Prerequisites

Almost essential Welfare: Basics Welfare: Efficiency

December 2006

Frank Cowell: Microeconomics

Welfare: The Social-Welfare Function

MICROECONOMICS
Principles and Analysis Frank Cowell

Social Welfare Function

Frank Cowell: Microeconomics

Limitations of the welfare analysis so far: Constitution approach

Arrow theorem is the approach overambitious? Efficiency nice but indecisive Extensions contradictory?

General welfare criteria

SWF is our third attempt Something like a simple utility function?

Requirements

Overview...
Frank Cowell: Microeconomics

Welfare: SWF

The Approach

What is special about a socialwelfare function?

SWF: basics

SWF: national income SWF: income distribution

The SWF approach

Frank Cowell: Microeconomics

Restriction of relevant aspects of social state to each person (household) Knowledge of preferences of each person (household) Comparability of individual utilities

utility levels utility scales contrast with constitution approach there we were trying to aggregate orderings
A sketch of the approach

An aggregation function W for utilities

Using a SWF
ub W(ua, ub,... )
Take the utility-possibility set Social welfare contours A social-welfare optimum?

Frank Cowell: Microeconomics

W defined on utility levels

Not on orderings Imposes several restrictions

ua questions

and raises several

Issues in SWF analysis

Frank Cowell: Microeconomics

What is the ethical basis of the SWF? What should be its characteristics? What is its relation to utility? What is its relation to income?

Overview...
Frank Cowell: Microeconomics

Welfare: SWF

The Approach

Where does the social-welfare function come from?

SWF: basics

SWF: national income SWF: income distribution

An individualistic SWF
Frank Cowell: Microeconomics

The standard form expressed thus W(u1, u2, u3, ...)

an ordinal function defined on space of individual utility levels not on profiles of orderings

But where does W come from...? We'll check out two approaches:

The equal-ignorance assumption The PLUM principle

1: The equal ignorance approach

Frank Cowell: Microeconomics

Suppose the SWF is based on individual preferences. Preferences are expressed behind a veil of ignorance It works like a choice amongst lotteries

don't confuse w and q! knows the distribution of allocations in the population knows the utility implications of the allocations knows the alternatives in the Great Lottery of Life does not know which lottery ticket he/she will receive

Each individual has partial knowledge:

I would get if I Equalpayoffs identity 1,2,3,...were formalisation ignorance: assigned in the Great Lottery of Life The individualistic welfare model:

W(u1, u2, u3, ...)

use theory of choice under uncertainty to find the shape of SWF W pw: probability assigned to w u: cardinal utility function, independent of w uw: utility payoff in state w

Frank Cowell: Microeconomics

vN-M form of the utility function:

w pwu(xw) w pwuw

Equivalently:

Replace by the set of identities {1,2,...nh}:

h phuh

welfare is expected utility from a "lottery on identity

An additive form of the welfare function

A suitable assumption about probabilities?

W = S uh
1 nh
h=1

nh

Questions about equal ignorance

Frank Cowell: Microeconomics ph
Construct a lottery on identity The equal ignorance assumption... Where people know their identity with certainty Intermediate case

The equal ignorance assumption: ph = 1/nh But is this appropriate? Or should we assume that people know their identities with certainty? Or is the "truth" somewhere between...?

| |

1 2 3

identity

nh

2: The PLUM principle

Frank Cowell: Microeconomics

Now for the second rather cynical approach Acronym stands for People Like Us Matter Whoever is in power may impute:

...either their own views, ... or what they think societys views are, ... or what they think societys views ought to be, ...probably based on the views of those in power

Theres a whole branch of modern microeconomics that is a reinvention of classical Political Economy

Concerned with the interaction of political decision-making and economic outcomes. But beyond the scope of this course

Overview...
Frank Cowell: Microeconomics

Welfare: SWF

The Approach

Conditions for a welfare maximum

SWF: basics

SWF: national income SWF: income distribution

The SWF maximum problem

Frank Cowell: Microeconomics Take the individualistic welfare model

W(u1, u2, u3, ...)

Standard assumption

Assume everyone is selfish:

uh = Uh(xh) , h=1,2,...nh

my utility depends only on my bundle

Substitute in the above:

W(U1(x1), U2(x2), U3(x3), ...)

