INTRODUCTION

The objective of welfare economics is the evaluation of

social desirability of alternative economic states.
It is not always possible to prescribe a unique method
for selection of the alternative states.
Two choices;
1 - Unambiguous welfare improvement is
possible .Some individuals are better and no one is
worse. Efficient allocation of resources is present.
2 -Proposed social changes improve a lot of some and
deteriorates a lot of others . Interpersonal comparison of
utilities is needed .
Different types of assumption is needed and broader
class of situations should be analyzed.

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Pareto Optimality
A situation is Pareto optimal if production and consumption can not be reorganized to
increase the utility of one or more individuals without decreasing the utility of
others.
No situation can be Pareto optimal unless all possible movement of this variety have
been made.
P. O. FOR CONSUMPTION
A distribution of consumer goods is P. O. if every possible reallocation of goods that
increases the utility of one or more consumers would result in a utility reduction of
at least one other.
Max u1=u1(q11 ,q12)
S.T. u2(q21 , q22) = u20
q11+q21 =q10
q12 +q22=q20
U1* = u1(q11 , q12) + λ[u2( q10 – q11 ,, q20 – q12 ) – u20 ]
∂u1*/∂q11 = ∂u1/∂q11 - λ ( ∂u2/∂q21 ) =0
∂u1*/∂q12 = ∂u1/∂q12 - λ ( ∂u2/∂q22 ) =0
∂u1*/∂λ = u2(q10 – q11 ,, q20 – q22) – u20 = 0

H & Q WELFARE ECONOMICS 2

Pareto Optimality

(∂u1/∂q11) /(∂u1/∂q12)= (∂u2/∂q21) /(∂u1/∂q22)

MRS121 = MRS122 marginal rate of substitutions is required

q21
O2
A
q12 q22
N
M
MN : locus of efficient
points on contract curve
AMN ; efficiency area
ََ

O1 q11
H & Q WELFARE ECONOMICS 3
 Pareto Optimality
Pareto Optimality for production
Pareto optimality among producers requires that the output level of each consumer
goods be at a maximum given the output level of all other consumer goods.
Max q1 = f1(x 11 , x12)
S.T. f2( x21,x22)=q20
x11+x21 =x10
x12+x22=x20
L= f1 (x11 , x12) + λ [ f2 (x10 – x11 , x20 – x12 ) - q 20 ]
∂L/∂x11= ∂f1/ ∂x11 - λ∂ f2/∂x21 = 0
∂L/∂x12= ∂f1/ ∂x12 - λ∂ f2/∂x22 = 0
∂L/∂λ=f2 (x10 – x11 , x20 – x12 ) - q 20=0
(∂f1/ ∂x11)( ∂f1/ ∂x12)= (∂ f2/∂x21) (f2/∂x22 ),
RTS1x1,x2 =RTS2x1,x2
Rate of technical substitution of inputs in the production of each output must be equal to each other to
achieve Pareto optimality.

H & Q WELFARE ECONOMICS 4

 Pareto Optimality
Pareto Optimality in general
Each consumer consumes all produced goods, each producer uses all primary
factors and produces all goods.
Number of consumers = m Number of producers or firms= N
Number of produced goods = S Number of primary factors = n
ui = ui(qi1* ,,,, qis* , xi10 – xi1* ,,,, xin0 – xin*)
qin* ; commodity qn consumed by ith consumer .
x in0 ; fixed endowment of primary factor ,n, for consumer , i .
xin* = supply of n th primary factor to the production sector by i th consumer
(xin0 – xin*) ; amount of n th primary factor consumed by i th consumer .
Fh(qh1,…qhs,, xh1,…xhn ) =0 firm h (h=1,2…N) producing S produced goods using n
primary factor )
Σi=1m xij * = Σh=1 N xhj [i=1,2,…m consumer j=primary factor]
Σi=1m xij * = Primary factor j supplied by m consumers =Primary factors demanded
by N firms = Σh=1 N xhj
Σi=1m qik* = Σh=1N qhk
Σi=1m qik* = aggregate consumption of commodity k by m consumers = aggregate
production of k by N firms = Σh=1N qhk

H & Q WELFARE ECONOMICS 5

 Pareto Optimality
Z = u1(q11*, …q1s*, x110 – x11*,,,, x1n0 – x1n* ) + Σi=2m λi [ui(qi1* ,,, qis* ,
xi10-xi1* ,,, xin0 – xin*) – ui0] + Σh=1N θh Fh(qh1 , qhs , xh1,,,xhn) +
Σj=1nψi(Σi=1m xi j* - Σh=1N xhj ) + Σk=1sσk(Σh=1N qhk - Σi=1m qik*)

∂z/∂q1k* = ∂u1/∂q1k * - σk = 0 k=1,2,,,,,,,s commodity

∂z/∂qi k* = λi∂ui/∂qik * - σk = 0 i=2,3,, …m consumer
∂z/∂qh k = θh ∂ Fh /∂qh k + σk =0 h=1,2,….N firm
∂z/∂x1j* = - ∂u1/∂(x1j0 – x1j*)+ψj = 0 j=1,2,3….n primary factor
∂z/∂xi j* = -λi∂ui /∂(xij0 – xij*)+ψj = 0 i=2,3,, …m consumer
∂z/∂xhj =θhσFh/∂xhj - ψj = 0

(I) σj/σk = (∂u1/∂q1j *)/ (∂u1/∂q1k *)=…. (∂um/∂qmj *)/ (∂um/∂qmk *)=
(∂F1/∂q1j )/ (∂ F1/∂q1k)=…(∂ FN/∂qNj)/ (∂ FN/∂qNk) j , k = 1,2,3….s

MRS for all consumers and RPT for all producers should be equal for every pair
of produced goods.

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 Pareto Optimality
(II) ψj/ψk=[∂u1/∂(x1j0 – x1j*)] / [∂u1/∂(x1k 0 – x1k *)] = …… =
[∂um/∂(xmj0 – xmj*)]/[∂um/∂(xmk 0 – xmk *)] = (∂F1/∂x1j) / (∂F1/∂x1k)…….=
(∂FN /∂xNj) / (∂FN/∂xNk) j,k= 1,2,3…….n

MRS of all consumers and RTS for all producers must be equal for every pair of
primary factors.

(III) ψj/σk = [∂u1/∂(x1j0 – x1j*)]/( ∂u1/∂q1k *)= …………

[∂um /∂(xmj0–xmj*)]/(∂um//∂qmk*)=-(∂F1/∂x1j)/(∂F1/∂q1k)…=
-(∂FN/∂xNj)/(∂FN/∂qNk) j=1,2….n k=1,2,….s

MRS of consumers between primary factors and commodities must equal the
corresponding producers rates of transforming factors into commodities (their
marginal productivities),
(I) , (II) , (III), will explain the Pareto-Optimal conditions . It is not possible to
increase the utility of one or more consumer without diminishing the utility of
others by reallocation of factors of production among the production of
commodities.

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 THE EFFICINCY OF PERFECT COMPETITION
Ψj(j=1,2,3…n) and σk(k=1,2,3…s) are efficiency prices . Pareto optimality will be
achieved if consumers and producers adjust their rates of substitution to efficiency
prices , which we will see in the perfect competition case .
THE EFFICINCY OF PERFECT COMPETITION
All prices are fixed for all consumers and producers. Nobody could influence the
market.
MRSkj=MUj/MUk=Pj /Pk ⇒ j,k are primary factors or commodities for consumer
consumption .
RPTkj =(∂Fi/∂qij)/ (∂Fi/∂qik)=Pj/Pk ⇒ j,k are outputs of firm i .
RTSkj =(∂Fi/∂xij)/ (∂Fi/∂xik)=Pj/Pk ⇒ j,k are factors of production for firm i.
MPjk=Pj/Pk ⇒ Pk MPjk=Pj ⇒ price of input j is equal to its VMP in
producing output k
Comparison of the four above relation shows that the condition of Pareto-Optimality is
satisfied. Perfect competition is sufficient for Pareto-Optimalty.
RPTkj =MCj/MCk = (Pi/MPij)/ (Pi/MPik) = (Mpik) / (Mpij) , k&j are inputs. i is output.
MCj/MCk = Pj/Pk = MRSkj → MRSkj = RPTkj
i is input and j and k are outputs and VMPji = VMPKi
If prices were not equal to marginal cost , the above relation could hold if prices were
proportional to marginal cost.

