Pareto Efficiency, Social Welfare and Size ofGovernment

Doc. Dr. Sezgin Polat

Public Economics CoursePolitical Science Department

Galatasaray University

Fall, 2017

Outline

Social Welfare and NotionsMarket EquilibriumEfficiencyEquity

Public Sector GrowthTheories of Public Sector Growth

Market Equilibrium

Ways to Allocate Apartments

I Market Equilibrium

I The Discriminating Monopolist

I The Ordinary Monopolist graph

I Rent Control graph

Utility and Choice

Utility and Choice 2

Social Welfare and Notions

Efficiency : Price mechanism as a means of allocating resources.

I First Fundamental Theorem of Welfare Economics : Thecompetitive equilibrium, where supply equals demand,maximizes social efficiency. First Theorem

I Second Fundamental Theorem of Welfare Economics : Societycan attain any efficient outcome by suitably redistributingresources among individuals and then allowing them to freelytrade. Second Theorem

The Edgeworth Box 1

I Graphical tool known as the Edgeworth box 1 can be used toanalyze the exchange of two goods between two people.

1. The Edgeworth box is named in honor of Francis Ysidro Edgeworth (1845–1926), an English economist whowas one of the first to use this analytical tool.

The Edgeworth Box 2I The exchange of two goods between two people.

The Edgeworth Box 3I The exchange of two goods between two people.

Pareto Efficiency

I A Pareto efficient allocation can be described as an allocationwhere :

1. There is no way to make all the people involved better off2. There is no way to make some individual better off without

making someone else worse off3. All of the gains from trade have been exhausted4. There are no mutually advantageous trades to be made

I The set of all Pareto efficient points in the Edgeworth box isknown as the Pareto set, or the contract curve. The lattername comes from the idea that all ”final contracts” for trademust lie on the Pareto set otherwise they wouldn’t be finalbecause there would be some improvement that could bemade !

The Edgeworth Box 4 - Market equilibrium

Social Welfare Functions 1

Equity : Contradictory objectives, preferences and values ?I The traditional means for representing the values of the

community in economics is to use a social welfare function(SWF). SWF requires a social planner maximizes in order todetermine the socially optimal policy.

I Utilitarian social welfare function : The seminal paper onSWFs is by Bergson (1938), with the most significant furtherexplication by Samuelson (1947, ch. 8). The SWF can bewritten as follows :SWF = U1 + U2 + U3 + ... + Un

where W is a real valued function of all variables, and the Ui sand SWF are chosen to represent the ethical values of thesociety or of the individuals in it (Samuelson, 1947, p. 221).

Social Welfare Functions 2

I The traditional means for representing the values of thecommunity in economics is to use a social welfare function(SWF)

I Rawlsian Social Welfare Function : Another popular form ofsocial welfare function is the Rawlsian SWF, named for thephilosopher John Rawls. He suggested that society’s goalshould be to maximize the well -being of its worst -offmember.5 The Rawlsian SWF has the form :SWF = min(U1,U2,U3, ...Un) Rawls- Theory of Justice

Since social welfare is determined by the minimum utility insociety, social welfare is maximized by maximizing the well-being of the worst -off person in society.(The maximin criterion.) Human Rights

John Rawls (Theory of Justice) : The Difference Principle permitsdiverging from strict equality so long as the inequalities in questionwould make the least advantaged in society materially better offthan they would be under strict equality.

I First : Each person is to have an equal right to the mostextensive scheme of equal basic liberties compatible with asimilar scheme of liberties for others.

I Second : Social and economic inequalities are to be arrangedso that they are both

I to the greatest expected benefit of the least advantagedI attached to offices and positions open to all under conditions

of fair equality of opportunity.

In Rawls’s theory, life is a game of chance in which Nature deals out attributesand social positions in a random or accidental way. Now this naturaldistribution of attributes and chance determination of social position is neitherjust nor unjust. But it is unjust for society simply to accept these randomoutcomes, or to adopt institutions that perpetuate and exaggerate them. Thus,a set of just institutions is one that mitigates the effects of chance on thepositions of individuals in the social structure. back

I (The maximin criterion : Declaration des droits de l’homme etdu citoyen, 1789, article 1) Les hommes naissent etdemeurent libres et egaux en droits. Les distinctions socialesne peuvent etre fondees que sur l’utilite commune - Men areborn and remain free and equal in rights. Social distinctionscan only be based upon common utility

I Amartya Sen develops a more concrete approach to rights and”capabilities” : A. Sen defines capabilities as ”the freedomthat a person has in terms of the choice of functionings, givenhis personal features (conversion of characteristics intofunctionings) and his command over commodities.”

