used automobiles may have information about quality of various automobiles
that may be difficult (costly) for potential buyers to acquire
When there is asymmetry in information buyers may purchase a product in excess of a given quality
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Market Failure
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Market Failure
For example, local zoning ordinances may restrict a firms use of inputs
that generate noise, smoke, or odors
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