APPLIED WELFARE ECONOMICS
LESSON 1 + 2: INTRODUCTION AND THE ROLE OF THE GOVERNMENT
INTRODUCTIE
Study points
• Master EP (required course): 6 SP
• Master SEW (part of cluster; required): 4 SP
• Master SEW (elective course): 6 SP
• Master HI, etc. (elective course): 6 SP
Organization of the course
• Formal lectures
• Exercises in class
• Exercises assigned as ‘homework’
• Presentation in class (only if course is taken for 6 SP and Covid19 allows it)
• Required reading (with class discussion)
• Suggested reading
Course material
• There is no formal textbook for the course
• Elaborate set of PP-slides
• Readings and problem sets will be posted on BB as the course goes along
• Exam sample questions will be provided in the second half of the semester
• Start with the lectures = base; slides are quite detailed; exercises are for further practice of the theories;
suggested reading (no direct questions if it is not discussed in class)
Evaluation of the course
• In case of 4 SP (cluster SEW): a final exam only
Prerequisites
• Intermediate microeconomics
o UA-students : “Micro-economie” (2BA)
• Welfare economics mainly uses techniques from microeconomics, including
o Utility functions and utility maximizing behavior
o Production functions, cost functions
o Markets and government intervention
o Concepts of welfare analysis: consumer surplus, producer surplus, deadweight loss…
• Basic mathematics (derivatives, equation systems,…), statistics (distributions, …) and econometrics
(regression analysis, …)
1
,Purpose of the course
• Welfare economics looks at government proposals
o When there is an intervention/government proposal → welfare economics looks if
policy/intervention was good or bad
• Show that welfare economics contributes to a better understanding of public policy problems
o F.ex. should public transport be free in Belgium? Wat would be cost and benefits, and the
distribution of income? What would be the most equal solution?
• Show that it helps to
o Describe alternative solutions to policy issues
o Analyze the effect of the various alternatives
▪ At the individual level
▪ At the aggregate level (efficiency, inequality, government budget)
o Select the most appropriate alternative, given policy objectives
Approach
• Study some extensions of standard microeconomic theory that are useful
o For analyzing policy problems (perspective of government)
o For proper interpretation of the outcomes of policy studies
o We look at the aggregate level: how is welfare distributed in society?
• Apply microeconomic principles to specific economic policy issues
Tentative overview of the course
1. Introduction and the role of the government
– Public goods and externalities
– Market failures and government failures
--> Market failure: If you leave the market to private players, the overall outcome
can be bad for society and government needs to intervene
2. Key concepts of welfare economics
– Evaluation of welfare changes at the individual level
– Aggregating individual welfare changes
3. Taxation
– Direct taxation
– Indirect taxation
4. Introduction to household economics
5. Some insights from behavioral economics
2
,THE ROLE OF THE GOVERNMENT
1. PUBLIC GOODS AND EXTERNALITIES
Externalities
• Externality as a by-product along with goods/services
o the actions of an agent have positive or negative side-effects on the well-being of agents
o Externality occurs when consumption by a consumer or the production of a producer doesn’t
take into account that they have an influence on society
• Examples
o Pollution: water, air
o Imposing infection risk on others (Covid19)
▪ F ex as a corona patient and you increase contact, you can choose to not take into
account the increasingly amount of covid patients.
o Accident risks
o Noise
IMPLICATIONS OF EXTERNALITIES
• Consider as an example the production of a chemical product
o suppose the production leads to emissions of various pollutants (nitrogen oxides NOx, CO2,
etc.)
