Summary of Part 2 - Microeconomics 2: Welfare economics (30L106-B-6)
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Course
Microeconomics 2: Welfare economics (30L106B6)
Institution
Tilburg University (UVT)
This is a summary of the lecture slides of the course Microeconomics 2: welfare economics given at Tilburg University. This document contains everything you need to know about part 2, namely the part given after the midterm. The midterm part can also be found in my account. There is also a bundle f...
Hoorcollege 7 Fairness
The Big Picture
● You learned that markets are often able to allocate resources in an efficient way:
market failures
● Public goods
○ Externalities & internalities
○ Imperfect competition
● But you also know about market failures, i.e. situations in which markets cannot
deliver efficient outcomes
○ market failures and government intervention as a reaction
● Is efficiency the only criteria to judge market outcomes?
● What about fairness?
○ Fairness is a criteria that shows up in many levels in a society
○ Equal and fair treatments are principals that almost everyone adheres
○ Can we include fairness in our analysis of markets?
Today’s questions
● Are efficiency and fairness related to each other?
● Can we define fairness precisely?
○ Much more complex to define
● Can we compare the outcomes of two persons?
○ We need to compare how person A and person B feel about an outcome
● Can we measure people’s ideas about fairness?
● How can we implement outcomes that are fair for society?
○ Practical applications of the concepts
● Refresher: Pareto efficiency
● Fairness
- The relation between fairness and efficiency
- What people think about fairness
- The theory of fair allocations
- Social welfare functions –covered in the book
● Conclusions & Take away msg
Pareto efficiency
● We say that a societal outcome x is a pareto improvement on an outcome y if
○ At least one person strictly prefers x to y, (at least one person is better off)
○ All persons weakly prefer x to y (no one is hurt)
● When we make a pareto improvement, nobody is worse off, hence, nobody objects
against making pareto improvements
● A societal outcome x is pareto efficient if there does not exist a pareto improvement
of it
○ We cannot pareto improve x
● In short, we cannot do better at all
,Pareto efficiency
● Economics are advocates of efficiency and have been criticised for only looking at
pareto efficiency
○ Fairness is intuitively a notion that we want to take into account when judging
market outcomes
○ In everyday language, efficiency is used for other meanings as we discussed
earlier:
■ Cost savings even if this means achieving less
■ Cost shifting: we reduce some cost, by increasing others
● Terminology needs to be clear: pareto efficiency means that it is impossible to obtain
an outcome that is better for everybody
● Who can be against efficiency?
Imagine
● A world with only bread
● Fixed amount of each good, shared between adam, eve
Relationship between pareto efficiency & fairness
● Assume you are the social planner (government) and your society constitutes of a
small population: adam and eve
● You have 10 breads to divide between adam and eve, and that bread is a standard
good for both (nobody dislikes having more of it)
○ There are two allocation you can implement (both of which are efficient)
○ Allocation A = adam 1 bread, eve 9 breads
○ Allocation B = adam 5 breads, eve 5 breads
, ● Why are both pareto improvements?
○ One cannot make one agent better off without hurting the other
○ Underlying assumption: they both like bread
● Now imagine that adam and eve are equally deserving
○ They worked equal amounts
● How can we select the fairest allocation?
○ One cannot make one agent better off without hurting the other
○ What does fair mean?
● How can we select the fairest allocation?
○ Equal share?
■ Underlying assumption: they have equal marginal utility (they like
bread to the same extend)
● Is this a reasonable assumption?
● This is a stronger assumption than saying we have an efficient
allocation (where we say they both like bread)
■ How can we measure that?
● What if adam likes bread more than eve?
● Ask them how much they like bread in a scale of 0-10
● Problem of comparability: but what if they use different scales?
How can we interpret their answers?
● Potential solution for policy makers:
○ We cannot decide how much they like bread if we just ask them
○ Work with monetary amounts instead:
○ Give bread a monetary value, look at market
○ And make a reasonable assumption that everyone has the same utility
function for money
○ If 1 bread equals 1 euros, and they are equally deserving
Take away msg: we need to compare utilities to talk about fairness and it is not obvious how
to do this
Pareto efficiency & fairness
● Expressing everything in monetary terms is practical
○ Even for things that do not have a market price
○ We can elicit people’s willingness to pay (WTP)
● To make a decision as a policy maker, we always face a trade-off:
○ Benefits
○ Costs
● Example: during corona how much would you be willing to pay to go back to
campus? As a manager, understand whether it is worth to come back to campus?
○ Benefits: students learn better (how much students value this, elicit their
WTP)
○ Costs: safety measures
, ● Some things are harder to evaluate. Example related to health care costs:
○ Do you prefer to live healthy for a short time or with a disease for a longer
time?
● Quality-adjusted life year (QALY): quantifies benefits of treatment - lenght of life and
quality of life - into a single number. This can be used for making cost-effectiveness
analysis
○ Ways to quantify the benefits and costs of treatments
■ Quality of life (questions like: like a healthy life of 10 years, and live for
15 years without a leg)
■ Costs of treatments
To sum up:
● Efficiency is easy to
○ Define
○ To agree with
● We care about fairness as much as we care about efficiency
○ Want societal outcomes to be fair
● However, even when two people deserve an equal treatment (so fairness it is easy to
define) we may need to make interpersonal comparisons
● Making interpersonal comparisons require
○ Strong assumptions
○ Difficult measures
Why fairness is left out:
● Fairness is difficult to formalize: even academics (economists, psychologist,
philosophers, etc..) do not agree among each other.
● Fairness is often overused and used in a very instrumental way in the political
discourse (ideological positions)
● Politicians often appeal to fairness but the notion of fairness to which they appeal is
not clearly defined & used in a self-serving way:
○ “Taxes are about more than money and they’re about more than economics.
They’re about fairness, and this bill is fair” (Senator Robert Packwood)
○ “For our economy, this is the wrong bill at the wrong time ... making deficit
reduction more difficult and less fair”(SenatorCarl M. Levin)
● Some forms of fairness (such as full equality) may lead to less efficiency
● Implementing fair outcomes may distort market incentives and lead to some welfare
losses (within classical theory)
Fairness - empirical evidence
● Recently economists started to be interested in fairness
○ To study the fairness perceptions across countries to help us understand why
some countries have large welfare states and some others have not
○ Use of new techniques: conduction empirical research - surveys, experiments
- on people’s fairness views
■ Experimental economics: new
● There is a renewed interest in fairness and the purpose is to
○ Learn what people consider to be fair (let the data speak)
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