PARETO OPTIMALITY AND THE EFFICIENCY GOAL

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PARETO OPTIMALITY AND THE EFFICIENCY GOAL
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SOCIAL GOALS AND THE ROLE OF THE RATIONAL
INDIVIDUAL

• CBA is based on neoclassical welfare economics
• CBA embodies (classic) Liberal philosophy with
  following components
• 1. individual is fundamental unit of society
• Individual preferences count
• 2. rational decision-making by individuals
• 3. rational individuals preferences can be
  meaningfully aggregated in some manner to make
  social decisions about resource allocation in
  society

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THE INDIVIDUAL AND SOCIETY

• Society essentially composed of individuals
  motivated by self-interest
• Law and government provide security against
  equally self-interested fellows
• Government and society exist to preserve the
  individuals rights
• Individuals acting in enlightened self-interest
  lead to the maximum common good
• Public interests are conceived in terms of
  private well-being

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THE INDIVIDUAL AND ECONOMY

• Individuals gain satisfaction or utility fromo
  consumption
• These individuals have preferences
• The values or strengths of this utility is
  manifested in prices formed in the market place
• The more individuals value or demand or derive
  satisfaction/utility, the higher the price and
  their willingness to pay

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THE INDIVIDUAL AND ECONOMY

• Thus, money valuations express individual
  preferences

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THE INDIVIDUAL AND ECONOMY

• Collective Rationality and Aggregation of Money
  Valuations
• Basic question is how to aggregate individual
  money valuations to form collective or social
  valuations
• These social valuations are used to make social
  (collective) decision-making
• Basic approach is to simply sum the individual
  money valuations
• Summation gives net benefits to society

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DISTRIBUTION OF INCOME AND WEALTH

• Judgements about the distribution of income and
  wealth are largely implicit in CBA
• Implicitly, the desired income distribution is
  the one prevailing at the time of CBA
• Because money valuations reflect willingness to
  pay
• But willingness to pay as reflected by market
  behavior is a function of ability to pay

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VALUES WHEN MARKETS DO NOT EXIST

• Individuals preferences are measured as prices
  and willingness to pay
• Gives the level of economic welfare from
  consumption
• Prices and hence values are formed by market
  activity

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VALUES WHEN MARKETS DO NOT EXIST

• Sometimes markets do not exist
• Biodiversity is one example
• No prices exist in a market that individuals are
  willing to pay
• However, prices and willingness to pay can, in
  principle, be imputed from observed behavior

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SUMMARY TO THIS POINT

• Benefit-cost analysis is based on neoclassical
  welfare economics
• CBA and welfare economics embody the philosophy
  of individual consumer sovereignty
• Social economic welfare is assumed to be the sum
  of self-expressed welfares of all individuals in
  society
• Expressed through market prices and WTP

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SUMMARY TO THIS POINT

• A benefit is considered a gain in welfare
• A cost is considered a loss in welfare
• Net benefits are an aggregation of all benefits
  minus an aggregation of all costs
• In making judgements about optimal resource
  allocations, decision criterion is required to
  evaluate alternative economic states

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SUMMARY TO THIS POINT

• That is, alternative economic states, i.e.
  alternative allocations of scarce social
  resources, each have corresponding summed net
  benefits
• Some criterion is required to evaluate these
  alternative economic states
• In welfare economics, and thus CBA, this
  criterion is Pareto optimality
• A value judgement

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THE CONCEPT OF PARETO OPTIMALITY

• Paretian System
• Concept of Pareto optimality underlies the value
  judgements used to choose among alternative
  resource allocations alternative economic
  states with the greatest net benefits

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PARETO OPTIMALITY

• Paretian System
• Two fundamental components of Paretian value
  system
• 1. Individual preferences count
• 2. Prevailing income distribution is desireable

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PARETO OPTIMALITY

• Pareto Criterion
• Purpose
• Pareto criterion is a technique for comparing or
  ranking alternative states of the economy
• Definition of Pareto Criterion
• If it is possible to make at least one person
  better off in moving from state A to state B
  without making anyone else worse off, state B is
  ranked higher by society than state B

