Welfare economics deals with normative issues or value judgements. Its purpose is not to
describe how the economy works but to assess how well it works.
Horizontal equity is the equal treatment of equals and vertical equity the unequal treatment
of unequals. Equity is concerned with the distribution of welfare across people. The
desirable degree of equity is a pure value judgement.
A resource allocation is a complete description of what, how and for whom goods are
produced. To separate as far as possible the concepts of equity and efficiency, economists
use Pareto efficiency. An allocation is Pareto-efficient if no reallocation of resources would make some people better off without making others worse off. If an allocation is inefficient it
is possible to achieve a Pareto gain, making some people better off and none worse off.
Many reallocations make some people better off and others worse off. We cannot say
whether such changes are good or bad without making value judgements to compare
different people’s welfare.
For a given level of resources and a given technology, the economy has an infinite number
of Pareto-efficient allocations that differ in the distribution of welfare across people. For
example, every allocation that gives all output to one individual is Pareto-efficient. But there
are many more allocations that are inefficient.
Under strict conditions, competitive equilibrium is Pareto-efficient. Different initial
distributions of human and physical capital across people generate different competitive
equilibria corresponding to each possible Pareto-efficient allocation. When price-taking
producers and consumers face the same prices, marginal costs and marginal benefits are
equated to prices (by the individual actions of producers and consumers) and hence to
each other.
In practice, governments face a conflict between equity and efficiency. Redistributive
taxation drives a wedge between prices paid by consumers (to which marginal benefits are
equated) and prices received by producers (to which marginal costs are equated). Free
market equilibrium will not equate marginal cost and marginal benefit and there will be
inefficiency.
Distortions occur whenever free market equilibrium does not equate marginal social cost
and marginal social benefit. Distortions lead to inefficiency or market failure. Apart from
taxes, there are three other important sources of distortions: imperfect competition (failure to
set price equal to marginal cost), externalities (divergence between private and social costs
or benefits), and other missing markets in connection with future goods risky goods or other
informational problems.
When only one market is distorted the first-best solution is to remove the distortion, thus
achieving full efficiency. The first-best criterion relates only to efficiency. Governments caring
sufficiently about redistribution might still prefer inefficient allocations with more vertical
equity. However, when a distortion cannot be removed from one market it is not generally
efficient to ensure that all other markets are distortion-free. The theory of the second best
says that it is more efficient to spread inevitable distortions thinly over many markets than to
concentrate their effects in a few markets.
Production externalities occur when actions by one producer directly affect the production
costs of another producer, as when one firm pollutes another’s water supply. Consumption
externalities mean one person’s decisions affect another consumer’s utility directly, as when
my garden gives pleasure to neighbours. Externalities shift indifference curves or production
functions.
Externalities lead to divergence between private and social costs or benefits because there
is no implicit market for the externality itself. When only a few people are involved, a system
of property rights may establish the missing market. The direction of compensation will
depend on who has the property rights. Either way, it achieves the efficient quantity of the
externality at which marginal cost and marginal benefit are equated. The efficient solution is
rarely a zero quantity of the externality. Transactions costs and the free-rider problem may
prevent implicit markets being established. Equilibrium will then be inefficient.
When externalities lead to market failure the government could set up the missing market by pricing the externality through taxes or subsidies. If it were straightforward to assess the
efficient quantity of the externality and hence the correct tax or subsidy, and straightforward
to monitor the quantities produced and consumed, such taxes or subsidies would allow the
market to achieve an efficient resource allocation.
In practice, governments often regulate externalities such as pollution or congestion by
imposing standards that affect quantities directly rather than by using the tax system to
affect production and consumption indirectly. Overall quantity standards may fail to equate
the marginal cost of pollution reduction across different polluters, in which case the
allocation will not be efficient. However, simple standards may use up fewer resources in
monitoring and enforcement and may prevent disastrous outcomes when there is
uncertainty.
Moral hazard, adverse selection, and other informational problems prevent the development
of a complete set of forward markets and contingent markets. Without these markets the
price system cannot equate social marginal cost and benefit for future goods or risky
activities.
Incomplete information may lead to inefficient private choices. Health, quality and safety
regulations are designed both to provide information and to express society’s value
judgements about intangibles, such as life itself. By avoiding explicit consideration of social
costs and benefits, government policy may be inconsistent in its implicit valuation of health
or safety in different activities under regulation.
