Welfare & Equilibrium

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ECONOMICS ANALYSIS WELFARE – as the state of well being of the persons comprising an economic system. EQUILIBRIUM – as state of rest, a position from which there is either no Incentive or no opportunity to move WELFARE Most economic analysis is concerned with the welfare aspects of economic activity- how to achieve or optimum welfare constitutes a major problem. As we noted in previous chapters, the concept is straightforward where only one person is being considered and is synonymous with that person’s well being. But when more than one individual is at issue, an objective definition of a unique optimum welfare position for the group as a whole becomes impossible, since such a definition would require interpersonal comparisons of satisfaction. The Pareto optimal situation, in which no one can be made better off without making someone else worse off, is the best solution that we can attain . There is no unique Pareto optimal situation for a group. The welfare of a group is much more difficult to handle, comparisons of this sort raise serious problems. How can changes in the well being of different persons be compared? In some specific cases we can make rough subjective judgments. Taking a Rembrandt away from a connoisseur of art and giving it to a person who does not understand or value art would surely reduce group welfare. We are left with a group welfare concept known as Pareto optimal situation exists when no even can increase the well being of someone else to consider the matter in another way, a situation is not Pareto optimal if one is to make persons can be made better off without making anyone else worse off. If a situation is not Pareto optimal, a movement towards it –making at least one person better off without making anyone else worse off-increases group welfare. Page 1 of 19 R. Tala / L. Dela Cruz / M.D. Jaranilla

Transcript of Welfare & Equilibrium

Page 1: Welfare & Equilibrium

ECONOMICS ANALYSIS

WELFARE – as the state of well being of the persons comprising an economic system.

EQUILIBRIUM – as state of rest, a position from which there is either no Incentive or no

opportunity to move

WELFARE

Most economic analysis is concerned with the welfare aspects of economic activity- how to achieve or optimum welfare constitutes a major problem. As we noted in previous chapters, the concept is straightforward where only one person is being considered and is synonymous with that person’s well being. But when more than one individual is at issue, an objective definition of a unique optimum welfare position for the group as a whole becomes impossible, since such a definition would require interpersonal comparisons of satisfaction. The Pareto optimal situation, in which no one can be made better off without making someone else worse off, is the best solution that we can attain. There is no unique Pareto optimal situation for a group.

The welfare of a group is much more difficult to handle, comparisons of this sort raise serious problems. How can changes in the well being of different persons be compared? In some specific cases we can make rough subjective judgments. Taking a Rembrandt away from a connoisseur of art and giving it to a person who does not understand or value art would surely reduce group welfare. We are left with a group welfare concept known as Pareto optimal situation exists when no even can increase the well being of someone else to consider the matter in another way, a situation is not Pareto optimal if one is to make persons can be made better off without making anyone else worse off. If a situation is not Pareto optimal, a movement towards it –making at least one person better off without making anyone else worse off-increases group welfare.

Equilibrium

Concept is important, not because equilibrium position is ever in fact attained but because these concepts show us the direction in which economic processes move. When equilibrium positions are unstable, disturbances will cause economic units to move farther away from rather than toward such positions.

Partial equilibrium

A large part of the analytical structure that we have built up is called partial equilibrium analysis. It has been concerned with the movements of individual economic units toward equilibrium positions in response to the given economic conditions confronting them. Thus, the consumer, with given tastes and preferences, is confronted with a given

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income and with given prices of goods and services. Each consumer adjusts his or her purchase accordingly to move toward equilibrium. The business firm-faced with given product demand situations-moves toward an equilibrium adjustment. The resource owner possesses given quantities of resources to place in employment, for which there is a given alternative employment possibilities and resource price offers. The equilibrium adjustment is made on the basis of the given data. Changes in the given data facing economic units and industries alter the position of equilibrium that each is attempting to reach and motivate movements toward the new positions.

Partial equilibrium is especially suitable for the analysis of two types of problems both of which we have met time and again through the book. Problems of the first type are those arising from economic disturbances that are not of sufficient magnitude to reach far and beyond the confines of a given industry or sector of the economy. Problems of the second type are concerned with the first order effects of an economic disturbance of any kind.