Gives SWF in terms of the allocation

a quick sketch

From an allocation to social welfare

Frank Cowell: Microeconomics
From the attainable set...

(x1a, x2a) (x1b, x2b)

A

...take an allocation Evaluate utility for each agent Plug into W to get social welfare

A
ua=Ua(x1a, x2a) ub=Ub(x1b, x2b)

But what happens to welfare if we vary the allocation in A?

W(ua, ub)

The marginal utility Varying the allocation derived by household h

Frank Cowell: Microeconomics

Differentiate w.r.t. xi : duh = Uih(xh) dxih

from good i h

The effect on h if commodity i is changed The effect on h if all commodities are changed

Sum over i: n h = S U h(xh) dx h du i i

i=1

Differentiate W
nh

The marginal impact on social welfare of h: Changes in utility with respectutility change social welfare . household hs to u

dW =

S Wh duh
h=1

Weights from the Weights from h in the above: the So changes in allocation Substitute for du n SWF n utility function h change welfare.

dW =

S Wh SUih(xh)
h=1 i=1

dxih

Use this to characterise a welfare optimum

Write down SWF, defined on individual utilities. Introduce feasibility constraints on overall consumptions. Set up the Lagrangean. Solve in the usual way

Now for the maths

Frank Cowell: Microeconomics

The SWF maximum problem

First component of the problem: W(U1(x1), U2(x2), U3(x3), ...) Second component of the problem: n F(x) 0, xi = S xih Usual h=1
h

Individualistic welfare function

Utility depends on own consumption

Frank Cowell: Microeconomics

The objective function

All goods are private

Feasibility constraint

The Social-welfare Lagrangean: n 1(x1), U2(x2), ...) lF(S xh ) W(U h=1

h

Lagrange multiplier

Note: constraint subsumes technological feasibility and materials balance From differentiating Lagrangean with respect to xih Usual modification for a corner solution

FOCs for an interior maximum: Wh (...) Uih(xh) lFi(x) = 0 And if xih =0 at the optimum: Wh (...) Uih(xh) lFi(x) 0

 From the first-order conditions :

Uih(xh)

Solution to SWF maximum problem

Any pair of goods, i,j Any pair of households h,

Frank Cowell: Microeconomics

= Ujh(xh) Uj(x)

Ui(x)

MRS equated across all h.

Weve met this condition before - Pareto efficiency

Also from the FOCs:

Uih(xh) = Vyhpi

This is new!

Wh Uih(xh) = W Ui(x)
Marginal utility of money

social marginal utility of toothpaste equated across all h.

Relate marginal utility to prices:

This is valid if all consumers optimise At the optimum the welfare value of a $ of income is equated across all h. Call this common value M

Substituting into the above:

Wh Vyh = W Vy

Social marginal utility of income

To focus on main result...

Frank Cowell: Microeconomics

Look what happens in neighbourhood of optimum Assume that everyone is acting as a maximiser firms households Check what happens to the optimum if we alter incomes or prices a little Similar to looking at comparative statics for a single agent

Changes in income, social welfare Social welfare can be expressed as:

Frank Cowell: Microeconomics

Differentiate the SWF w.r.t. {y }:

h

W(U1(x1), U2(x2),...) = W(V1(p,y1), V2(p,y2),...)

nh

SWF in terms of direct utility. Using indirect utility function Changes in utility and change social welfare

dW = S Wh duh =
h=1

Differentiate the SWF w.r.t. p :

h=1

dW = M S dyh
nh

nh

h=1 Change in total incomes - i.e. change in national income

S WhVyh dyh

nh

...related to income
Follows from i Roys identity n
h

dW = SWhVihdpi = SWhVyh xihdpi Change in total

h=1 nh expenditure h=1

Changes in utility and change social welfare

dW = M S xihdpi
h=1

...related to prices .
.

An attractive result?
Frank Cowell: Microeconomics

Summarising the results of the previous slide we have: THEOREM: in the neighbourhood of a welfare optimum welfare changes are measured by changes in national income / national expenditure But what if we are not in an ideal world?