8
H & Q WELFARE ECONOMICS
 THE EFFICINCY OF PERFECT COMPETITION

Pj =θMCj = θ(Pi/MPij) MRSij = Pi/Pj = 1/θMPij=(1/θ)RPTij

Pk =θMCk = θ(Pi/MPik) MRSik= Pi/Pk = 1/θMPik =(1/θ)RPTik
As it is seen MRSij≠RPTij and MRSik≠RPTik but
MCj/MCk=MRSjk = RPTjk
MRS and RPT between two commodities are the same , but MRS and
RPT between factors and commodities are not the same .
Perfect competition represent a welfare optimum in the sense that of
fulfilling the requirements for Pareto Optimality, unless one or more
of the assumptions of perfect competition are violated.
Violation of the perfect competition assumptions results in the relevant
equalities of rates of transformation and rates of substitutions not to
hold .
If one or more of the consumers are satiated the marginal utility of the
satiated commodity is zero. So transformation to other non satiated
consumer will increase his utility without decreasing the utility of the
first one.

H & Q WELFARE ECONOMICS 9

 The efficiency of imperfect competition
The efficiency of imperfect competition in consumption (monoposony)
Imperfect competition will exist if one or more consumers are unable
to buy as much as of a commodity without noticeably affecting its
prices. In his case consumer 1 has monopsony power over buying
q1
u1=u1(q11 , q12 , x10 – x1) , xi =factor of production supplied by
consumer i , i=1,2
u2=u1(q21 , q22 , x20 – x2) ,qij=jth commodity consumption for
consumer i , i,j = 1,2
P1=g(q1) g’(q1) > 0 q1=q11+q21
rx1 – g(q1)q11 –p2q12 = 0 budget constraint for the first
consumer
rx2 – g(q1)q21 – p2q22 =0 budget constraint for the second
consumer
Utility maximization for each consumer;
Max L1 = u1(q11,q12 ,x10 – x1)+λ1[rx1 – g(q1)q11 – p2q12]
Max L2 = u2 (q21,q22 ,x20 – x2)+λ2 [rx2 – g(q1)q21 – p2q22]
H & Q WELFARE ECONOMICS 10
 The efficiency of imperfect
competition
∂ ui/∂qi1 – λi[p1 + qi1g’(p1)] =0 ith consumer i= 1,2
∂ ui/∂qi2 – λi p2 =0
-∂ui/∂(xi0 – xi) +λir = 0
rxi – g(q1)qi1 – p2qi2=0
(∂ui/∂qi1)/(∂ui/∂qi2)=[p1 + qi1g’(q1)]/p2 = p1/p2 + qi1g’(q1)]/p2
(∂ui/∂qi1)/[∂ui/∂(xi0 - xi)]=[p1 + qi1g’(q1)] / r = p1/r + qi1g’(q1)]/r
if q11 ≠ q21 , the marginal costs of q1differ(price of q1 for
consumers) differ for the consumers ,and their MRS differ and
the allocation of q1 and q2 , between them is Non-Pareto
Optimal.
If q11=q21 their MRS are equal but differ from the RPT and
marginal product of producers which are equal to price ratios h .

H & Q WELFARE ECONOMICS 11

The efficiency of imperfect competition
Imperfect competition in commodity market (monopoly )
Single commodity q with fixed price equal to p
Single factor x with fixed price equal to r
MRS xq = r/p = MPxq = RPTx =P. O. Condition ;
In perfect competition ;
Consumers will satisfy the equality of MRS=r/p .
Producers will satisfy the equality of r=VMP=P MP xq
If one or more producers fail to satisfy the above relationship ( for example
( r=MRP=MR× MP ) then the resultant allocation will be Pareto Non-
Optimal.
Monopolist equates MR=MC ; Pareto Non Optimal
Discriminating monopolist equates MC to marginal price ;
Only If r and P could be interoperated as marginal price for both consumers
and producers , then Pareto Optimality could be achieved under
discriminating monopoly .
In perfect competition both buyer and seller gain from trade but in
discriminating monopoly all gains are absorbed by seller . The income
distribution which result from these two kinds of organizations are
quite different , but they are both Pareto Optimal.

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 The efficiency of imperfect competition
The revenue maximizing monopoly maximizes her sale’s revenue
subject to the condition that her profit is equal or exceed a minimum
acceptable level. The revenue maximizing monopolist would satisfy the
equality of P= r/MP =MC if ;
her minimum acceptable profit equated the profit that is earned
at an output for which price equals MC and MC is increasing , and
her MR were nonnegative at this point .
Duopoly and oligopoly will normally result in Pareto Non Optimal
allocation of resources .

Imperfect competition in factor market.

Consider a factor market in which the seller of the commodity behave
as perfect competitors selling his commodity with a price equal to p . If
each buyer of the input equates the value of marginal product to factor
price ( r= P MP) the P.O. condition will be fulfilled. Since RPT xq or MPxq
will be the same for all producers.
If one or more buyer fail to satisfy the above relationship the resultant
allocation will be Non Pareto-Optimal.
H & Q WELFARE ECONOMICS 13
 The efficiency of imperfect
competition
If one or more buyer fail to satisfy the above relationship the resultant
allocation will be Pareto-Non-Optimal. Nearly all theories of duopsony and
oligopsony involve equating the value of MP to some form of marginal input
cost, and thereby violate MP= r/P
The efficiency of bilateral monopoly
The specific outcome of the case of monopolistic buyer and monopolistic seller
depends upon the relative strength of the participants in bargaining
process.
Input and output level will be identical to perfect competition if monopolist and
monopsonist maximizing their joint profit. The resultant allocation is Pareto
Optimal and the distribution of their joint profit is immaterial from the view
point of Pareto-Optimality.
External effects in consumption and production
Interdependent utility function ;
u1 = u1(q11, q12, q21, q22) q11 + q21 = q10
u2 = u2 (q21, q22 ,q 11, q12) q12 + q22 = q20
u1*= u1(q11, q12, q10 – q11 , q20 – q12) +λ[ u2 (q10 – q11 , q20 – q12 , q11, q12, )– u20 ]

H & Q WELFARE ECONOMICS 14

 External effects in consumption and
production
∂u1* / ∂q11 = ∂u1/∂q11 - ∂u1/∂q21 +λ[∂u2/∂q11 - ∂ u2/∂q21]=0
∂u1* / ∂q12 = ∂u1/∂q12 - ∂u1/∂q22 +λ[∂u2/∂q12 - ∂ u2/∂q22]=0
∂u1*/ ∂λ = u2 (q10 – q11 , q20 – q12 ,q11, q12, ) – u20 = 0
[∂u1/∂q11 - ∂u1/∂q21] / [∂u1/∂q12 - ∂u1/∂q22] =
[∂u2/∂q11 - ∂u2 /∂q21] / [∂u2/∂q12 - ∂u2/∂q22]

Pareto Optimal conditions differ from perfect competition in which MRS of the consumers
should be the same. As it is seen MRS optimal position of each consumer depends upon
the consumption of the other one. Suppose that the only externality present is ∂u2/∂q11<0 ;
P.O. conditions = [∂u1/∂q11 ]/[∂u1/∂q12]=[∂u2/∂q11 - ∂u2 /∂q21]/[ - ∂u2/∂q22] =
∂u2 /∂q21/ ∂u2/∂q22 - ∂u2/∂q11 / ∂u2/∂q22
As it is seen in the absence of externality the MRS of the second consumer will be greater.
Diagrammatically it can be shown that the equality of MRS’s does not ensure the Pareto
Optimality.

