Ekonomika Kesejahteraan

8/13/2019 Ekonomika Kesejahteraan

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FUNDAMENTALS OF WELFARE ECONOMICS

2. Market efficiency

2.1. The invisible hand of competitive markets

2.2. Welfare economics and Pareto efficiency

2.3. Analyzing economic efficiency


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Market efficiencywelfare economics and Pareto efficiency

WELFARE ECONOMICS is the branch of economics that focuses on normativeissues:

what should be produced,

how it should be produced,

for whom,

who should make these decisions.

PARETO EFFICIENCY:Resource allocations that have the property that no one can be made better

off without someone being made worse off are said to be Paretoefficient, or Pareto optimal.


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Pareto efficiency and individualism:

The criterion of Pareto efficiency is concerned only with each individualswelfare, not with the relative well-being of different individuals.

It is each individuals perception of her own welfare function that counts.This is consistent with the general principle of CONSUMER SOVEREIGNTY,which holds that individuals are the best judge of their own needs andwants, of what is in their best interest.


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FUNDAMENTAL THEOREMS

OF WELFARE ECONOMICS:

Every competitive economy is Pareto efficient

Every Pareto efficient resource allocation can be attained

through a competitive market mechanism, with the

appropriate initial redistributions.


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EFFICIENCY FROM THE

PERSPECTIVE OD A SINGLEMARKET

In deciding how much to demand,individuals equate the marginalbenefit they receive fromconsuming an extra unit with the

marginal cost, the price they haveto pay.

In deciding how much to supply, firmsequate the marginal benefit theyreceive, which is just the price,with the marginal cost.

At the market equilibrium, wheresupply equals demand, themarginal benefit (to consumers) isequal to the marginal cost to firms

and each equals the price

Price

Quantity

E

Supply

curve

Demand

curve


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Market efficiencyanalyzing economic efficiency

EXCHANGE EFFICIENCY

concerns the distribution of goods,

means that, given the set of goods available in the economy,no one can be made better off without someone else being

made worse off.

It requires that there is no scope for trades, or exchanges thatwould make both parties better off.

It requires that all individuals have the same marginal rate ofsubstitution between any pair of commodities.

Competitive markets in which all individuals face the sameprices always have exchange efficiency.


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Robinsons Budget Constraint

Given income of $100, the price of oranges of

$2, and the price of apples of $1, an

individual can purchase any combinationof apples and oranges along or to the left

the budget constraint.

The slope of the budget constraint is based

on the relative price of oranges andapples.

Apples

Oranges

Budgetconstraint

100

50


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THE CONSUMERSCHOICE PROBLEM

The budget constraint gives thecombinations of apples & orangesthat Robinson can buy, given hisincome & given the price of apples& oranges.

The indifference curve gives thosecombinations of apples & orangesamong which Robinson isindifferent.

Robinson chooses the point along thebudget constraint which he mostprefers, that is, the point wherethe indifference curve I0is tangentto the budget constraint (point E).

E

B

A

D C

F

I0

I1

100

50 59 6017 18

18

17

89

80

Apples

Oranges


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Exchange

Two consumers, A and B. Their endowments of goods 1 and 2 are

E.g.

The total quantities available

A A A ( , )1 2

B B B ( , ).1 2

and

A ( , )6 4 B ( , ) .2 2and

1 1 6 2 8A B 2 2 4 2 6

A B

units of good 1

units of good 2.and

are


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Exchange

Edgeworth and Bowley devised a diagram,

called an Edgeworth box, to show all possible

allocations of the available quantities of goods

1 and 2 between the two consumers.


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Starting an Edgeworth Box


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Width =1 1 6 2 8A B


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Width =1 1 6 2 8A B

Height =

2 24 2

6

A B


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Width =1 1 6 2 8A B

Height =

2 24 2

6

A B

The dimensions of

the box are the

quantities available

of the goods.


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Feasible Allocations

What allocations of the 8 units of good 1and the 6 units of good 2 are feasible?

How can all of the feasible allocations be

depicted by the Edgeworth box diagram?


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Feasible Allocations

What allocations of the 8 units of good 1and the 6 units of good 2 are feasible?

How can all of the feasible allocations be

depicted by the Edgeworth box diagram? One feasible allocation is the before-trade

allocation; i.e. the endowment allocation.