As an illustration of the first kind of the first problem, suppose that the production workers of a small manufacturer or plastic products go on strike. Suppose further that the plant is located in a large city and that the workers are fairly well dispersed among the residential areas there. The effects of the strike will be limited largely to the company and the employers concerned. Partial equilibrium analysis will provide the relevant answer to most of the economic problems arising from the strike.

As an example of the second type of problem, supposed that a rearmament program increases the demand for steel suddenly and substantially. Partial equilibrium analysis will provide answers to the first order effects on the steel industry- what happens to each prices, output, demand for resources, resource price and its resource employments levels.

General Equilibrium

General equilibrium for the entire economy only exists if all economic units were to achieve simultaneous partials or particular equilibrium adjustments.

General equilibrium theory provides the analytical tools for accomplishing two objectives:

From the stand point of pure theory, it provides the Means of viewing the economic system in each entirety. The means of seeing what holds it together, what makes it works, and how it operate,

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It permits the determination of the second, third and higher order effects of an economic disturbance.

Supposed of that higher-order repercussions from the increase in demand for steel are to be examined. The first order or partial, equilibrium effects are higher prices, greater out puts with given facilities, larger profit, and higher to the owners of resources used in making steel. This effect generates additional disturbances. Higher incomes for the resource owner increase the demand for other product, setting off disturbances and adjustment in other industry. Demand also increase for steel substitute, generating another series of disturbances and adjustments.

Since general equilibrium analysis covers the interrelationships among all parts of the economy, it necessarily becomes exceedingly complex. There are two principal variants of it. In the first one, following Leon Walras most economists find it convenient to discuss general equilibrium in mathematical terms. The interdependence of economic units is shown through a system of simultaneous equation relating the many economic variables to one another the walrasian version of general equilibrium provides the essential theoretical apparatus for understanding the interrelationships of the various sector of the economy.

The second variant of general equilibrium analysis is Wassily W.Leontief’s input-output approach is an empirical descendants of the abstract Walrasian approach. It divides the economy into a number of sectors or industries including households and the government as “industries” of final demand. Each industry is viewed as selling its output to others; these outputs become inputs for the purchasing industries. Likewise, each industry is viewed as a purchaser of the outputs of other industries.

The attainment of general equilibrium in an economic system does not imply that Pareto optimality is also attained. A price system tends to move the economy toward general equilibrium. However, unless pure competition exist in both product and resource markets, and unless there are no externalities occurring, Pareto optimally will not follow.

The Theory of General Equilibrium

The French economy Leon Walras (1834-1910) was the first to design a model of the general equilibrium of a purely competitive economy.

Walra’s general equilibrium model is simple, that is to say, the economic ideas that are its building blocks are simple, modern versions of them have been presented earlier in this book. To a mathematician, Walra’s mathematics is not complex. But full and easy und of the general equilibrium of prices is denied to many students of economics.

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The mathematics gives a vision of interdependence of prices that is clear, precise in detail, complete and self checking in its logical consistency.

Limitations of the Model

The simple model has other but less serious limitations; the assumption of fixed production coefficients can be removed and in much more intricate models, replaced with an assumption of variable coefficients. More complicated models can also be constructed to contain increasing and decreasing returns to sale, money and securities, and even certain forms of imperfect competition.

Uses of General Equilibrium Theory

The simple general equilibrium model is a model of a private enterprise system at rest, all of the consumers and producers having made their best adjustments. In the domain of the discussion of economic and social philosophies and systems, the general equilibrium model is the strongest of the serious arguments for private enterprise and against collectivism but remember, maximum satisfaction means no more than the maximum attainable under the circumstances, whatever they might be. The economy might be poor, with meager resources, a primitive market and the eager pursuit of self interest, the poor economy would still approach the maximum satisfaction of its consumers that is consistent with its limited resources.

Some admirers of private enterprise might not like the fate of business people in the model. The entrepreneur’s in Walra’s model are drones. They control no prices, they exert no power over other person; they fulfil no social responsibilities. They are compelled by the system of prices to be efficient to produce at the lowest attainable costs. Infact their singular function is to be innovators and risk takers, entrepreneurs do not exist at all in Walra’s model. Neither do labor leaders.