H & Q WELFARE ECONOMICS 15

 External effects in consumption and production
Decrease in consumption of q1 by the first consumer has positive
effect on the utility of second consumer
Following relation should always hold
Because of interdependent utility function
q11 + q21 = q10
if q11 decrease, u2 increases , ∂u2/∂q11 <0
q12 + q22 = q 2
0

90
u2
q12 u1 MRSA=MRSF 80
q22
100 110
A & F not P .O .

2 moves from F to D
1 moves from A to C
F
AB=ED
uc = u A C D
BC=FE E
B A uD>uF
q11
q21
A= consumption point of the first consumer F = consumption point of the second consumer
H & Q WELFARE ECONOMICS 16
 External effects in consumption
and production
Public goods ;
Two main characteristics;
1- Non – rivality ; no one’s satisfaction is diminished by the satisfaction gained by the
others.
2-Non-exclusivity; it is not possible for anyone to appropriate a public good for her own
personal use as in the case with private goods.
Suppose that there are two consumers (u 1, u2) , one public good (q2) , one private good
(q1) , and one primary factor (x) .
Z= u1(q11 ,q2, x10 – x1) + λ[u2(q21 , q2 , x20 – x2) – u20)] + θF(q1 ,q2 ,x) +
ψ[x1 + x2 – x) + σ(q1 –q11 – q21)
∂z/∂q11 = ∂u1/∂q11 – σ = 0
∂z/∂q21 =λ∂u2 /∂q21 – σ = 0
∂z/∂x1= - ∂u1/∂(x10 – x1)+ ψ =0
∂z/∂x2= - λ∂u2 /∂(x20 – x2) +ψ =0
∂z/∂q2 =∂u1/∂q2 + λ∂u2/∂q2 + θ∂F/∂q2 = 0
∂z/∂q1 = θ∂F/∂q1 + σ = 0
∂z/∂x = θ∂F/∂x - ψ = 0
From the above seven equations we could derive the following relations ;

H & Q WELFARE ECONOMICS 17

External effects in consumption
and production
[∂u1/∂q2] / [∂u1/∂q11]+ [∂u2/∂q2] / [∂u2/∂q21] = [∂F/∂q2] / [∂F/∂q1]
MRS1 q1q2 + MRS2 q1q2 = RPT q1q2 (I)
vertical summation of the demand curve = opportunity cost
[∂u1/∂q2]/[∂u1/∂(x10 – x1) ]+ [∂u2/∂q2]/[∂u2/∂(x20 – x2) ] = [∂F/∂q2] / [∂F/∂x]
MRS1xq2 + MRS2xq2=1/(MPq2x) (II)
ψ/σ=[∂u1/∂(x10–x1)]/[∂u1/∂q11]+[∂u2/∂(x20–x2)]/[∂u2 /∂q21]=[∂F/∂x]/ [∂F/∂q1]
MRS1xq1 + MRS2xq1=(MPq1x)= ∂q1/∂x (III)
Lindal Equilibrium
Public goods can not be sold and purchased in the market in the same
way as ordinary goods.
However it is possible to design a scheme that result in equilibrium in a
“pseudo market “ for public goods.

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 External effects in consumption and
production
u1 = u1(q11 , q2) u2 = u2(q21 , q2)
F(q1 , q2) = x0 x0 = x10 + x20
q1 private good q2 public good
p1 price of commodity q1
p2 price received by producer per unit of public good.
αp2 price paid by consumer I per unit of public good .
(1- α)p2 price paid by consumer II per unit of public good.
price of primary factor (x) =1
p1q11 + αp2q2 = x10 budget constraint first consumer .
p1q21 + (1 – α)p2q2 = x20 budget constraint second consumer .
MRS (for each consumer ) = price ratio ( for each consumer )
αp2/p1 = (∂u1/∂q2)/ (∂u1/∂q11 ) = MRSI I
(1 – α)p2/p1 = (∂u2/∂q2)/ (∂u2/∂q21) = MRSII II
(I+II) =αp2/p1+(1 – α)p2/p1=p2/p1=(∂u1/∂q2)/ (∂u1/∂q11)+(∂u2/∂q2)/(∂u2/∂q21)= MRSI +
MRSII )=p2 / p1
RPT q1q2 (for producer) =(∂F/∂q2)/(∂F/∂q1= MC2 / MC1 = P2 / P1 = ratio for
producer
RPT q1q2 = MRSI + MRSII Pareto Optimal

H & Q WELFARE ECONOMICS 19

 External effects in consumption
and production
F(q1 , q2) = x0
p1q11 + αp2q2 = x10
p1q21 + (1 – α)p2q2 = x20
αp2/p1 = (∂u1/∂q2)/ (∂u1/∂q11 )
(1 – α)p2/p1 = (∂u2/∂q2)/ (∂u2/∂q21)
(∂F/∂q2)/(∂F/∂q1)=p2/p1
q1 = q11 + q21
7 equations and 7 unkowns
q1* , q2* , q11* , q21* , p1* , p2* , α* Lindal equilibrium values
An alternative way;
f11(p1 , αp2) DEMAND FUNCTONS
f12(p1 , αp2) DERIVED FROM UTILITY MAXIMIZATION
f21(p1 ,(1- α)p2)
f22(p1 ,(1- α)p2)
H & Q WELFARE ECONOMICS 20
 External effects in consumption and
production
g1(p1, p2) producer supply functions derived from profit maximization
g2(p1, p2)

f11(p1 , αp2)+ f21(p1 ,(1- α)p2) = g1(p1, p2) (private ) demand = supply
f12(p1 , αp2)= f22(p1 ,(1- α)p2) = g2(p1, p2) (public) for each good

f12(p1 , αp2) = g2(p1, p2) each consumer demands all of the

f22(p1 ,(1- α)p2) = g2(p1, p2) the public good

f11(p1 , αp2)+ f21(p1 ,(1- α)p2) = g1(p1, p2)

f12(p1 , αp2) = g2(p1, p2)
f22(p1 ,(1- α)p2) = g2(p1, p2)
three equations and three unknowns p1 , p2 , α
as it is seen a “Pesudo market” is designed for the public good and its price in this
imaginary market could be determined which approximately might show the MRS of
the consumers .

H & Q WELFARE ECONOMICS 21

External effects in consumption and production
External economies and diseconomies
Marginal price criterion is necessary for Pareto Optimality in the producing sector . The
equality of price and marginal cost for all commodities and firms ( in perfect
competition situation) implies that the corresponding RPT of different firms are the same.
RPT measures the opportunity cost or the real sacrifice in terms of opportunity foregone.
The opportunity cost is the same from the private and social point of view in the absence
of externality.
externality
Assume that there are two firms with the following cost functions;
C1=C1(q1 , q2) , C2=C2(q1 , q2 )
If each firm maximize its profit individually;
p=∂c1/∂q1 p=∂c2/∂q2
The profit of each firm depends upon the output level of the others, but neither can affect
the output of other and thus each firm maximizes its profit with respect to the variables
under his control.

Individual profit maximization requires that ;

P = MCP or price equal to private marginal cost (∂ci / ∂qi) and S.O.C implies that private
marginal cost should be increasing.

H & Q WELFARE ECONOMICS 22

 External effects in consumption and
production
In order to obtain Pareto Optimality , one must maximizes the
entrepreneur's joint profits on the assumption that neither can
influence price.
Π= Π1+Π2= p(q1+q2) – c1(q1,q2) – c2(q1 , q2)
∂Π/∂q1 = p - ∂c1/∂q1 - ∂c 2/∂q1 = 0
∂Π/∂q 2 = p - ∂c1/∂q2 - ∂c2/∂q2 = 0

The second order condition requires that the principle minor of the
relevant hassian matrix alternate in sign;
- ∂2c1/∂q12 - ∂2c2/∂q12 0 - ∂2c1/∂q1 ∂q2 - ∂2c2/∂q1 ∂q2
>0
- ∂2c1/∂q1 ∂q2 - ∂2c2/∂q1 ∂q2 - ∂2c1/∂q2 2 - ∂2c2/∂q22

Individual profit maximization requires that ;

P = MCP or price equal to private marginal cost (∂ci / ∂qi) and S.O.C
implies that private marginal cost should be increasing.