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Width =1 1 6 2 8A B

Height =

2 24 2

6

A B

The endowment

allocation is

A ( , )6 4

B ( , ) .2 2

and

The Endowment Allocation


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Width =1 1 6 2 8A B

Height =

2 24 2

6

A B

A ( , )6 4 B ( , )2 2



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A ( , )6 4OA

OB

6

8

B ( , )2 2



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A ( , )6 4OA

OB

6

8

4

6



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B ( , )2 2

OA

OB

6

8

4

6

2

2The Endowment Allocation


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A ( , )6 4 B ( , )2 2

OA

OB

6

8

4

6

2

2

The

endowment

allocation



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More generally,



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OA

OB

The

endowment

allocation

1 1

A B

2A

2

2

A

B

1A

1B

2B


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Other Feasible Allocations

denotes an allocation to consumerA.

denotes an allocation to consumer

B. An allocation is feasibleif and only if

( , )x xA A1 2

( , )x xB B1 2

x xA B A B1 1 1 1x xA B A B2 2 2 2 .and


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Feasible Reallocations

OA

OB

1 1

A B

xA

2

2

2

A

B

xA1

xB1

xB2


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OA

OB

1 1

A B

xA2

2

2

A

B

xA1

xB1

xB2


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All points in the box, including the boundary,

represent feasible allocations of the combined

endowments.


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All points in the box, including the boundary,

represent feasible allocations of the combined

endowments.

Which allocations will be blocked by one or

both consumers?

Which allocations make both consumers

better off?


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Adding Preferences to the Box

2A

1A

xA

2

xA1

OA

For consumer A.


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2A

1A

xA

2

xA1

For consumer A.

OA


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2B

1B

xB

2

xB1

For consumer B.

OB


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xB

2

xB1

For consumer B.

OB

2B

1B


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2B

1B

xB

1

xB2

For consumer B.OB


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2A

1A

xA

2

xA1

OA

For consumer A.


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2A

1A

xA

2

xA1

OA

2B

1BxB1

xB2

OB


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Edgeworths Box

2

A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB


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Pareto-Improvement

An allocation of the endowment that

improves the welfare of a consumer without

reducing the welfare of another is a Pareto-

improving allocation.

Where are the Pareto-improving allocations?


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Edgeworths Box

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

P t I t


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Pareto-Improvements

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

The set of Pareto-

improving allocations


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Pareto-Improvements

Since each consumer can refuse to trade, the

only possible outcomes from exchange are

Pareto-improving allocations.

But which particular Pareto-improving

allocation will be the outcome of trade?

P t I t


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Pareto-Improvements

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

The set of Pareto-

improving reallocations


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Pareto-Improvements


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Pareto-Improvements


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Pareto-Improvements

Trade

improves both

As and Bs welfares.

This is a Pareto-improvementover the endowment allocation.

P t I t


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Pareto-ImprovementsNew mutual gains-to-trade region

is the set of all further Pareto-

improving

reallocations.

Trade

improves both

As and Bs welfares.

This is a Pareto-improvementover the endowment allocation.


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Pareto-ImprovementsFurther trade cannot improve

both A and Bs

welfares.


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Pareto-Optimality

Better for

consumer B

Better for

consumer A


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Pareto-OptimalityA is strictly better off

but B is strictly worseoff


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B is strictly betteroff but A is strictly

worse off


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worse off

Both A and

B are worse

off


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worse off

Both Aand B are

worse

off

Both A and

B are worse

off


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Pareto-Optimality

The allocation is

Pareto-optimalsince the

only way one consumers

welfare can be increased is to

decrease the welfare of the other

consumer.


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Pareto-Optimality

The allocation is

Pareto-optimal since the

only way one consumers

welfare can be increased is to

decrease the welfare of the other

consumer.

An allocation where convex

indifference curves are only

just back-to-back is

Pareto-optimal.


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Pareto-Optimality

Where are all of the Pareto-optimal

allocations of the endowment?


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Pareto-Optimality


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Pareto-Optimality

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

All the allocations marked by

a are Pareto-optimal.


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Pareto-Optimality

The contract curveis the set of all Pareto-

optimal allocations.

Pareto-Optimality


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Pareto-Optimality

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

All the allocations marked by

a are Pareto-optimal.

The contract curve


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Pareto-Optimality

But to which of the many allocations on the

contract curve will consumers trade?

That depends upon how trade is conducted.

In perfectly competitive markets? By one-on-

one bargaining?


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The Core

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

The set of Pareto-

improving reallocations


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The Core

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

The Core


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The Core

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

Pareto-optimal trades blocked

by B

Pareto-optimal trades blocked

by A


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The Core


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The Core

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

Pareto-optimal trades not blocked

by A or B are the core.


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The Core

But which core allocation?

Again, that depends upon the manner in

which trade is conducted.


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Trade in Competitive Markets

Consider trade in perfectly competitive

markets.

Each consumer is a price-taker trying to

maximize her own utility given p1, p2and herown endowment. That is, ...



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2

A

1A

xA2

xA1

OA

For consumer A.

p x p x p pA A A A1 1 2 2 1 1 2 2

x A2*

x A1*


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So given p1and p2, consumer As net demands

for commodities 1 and 2 are

x A A1 1* x A A2 2* .and


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And, similarly, for consumer B



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2B

1B

xB2

xB1

For consumer B.