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PARETO OPTIMALITY

• Pareto Criterion
• Pareto Improvement
• A movement from state A to state B
• Pareto Criterion vs.Unanimity
• Pareto criterion allows indifference by some
  individuals (some not made worse off)

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PARETO OPTIMALITY

• Pareto Optimum
• A state of the economy from which it is
  impossible to make one person better off without
  making another person worse off.
• If society finds itself in a position from which
  there is no Pareto improvement, then there is a
  Pareto optimum
• If economy is not in Pareto optimum, some
  inefficiency in the economy

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PARETO OPTIMALITY

• Weak Pareto Criterion
• Everyone is made better off.
• Strong Pareto Criterion
• Some people are made better off, while noone is
  made worse off.
• Pareto criterion breaks down if even one
  individual is made worse off.

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PARETO OPTIMALITY

• Graphically

Utility Person B
Set of Pareto improvements

• Utility Possibility
• Curve
• Corresponds to all
• possible combinations of
• utility for individuals A and
• B for given production
• possiblity frontier

Pareto-inefficient starting point
Utility Person A
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PARETO OPTIMALITY AND INCOME DISTRIBUTION

• Pareto optimality gives an efficient resource
  allocation and maximum social welfare for a given
  income distribution
• If change existing income distribution, then new
  Pareto optimum
• Hence, many Pareto optimum may exist associated
  with different factor endowments (incoome
  distributions)

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PARETO OPTIMALITY AND INCOME DISTRIBUTION

• Implies cannot solve problem of efficiency and
  income distribution in two stages by
• 1. First, Pareto-efficient resource allocation
• 2. Optimum distribution
• No solution by Pareto criterion

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PARETO OPTIMALITY AND INCOME DISTRIBUTION

• Two different distributions of income give
• two different Pareto optimums, A and B
• All such combos of utility, for given income
• distribution, gives UPF
• How to choose A vs. B?
• Cannot by Paerto criterion
• Need social welfare function
• But Arrows Impossibility Theorem says
• cannot for democratic society

• Graphically

Utility Individual A
Contract curve A
A
Utility Possibility Frontier
B
Contract curve B
Utility Individual B
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LIMITATIONS TO PARETO CRITERION

• 1. Breaks down if single individual made worse
  off
• 2. Many alternatives simply not comparable
• Alternative Pareto optimum (corresponding to
  different income distributions) not Pareto
  comparable
• Pareto criterion does not allow choosing between
  alternative income distributions
• 3. Favors status quo
• 4. Not all first-best Pareto-optimal choices are
  superior to some second-best (Pareto-inefficient)
  choices
• Second-best may have superior income distribution

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POTENTIAL PARETO CRITERION

• Potential Pareto criterion is a way out of the
  limitations of the (pure) Pareto criterion
• Is modification of Pareto criterion and forms the
  basis for comparing or ranking alternative states
  of the economy by CBA
• Sometimes called Kaldor-Hicks Compensation Test
• Relies on compensation principle

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POTENTIAL PARETO CRITERION

• Definition of Potential Pareto Criterion
• State A is preferable to state B if it is
  potentially possible to for the gainers to
  compensate the losers and still remain better off
• Actual compensation is not required

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POTENTIAL PARETO CRITERION

• Example
• Gainers in state A receive 100 units of benefit
• Losers in state A penalized 90 units (their cost)
• If gainers potentially compensate losers by 90
  units, gainers receive net benefit of 10 units

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POTENTIAL PARETO CRITERION

• In market economies, compensation is not
  typically direct
• Instead, various forms of transfer payments
• Purpose of potential compensation is to separate
  efficiency and equity components of a policy
  change under consideration

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POTENTIAL PARETO CRITERION

• I to any point between S0 and S1 is Pareto
  improvement
• All points on UPF in range S0S1 is
  Pareto-superior to I
• Move from I to E is not Pareto improvement in
  itself

Utility A
E
S0

• Potential Pareto Criterion ranks a
• Pareto-optimal allocation, such as E,
• superior to any allocation not Pareto
• optimal, such as I
• Potential Pareto Criterion allows point
• Such as E to be reached by potential
• compensation

S
S1
I
Utility Possibility Fronter
Utility B