o The marginal external cost 𝑀𝐸𝐶 is the value of the damage inflicted on society (mainly health
effects)
▪ Marginal external cost: negative health effects of the pollution => not internalized by
the producer
• The marginal social cost 𝑀𝑆𝐶 is the sum of the marginal production cost and the marginal external
cost
o Total production cost of product + marginal external cost = marginal social cost (cost for
producer + cost for society)
Graphic illustration
– horizontal: production of chemical
– Demand for chemical: D
– 3 cost curves
– 1) marginal production cost: cost for the producer to produce the
chemical
– 2) damage on health by pollutant: mec, increasing curve
– 3) MEX + MPC = MSC (marginal social cost)
– 2 equilibria, 2 outcomes:
– A) private equilibrium (no government intervention): Q1, MPC = D
– B) take into account full cost MSC: Q*, MSC = D
– If they ignore the real cost, then they produce too much, they need
to produce less to maximize society’s welfare
– M cannot be good: cost is higher than demand
3
, • Producers consider the private cost, but typically ignore the external cost in their production decisions
o they produce where demand equals supply; quantity 𝑸𝟏 is sold at maraket price 𝑷𝟏
• This is more than what is socially desirable
o consumers are not willing to pay the full marginal social cost of the units between 𝑸∗ and 𝑸𝟏
• There is too much output produced and too much pollution from a social perspective
Social optimum (𝑷∗ , 𝑸∗ ) VS Market outcome (𝑷𝟏 , 𝑸𝟏 )
- From Q1 to Q*: intersection D = MPC, consumer surplus is A+B +G+ K, the consumer has only A
- Benefit: to social outcome, than lower externality cost: diff between SC and PC between Q1 and Q* is
MNK → positive for society that we can avoid this
- For producer: triangle between P1 and MPC, new producer service is between P* and MSC, he looses
N, but he has a higher price because he sells at a higher price P*
- Sum of all these changes: N remains, from private equilibrium to social optimum: you gain N
- Welfare loss M in private equilibrium: area where MSC is higher than Marginal benefit
A PRIVATE SOLUTION TO NEGATIVE EXTERNALITIES
Private solution: government doesn’t really intervene; there should be property rights
COASE THEOREM
• A property right is a legal rule that gives economic agents exclusive control over the use of an asset or
resource
o can be applied to objects (parcel of land) or ideas (patent)
o Property right: the right of the exclusive use of an object/idea/…
• Property rights may resolve the externality problem and restore efficiency
o the externality is ‘internalized’; taken into account in agents’ decisions
o Property rights in place, then they do resolve the externality issue, producers take into their
account the value of the externality, affect of their decision of other people
o example:
▪ community surrounding polluting firm has legal right to clean air
▪ cost of externality no longer “external” to the producer --> Producers need to
compensate the community, because it is the right of the community to have clean
air
4
LESSON 1 + 2: INTRODUCTION AND THE ROLE OF THE GOVERNMENT
INTRODUCTIE
Study points
• Master EP (required course): 6 SP
• Master SEW (part of cluster; required): 4 SP
• Master SEW (elective course): 6 SP
• Master HI, etc. (elective course): 6 SP
Organization of the course
• Formal lectures
• Exercises in class
• Exercises assigned as ‘homework’
• Presentation in class (only if course is taken for 6 SP and Covid19 allows it)
• Required reading (with class discussion)
• Suggested reading
Course material
• There is no formal textbook for the course
• Elaborate set of PP-slides
• Readings and problem sets will be posted on BB as the course goes along
• Exam sample questions will be provided in the second half of the semester
• Start with the lectures = base; slides are quite detailed; exercises are for further practice of the theories;
suggested reading (no direct questions if it is not discussed in class)
Evaluation of the course
• In case of 4 SP (cluster SEW): a final exam only
Prerequisites
• Intermediate microeconomics
o UA-students : “Micro-economie” (2BA)
• Welfare economics mainly uses techniques from microeconomics, including
o Utility functions and utility maximizing behavior
o Production functions, cost functions
o Markets and government intervention
o Concepts of welfare analysis: consumer surplus, producer surplus, deadweight loss…
• Basic mathematics (derivatives, equation systems,…), statistics (distributions, …) and econometrics
(regression analysis, …)
1
,Purpose of the course
• Welfare economics looks at government proposals
o When there is an intervention/government proposal → welfare economics looks if
policy/intervention was good or bad
• Show that welfare economics contributes to a better understanding of public policy problems
o F.ex. should public transport be free in Belgium? Wat would be cost and benefits, and the
distribution of income? What would be the most equal solution?
• Show that it helps to
o Describe alternative solutions to policy issues
o Analyze the effect of the various alternatives
▪ At the individual level
▪ At the aggregate level (efficiency, inequality, government budget)
o Select the most appropriate alternative, given policy objectives
Approach
• Study some extensions of standard microeconomic theory that are useful
o For analyzing policy problems (perspective of government)
o For proper interpretation of the outcomes of policy studies
o We look at the aggregate level: how is welfare distributed in society?
