A P. O. Is a C. E. © 1998 by Peter Berck
What Is It Good? § Sum of surplus and profits allows for policies that make income less evenly distributed. § A dam that increases banana plantation owners incomes by more than it decreases native American’s incomes increases surplus profits. § We can do better.
Pareto Optimal (Easy Definition) § An allocation is Pareto optimal if there is no way to make any agent better off without making some other agent worse off.
The First Welfare Theorem § A Competitive Equilibrium is a Pareto Optimum
The Point § When all goods are traded in a competitive market, the outcome is Pareto optimal. l l l This is the justification for “letting the market work” or non-interference by government. It is not true when goods like “clean air services” are not traded freely. It does not imply that income is distributed in an even fashion.
Does Ownership of the Air Matter? § The Coase theorem: it does not matter whether the polluter or pollutee owns the rights to clean air, the amount of clean air will be the same.
Additional Profits From One More Unit of CAS Two Firms No matter who owns the CAS to begin with, the firms always trade to the intersection of their bid curves. Firm 1 Clean Air Services Firm 2
Additional Profits From One More Unit of CAS Two Firms Dead weight loss is greatest, with no trade, if the Red firm is prohibited from polluting. If the red firm were liable for the damages of its pollution, it would pollute and pay the damages. Firm 1 Clean Air Services Firm 2
Smoker and Asthmatic § In this example there are two consumers, smoker and asthmatic. § There are two goods, clean air (CAS) and chocolate available in fixed supply. § The initial allocation of the goods makes a big difference for how clean the air is. § The initial allocation makes a big difference for how much each agent gets.
Edgeworth-Bowley Box S l l Asthmatic uses CAS to breathe Smoker, to smoke § The height is the amount of chocolate Chocolate § The width is the amount of CAS A CAS
Who Got What?
Picture of a P. O.
The “Lens” of Pareto Preferred
A Possible Trade to a P. O.
Which Are P. O. ?
All Possible P. O. ’S Does Endowment Matter Now? ? Is there a Coase Theorem? S A
Coase Theorem (Revised) § When changes in income don’t change the demand for the environmental good. § And the costs of transaction between agents is small. § And the property rights in clean air services are defined. § Then, trading in clean air will lead to a unique amount of clean air and pollution.
The First Welfare Theorem § When all the goods are freely traded, a competitive equilibrium is a Pareto optimum. § There are many Pareto optima. l All of them can be achieved as competitive equilibrium starting at SOME initial allocation. § Agent’s have very different incomes in the different Pareto optima.
Gloria’s comment: § An economy can be perfectly (Pareto) efficient and perfectly disgusting.
Free Rider Problem § When I buy a candy bar, who benefits? § When I buy an SO 2 certificate, who benefits? l l Do all the beneficiaries contribute to the cost of buying and retiring the certificate? Nother example: 6 of us go out to dinner and split the bill. What happens to the size of our tab?
First Welfare Theorem and Pollution § The theorem applies to goods that are traded. § Consumers’ demand for clean air isn’t effective because: l l Costs to much to trade small amounts of CAS. Benefits from buying it do not accrue only to the consumer who bought it. § Government is needed to assure clean air.