H & Q WELFARE ECONOMICS 23

External effects in consumption and
production
Pareto Optimality requires that price equal to social marginal cost for each
entrepreneur ;
p = ∂c1/∂q1 + ∂c 2/∂q1
p = ∂c2/∂q2 + ∂c1/∂q2

The S O C implies that private marginal cost of each entrepreneur should be

increasing .
Suppose that ∂c1/∂q2 <0 , and ∂c 2/∂q1>0 , since p >0 and each social
marginal cost is greater than zero so ;
p = ∂c1/∂q1 + ∂c 2/∂q1>0 , ∂c1/∂q1>0 , ∂c 2/∂q1>0 , p> ∂c1/∂q1 So

∂c1/∂q1 is greater than social optimum when firm is maximizing its profit
individually. Because when the firm 1 is maximizing its profit individually she
will equate price to marginal cost ( P= ∂c1/∂q1 ) .Consequently the firm will
produce more than optimal when maximizing his profit individually.
If [∂c2/∂q2 ]>0 , and there is external economies , ∂c 1 /∂q2 < 0 then ;
[∂c2/∂q2 ]social > [∂c2/∂q2 ] ]individual and q social > q individual ,
with the same reasoning , firm 2 which is the cause of externality will produce
less than optimal when maximizing his profit individually.
H & Q WELFARE ECONOMICS 24
 External effects in consumption
and production
Example ;
C1= 0.1 q12 + 5q1 – 0.1 q22
C2= 0.025 q12 + 7q 2 + 0.2 q22
p=15
individual profit maximization ; p=MC
15 = 0.2 q1 +5 q1=50 Π1=290 q2 is fixed
15 = 0.4 q2 +7 q 2=20 Π 2=17.5 q1 is fixed
Pareto Optimality ;
Π = 15(q 1 + q 2 ) – 0.125 q 12 – 5 q1 – 0.1 q22 – 7 q 2
∂Π/∂q 1 = 15 – 0.25q 1 - 5 =0
∂Π/∂q 2= 15 – 0.2q 2 - 7 =0
q1 = q 2 = 40 , Π = Π 1 + Π 2 = 400 + (- 40 ) = 360>290+17.5 = 307.5
In the presence of externality individual maximization of profit results in
the fulfillment of socially wrong or irrelevant marginal conditions .
H & Q WELFARE ECONOMICS 25
 External effects in consumption
and production
After these two firms agree to produce 40 each , aggregate profit have
to be redistributed among the individual firms.
Without such redistribution , some firms would experience a diminution
in their profit , and the resulting position could not said to be socially
preferable. In the above example 400 is the profit of the first one
and - 40 is the profit of the second one as the result of the joint
maximization .

A redistribution of any amount grater than 57.5 ( 40 +17.5 ) and less

than 110 ( 400 -290 ) from one to two will leave each better off
under social maximization .

H & Q WELFARE ECONOMICS 26

 Taxes and Subsidies
Usually market economies deviates from the marginal
conditions necessary for Pareto optimality.
Such economies could be led to Pareto Optimality through
imposition of the appropriate taxes and subsidies .
Per unit taxes ( or subsidies ) will decrease ( increase) the
level of consumption or production activities by changing
their marginal cost.
Lump sum taxes or subsidies which do not affect activity
levels , may be used to distribute the gains from a
movement to a Pareto Optimal allocation.
The achievement of Pareto Optimality through taxation is
illustrated for the two specific cases; external effect in
production and monopoly.
External effect in production

If external effects are present , Pareto Optimality could be

achieved by imposing unit subsides and taxes ;
H & Q WELFARE ECONOMICS 27
 Taxes and Subsidies
Suppose that there are two firms 1 and 2 with the following cost function
producing output q ;
C1= 0.1 q12 + 5q1 – 0.1 q22
C2= 0.2 q22 + 7q2 + 0.025 q12 qi = output of the firm i
p= 15 price of q .
Pareto Optimality requires that joint profit be maximized ;
Π=Π1+Π2=15 q1–(0.1 q12 + 5q1 – 0.1 q22)+15q2–(0.2q22 + 7q2 + 0.025q12)
∂ Π/ ∂q1 = 0.25 q1 +5 =15 q1* = 40 Π1* = 400
∂ Π/ ∂q2 = 0.20 q2 +7 =15 q2 * = 40 Π2 * = - 40

In order to reach the parteo optimality a tax of t dollars per unit be imposed
on the output of firm 1 and a subsidy of s dollars per unit be imposed on
the output of firm 2 so that with their individual profit maximization they
produce the quantities equal to Pareto Optimal situation.
Equating price (p=15) to private marginal cost for each firm and substituting
the quantity equal to 40 for each firm (q1=q2=40 )would result Pareto
Optimality ;
(0.2 q1 + 5 + t ) =15
(0.4 q2 + 7 – s) = 15 t =2 s= 8
H & Q WELFARE ECONOMICS 28
 Taxes and Subsidies
In order to leave the profit level unchanged a lump sum taxes of L 1 and L2 could be
imposed on firm one and two as follows ;

L1 = Π1* - Π10 – tq1*= 400 – 290 - (2 )(40) = 30

L2 = Π2* - Π20 +sq2*= - 40 – 17.5+(8)(40)=262.5
Πi* = optimal profit for firm i (when total profit is maximized)
Πi0 = profit of firm i when doing private marginal cost pricing .
q1*=q2* = 40 optimal quantity which should be produced by each firm
Lump sum tax of 30 on firm 1 and 262.5 on firm 2 , with per unit tax of 2 on firm one
and per unit subsidy of 8 on firm 2 will remain the profit level of each firm unchanged
(under private maximization) and their quantity level on the optimal level.

Since profit remains unchanged , the utility level of those who receive the profit remains
unchanged by the move to Pareto Optimality , a net tax of this policy is called the
social dividend and can be defined as follows;
S= tq1* - sq2* + L1 + L2 =(2)(40)-(8)(40)+30+262.5= 52.5
This net tax could be used to increase the utility of one or more members of society.
We should note that we have not touched the notion of equity . Only the
efficiency criterion is taken into account

H & Q WELFARE ECONOMICS 29

 Taxes and Subsidies
Monopoly

P=f(q) monopolistic demand function

C=C(q) monopolistic cost function .
MC = MR , [p+qf ’(q) = c’(q)] . P0 and q0 .

But Pareto Optimality achieved when P= MC . A per unit subsidy

could increase the monopolist marginal revenue and may be used
to induce her to expand her output to Pareto Optimality level.

In the case of per unit subsidy the marginal revenue would increase by
the amount of per unit subsidy. So the amount of subsidy could be
determined in such a way to reach the optimal amount of output
when marginal revenue is equated to marginal cost.

It could be seen in the following figure ;

H & Q WELFARE ECONOMICS 30

 Taxes and Subsidies
p

MC MR= p* + q* f ’ (q*)
MR’ = p* + q* f ’ (q*) + s
S= AC
E
p0
MC =C’ (q*) = p* + q* f ’ (q*) + s
p* A
Total subsidy = P*ACF
B As a result of subsidy,
production goes up from q0 to q*
D
F C MR’
MR
q
q0 q*

H & Q WELFARE ECONOMICS 31

 Taxes and Subsidies
As it can be seen from the figure , monopolist profit reduction ( not
taking in to account the subsidy )equals to cost increment for
moving from q0 to q* minus revenue increment for moving fromq0 to
q*. Equal to the area CAB .
SCAB = ∫q0 q* [ f (q) +q f ’(q) – C ’(q) ] dq= ∫q0 q* [ MR-MC] dq , therefore ;
Subsidy value (Sp*ACF) > profit reduction value (SCAB).
A lump sum tax equal to the difference of subsidy and profit reduction
will leave the monopolist profit as its initial level.
Lump sum tax = LM = Subsidy (Sp*ACF) - profit reduction (SCAB)= SFCBAP*
Assume that the income elasticity of demand for commodity under
consideration is zero for every consumer, (compensated demand),
the area under the demand curve from q0 to q* gives the amount
the consumers are willing to pay while retaining the utility level that
they achieved under the monopoly .