Overview...
Frank Cowell: Microeconomics

Welfare: SWF

The Approach

A lesson from risk and uncertainty

SWF: basics

SWF: national income SWF: income distribution

Derive a SWF in terms of incomes

Frank Cowell: Microeconomics

What happens if the distribution of income is not ideal?

M is no longer equal for all h

Useful to express social welfare in terms of incomes Do this by using indirect utility functions V

Express utility in terms of prices p and incomes y

Assume prices p are given Equivalise (i.e. rescale) incomes y

allow for differences in peoples needs allow for differences in household size

Then you can write welfare as W(ya, yb, yc, )

Income-distribution space: nh=2

Frank Cowell: Microeconomics
The income space: 2 persons An income distribution

Bill's income

Note the similarity with a diagram used in the analysis of uncertainty

y
45 O Alf's income

Extension to nh=3
Frank Cowell: Microeconomics
Here we have 3 persons

Charlie's income

An income distribution.

y
O

Welfare contours
yb
Frank Cowell: Microeconomics
An arbitrary income distribution Contours of W Swap identities equivalent in welfare terms Distributions with the same mean Equally-distributed-equivalent income

x Ey
higher welfare

Anonymity implies symmetry of W. Ey is mean income

Richer-to-poorer income transfers increase welfare.

x is the income that, if received uniformly by all, would yield same level of ya social welfare as y. Ey x is the income that, society would give up to eliminate inequality

x Ey

A result on inequality aversion

Frank Cowell: Microeconomics

Principle of Transfers : a mean-preserving redistribution from richer to poorer should increase social welfare

THEOREM: Quasi-concavity of W implies that social welfare respects the Transfer Principle

Special form of the SWF

It can make sense to write W in the additive form W = S z(yh)

1 nh
h=1

Frank Cowell: Microeconomics

nh

where the function z is the social evaluation function (the 1/nh term is unnecessary arbitrary normalisation) Counterpart of u-function in choice under uncertainty

Can be expressed equivalently as an expectation: W = E z(yh)

where the expectation is over all identities probability of identity h is the same, 1/nh , for all h
1

Constant relative-inequality aversion: z(y) = y1 i

1i

where i is the index of inequality aversion works just like r,the index of relative risk aversion

Concavity and inequality aversion

Frank Cowell: Microeconomics
W
The social evaluation function Let values change: is a concave transformation.

lower inequality aversion

z(y) z(y)

More concave z() implies higher inequality aversion i ...and lower equallydistributed-equivalent income and more sharply curved contours

higher inequality aversion

z = (z)

y
income

Social views: inequality aversion

Frank Cowell: Microeconomics
yb yb Indifference to inequality

i=0

i=

Mild inequality aversion Strong inequality aversion

Priority to poorest

Benthamite case (i=0):

O

ya

ya

yb

yb

W= S yh
h=1

nh

i=2

i=

General case (0<i<): W = S [yh]1i/ [1i]

h=1

nh

ya

ya

Rawlsian case (i=): W= min yh

h

Inequality, welfare, risk and uncertainty

Frank Cowell: Microeconomics

There is a similarity of form between

personal judgments under uncertainty social judgments about income distributions.

Likewise a logical link between risk and inequality. This could be seen as just a curiosity Or as an essential component of welfare economics

Uses the equal ignorance argument

In the latter case the functions u and z should be taken as identical Optimal social state depends crucially on shape of W

In other words the shape of z Or the value of i

Three examples

Social values and welfare optimum

yb
The income-possibility set Y Welfare contours ( i = 0) Welfare contours ( i = ) Welfare contours ( i = )

Frank Cowell: Microeconomics

Y derived from set A or U Nonconvexity, asymmetry come from heterogeneity of households y* maximises total income irrespective of distribution

y*** y**

y* ya

y** trades off some income for greater equality y*** gives priority to equality; then maximises income subject to that

Summary
Frank Cowell: Microeconomics

The standard SWF is an ordering on utility levels

Analogous to an individual's ordering over lotteries Inequality- and risk-aversion are similar concepts

1.

2.

In ideal conditions SWF is proxied by national income But for realistic cases two things are crucial: Information on social values Determining the income frontier This requires a modelling of what is possible in the underlying structure of the economy... ...which is what Micro-Economic principles is all about