OB

x B1*

x B2*

p x p x p pB B B B1 1 2 2 1 1 2 2


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So given p1and p2, consumer Bs net demands

for commodities 1 and 2 are

x B B1 1* x B B2 2* .and


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A general equilibriumoccurs when prices p1and p2cause both the markets for

commodities 1 and 2 to clear; i.e.

x xA B A B1 1 1 1* *

x xA B A B

2 2 2 2* *

.and


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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

Can this PO allocation be

achieved?



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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

Budget constraint for consumer A



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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB


x A2*

x A1*



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2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

Budget constraint for consumer B

x A2*

x A1*



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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB


x A2*

x A1*

x B

1

*

x B2*



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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

x A2*

x A1*

x B

1

*

x B2*

But

x xA B A B

1 1 1 1* *



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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

x A2*

x A1*

x B

1

*

x B2*

and

x xA B A B

2 2 2 2* *

T d i C i i M k


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So at the given prices p1and p2there is an

excess supply of commodity 1

excess demand for commodity 2.

Neither market clears so the prices p1and p2do not cause a general equilibrium.



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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

So this PO allocation cannot be

achieved by competitive trading.



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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

Which PO allocations can be

achieved by competitive trading?

T d i C titi M k t


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Since there is an excess demand forcommodity 2, p2will rise.

Since there is an excess supply of commodity

1, p1will fall.

The slope of the budget constraints is - p1/p2

so the budget constraints will pivot about the

endowment point and become less steep.



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2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB





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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB





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p

2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB





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2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB




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2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB


x A

2

*

x A1*



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2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB


x A

2

*

x A1*



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2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB


x A

2

*

x A1*

x B1*

x

B

2

*



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2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

x A

2

*

x A1*

x B1*

x

B

2

*

So

x xA B A B

1 1 1 1

* *



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2A

1A

xA2

xA1

OA

2B

1B

xB1

xB2

OB

x A

2

*

x A1*

x B1*

x

B

2

*

and

x xA B A B

2 2 2 2

* *



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At the new prices p1

and p2

both markets

clear; there is a general equilibrium.

Trading in competitive markets achieves a

particular Pareto-optimal allocation of the

endowments.

This is an example of the First Fundamental

Theorem of Welfare Economics.



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PRODUCTION EFFICIENCY

It requires that, given the set of resources, the economy not be able toproduce more of one commodity without reducing the output of someother commodity.

The economy must be operating along its production possibility curve.

It requires that all firms have the same marginal rate of technicalsubstitution (MRTS) between any pair of inputs.

Competitive markets in which firms face the same prices always haveproduction efficiency.



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PRODUCTION EFFICIENCY &THE PRODUCTION POSSIBILITIESFRONTIER

Points inside the frontier areattainable but inefficient.

Points along the frontier are feasible& efficient.

Points outside the frontier areunattainable, given the resources

of the economy.

Apples

Oranges

Production

Possibilities

Frontier



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ISOQUANTS & ISOCOST LINES

An isoquant gives combinations of inputs(land & labor) which yeald the same

output.

The slope of the isoquant is the MRTS.

The isocost line gives those combinations ofinputs which cost the same amount.

The slope of the isocost line is given by therelative prices of the two inputs.

The firm maximizes its output, given aparticular level of expenditures oninputs, at the point where the isoquant istangent to the isocost line.

At that point, the MRTS equals the relativeprice.

Land

Labor

Q1

Q0

Isoquants

Isocost line

Labor input into apples

A 0


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PRODUCTION EFFICIENCY

The sides of this Edgeworth-Bowley Box give the available supplies ofresourcesland & labor.

It requires the tangency of the isoquants.

At tangency points (such as E) MRTS of land for labor is the same in theproduction of apples & oranges.

Apple

isoquants

E

Orangeisoquant

Apple

isoquants

D C

Land input

into oranges

Labor input into oranges

Land inputinto apples

Land

Labor

A

B

0

0

B

A

Q1

Q0

Q2



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PRODUCT MIX EFFICIENCY

It requires that the marginal rate of transformation (MRT)the

slope of the production possibilities curveequal

individuals marginal rate of substitution (MRS)

Competitive markets have product mix efficiency.



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PRODUCT MIX EFFICIENCYrequires that MRT equal

consumers MRS

In order to reach the highest level ofconsumers utility, the

indifference curve & the

production possibilities schedule

must be tangent (point E).

E

Indifference curves

Production

Possibilities Curve

Apples

Oranges

E



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Basic conditions for Pareto efficiency:

1. EXCHANGE EFFICIENCY: MRS between any two goodsmust be the same for all individuals.

2. PRODUCTION EFICIENCY: MRTS between any two inputsmust be the same for all firms.

3. PRODUCT MIX EFFICIENCY: MRT must equal MRS.

Competitive economies satisfy all three conditions

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