• Apply microeconomic principles to specific economic policy issues
Tentative overview of the course
1. Introduction and the role of the government
– Public goods and externalities
– Market failures and government failures
--> Market failure: If you leave the market to private players, the overall outcome
can be bad for society and government needs to intervene
2. Key concepts of welfare economics
– Evaluation of welfare changes at the individual level
– Aggregating individual welfare changes
3. Taxation
– Direct taxation
– Indirect taxation
4. Introduction to household economics
5. Some insights from behavioral economics
2
,THE ROLE OF THE GOVERNMENT
1. PUBLIC GOODS AND EXTERNALITIES
Externalities
• Externality as a by-product along with goods/services
o the actions of an agent have positive or negative side-effects on the well-being of agents
o Externality occurs when consumption by a consumer or the production of a producer doesn’t
take into account that they have an influence on society
• Examples
o Pollution: water, air
o Imposing infection risk on others (Covid19)
▪ F ex as a corona patient and you increase contact, you can choose to not take into
account the increasingly amount of covid patients.
o Accident risks
o Noise
IMPLICATIONS OF EXTERNALITIES
• Consider as an example the production of a chemical product
o suppose the production leads to emissions of various pollutants (nitrogen oxides NOx, CO2,
etc.)
o The marginal external cost 𝑀𝐸𝐶 is the value of the damage inflicted on society (mainly health
effects)
▪ Marginal external cost: negative health effects of the pollution => not internalized by
the producer
• The marginal social cost 𝑀𝑆𝐶 is the sum of the marginal production cost and the marginal external
cost
o Total production cost of product + marginal external cost = marginal social cost (cost for
producer + cost for society)
Graphic illustration
– horizontal: production of chemical
– Demand for chemical: D
– 3 cost curves
– 1) marginal production cost: cost for the producer to produce the
chemical
– 2) damage on health by pollutant: mec, increasing curve
– 3) MEX + MPC = MSC (marginal social cost)
– 2 equilibria, 2 outcomes:
– A) private equilibrium (no government intervention): Q1, MPC = D
– B) take into account full cost MSC: Q*, MSC = D
– If they ignore the real cost, then they produce too much, they need
to produce less to maximize society’s welfare
– M cannot be good: cost is higher than demand
3
, • Producers consider the private cost, but typically ignore the external cost in their production decisions
o they produce where demand equals supply; quantity 𝑸𝟏 is sold at maraket price 𝑷𝟏
• This is more than what is socially desirable
o consumers are not willing to pay the full marginal social cost of the units between 𝑸∗ and 𝑸𝟏
• There is too much output produced and too much pollution from a social perspective
Social optimum (𝑷∗ , 𝑸∗ ) VS Market outcome (𝑷𝟏 , 𝑸𝟏 )
- From Q1 to Q*: intersection D = MPC, consumer surplus is A+B +G+ K, the consumer has only A
- Benefit: to social outcome, than lower externality cost: diff between SC and PC between Q1 and Q* is
MNK → positive for society that we can avoid this
- For producer: triangle between P1 and MPC, new producer service is between P* and MSC, he looses
N, but he has a higher price because he sells at a higher price P*
- Sum of all these changes: N remains, from private equilibrium to social optimum: you gain N
- Welfare loss M in private equilibrium: area where MSC is higher than Marginal benefit
A PRIVATE SOLUTION TO NEGATIVE EXTERNALITIES
Private solution: government doesn’t really intervene; there should be property rights
COASE THEOREM
• A property right is a legal rule that gives economic agents exclusive control over the use of an asset or
resource
o can be applied to objects (parcel of land) or ideas (patent)
o Property right: the right of the exclusive use of an object/idea/…
• Property rights may resolve the externality problem and restore efficiency
o the externality is ‘internalized’; taken into account in agents’ decisions
o Property rights in place, then they do resolve the externality issue, producers take into their
account the value of the externality, affect of their decision of other people
o example:
▪ community surrounding polluting firm has legal right to clean air
▪ cost of externality no longer “external” to the producer --> Producers need to
compensate the community, because it is the right of the community to have clean
air
4
