Econ 321 Notes 2 – Welfare Economics

Adam Smith : “…every individual . . . endeavors as much as he can . . . to direct . . . industry so that its
produce may be of the greatest value . . . neither intend[ ing] to promote the public interest, nor know[
ing] how much he is promoting it. . . He intends only his own gain, and he is in this, as in many other cases,
led by an invisible hand to promote an end that was no part of his intention.. By pursuing his own interest
he frequently promotes that of society more effectually than when he really intends to promote it.“

First fundamental theorem of welfare economics:

The market equilibrium of an ideal market system yields an efficient (Pareto optimal) allocation of
resources.

The net benefits (Total benefit – Total

P
cost) is maximized at q* level of
production (consumption)
MC
Remember total benefit equals to the
area under MB curve and similarly
total cost is the area under MC curve.
C
Either more than q* and less than q*
B
yields smaller net benefit to the
society.

Clearly competitive markets will

produce q* level of production
MB (consumption)

Thus competitive markets maximize

q` q* q`` net benefit (social welfare)
O Q

ANOTHER REPRESENTATION OF EXCHANGE EFFICIENCY

MBN MBB
When the MB is the same for both
individuals, we have the exchange
efficiency. The sum of areas under the MB
curves (total benefit) maximized.

Remember at competitive markets

equilibrium occurs ( Nihan consumes at qn
and Bahattin at qb) where MBn = MBb

P
On MBn MBb
Efficicient amount of Os
consumption by Nihan Efficient amount of consumption by Bahattin qn qb Q
Total available amount

1
 Econ 321 Notes 2 – Welfare Economics

EDGEWORTH DIAGRAM

Bahattin’s consumption of biscuits

Oa

of tea
cosnonsumption
Bahattin’s
f
tea
Nihan’s consumption of

t
g

h Contract curve

Om

Nihan’s
consumption
of biscuit

Assume initially we are at point f. If we move from point f to point t Nihan’s utility stays constant (at
the same indifference curve), however Bahattin is better off (at a higher indifference curve). The
movement from point f to t is called Pareto Improvement. At point t we cannot make Bahattin
better off without hurting Nihan (making her worse off). So we completed the Pareto Improvement
opportunities, thus point t is called Pareto Optimum (efficient) point. Similarly g is another Pareto
Optimum point. Every point on Contract Curve is also Pareto Optimum.

Pareto efficiency: If you cannot make anybody better off without hurting somebody else, you are at
Pareto efficient point.

Notice that marginal rate of substitutions of tea and biscuit is the same both Nihan and Bahattin at
Pareto Optimum points (slopes of their indifference curves). Marginal rate of substitution is a
person’s willing to exchange x for y. For an allocation point to be efficient, it must be the case for
both individuals to have same marginal rate of substitution. (Notice that at each Pareto Optimum
point indifference curves of Nihan and Bahattin are tangent to each other, thus their slopes and
MRSs.)

Now the question is whether we are going to be able to reach this Pareto Optimum point with the
free markets.

Remember from microeconomics courses that utility maximizing individuals will have the
consumption bundle such that their indifference curves are tangent to budget lines.

2
 Econ 321 Notes 2 – Welfare Economics

Tea

Notice that for Bahattin utility

maximizing consumption bundle
mbahattin (X*Tea, X*Biscuit) is where budget
Ptea line is tangent indifference curve.
At this point indifference curves
slope is equal to budget line’s
slope
X*Tea
mbahattin
Ptea Ptea
mbahattin Pbiscuit
Pbiscuit
Biscuit
X*Biscuit mbahattin Where mbahattin is the income of
Pbiscuit Bahattin
Bahattin

Tea

mnihan Utility maximizing Nihan also

Ptea choose the consumption bundle
where her own utility curve is
tangent to her own budget line.
(Notice that her indifference
X*Tea curves and income levels can be
different than Bahatttin’s).

