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 aff ect 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
was 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.