General equilibrium theory has furnished the conceptual foundation for input-output analysis, which was created by Wassily Leontief of Harvard University. Input-output analysis is the statistical measurement of the input and outputs of all industries taken together in an interdependent system of commodity flow.

The Conditions of Optimum Welfare

Optimum welfare conditions in an economy are usually grouped into three sets. 1.) Consist of the conditions leading to maximum consumer welfare when supplies

of goods and services are fixed 2.) Consist of the conditions of maximum efficiency in production, assuming that

resource supplies are fixed.

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3.) Consumer welfare and maximum productive efficiency are brought together to determine conditions under which the outputs of different goods and services are optimal.

WELFARE

Up until now we have focused on considerations of Pareto efficiency in evaluating economic allocations. But there are other important considerations. It must be remembered that Pareto efficiency has nothing to say about the distribution of welfare across people; giving everything to one person will typically be Pareto efficient. But the rest of us might not consider this a reasonable allocation. In this chapter we will investigate some techniques that can be used to formalize ideas related to the distribution of welfare.

Pareto efficiency is in itself a desirable goal- if there is some way to make some group of people better off without hurting other people, why not do it? But there will usually be many Pareto efficient allocations; how can society choose among them?

The major focus of this chapter will be the idea of a welfare function, which provides a way to “add together” different consumers` utilities. More generally, a welfare function provides a way to rank different distributions of utility among consumers. Before we investigate the implications of this concept, it is worthwhile considering just how might go about “adding together” the individual consumers` preferences to construct some kind of “social preferences.”

EXTERNALITIES:

We can say that an economic situation involves a consumption externality if one consumer cares directly about another agent`s production or consumption. For example, I have definite preferences about my neighbor or playing loud music at 3 in the morning, or the person next to me in a restaurant smoking a cheap cigar, or the amount of pollution produced by local automobiles. These are all examples of negative consumption externalities. On the other hand, I may get pleasure from observing my neighbor`s flower garden-this is an example of a positive consumption externality.

Similarly, a production externality arises when the production possibilities of one firm are influenced by the choices of another firm or consumer. A classic example is that of an orchard located next to a bookkeeper, where there are mutual positive production externalities-each firm`s production positively affects the production possibilities of the

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other firm. Similarly, a fishery cares about the amount of pollutants dumped into its fishing area, since this will negatively influence its catch.

In earlier chapters we saw that the market mechanism was capable of achieving Pareto efficient allocations when externalities were not present .If externalities are present, the market will not necessarily result in a Pareto efficient provision of resources. However, there are other social institutions such as the legal system or government intervention that can “mimic” the market mechanism to some degree and thereby achieve Pareto efficiency.

My neighbor may believe that he has the right to play his trumpet at 3 in the morning, and I may believe that I have the right to silence. A firm may believe that it has the right to dump pollutants into the atmosphere that I breathe, while I may believe that it doesn’t. Cases where property rights are poorly defined can lead to an inefficient production of externalities-which means that there would be ways to make both parties involved better off by changing the production of externalities. If property rights are well defined, and mechanisms are in place to allow for negotiation between people, then people can trade their rights to produce externalities in the same way that they trade rights to produce and consume ordinary goods.

PREFERENCES

The economic model of consumer behavior is very simple: people choose the best things they can afford. This chapter will be devoted to clarifying the economic concept of “best things.” We call the objects of consumer choice consumption bundles .This is a complete list of the goods and services that are involved in the choice problem that we that we are investigating. The word “complete” deserves emphasis: when you analyze a consumer`s choice problem, make sure that you include all of the appropriate goods in the definition of the consumption bundle.

If we are analyzing consumer choice at the broadest level, we would want not only a complete list of the goods that a consumer might consume, but also a description of when, where, and under what circumstances they would become available. After all, people care about how much food they will have tomorrow as well as how much food they have today.

The Conditions of Optimum Welfare:

Optimum welfare conditions in an economy are usually grouped into three sets. The first consists of the conditions leading to maximum consumer welfare when supplies of goods and services are fixed. The second consists of the conditions of maximum efficiency in production, assuming that resource supplies are fixed. In the third, consumer welfare

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and maximum productive efficiency are brought together to determine conditions under which the outputs of different goods and services are optimal.