H & Q WELFARE ECONOMICS 32

 Taxes and Subsidies
The corresponding area under the MR curve gives the amount that
they actually pay for a move from q0 to q* . The area that lies
between the demand and MR curves is the total of lump sum taxes
(Lc) that can be collected from consumers leaving them at their initial
levels ;
Lc= ∫q0q* [ P – MR] dq= ∫q0q* [ -q f ’(q) ] dq= SBCAE
corresponding social dividend is the net tax collected from consumers
and producers.
S= LC (S BCAE) +LM (SFCBAP*) - sq*(SFCAP*) = S BAE = dead weight lost
As it is seen the social dividend is positive , so dead weight lost.

H & Q WELFARE ECONOMICS 33

 Social Welfare Function
Main question ; whether a change from which some individuals gain and some loose is
desirable or not . Pareto optimality is not sufficient for this purpose. Social welfare
function is needed .
Social welfare function is a function of the utility level of all individuals.
w = w (u1 ‘ u2 , u3 , … , un )
Social welfare function may be an ordinal index while individual utilities must be cardinal.
The form of the social welfare function is not unique.
Social preferences and social indifference locus
In an effort to create a social analog to individual indifference curves economist have tried
to find the combination of commodities among which society as a whole is indifferent .
Scitovsky contours are derived in such away as will be mentioned in the followings ;
In a two persons two commodities world , what is the minimum amount of q1 which can be
distributed among the consumers given the utility level of each consumer and amount
of other commodity q2 .

H & Q WELFARE ECONOMICS 34

 Social Welfare Function
Min q11 + q21 = q1
s.t. U1(q11 , q12 ) = u10
u2( q21 , q22 ) = u20
q12 + q22 = q20
V= q11 + q12 + λ1[u1(q11,q12) – u10] + λ2[u2(q21 ,q20 – q12) – u20]
Vq11 =0 , 1+λ1 [∂u1(q11,q12)/∂q11] =0
Vq21 =0 , 1 +λ2 [∂u2(q21 , q20 – q12)/∂q21] =0
Vq12 = 0 , λ1 ∂u1(q11,q12)/∂q12 = 0
Vλ1 =0 , u1(q11 , q12) - u10 = 0
Vλ2 =0 , u2(q21 , q20 – q12) - u20 = 0
As it could be seen from first order condition , for each level of q 20 we
could find one level for q10(= q110 + q210). The locus of q10 and q20
form the Scitovsky contour . If the utilities are convex then the
Scitovsky contour is also convex. But it should be mentioned that
these contours are not social indifference curves .

H & Q WELFARE ECONOMICS 35

 Social Welfare Function
For each pair level of (u1 , u2) , a Scitovsky contour could be found .
These contours might intersect each other or even may coincide
with each other. Nothing is said to indicate that a pair of individual
utilities which satisfies a contour do not satisfy the other one

q2 S2(u11, u21)

Scitovsky contour

S1(u10,u20)

q1

H & Q WELFARE ECONOMICS 36

 Social Welfare Function
Intersecting the social indifference curves can be eliminated through
the introduction of welfare function and optimization as follows ;
If w=w(u1, u2) defines the social welfare function , find all the Scitovsky
contours corresponding to all distributions of utilities (u 1 , u2) , for
which w(u1 , u2) =w0 . These are shown in the following figure;

q2
s3[w=w0]

S2[w=w0]
w=wo
S1[w=w0]
q1
Bergson contour
H & Q WELFARE ECONOMICS 37
 Social Welfare Function
The least ordinate corresponding to any value of q1 represents the minimum
amount of q2 necessary to ensure society the welfare level of w0 . Therefore
the envelope of the locus of minimal combinations of q1 and q2 necessary
to ensure society the welfare level of w0 is called Bergson contour .
the problem of finding the point of maximum welfare can thus be solved in two
equivalent ways;
First; each point on the aggregate transformation function defines a commodity
combination that can be attained with the available resources . If Pareto
Optimality distribution of commodities are considered as a contract curve,
infinite number of ways in which utility can be distributed among consumers
can be found for each point on the aggregate transformation function.
We should find all the possible ways of distributing utilities among consumers
corresponding to all points satisfying the transformation function. From all the
utility distributions we should choose the one for which w(u1, u2, .) is the
maximum . The solution will be found by examining points in the utility space.

H & Q WELFARE ECONOMICS 38

 Social Welfare Function
In this way we will find the optimal bliss point.
O2
q21
u2 1
u21
q2
PPF O1 q11
q2
1
q20 O2
q2
0
O u20 u10

q1
q11 q10 O1 q10
u1

u10 O
W=W(u1 ,u2) = social welfare function

UPF(q10,q20)
u20 u2 UPF(q11, q21)
H & Q WELFARE ECONOMICS 39
 Social Welfare Function
Second; first we should determine all Bergson contours. Each of these
contours corresponds to a different welfare level . Then we should
choose on the aggregate production possibility frontier the point
which corresponds to the highest attainable Bergson contour .
q1 B[Ιq1 , q2 Ιw=w1 (u1,u2)]

P.P.F.

0
q10

B[Ιq1 , q2 Ιw=w0(u1,u2)]
q2
q20

H & Q WELFARE ECONOMICS 40

 Social Welfare Function
Both of these alternatives are equivalent to maximize w(u 1, u2) subject to the production and
consumption constraint .
Max w=w(u1, u2,)
s.t. U1= u1(q11 , q12 , x10 - x1) q11 + q12 = q1
u2= u2(q21 , q22 , x20 – x2) q21 + q22 = q2
F(q11+q21 , q12+q22 , x1+x2)=0 x1+x2 = x
W * =w[u1(q11, q12 , x10 - x1), u2(q21,q22,x20-x2)]+λF(q11+q21,q12+q22 , x1+x2)
∂w*/∂q11 = w1 ∂u1/∂q11 +λF1=0 [F1 = ∂ F( q11+q21 , q12+q22 , x1+x2 )/ ∂q1]
∂w /∂q12 = w1 ∂u1/∂q12 +λF2 =0
*
[F2 = ∂ F( q11+q21 , q12+q22 , x1+x2 )/ ∂q2]
∂w*/∂q 21 = w2 ∂u2 /∂q 21 +λF1=0 [ F3 = ∂ F( q11+q21 , q12+q22 , x1+x2 )/ ∂x ]
∂w*/∂q 22 = w2 ∂u2 /∂q 22 +λF2=0
∂w*/∂x1 = - w1 ∂u1/∂(x10 – x1) + λF3=0
∂w*/∂x2 = - w2 ∂u2 /∂(x20 – x2) + λF3=0
∂w*/∂λ= F( q11+q21 , q12+q22 , x1+x2 )=0 7 equations 7 unkowns
(∂u1/∂q11 )/ (∂u1/∂q12 )= F1/F2=( ∂u2 /∂q 21 )/( ∂u2 /∂q 22 ) → MRS121=MRS122=RPT12
(∂u1/∂q11 ) / (∂u1/∂(x10 – x1)) =F1 / F3 = (∂u2 /∂q 21 )/ (∂u2 /∂(x20 – x2) ) → MRSx1q11=MRSx2q2 2=MPx
w1 (∂u1/∂q11 ) = w2 (∂u2 /∂q 21 ) = λF1 → social marginal utility of commodity one should be equal for
each consumer .
w1 (∂u1/∂q12 ) = w2( ∂u2 /∂q22 ) = λF2 → social marginal utility of commodity two should be equal for
each consumer

