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

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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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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
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