2.

3
Social Efficiency
Chapter 2 Theoretical Tools of Public Finance

Social efficiency: When there is no ``free lunch’’. Someone has to

pay.
Autarky, trade, and free lunch.
A PARETO-efficient state is where the is no more free lunch.
A Pareto-efficient state is when on cannot make someone better
off without making somebody else worse off.
Having a free lunch is referred to as a Pareto improvement or
making a Pareto improving move.
Pareto improvement: Making someone better off without
making anybody else worse off (as in free trade).

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 1 of 43
 2.3
Social Efficiency and Competitive Markets
Chapter 2 Theoretical Tools of Public Finance

A competitive market tends to realize all free lunches.

A competitive market is Pareto efficient.
This is called: The First Fundamental Theorem of Welfare
Economics.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 2 of 43
Chapter 2 Theoretical Tools of Public Finance 2.3

“Every individual necessarily labours to render the annual

revenue of the society as great as he can. He generally indeed
neither intends to promote the public interest, nor knows how
much he is promoting it… . He intends only his own gain, and he
is in this, as in many other cases, led by an invisible hand to
promote as end which was no part of his intention.”

Adam Smith, The Wealth of Nations, Book IV

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 3 of 43
 2.3
Equilibrium and Social Welfare
Equilibrium
Chapter 2 Theoretical Tools of Public Finance

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 4 of 43
 2.3

Social Efficiency
Chapter 2 Theoretical Tools of Public Finance

Social efficiency represents the net gains to society from all trades that are
made in a particular market, and it consists of two components: consumer
and producer surplus.

consumer surplus The benefit that

consumers derive from consuming a
good, above and beyond the price they
paid for the good.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 5 of 43
 2.3

Social Efficiency
Chapter 2 Theoretical Tools of Public Finance

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 6 of 43
 2.3

Producer Surplus
Chapter 2 Theoretical Tools of Public Finance

producer surplus The benefit

that producers derive from selling
a good, above and beyond the cost
of producing that good.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 7 of 43
 2.3
Producer Surplus
Chapter 2 Theoretical Tools of Public Finance

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 8 of 43
 2.3

Social Surplus
Chapter 2 Theoretical Tools of Public Finance

total social surplus (social

efficiency) The sum of consumer
surplus and producer surplus.

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 2.3

Social Surplus
Chapter 2 Theoretical Tools of Public Finance

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 2.3

Competitive Equilibrium Maximizes Social Efficiency

Chapter 2 Theoretical Tools of Public Finance

First Fundamental Theorem

of Welfare Economics The
competitive equilibrium, where
supply equals demand, maximizes
social efficiency.

deadweight loss The reduction

in social efficiency from denying
trades for which benefits
exceed costs.

It is sometimes confusing to know how to draw deadweight loss triangles. The key to
doing so is to remember that deadweight loss triangles point to the social optimum, and
grow outward from there.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 11 of 43
 2.3

From Social Efficiency to Social Welfare: The Role of

Chapter 2 Theoretical Tools of Public Finance

Equity

social welfare The level of

well-being in society.

Governments have certain redistributive

programs because their citizens care not only
about efficiency but also about equity, the fair
distribution of resources in society. The
competitive equilibrium, while being the social
efficiency-maximizing point, may not be the social
welfare-maximizing point.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 12 of 43
Chapter 2 Theoretical Tools of Public Finance 2.3

equity–efficiency trade-off
The choice society must make
between the total size of the
economic pie and its distribution
among individuals.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 13 of 43
 2.3

From Social Efficiency to Social Welfare: The Role of

Chapter 2 Theoretical Tools of Public Finance

Equity

social welfare function (SWF) A

function that combines the utility
functions of all individuals into an
overall social utility function.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 14 of 43
 2.3

The Social Welfare Function: W=W(.)