H & Q WELFARE ECONOMICS 41

 Social Welfare Function
Arrow’s Impossibility Theorem
K.J. Arrow has investigated the formation of social preferences . There are many
ways in which social preferences may be formed from individual preferences . For
example it might be determined by dictator , or by majority voting or any other
ordering like soicial convention. Arrow has stated five axioms which he believes
that social preference structure must satisfy to be minimally acceptable .
1- complete ordering
Social ordering must satisfy the conditions of completeness , reflexivity, transitivity .
2- Responsiveness to individual preferences.
A is socially preferable to B for a given set of individual preferences , if individual
ranking change so that one or more individuals raise A to a higher degree and no
one lowers A in a rank. This axiom violates if there were some individuals against
whom society discriminates.
discriminates

H & Q WELFARE ECONOMICS 42

 Social Welfare Function
3- Non imposition .
Social preferences must not be imposed independently of
individual preferences. If no individual prefers B to A
and at least one individual prefers A to B , society must
prefer A to B . This axiom ensures that social
preferences satisfy the Pareto ranking.
4- Non dictatorship
Social preferences must not totally reflect the preferences
of any single individual.
5- Independence of irrelevant alternatives.
The most preferable state in a set of alternatives must be
independent of the existence of other irrelevant
alternatives

H & Q WELFARE ECONOMICS 43

 Social Welfare Function
ARROW ‘ S IMPOSSIBILITY THEOREM states that in general it is not
possible to construct social preferences that satisfy all the above axioms .
Whenever one or more of the above axioms discarded , then it might be
possible to construct a social ordering .
One of famous rules that doest not work with the acceptance of the above five
axioms is the majority rule. suppose that there are three individuals ( A, B
and C )preferences over there states of the world( x1 , x2 , x3 ) ;
individual A individual B individual C
x1 x2 x3
x2 x3 x1
x3 x1 x2
Taking in to account the majority rule ;
1- x3 is preferred to x1
2 - x1 P x2 and x2 P x3 , so by transitivity rule ; x1 P x3 .
But these result contradict with each other . So no clear ordering could be
found . Arrow’s theorem showed that we have to be able to compare the
utility of different individuals in order to find a consistent ordering of social
situations , and form a welfare function .

H & Q WELFARE ECONOMICS 44

 Social Welfare Function
Income distribution and equality
Until recently most economists believed that interpersonal utility comparison
were outside the domain of economic analysis. Consequently they had
nothing or just a little to say about income distribution and equity.
An extreme is provided by Rawl’s principle of social justice which states
that society is no better than it’s worst-off member. So the corresponding
social welfare function should be ; W=Min (u1 , u2 ,.... ,un )
In this way , cardinal and comparable utilities are assumed . Maximization
of the above welfare function results in equal utility levels for all
members of the society in the absence of production h. But we should
notice that some inequality would exist in the society with production
present in the model , if inequality would provide adequate production
incentives.

H & Q WELFARE ECONOMICS 45

 Social Welfare Function
Assume that there is an income of given size y 0 to be distributed among individuals. Let this
income be distributed in such a way to maximize the social welfare function subject to an
aggregate budget constraint.
W = Σi=1n uiα
ui = βi yi
W = Σi=1n βi α yi α
L= Σi=1n βi α yi α + δ ( y0 - Σi=1n yi)
(∂L/∂yi ) = α βi α yi α -1 – δ = 0
(∂L/∂ δ) = y0 - Σi=1n yi = 0
From the first order condition we got (y i/yj) = (βi/βj)α/(1-α)
If the values of β is the same for all individuals , income equality is achieved for any value
of α within the per unit interval. Otherwise ,
As α→0 then (yi/yj) →1 , complete income equality .
As α→1 then (yi/yj) → 0 [if (βi/βj)<1]
As α→1 then (yi/yj) → ∞ [if (βi/βj)>1]
Suppose that u1=2y1 and u2=y2 , then (y1/y2) = 2α/(1-α) . Since y1+y2=y0 , then
y1= [2α/(1-α) ] / [1+ 2α/(1-α) ]y0 , for example if ;
If α=0.75 then individual one receives 89 percent of the total y 0 .
If α=0.5 then individual one receives 67 percent of the total y 0 .

H & Q WELFARE ECONOMICS 46

 Social Welfare Function
Theory of second best
It is quite often that one or more of the Pareto Optimality conditions might
not be satisfied (mainly because of institutional restrictions). When the
first best is not attainable and it is not relevant to inquire whether the
second best position can be attained by satisfying the remaining
Pareto conditions .
What we mean by theory of second best is that is that ; if one or more of
the necessary conditions for Pareto Optimality can not be satisfied , in
general it is neither necessary nor desirable to satisfy the remaining
conditions .
Suppose that we have one consumer , one implicit production function ,
n commodities , fixed supply of primary factors . First best ;
L= u(q1 , q2 , …qn) – λF(q1 , q2 ,…., x0)

H & Q WELFARE ECONOMICS 47

 Social Welfare Function
∂L/∂qi = ui – λFi = 0 i= 1,2,3……n
ui/uj = Fi/Fj i,j = 1,2,3…n → first best result .
suppose that there is institutional constraints such that ; u 1 – kF1=0, k≠λ.
In this manner the second best will be as following ;
L= u(q1 , q2 , …qn) – λF(q1 , q2 ,…., x0) – η(u1 – kF1)
∂L/∂qi = ui – λFi – η(u1i – kF1i)= 0
∂L/∂λ = -F(q1 , .. Qn ,x0) = 0
∂L/∂η = - (u1 – kF1) = 0
ui/uj =[λFi + η(u1i – kF1i) ] / [λFj + η(u1j – kF1j) ]→ second best condition
The theory of second best has been used to question the desirability of
pareto – equilibrium policies that might be used to attain the Pareto
conditions on a piecemeal basis for markets considered in isolation.
The counterargument to this is that although piecemeal policy is not valid
in general, it is valid for many specific cases.
H & Q WELFARE ECONOMICS 48
 Social Welfare Function
For example assume that the commodities are numbered so that
Paretian violation in consumption is limited to qi with i≤h, and
violation in production are limited to qi with i≤k . If utility and
production functions are both weakly separated so that ;
u = u[u1(q1,q2,..qh) , u2(qh+1 ,….qn)] , and
F[F1(q1,q2,q3,….qk), F2(qk+1,…qn, x0)=0
The Paretian conditions hold for all goods with index i ≥ max(h,k) and
piecemeal analysis is valid for these goods.
Proponents of piecemeal policy argue that the Pareto conditions
provide reasonable guidelines for policy for qi unless qi is closely
related to a good for which the Pareto condition is violated.
If η(u1i – kF1i) is quite small , the result of the second best is the same
as the first best. For example policy for locomotive industry should
not be influenced by imperfect competition in the chewing gum
industry .

H & Q WELFARE ECONOMICS 49

 Problems
11-1,
11-1 consider a two person , two-commodity , pure exchange economy with u1 =
q11α q12 , u2 = q21β q22 , q11 + q21 = q10 , q12 + q22 = q20 . Drive the contract curve as
an implicit function of q11 and q12 . What conditions on the coefficients α and β
will ensure that the contract curve is a straight line.
Solution ;
∂u1/∂q11 = αq11α-1q12
∂u1/∂q12 = q11α
∂u2/∂q21=βq21β-1q22
∂u2/∂q22 = q21β
MRS112 = αq11α-1q21 / q11α = αq21 / q11
MRS212 = βq21β-1q22 / q21β = βq22 / q21
MRS112=MRS212 locus of the points on contract curve .
αq12 / q11 = βq22 / q21 → αq12 (q10 – q11) = βq11(q20 – q12)→→
q11q12(β-α) –βq11q20 + αq12q10 = 0
If α=β , then q12q10 = q11 q20 →→ straight line .

