First Theorem of Welfare Economics
Pareto efficiency
• No welfare enhancing trades can be made
• It is impossible to make somebody else better off without
making somebody else worse off
First theorem of welfare economics: the
equilibrium of a competitive market economy is
Pareto efficient if
• all goods are private
• no difference between private/social cost differences
Formalizes Adam Smith’s concept of an invisible
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Invisible Hand
“Every individual … neither intends to promote
the public interest, nor knows how much he is
promoting it. He intends only his own security,
his own gain. And he is in this led by an
invisible hand to promote an end which was no
part of his intention. By pursuing his own
interest he frequently promotes that of society
more effectively than when he really intends to
promote it.”
“It is not from the benevolence of the butcher, the
brewer, or the baker that we expect our dinner, but
from their regard to their own interest.”
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Invisible Hand
Idea behind invisible hand
• Societal perspective:
A good should be produced if the “utility” to the user
exceeds the cost of producing it
• Firm perspective
Can make a profit if the “utility” to the user (the
maximum he/she is willing to pay) exceeds the cost of
producing it
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Key Concepts I: Private / Public Good
Public versus private goods
• Private good
Rival: if I eat an apple, somebody else can’t eat the
same apple
Excludable: I can keep other people from eating my
apple
• Public good
Non-rival: if I walk in a park, my neighbor can do so
at the same time
Non-excludable: I can’t keep my neighbor from
walking in the park
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Key Concepts II: Private / Social Cost
Private costs (benefits) of an action
• accruing to the actor only
Social costs (benefits)
• total costs of activity including those that
accrue to people other than the actor
Example: driving a car
• Private costs: fuel, maintenance
• Social costs include pollution, road wear
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External Effects
Any difference between private and social
costs is referred to as an “externality” or
“external effect”
Recall how markets work
• in seeking profits firm produce a good
If “utility” to consumer (maximum willingness to pay)
exceeds the cost of producing it
• Problem: if private cost are different from social
cost, firm doesn’t act in societies best interest
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Left - social cost 15, private 10
Right - private & social cost of 12
16
14
12
10
Private-Social difference
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Costs
Private
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A B
Choices
Corporation will choose A as private cost is lower
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Examples of Private v. Social
Conserving tropical forests
• Private benefits: may be small for landowner
some sales of non-timber forest products
Eco-tourism
• Social benefits:
carbon sequestration
biodiversity conservation
Etc
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Summary
Markets work very well when
• Assumption of first welfare theorem are met
goods are private
private & social costs are equal
Less satisfactory otherwise
• “market failure” & rationale for intervention
• How best to intervene?
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Market Failure
Social benefits > private benefits
• Good is underprovided
• Provider has too little financial incentive, i.e.,
doesn’t capture all benefits
• Example: rainforest
Social costs > private cost
• good is over-provided
• Provider does not account for all costs it
imposes on society
• Example: transportation, fossil fuel.
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Policy Responses
What to do if there is a difference between
private and social costs
• Impose a tax (or subsidy)
equal to difference between private and social costs
• introduce of property rights
Based on the view that an excess of social over
private costs arises from the inability to own certain
key resources, such as the atmosphere.
Afterwards market outcome will be Pareto-
efficient again
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Side note: Equity & Efficiency
First welfare theorem maximizes “the size
of the pie”, but says nothing about its
distribution
Pareto efficiency is separate from
distribution and any concept of equity.
• It states that all opportunities for mutual gain
are exploited. But not that the outcome is in any
way fair.
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Greenhouse Gases
Two views on CO2 emissions
• social costs of burning fuels > private costs
Solution: impose a carbon tax.
• use of the atmosphere for waste disposal without
any payment
atmosphere should be someone’s property
if we want to pollute it we have to obtain their permission
and compensate them for damage to it
Leads to tradable SO2/CO2 permits
• Requires well-defined property rights!
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Cap & Trade Systems
Amount to establishing property rights
in environmental assets
Give out limited, tradable rights to carry
out an environmentally harmful activity
Leads to mitigation banking
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Examples of Cap -&-Trade:
Title IV of Clean Air Act Amendments
• SO2 permit market
• Number of permits: 50% of historic emissions
• Permits are grandfathered (allocated based on
historic emissions)
• Advantage of permit market:
Firms with lowest abatment cost will abate
gives firm incentive to innovate
• Initial cost estimates by industry > 1000 per ton SO2
• EPA: 250-350 per ton SO2 (Phase 1)
500-700 per ton SO2 (Phase 2)
• Permit price ~150 per ton SO2
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Examples of Cap -&-Trade:
Fox River in Wisconsin
• Allowable firms to trade pollution rights
• Problem: each trade had to be approved
Only 1 trade in many years
Lessons: Permit market works best
• Clearly defined property rights
• Many potential buyers and sellers
• Low transaction cost
• Uniformly mixing pollutant
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Examples of Cap -&-Trade:
Wetlands banking
• www.wildlandsinc.com
Kyoto
• Chicago Climate Exchange
• www.chicagoclimatex.com
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Kyoto Protocol
Cap-and-trade on emissions by industrial
countries and transitioning countries
No significant restrictions on emissions by
developing countries
• “Clean development mechanism”
Develop countries can get “credits” for reduction in
developing countries
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Kyoto Protocol – Annex B Countries
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Historic Emissions
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Kyoto - targets
European Union (15 members) -8%
US -7%
Canada, Hungary, Japan, Poland -6%
Croatia -5%
New Zealand, Russian Federation, Ukraine 0%
Norway +1%
Australia +8%
Iceland +10%
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Example: Burden-sharing agreement
(Europe)
Austria -13% Italy -6.5%
Belgium -7.5% Luxembourg -28%
Denmark -21% Netherlands -6%
Finland 0% Portugal +27%
France 0% Spain +15%
Germany -21% Sweden +4%
Greece +25% United Kingdom -12.5%
Ireland +13%
European -8%
Community
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Kyoto Protocol
Doesn’t tackle India-China problem:
• Large fraction of world population
Historically low per-capita emissions
Very few “grandfathered” permits
Problems is not theirs but of developed world
Could not stabilize emissions without radically new
technologies
India / China has no incentive to join
• Without participation by China / India
Kyoto Protocol will not come close to solving the
problem so other countries have little incentive to join.
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An Agreement on GHGs
Developed world
• lead in development of new technologies
• might be sufficient to bring developing countries
on board
Clean coal technologies
• China could use all of its coal, as could India
• This would be of immense value to them.
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An Agreement on GHGs
China’s dilemma:
• burning coal generates terrible pollution
domestic political issue.
• Switch away from coal will increase energy costs
Development of clean coal technologies
• valuable to China (reduces other pollution)
• should encourage China and India to participate
in an agreement to reduce GHGs
• understanding that tight standards would only
apply once a new technology were in place.
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