At her best consumption point

the slope of the indifference
curve is:
Biscuit
mnihan
X*Biscuit Ptea Ptea
mnihan mnihan Pbiscuit
Pbiscuit Pbiscuit
Nihan
Where mnihan is the income of
Nihan

So free markets with utility maximizing individuals are going to reach us to the
point where the slopes of indifferences curves (marginal rate of substitutions) of
every individual in the society are equal to each other.

Notice that this is the point at which social welfare maximizing point (Pareto
Optimum) on Edegeworth Box.
3
 Econ 321 Notes 2 – Welfare Economics

First fundamental theorem of welfare economics: The market equilibrium of an ideal market system
yields an efficient (Pareto optimal) allocation of resources.

Exercise: In the Edgeworth diagram discuss what happens if the government seizes some portion
of one individual’s endowment and give it to the other one. (It is still going to be efficient.)
Point g is better than point f. But what about point h, is h better than f. (certainly more efficient)

Redistribution of income.
Bahattin’s consumption of biscuits

Oa

of tea
cosnonsumption
Bahattin’s
f
tea
Nihan’s consumption of

t
g

h Contract curve

Om

Nihan’s
consumption
of biscuit

Which point is better f or g? Both points are Pareto Optimum (efficient). However, at point g the
income is shared between Nihan and Bahattin more fairly. Generally societies prefer more even
income distribution, thus point g is better than point h. (though they are equally efficient)

What about comparison of point h and point f?

Efficiency is not the only concern of the society. (Efficiency vs. equity)

However, the fact that markets fail is not enough reason for government intervention. There have to
be policies that solve these problems or at least lowers the magnitude of them.

Second fundamental theorem of welfare economics: Society can attain any Pareto Efficient
allocation of resources by making a suitable assignment of initial endowments and then letting
people freely trade with each other.

4
 Econ 321 Notes 2 – Welfare Economics

Efficiency in Production Economy

Above we analyzed that with free markets the goods are going to be allocated between the
individuals in a way such that social welfare is maximized. However, real life is more complex than
this simple world. Below we are going to study the efficiency of production with profit maximizing
firms.

Let’s assume there are only two goods, biscuit and tea, and two production inputs, capital and labor,
to manufacture those two goods. There are fixed amount of labor and capital in the world and we
want to maximize social welfare (total production). How should we allocate capital and labor
between tea and biscuit production?
Labor used in tea production

Tea

tea production
Capital used in
f
production
Capital used in biscuit

t g

Biscuit

Labor used in
biscuit
production
consumption
Lets assume of biscuit
that initially
we are at point f. Black and blue curves are isoquant curves
(which shows the possible combination of input uses which yield the same of production
output) for the tea and biscuit production. It is obvious from the graph that if we reallocate
the capital and labor use between tea and biscuit production and reach to point t, we are
going to be able increase tea production without lowering biscuit production. (Or move to
point g and increase both production levels).

Thus at optimum level the slopes of isoquants of tea and biscuit production are equal to
each other.

5
 Econ 321 Notes 2 – Welfare Economics

Capital

Notice that for profit maximizer

(or cost minimizer) biscuit
TCbiscuit producers are going to use the
r capital and labor inputs in a way
that isoquant curves are tangent to
isocost line. At this point isocost
curve’s slope is equal to isocost
K*Tea
line’s slope
TC biscuit
r w
TC biscuit r
Labor w
L*Biscuit TCbiscuit
w w: wage rate of labor
Biscuit production r: rental rate (price) of capital
TCbiscuit: Total cost of biscuit
production

Capital

Similar to biscuit producers tea

TC tea producers are also going to
r choose capital labor use where
their own isoquant curves are
tangent to isocost lines. (Notice
K*Tea that their indifference curves
and Total Costs can be different
than biscuit producers).

Labor At this best possible point the

slope of isoquant curve:
L*Tea TC tea TC tea
w r w
TC tea r
w
Tea production

So free markets with profit maximizing firms are going to reach us to the point
where the slopes of isoquant curves (marginal rate of technical substitutions) of
every good (and firm) in the society are equal to each other.

Notice that this is the point at which social welfare maximizing point on
Edegeworth Box.