H & Q WELFARE ECONOMICS 50

 Problems
11-2 An economy satisfies all the conditions for Pareto-Optimality
except for one producer who is a monopolist in the market for her
output and a monopsonist in the market for her single input that she
uses to produce her output. Her production function is q=0.5 x . The
demand function for her output is p= 100 – 4q , and the supply
function for her input is r = 2 + 2x . Find the value of q , x, p, and r
that maximize the producer’s profit . Find the values for these
variables that would prevail if she satisfied the appropriate Pareto
condition
Solution;
Private profit maximization ;
Π = pq –rx = (100-4q)q – ( 2 + 2x)x= [100 – 4(0.5x)](0.5x) – (2+2x)x
∂Π/∂x = 0 → 48 – 6x = 0 → x=8 , q=4 , p=84 , r=18 .

H & Q WELFARE ECONOMICS 51

 Problems γ
Pareto Optimal condition ;
TC = rx = 2rq , MC = 2r , p=100-4q
P=MC →100 -4q=2r→100–4q= 4+4x=4+8q→q=8 , x=16 , p=68 , r=34
11-3
Consider a two person , two commodity , pure-exchange economy with
u1=q11αq12q21γq22δ , u2 = q21βq22 , q11+q21=q10 , q12+q22=q20 . Derive the
contract curve of Pareto optimal allocations as an implicit function q11 and
q12 . How this does differ from the contract curve for Exercise 11-1 . Under
what conditions will the two curves be identical.
Solution
u1= q11αq12(q10 – q11)γ(q20 - q12)δ
∂u1/∂q11 = αq11α-1q12 (q10–q11)γ(q20 -q12)δ – γ (q10–q11)γ-1q11αq12(q20 - q12)δ
∂u1/∂q12 =q11α(q10 – q11)γ(q20 - q12)δ -δ(q20 - q12)δ-1 q11αq12(q10 – q11)γ

H & Q WELFARE ECONOMICS 52

 Problems
MRS121 = { [α(q10-q11)-q11] / γ (q10-q11)q11} / {(q20-q12-δq12)/(q20-q12) }
∂u2/∂q21 = βq21β-1q22
∂u2/∂q22 = q21β
MRS122 = βq21β-1q22/q21β = βq22/q21= β (q20 – q12) /q21
MRS121 = MRS122 →
If δ=γ=0 , there will not be any externality and the two curves will be
identical .
11-4
Consider an economy with two consumers , two public goods , one
ordinary good , one implicit production function , and fixed supply of
one primary factor which does not enter the consumer’s utility
functions. Determine the first order condition for a Pareto Optimal
allocation . In particular what combination of MRS must equal the
RPT for the two public goods?

H & Q WELFARE ECONOMICS 53

 Problems
Solution ;
u1 = u1(q11 , q2 , q3) u2 = u2(q21 , q2 , q3)
F(q1 , q2 , q3 , x ) =0 q11 + q21 = q10
L = u1 (q11 , q2 , q3 ) + λ1[u20 – u2(q21 , q2 , q3 )] +λ2 F(q11 +q12 , q2 ,q3 , x )
∂L/∂q11 = ∂u1/∂q11 + λ2F1 = 0
∂L/∂q21 =-λ1 ∂u2 /∂q21+ λ2F1 = 0
∂L/∂q2 = ∂u1/∂q2 – λ1 ∂u2/∂q2 +λ2F2 =0
∂L/∂q3 = ∂u1/∂q3 – λ1 ∂u2/∂q3 +λ2F3 =0
∂L/∂λ1 = u20 – u2(q21 , q2 , q3 ) = 0
∂L/∂λ2 = F(q11 +q12 , q2 ,q3 , x )=0
RPT23 = F2/F3 = (∂u1/∂q2 – λ1 ∂u2/∂q2)/( ∂u1/∂q3 – λ1 ∂u2/∂q3)
λ1 =(- ∂u1/∂q11 / ∂u2 /∂q21)

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 Problems
RPT23=[∂u1/∂q2+(∂u2/∂q2)( ∂u1/∂q11 /∂u2 /∂q21)]/[∂u1/∂q3+(∂u2/∂q3 )(∂u1/∂q11/ ∂u2 /∂q21)]
Bring ∂u1/∂q11 out of the brackets and delete ∂u1/∂q11 from numerator and enumerator
RPT 23 = (MRS 211 + MRS 212 ) / (MRS 311 + MRS 312 )
RPT 23 = (Σ MRS 12) / (Σ MRS 13)
11-5
Construct excess demand function for the two goods of the Lindal-equilibrium example given by (11-27) to (11-
35) , and solve these functions to obtain equilibrium solution .
Solution from slide no 20 and 21
Excess demand for private good (q 1) = total demand for private good minus supply of private good =0
f11(p1 , αp2)+f21(p1 , (1-α)p2) – g1(p1, p2)=0 1
Excess demand for public good = excess demand for consumer one = excess demand for consumer two=0
f12 (p1 , αp2) – g2(p1 , p2 ) =0 2
f22 (p1 ,(1- α)p2) – g2(p1 , p2) =0 3
Three equations 1 ,2 ,3 and three unkowns ; p 1 ,, p2 , α .
p1 = p1 (x10 , x20 , q10 )
p2 = p2 (x10 , x20 , q10 )
α = α (x10 , x20 , q10 )

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 Problems
11-6
Assume that the cost functions of two firms producing the same
commodity are ; C1 = 2q12 +20q1 -2q1q2 , C2= 3q22 + 60q2
Determine the output levels of the firms on the assumption that each
equates its private MC to a fixed market price of 240. Determine their
output levels on the assumption that each equates its social MC to
the market price .
Solution ;
Private profit maximization MC1 = 4q1 + 20 – 2q2 = p =240
MC2 = 6q2 + 60 = p = 240 , q1=70 , q2=30
Social marginal cost ; ∂(C1 + C2 )/∂q1 =p, 4q1 + 20 – 2q2 = 240
∂(C1 + C2 )/∂q2 =p, -2q1 + 6q2 + 60=240
q1 = 84 q2 = 58

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 Problems
11-7
Determine the taxes and subsidies that will lead the producer described
in exercise 11-2 to a Pareto-Optimal allocation and leave her profit
unchanged.
q=0.5x , p= 100 – 4q , r = 2 + 2x
optimal values ; q=8 , x=16 , p=68 , r=34
private profit maximization ; q’=4 , x’ = 8 , p’ = 84 , r’ = 18 ,
Π’ = pq –TC = pq – rx = pq – 2x - 2x 2 = pq – 4q – 8q2 =192
subsidy = s per unit of production (sale)
Π = pq +sq -4q -8q2 = 100q – 4q2 +sq -4q -8q2 = -12q2 + 96q +sq
∂Π/∂q = -24q +96 +s =0 , if q=8=optimal value , s= 96
Π=-12(8)2 +96(8) + 96(8)=768
Π - Π’ = 768 – 192 = 576
Lump-sum tax = 576 , per unit subsidy = 96 ,
total subsidy=s (q)= 96(8)=768

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 Problems
11-8
Determine taxes and subsidies that will lead the firms described in 11-6 to
their Pareto-Optimal output levels but leave their profits unchanged. What
is the size of the social dividend secured by this change in allocation .
Solution
C1 = 2q12 +20q1 -2q1q2 , C2= 3q22 + 60q2 , p=240
Private profit maximization MC1 = 4q1 + 20 – 2q2 = p =240
MC2 = 6q2 + 60 = p = 240 , q1=70 , q2=30
Π10 = pq1-2q12 - 20q1 +2q1q2 =240(70)–2(70)2 -20(70)+2(70)(30)=9800
Π20 = pq2 -3q22 - 60q2 =240(30) – 3 (30)2 -60 (30) = 2700
With subsidy ;
C2 = 3q22 + 60q2 - sq2 → MC2 – s = p → 6q2 + 60 – s = 240 ,
MC1 = p → 4q1 + 20 – 2q2 = 240
if q1*=84 , q2*=58 (social optimum ), then , s=168

