# ECON361 Chapter Notes - Chapter 2: Social Welfare Function, Pareto Efficiency, Pareto Principle

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9 Aug 2016

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CHAPTER 2: CONCEPTUAL FOUNDATIONS OF COST-BENEFIT ANALYSIS

Purpose: Introduction to Pareto efficiency (primary definition of allocative efficiency).

CBA AS A FRAMEWORK FOR MEASURING EFFICIENCY

CBA is a Framework for measuring allocative efficiency.

Allocative efficiency: Resources are deployed in their highest valued use in terms of the goods and

services they create.

Pareto Efficiency

Pareto efficiency: An allocation of goods is Pareto efficient if no alternative allocation can make

at least one person better off without making anyone else worse off. CBA can be used to provide

information about the relative efficiency of alternative policies.

Net Benefits and Pareto Efficiency

The link between net benefits and Pareto efficiency is straightforward: if net benefits are positive,

then it is possible to find a set of transfers that makes at least one person better off without

making anyone else worse off.

Willingness to Pay (WTP) is the payment that one would have to make or receive under the

policy so one would be indifferent between the status quo and the policy with the payments.

The algebraic sum of the WTP values is the appropriate measure of the net benefits of the impacts

of a policy. If and only if the aggregate net benefits of the policy (as measured by WTP of

affected individuals) are positive, then there exists a set of contributions and payments that make a

Pareto improvement over the status quo.

Opportunity Cost places a dollar value on inputs required to implement policies. The

opportunity cost of an input is its value in its best alternative use.

Using CBA for Decision Making

If all impacts are valued using WTP and all inputs are valued using opportunity costs, then the

sign of net benefits indicates if it is possible to increase Pareto efficiency. Using a decision rule to

implement only Pareto efficient policies is impractical for the following reasons:

The information burden of measuring benefits and costs for each individual.

The administrative burden of actually making each required transfer.

Compensation would induce people to overstate costs and understate benefits.

Boardman, Greenberg, Vining, Weimer / Cost-Benefit Analysis, 4th Edition

Instructor's Manual 2-1

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find more resources at oneclass.com

Potential Pareto Efficiency (i.e. Kaldor-Hicks criterion)

Alternative decision rule: Adopt only policies that have positive net benefits.

Reasons for adopting it:

It is feasible.

Society maximizes aggregate wealth.

If different policies have different winners and losers, then, in aggregate, costs and benefits

will average out over the entire population.

It counters incentive to give too much weight to organized groups and too little weight to

unorganized groups.

It is possible to do redistribution wholesale rather than within each separate policy.

Application of the Decision Rule in Practice

1. Adopt all policies that have positive net benefits (if all policies are independent).

2. If policies interfere or enhance each other, choose the combination of policies that maximizes

net benefits.

3. Benefit-Cost Ratio = Benefit/Cost

4. The benefit/cost ratio can confuse choice: Does one choose the policy with the best ratio or

the highest net benefits? One should generally choose the policy with the largest net benefits

because the ratio can be manipulated (i.e., is something a negative benefit or a positive cost?).

5. Care must be taken to determine interactions among projects so that combinations of projects

providing the greatest aggregate net benefits can be identified (i.e., find interferences and

synergies).

FUNDAMENTAL ISSUES RELATED TO WTP

Theoretical Limitations of WTP as Basis for Social Orderings

The rule for creating a social ranking of alternatives is not fully satisfactory.

Arrow’s Theorem (AT): K. Arrow (1951) proved that any social choice rule that satisfies a

basic set of fairness conditions could produce illogical results. The conditions are:

Individuals may have any transitive preferences (axiom of unrestricted domain).

If alternative1 is unanimously preferred by all individuals over alternative 2, then

alternative 2 should not be chosen (axiom of Pareto choice).

The ranking of two alternatives should not depend on what other alternatives are available

(axiom of independence).

No one person should have dictatorial power (axiom of non-dictatorship).

AT states that any rule that satisfies all four conditions will fail to ensure a transitive social

ordering of policy alternatives. Therefore, the net benefits rule needs to violate at least one

axiom if it is always to produce a transitive social ordering of policies. In order to ensure the

use of WTP in implementing the potential Pareto principle will produce a transitive ordering of

policies, assumptions (violating the axiom of unrestricted domain) must be placed on individual

preferences (i.e., the utility function of individuals must be such that the individual demand

functions that they imply can be aggregated into a market demand curve that has the sum of

Boardman, Greenberg, Vining, Weimer / Cost-Benefit Analysis, 4th Edition

Instructor's Manual 2-2

find more resources at oneclass.com

find more resources at oneclass.com