Maximum Consumer Welfare: Fixed Supplies:

The conditions of maximum welfare consumer with fixed supplies of goods and services per time unit are illustrated in the two-good, two-person model of Figure 84. If the distribution of goods X and Y between the two consumers A and B is initially off the contract curve at some point such as D, exchanges can be made that will increase the welfare of either without decreasing that of the other. A movement from distribution D to distribution E increases the welfare of both. Once a contract curve distribution is achieved, any further exchanges can benefit only one consumer at the expense of the other. Any point on the contract curve represents a Pareto optimal distribution of X and Y between the two consumers. Each such point is defined by the condition that

MRSxy = MRSxy

This condition can be extend to as many goods and services and as many consumers as there in the economy.

Figure 84Optimum Consumer Welfare: Fixed Supplies

Sometimes there are externalities involved in the consumption of a good service. An externality in consumption occurs if the consumption of a good by someone else affects the level of satisfaction attained by any given consumer. Suppose for example, that A and

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B are neighbors, that A increases her stereo capacity and that B whose musical taste parallel those of A, can now hear and enjoy the music she plays. B receives an external benefit from A`s consumption-his set of indifference curves between music and other goods and services is shifted inward toward the origin of his indifference curve map. On the other hand, the externality could have operated in the opposite direction: the music played by A could have annoyed B, interfering with his sleep and shifting his set of indifference curves between music and other goods and services outward from the origin of his indifference map.

When an externality in consumption occurs, we can no longer be sure that a point on the contract curve such as E in Figure 85 is Pareto optimal. Suppose that B`s satisfaction is enhanced by A`s increased purchase of music via an expansion of stereo capacity. An exchange of other goods and services for distribution F would not change A`s level of satisfaction. Suppose that the external benefits that B receives from A`s increased consumption of music shifts to B`s indifference curves toward origin Qb so that the satisfaction level formerly represented by Ub. At point F, B will be at higher level of satisfaction, represented by U, than before; since A`s satisfaction has not been lessened, by welfare of the two consumers combined is greater than it was at point E.

Figure 85Externalities in Consumption

The Conditions of Efficiency: No Externalities

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Maximum efficiency in production refers to Pareto optimality in production processes. Given the supplies of resources available, these must be allocated among the production of goods and services in such a way that the production of any one good cannot be increased unless the production of another decreased.

The conditions of efficiency are illustrated in the two-resource, two-product model of Figure 86. Fixed supplies of resources A and B are used in the production of products X and Y. Any distribution of resources between the two products that lie on the contract curve, such as that at E, is more efficient than in any distribution not on that curve, such as that at N. Given any initial distribution such as N, the output of either product can be increased with no sacrifice of the other. It is also possible to increase the outputs of both products by allocating more A and less B to the output of Y, thus moving from N to E. With any distribution such as E, neither product`s output can be increased unless some of the other is sacrificed. Any point on the contract curve represents a maximum efficiency allocation of resources. The condition that determines any such point is that

MRTSab = MRTSYab

These conditions can be expanded to include as many resources and as many goods and services as exist in the economy.

The infinite number of efficiently produced combinations of X and Y shown by the contract curve of Figurer 86 are also shown by the transformation curve of Figure 87. For every combination of X and Y on the transformation curve, resources are allocated to each product in the optimal combinations. The transformation curve is often appropriately called the production possibilities curve. Its slope at any point measures the rate at which one product must be given up to obtain an additional unit of the labor, that is, the MRT.

Figure 86Optimum Productive Efficiency

EXTERNALITIES

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Can arise between producers, between customers, or between both the producers and the customers.

Is a consequence of an economic activity that is experienced by unrelated third parties. Externalities are not reflected in market prices, they can be a source of economic inefficiency when producing firms do not take into account the harm associated with negative activities.

Source: investopedia

An externality can be either positive or negative.

Negative Externalities – Occurs when action of one party imposes costs to other party.

Example:

(1) Pollution emitted by a factory that spoils the surrounding environment and affects the health of nearby residents is an example of a negative externality.

