2. Welfare economics_EN

Welfare Economics: Rationale for Public Sector Intervention in the Economy

Introduction

Welfare economics serves as a framework to understand how public sector intervention can enhance economic efficiency and well-being in society. This document provides an overview of the principles of welfare economics and the role of the public sector in addressing market failures that hinder efficient resource allocation.

Contents Overview

• Defining Economic Efficiency: Exploring individual versus societal efficiency.

• Achieving Efficiency: The role of welfare economics in maximizing social welfare.

• Pareto Efficiency: Understanding the implications of optimal resource allocation.

• Market Failures: Identifying situations where markets fail and the need for public intervention.

• Social Optimum: Defining the ideal state for welfare and efficiency in the economy.

Defining Economic Efficiency

Economic efficiency can be viewed from both individual and collective perspectives. For individuals, efficiency involves achieving objectives using available resources fully. For the economy at large, it means allocating scarce resources among producers rationally to satisfy consumer demands effectively. This concept serves as a normative criterion for assessing how resource allocation impacts individual welfare.

Historical Context

Adam Smith first articulated the notion of economic efficiency in his seminal work, "Inquiry into the Wealth of Nations" (1776). Smith posited that individuals acting in their self-interest inadvertently contribute to societal welfare through an "invisible hand" mechanism, aligning personal gain with social benefit.

Achieving Economic Efficiency

Welfare economics answers the fundamental question of how economies can attain efficiency. It is primarily concerned with societal decisions among alternatives aimed at maximizing social welfare, often referred to as normative microeconomics. It is grounded in two essential theorems:

• Technical Efficiency (Production Efficiency): This principle suggests that maximum output is achieved with given inputs.

• Allocative Efficiency: This emphasizes the optimal distribution of resources to produce goods and services that align with consumer preferences.

Fundamental Theorems of Welfare Economics

First Fundamental Theorem

The first theorem posits that perfect competition results in Pareto optimality, meaning that individual benefits cannot be improved without diminishing another's benefit. Pareto efficiency is thus considered a crucial criterion for evaluating economic efficiency in both economic theory and finance.

Second Fundamental Theorem

The second theorem focuses on allocative efficiency, asserting that all economic decisions should be made by free market participants, achieving an optimal distribution along the utility possibility frontier, which illustrates potential welfare distributions between individuals.

Characteristics of a Perfectly Competitive Market

In a perfectly competitive environment, several conditions must be met:

• Private ownership of productive resources.

• Standardized products offered by competing sellers.

• Dispersed economic power preventing any single entity from influencing prices.

• Transparent access to information for all market participants.

• Flexibility in resource movement across enterprises.

Market Failures and the Role of Public Sector

Market failures occur when the market fails to provide a Pareto efficient quantity of goods, often marked by disparities between marginal social benefits (MSB) and marginal social costs (MSC). Instances requiring public sector intervention include:

• Monopolies: Situations where single sellers dominate, distorting price and output levels.

• Externalities: Costs or benefits to third parties not included in market transactions.

• Public Goods: Goods that are non-excludable and non-rivalrous, often under-provided by the market.

• Asymmetrical Information: Scenarios where one party holds more information than another, leading to inefficiencies.

Understanding Externalities

Externalities can be detrimental or beneficial:

• Negative Externalities can arise from production activities imposing costs on third parties. For example, a factory polluting a river affects local residents, leading to additional social costs.

• Positive Externalities provide benefits to third parties, as illustrated by vaccinations, which protect not just the vaccinated individuals but also reduce the spread of illness in the community.

Coase Theorem and Market-Based Solutions

The Coase Theorem suggests that establishing property rights can help internalize externalities without direct government interventions. One approach includes the cap-and-trade system, setting emission limits while allowing businesses to trade emission permits.

Asymmetrical Information and Market Failures

Asymmetrical information leads to market inefficiencies through adverse selection and moral hazard:

• Adverse Selection occurs when one party possesses more information before a transaction (e.g., hidden defects in a used car).

• Moral Hazard occurs post-transaction when one party takes risks knowing another will bear the cost.

Merit and Demerit Goods

Merit goods are underconsumed as their true benefits are underestimated, while demerit goods are overconsumed due to overestimation of their value. Public policies can include regulations and taxes to correct these consumption patterns.

Social Optimum

The concept of social optimum relates to maximizing social welfare, where utility functions intersect at optimal points. The social welfare function assesses the distribution of welfare within an economy, aiming for equilibrium that ensures both economic efficiency and equity.

Asymmetrical Information

Definition: Asymmetrical information occurs when one party in a transaction has more or better information than the other party, leading to an imbalance in understanding and influencing decision-making.

Why It Is a Market Failure: This phenomenon is considered a market failure because it can lead to inefficient resource allocation and prevent optimal market outcomes. When information is not equally shared, it distorts the decisions made by consumers and producers, resulting in suboptimal practices that do not reflect true market value.

Types of Problems Caused:

• Adverse Selection: This situation arises when one party has an information advantage before a transaction occurs. For instance, in the used car market, the seller knows the car’s defects while the buyer does not, leading to potential buyers overpaying for low-quality vehicles.

• Moral Hazard: This problem occurs after a transaction, where one party may take risks knowing that the other party will bear the costs. An example is a person with insurance taking higher risks (like reckless driving) because they are protected from the consequences of their actions (such as accident costs).