Welfare economics - ECON 208 - Microeconomics

Chapter 5

Welfare economics


Welfare economics: asses how well the economy allocates its scarce resources in accordance with the goals of efficiency and equity.

  1. Efficiency: How well the economies resources are used and allocated.
  2. Equity: how society’s goods and rewards are/ should be, distributed among its different members and how the associate costs should be assigned.

Consumer and producer surplus

Consumer surplus: Distance between market price and individual valuation (relates to the demand side of the market)

Supplier surplus: excess of market price over the reservation price of the supplier. (relates to the supply side of the market)

                The suppliers and demanders are willing to participate in this market because they earn this surplus.

Computing total surplus

The sum of each participant’s surplus in defines the total surplus in the market.

Consumer surplus is the difference between the demand curve and the equilibrium price (forming a triangle) Computed as half the base X perpendicular height.

CS = (demand value – price) = ½ X base X perpendicular height

CS = ½ X 500 X 5 = 1250



Efficient market outcomes

Efficient market: Maximizes the sum of producer and consumer surpluses.

                The market mechanism, in which suppliers and demanders freely trade, leaves no scope for additional trades that would improve the well-being of participants.

Taxation and efficiency

Tax wedge: tax wedge is placed between the price consumers must pay and the price that the supplier receives. The price received by the supplier is lower than that paid by the buyer by the amount of the tax wedge.

Two burdens associated with tax

  1. Revenue burden:  the amount of tax revenue paid by the market participants and received by the government.
  2. Excess burden (dead weight loss):  component of the economic surplus that is not transferred to the government in the form of tax revenue. It is the component of consumer and producer surpluses forming a net loss to the whole economy.

Distortions: Impact of taxes and other influences that result in an efficient use of the economy’s recourses.

Elasticity’s revisited

Elasticity is important in determining the size of the dead weight loss.


Triangle ABC forms the area of deadweight loss.

A wage tax

When income tax is imposed, the net wage falls. Less labour is supplied because the net wage is lower. The government now generates tax revenue. A larger reduction in labour supply is generally accompanied by a bigger excess burden.

Market failures Negative externalities

Externality: impact individuals who are not participants in the market in question. The effects of the externalities may not be captured in the market price.

Markets characterized by externalities are not efficient.


An externality creates a divergence between private costs/ benefits and social costs/ benefits. This is represented on a graph by the difference between the cost to the supplier and the full cost of society. As output increases the external cost per unit rises, because the difference between the two supply curves increases with output.

Corrective tax: Seek to direct the market towards a more efficient output. A corrective tax is imposed on the production of the good that causes the externality; with the appropriate increase in the price, consumers will demand less quantity.

Market failures and positive externalities

Positive externalities: enable individuals or producers to get a free ride on the effort of others. The social value becomes greater than the private value. The value to society is greater than the sum of values individuals put on them. A subsidy (corrective action) would reduce the price and shift the supply downward.


            Other market failures

Monopolies that restrict output in order to increase output create inefficient markets.

Climate change and the environment policy


Economic policies for climate change

 Greenhouse gasses: associated with a variety of economic activities such as coal burning, oil burning, wood burning and production of carbon dioxide. When such gasses accumulate, excessively in the earth’s atmosphere they prevent heat from escaping and lead to global warming.

Three main ways in which polluters can be controlled

  1. Direct control
  2. Taxes on each unit of pollution (Incentives)
  3. Tradable permits to pollute (Incentives)

In graphing a diagram representing these variables, the horizontal axis measures the quantity of environmental damage, and the vertical axis measures the dollar value or cost.  The upward slopping damage curve represents the cost to society of each additional unit of pollution.

The marginal damage curve: Represents the cost to society of an additional unit of pollution.

The marginal abatement curve: reflects the cost to society of reducing the quantity of pollution by one unit



At a level of pollution above E*, the cost of reducing it is less than the damage it inflicts, and therefore a net gain occurs to society as a result of the reduction. To reduce pollution below the point E* would involve an abatement cost greater than the reduction in pollution damage and therefore is not a net gain to society.

An optimal quantity of pollution occurs when the marginal cost of abatement equals the marginal damage.

To attain a level of pollution at minimum resource cost, the marginal abatement cost of each firm would be the same.

Incentive mechanism 1: pollution permits

Tradable permits are referred to as the cap and trade system, because it limits or caps the total amount the total permissible emission, while allowing the market to develop in permits. Such tradable permits can attain a pollution target in an effective manner.

Incentive mechanism 2: corrective taxes

Corrective taxes = Pigovian taxes

To attain the equilibrium level of pollution among firms at the least costly manner is for each firm to incur the same marginal abatement cost. The government imposes a tax on each unit of pollution, in deciding how much pollution to emit, the firm will consider the amount of tax it has to pay on each unit, and compare the tax with the alternative of reducing it.

Corrective taxes, if set at an appropriate level; can induce an efficient pattern of pollution reduction emission.

Taxes on pollution generate revenue for the government whereas permits do not, or produce little revenue.

Equity justice and efficiency

Horizontal equity: indicate similar individuals should be treated similarly.

Vertical equity: is the different treatment of different individuals in order to reduce the consequences of these innate differences.

Intergenerational equity: Requires a balancing of the interest and individual well being of different generations and cohorts.






StudyUp Author: James Bagshaw
Business Administration, Accounting and Management Technology
Major: Business Administration

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