I The functioning of a person is an achievement ; it iswhat the person succeeds in doing with the commodities andcharacteristics at his or her command.For example, bicycling has to be distinguished from possessing a bike. Ithas to be distinguished also from the happiness generated by [bicycling].

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Public Sector Growth

I The historical development of the public sector over the pastcentury can be summarized as one of significant growth.

I For the typical industrially developed economy, governmentexpenditure was only a small proportion of gross domesticproduct at the start of the twentieth century.

I Expenditure then rose steadily over the next sixty years,leveling out toward the end of the century.

Government Expenditure / GDP

Types of Government Expenditures

Theories of Public Sector Growth

I Development Models : The basis of the development modelsof public sector growth is that the economy experienceschanges in its structure and needs as it develops.

I infrastructural expenditure in the development of citiesI Increasing proportion of public expenditure is diverted away

from spending on infrastructure to urbanization and itsexternalities

I Transfer payments, such as social security, health, andeducation, becoming the main items of expenditure

Size of Government

I Wagner’s Law : Adolph Wagner was a nineteenth-centuryeconomist who analyzed data on public sector expenditure forseveral European countries, Japan, and the United States.

I Economic growth requires continual introduction of new lawsand the development of the legal structure. Law and orderimply continuing increases in public sector expenditure.

I The process of urbanization and the increased externalitiesassociated with.

I The goods supplied by the public sector have a high incomeelasticity of demand.

I Demand increases more than proportionally with respect toincome.

Size of Government

I Baumol’s Law : The basic hypothesis is that the technology ofthe public sector is labor-intensive relative to that of theprivate sector.

I The public sector cannot substitute capital for labor, the wageincreases in the private sector feed through into cost increasesin the public sector.

I Technological advances in the private sector lead to increasesin productivity.

Size of Government

I The government as re-distributor of income and wealth

I The Meltzer and Richard model. Meltzer and Richard (1978,1981, 1983) r = tymean inequality

I Kuznets’ (1955) famous inverted-U curve. Piketty inequality curve

I Redistribution is limited through deadweight loss in taxation.I Politics is majoritarian, equal (one person, one vote) and with

full participation (all economic agents vote).

I Cusack (1997) : Left of-center governments are assumed tofavor more redistribution and larger budgets thanright-of-center governments.

I Kristov, Lindert, and McClelland (1992) : Redistribution as afunction of the social affinity between different groups in theincome distribution.

I Peltzman (1980) : Increasing equality of income amongpotential coalition members drive the growth of government

Size of Government

I Interest groups and the growth of governmentI Tullock (1959) : discussion of majority rule. more is spent than

would be spent under the unanimity rule. Second, if theunanimity rule were in use, there would be no incentive to havethe government.

I Rice (1986) presented evidence suggesting that labor unionsand other interest groups were able to induce governments tointroduce programs to offset economic hardships

I North and Wallis (1982) : Growth of government and thegrowth of white-collar and managerial employment in theprivate sector. Response to the greater transaction costs fromorganizing a market economy with increasing specialization.

Size of Government

I Bureaucracy and the growth of government

I Budget-maximizing bureaucrats : Niskanen (1971) postulatedthat a bureaucrat’s ”salary, perquisites of the office, publicreputation, power [and] patronage” are all positively related tothe size of the bureau.

I Government Agency :The lack of information available tovoters. The imperfect information of voters enables thegovernment to grow larger by increasing the tax burden. Mill(1861) felt that direct taxes were more visible and, byimplication, that excessive government growth would have torely on indirect taxes.The issue of what sources of revenue areless visible to citizens, as well as the magnitude of any fiscalillusion caused, must be regarded as largely empirical.

I Corruption : Predatory regulation. The governmentintentionally creates regulations that entrepreneurs have to paybribes to get around. Goel and Nelson (1998) use convictionsfor public abuse of office as an index of corruption, and findthat corruption at the state level in the United States increaseswith the size of state governments.

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