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Week 4: Welfare economics : PARETO (Pigou-Private vs social costs/benefits…
Week 4: Welfare economics : PARETO
Pareto-Utility and demand
Concept of indifference curves
Based on Edgeworth
Pareto:
relationship between utility function and indifference curvesindifference map
Contrast
Edgeworth
Utility is cardinal
Given utility
Decreasing marginal utility
Pareto
Given indifference curve
Convexity of indifference curve
Utility is ordinal
Utility theory could be used to derive hypotheses about demand
Pareto-Optimality
Maximum welfare, when there are no further opportunities to make someone better off while making no one worse off
--> Pareto optimality
Implications:
Optimal technical allocation of resources
Identical marginal rates of technical substitution between L & C
Optimal quantities of outputs
Marg. rate of substitution = Marg. rate of transformation
Optimal distribution of goods
Identical marginal rates of substitution
Proof that Walrasian equilibrium satisfied the conditions for maximum welfare.
Arthur Pigou (1877-1959)
Partial equilibrium approach
Works:
Economics of Welfare (1920)
Professor at Cambridge University (1908)
Succeeded Marshall
Pigou-Income distribution
Greater equality of incomes could increase economic welfare – under certain conditions
Diminishing marginal utility of money
Interpersonal utility comparison possible (Opposite to Pareto)
Convinced utilitarian: income redistribution improves welfare: Government intervention justified (Opposite to Adam Smith)
Pigou-Private vs social costs/benefits
Private marginal benefit: extra satisfaction for buyer
Social marginal benefit: extra satisfaction for society from
buying this unit
Social marginal cost: expense to society as consequence of producing this unit
Private and social cost/benefit may differ due to spillovers:
--> externalities (inheritance Marshall)
-->government intervention : Pigouvian tax
Private marginal cost: expense a producer incurs in making one more unit
Conclusion
Pareto is still known for his innovations in demand theory and welfare economics, but one should also remember him for his efforts to promote more rigorous use of mathematical methods in economics.
While Pareto laid the foundations for theoretical welfare economics, Pigou showed how it could be used to derive guidelines for economic policy.