(2) When a producing plant of steel dumps their waste in a river basin which fisher folks is dependent on their daily catch of fish for their daily living; producing plant has no incentive to account for the external cost that they imposes on the affected fishermen when making its production decision.

(3) Suppose, that a two way lane highway are used by the producers of automobiles, producers of can goods and other manufacturing industries, and other marketing sources for delivering their goods to consumers

Positive Externalities – When the action of one party benefits another party.

Example:

A positive externality is the effect of a well-educated labor force on the productivity of a company.

The effects of Externalities:

If externalities occur in the production of a good and services, the contract curve may no longer show the conditions of maximum efficiency. Furthermore, there is no market in which these external costs can be reflected in the price of goods and services.

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One of the common examples is the condition of Philippine road network (Major Highways, secondary road and other form of roads):

Other Resources

per unit of timeQa

a2Highway Facilities Highway Facilitiesper Unit of Time per Unit of Time

a1E

F

QwOther Resourcesper unit of time

Suppose, producers of automobiles, producers of can goods and producers of processed meat products used the two way lane highway at the same time without consideration

with other road users; tendencies are, congestion in the highway is inevitable and will cause transportation delays in the delivery goods and other services.

The marginal rate of technical substitution between highway facilities and other resources is the same at point “E”. This distribution or allocation of resources is not optimal. If one firm decreases their usage of highway facilities by using other alternative road, production productivity of highway facilities and the remaining firms using the same facilities will tend to increase provided that they maintained their output level.

Efficiency in Exchange:

Allocation of goods in which no one can be made better off unless someone else is made worse off.*

Source: *Microeconomics by: R. Pindyck & D. Rubinfield

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The optimum distributions of the two commodities between two persons. “Let us assume that two persons engage in barter transactions in the absence of money and prices. Is trade or exchange always mutually advantageous?”

As a rule, voluntary trade between two people or two countries is mutually beneficial1.

If trade is beneficial, which trades can occur? Which of those trades will allocate goods efficiently among customers? How much better off will consumers then be?

The EDGEWORTH BOX Diagram

Showing all possible allocations of either two goods between two people or two inputs between production processes.

Illustration 1Kathy's Food

10 F 4 F 3 F OK

6C

Jaime’s Kathy'sClothing Clothing

B 2C 4C

+ 1C

1C 5C - 1F A 6C

OJ Jaime’s Food 6 F 7 F 10 F

Note: Each point in the Edgeworth box simultaneously represents Jaime’s and Kathy’s market baskets of food and clothing. At point A, Jaime has 7 units of food and 1 unit of clothing; and Kathy has 3 units of food and 5 units of clothing.

1

1 There are several situations in which trade may not be advantageous. First, limited information may lead people to believe that trade will make them better off when in fact it will not. Second, people may be coerced into making trades, either by physical threats or by the threat of future economic reprisals. Third, barriers to free trade can sometimes provide a strategic advantage to a country.2 Even if a trade from an inefficient allocation makes both people better off, the new allocation is not necessarily efficient.

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Name of Individua

lAllocation (Initial) Exchange Allocation (Final)

Food Clothing Food Clothing Food ClothingKathy 3 5 1 -1 4 4Jaime 7 1 -1 1 6 2

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Efficient Allocations:

A trade from point A to point B thus made both (Jaime & Kathy) better off. But is point B an efficient allocation?

Answer: It is depends on whether Jaime & Kathy’s MRS are at the same at B, which depends in turn on the shape of their indifference curves. In the illustration below show several indifference curves for both Jaime & Kathy. Their allocation2 are measured from the OJ, Jaime’s indifference curves are drawn in the usual way while for Kathy, it was rotated the indifference curves opposite (180 degrees) of Jaime, so that the origin is at the upper right hand corner of the box. Kathy’s indifference curves are convex, while Jaime indifference curves are concave.

Illustration 2

10 F Kathy's Food OC

6C

Jaime's Kathy'sClothing Clothing

6COJ Jaime’s Food 10F

Note: The Edgeworth box illustrates the possibilities for both consumers to increase their satisfaction by trading goods. If “A” the initial allocation of resources, the shaded area describes all mutually beneficial trades.

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