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 Problems
Π1* = pq1-2q12-20q1+2q1q2=240(84)–2(84)2–20(84)+2(84)(58)=14112
Π2* = pq2 -3q22 - 60q2 + sq2 = 240(58) -3(58)2 – 60(58)+168(58)=24204
L1 = Π1* -Π10 = 14112 = 14112 – 9800 = 4312
L2 = Π2 * -Π2 0 = 24204 = 24204 - 2700 = 21504
Social dividend = L1 + L2 –sq2 = 4312 + 21504 - 168(58) = 16072
11-9
Consider an economy with two commodities and fixed factor supplies. Assume that
the social welfare function defined in commodity space is W=(q 1+2)q2 and that
society implicit production function is q1+2q2-1 =0 . find values for q1 and q2 that
maximize social welfare.
Solution
Max W= (q1+2)q2
s. t. q1+2q2 – 1 ≤ 0
L= (q1+2)q2 + λ(1 – q1 – 2q2 )
∂L/∂q1 = q2 - λ ≤0 , q1 ∂L/∂q1 =0
∂L/∂q2 = q1 + 2 –2 λ ≤ 0 , q2∂L/∂q2 =0
∂L/∂λ = 1-q1-2q2 ≥ 0 , λ ∂L/∂λ =0

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 Problems
q1 = 0 , q2 -λ < 0 ,
q2 ≠ 0 , 2 - 2λ =0 , λ =1
λ ≠ 0 , 1 - 2q2 = 0 , q2=1/2
q2

1/2
W =( q1 + 2 )q2

1-q1-2q2 = 0
q1
1
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 Problems
11-10
Assume that there are two consumers and two commodities . Let the utility functions be given by
u1=q11q12 , u2=q21q22 , with q1=q11+q12 and q2=q21+q22 . Show that the Scitovsky contour are
given by
q1q2=(√u1 + √u2 ) 2 .
Solution
Min q1=q11+q12
S.T. q20 = q21 + q22
u10 = q11q12
u2 0 = q21q22
L= q11 +q21 + λ1 (q11q12 – u10) + λ2(q21(q20 – q12) – u20)
∂L/∂q11 = 1+ λ1 q12 =0
∂L/∂q12 = 1+ λ2 q11 - λ2q21 =0
∂L/∂q21 = 1+ λ2 (q20 – q12 ) =0
∂L/∂ λ1 = q11 q12 – u10 = 0
∂L/∂ λ2 = q21(q20 – q12) – u20 = 0
Using the first order conditions and the constraints , λ1 and λ2 can be eliminated from the result ;

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 Problems
u10 – u20 - q1 q2 + 2(√u20q1q2) =0
Letting q1q2 = Z2 , this is a quadratic equation ;
Z2 - (2√u20)Z +(u20 – u10)=0 , which has the solution as follows;
Z= (2√u20 ± √4u10)/2 = √u20 ± √u10
Since the solution √u20 - √u10 might make Z negative , which make no sense in
the present context, the final solution is ;
q1q2= Z2 = (√u20 + √u10 )2
11-11
Consider a society of n individuals and m alternatives with the following
preferences structure . Each individual ranks the alternatives from 1 to m in
decreasing order of preferences. The ranks are summed over individuals,
and the alternatives with the smallest sum is chosen . Verify the first four of
the Arrow’s axioms are satisfied by this method of social choice , and that
the axiom of the independence of irrelative alternatives is not .

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 Problems
Solution
Supposed that n=4 , and there is 4 alternatives ; A , B , C , D . The best alternative
takes the value of 4, the next takes 3, next 2, and the last takes 1 .
individuals society preference of
1 2 3 4 of 4 society
A 4 3 2 1 10 second
B 3 4 3 2 12 fourth
C 2 2 4 3 11 third
D 1 1 1 4 7 first
1- complete ordering
Social ordering must satisfy the conditions of completeness , reflexivity, transitivity
.
As it seen from the table , it is complete .

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 Problems
2- Responsiveness to individual preferences.
A is socially preferable to B for a given set of individual preferences , if
individual ranking change so that one or more individuals raise A to
a higher degree and no one lowers A in a rank. This axiom violates
if there were some individuals against whom society discriminates.
As is seen it is responsive . Changing any of the individual preferences
( numbers) could change the society preference .
3- Non imposition .
Social preferences must not be imposed independently of individual
preferences. If no individual prefers B to A and at least one
individual prefers A to B , society must prefer A to B . This axiom
ensures that social preferences satisfy the Pareto ranking.
As it is seen the society preferences is not independent of any
individual preference .

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 Problems
4- Non dictatorship
Social preferences must not totally reflect the preferences of any
single individual.
As it is seen , the social preference is not only reflecting any single
individual preference .
5- Independence of irrelevant alternatives.
The most preferable state in a set of alternatives must be independent
of the existence of other alternatives.
Introducing another alternative like E , may change the numbers in
such a way that the first choice may not be the alternative D. so this
assume does not hold .
11-12
Determine the consequences of distributing a given income to
maximize the social welfare given by (11-50) in each of the cases ;
(a) α<0 (b) α =0 (c) α ≥ 1

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 Problems
Solution ;
W=Σi=1n βiαyiα
yi0 = Σi=1n yi
L = Σi=1n βiαyiα + λ (yi0 - Σi=1n yi )
∂L/∂yi = αβiα yiα-1 – λ = 0
∂L/∂λ = yi0 - Σi=1n yi = 0
yi/yj = (βi/βj)α/(1-α)
(a) α<0 , 0 >α/(1-α) , if βi > βj → yi < yj , but if βi < βj → yi > yj
(b) α =0 , α/(1-α)=0 , yi/yj = 1 , yi = yj
(c) α = 1 , α /(1- α) = ∞ , yi/yj = ∞ ,
α>1 α /(1- α) <0 , if βi > βj → yi < yj , but if βi < βj → yi > yj

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11-13
Problems
Consider a simplified economy with one consumer , one implicit production function , three
commodities , and a fixed supply of primary factor where ;
u=q1q2q3 , α1q1 + α2 q 2 + α3 q 3 – x0 = 0
Find values for q1 , q2 , q3 that maximize utility subject to production function . Assume that institutional
constraints result in a violation of the Pareto conditions such that ; (∂u/∂q 1)/ (∂u/∂q3)= kα1/α3 , k≠1 .
Find second best values for q 1 , q2 , q3 .
Solution ;
L = q1q2q3 + λ (α1q1 + α2 q 2 + α3 q 3 – x0 )
∂L/∂q1 = q2 q3 + λ α1 = 0
∂L/∂q2 = q1 q3 + λ α2 = 0
∂L/∂q3 = q1 q2 + λ α3 = 0
∂L/∂λ = α1q1 + α2 q 2 + α3 q 3 – x0 = 0
α1q1 = α2 q 2 = α3 q 3 , q1= x0/3 α1 ,, q2 = x0/3 α2 , q3 = x0/3 α3
Second best ;
(∂u/∂q1)/ (∂u/∂q3)= kα1/α3 → q2q3/q1q2 = q3/q1 = kα1/α3
L = q1q2q3 + λ1 (α1q1 + α2 q 2 + α3 q 3 – x0 ) + λ2 (q3 – q1 k α1/α3 )

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 Problems
∂L/∂q1 = q2q3 + λ1α1 – λ2 k α1/ α3 = 0
∂L/∂q2 = q1 q3 + λ1α2 = 0
∂L/∂q3 = q2q1 + λ1α3 + λ2 = 0
∂L/∂ λ1 = α1q1 + α2 q 2 + α3 q 3 – x0 =0
∂L/∂ λ2 = q3 – q1 k α1/α3 =0
q1 , q2 , q3 , λ1 , λ2 could be found as a function of k, x0 , α1 , α2 , α3 .

THE END

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