Chapter 2 Theoretical Tools of Public Finance

 The basis idea of the SWF is to make the society’s notion of

“fairness” explicit.
 Introduced by Samuelson and Bergson some fifty years ago.
 Often people talk about being “fair” without specifying what they
mean:
 John Edwards often talks about “two Americas’’.
 Is it only “two”? What does “one America’’ look like?
 Bill Clinton, in his ’92 presidential campaign, talked about an
“America in which the wealthiest, those making over 200,000
dollars a year, are asked to pay their fair share.”

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 15 of 43
 2.3

The Social Welfare Function: W=W(.)

Chapter 2 Theoretical Tools of Public Finance

But one can interpret this as :

 Higher income people should pay more taxes. If we accept this
interpretation we are still left with the question of “How
much?”
 Higher income people pay more in terms of average taxes. But
again “How much?”
 Higher income people pay more in terms of marginal taxes.
But again “How much?”
William Safire, a previous columnist for New York Times, defines
“tax fairness” as “the poor should pay nothing, the middlers
something, and the rich the highest percentage.” So his is in terms
of averages. But the question of how much still remains.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 16 of 43
 2.3

Some Specific Examples

Chapter 2 Theoretical Tools of Public Finance

Utilitarian SWF

With a utilitarian social welfare function, society’s goal is to maximize the

sum of individual utilities:

SWF = U1 + U2 + . . . + UN

The utilities of all individuals are given equal weight, and summed to get
total social welfare.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 17 of 43
 2.3
Linear Iso-Welfare Curves
Chapter 2 Theoretical Tools of Public Finance

U2

U1

Same MRS everywhere: perfect substitute

Jeremy Bentham: Utilitarianism

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 18 of 43
Chapter 2 Theoretical Tools of Public Finance

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Chapter 2 Theoretical Tools of Public Finance 2.3

Rawlsian Social Welfare Function

John Rawls suggested that society’s goal should be to maximize the well-
being of its worst-off member. The Rawlsian SWF has the form:

SW = min (U1, U2, . . ., UN)

Since social welfare is determined by the minimum utility in society, social

welfare is maximized by maximizing the well-being of the worst-off person
in society.
Deciding under the “veil of ignorance.”

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 20 of 43
 2.3
L-shaped Iso-Welfare Curves
45°
Chapter 2 Theoretical Tools of Public Finance

U2

U1

Perfect complements

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 21 of 43
 John Rawls
Chapter 2 Theoretical Tools of Public Finance

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 22 of 43
 2.3

Atkinson social welfare function

Chapter 2 Theoretical Tools of Public Finance

1
W (u1h  1).
1  h

*ε is the Inequality Aversion Parameter.

*We have
-As   0, W  to a Utilitarian SWF
-As   , W  to a Rawlsian SWF

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 23 of 43
 Anthony Atkinson
Chapter 2 Theoretical Tools of Public Finance

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 24 of 43
 2.3

U2
Chapter 2 Theoretical Tools of Public Finance

ε2
ε1
U1
ε2 > ε1

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Chapter 2 Theoretical Tools of Public Finance 2.3

 NOZIK: Equality of opportunity not outcomes:

The principle that society should ensure that all

individuals have equal opportunities for
success, but not focus on the outcomes of
choices made.

 The island example

 The measurement problem

 Ex-ante versus Ex-post

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 26 of 43
 Robert Nozick
Chapter 2 Theoretical Tools of Public Finance

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 27 of 43
 2.3

Another idea
Chapter 2 Theoretical Tools of Public Finance

Commodity Egalitarianism
The principle that society should
ensure that individuals meet a
set of basic needs, but that beyond
that point income distribution is
irrelevant.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 28 of 43
 2.5
Conclusion
Chapter 2 Theoretical Tools of Public Finance

• The notion of Pareto efficiency.

• The relationship between competitive markets and
efficiency.
• Market failures.
• Efficiency gain and loss calculations.
• Equity and efficiency tradeoff.
• The notion of a social welfare function.
• Different types of SWF.

© 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 29 of 43