WELFARE ECONOMICS AND ENVIRONMENT

Positive and Normative Economics: Distinction

The use of economics to describe the state of world in the ‘what is’ perspective is
known as positive economics. A key feature of positive statements is that they can
be tested (in principle) using evidence. ‘Positive economics’ is free of value
judgement i.e. it is neutral in its approach.

Alternately, economics can be used to explain ‘what should be’, or, how we wish the
economy to allocate its resources alternatively for increasing the overall welfare.
This alternate perspective is called normative economics. normative economics,
attempts to suggest how the economy should function. It therefore inevitably
involves defining what may be the ‘best’ way to do so. Hence, it entails making
(often unverifiable) value judgements. These statements typically include words
such as ‘should’, and ‘must’.
In general, an environmental problem can be viewed both from the positive and
normative lens. For instance, a positive analysis of the climate change issue would
entail measuring the effect of climate change on various sectors (e.g. agriculture and
fisheries).
More precisely, it could attempt the quantification of the observed losses in
agricultural productivity and fishery yield due to climate change and also project
under different scenarios value neutral assessment of the problem. On the other hand,
a normative evaluation of the issue would enable policy makers to answer questions
such as: ‘what action should be taken to mitigate the effects of climate change’,
‘when should the abatement policies be put into action’, and so on.
Economic efficiency
1. An allocation of resources is said to be efficient if it is not possible to make
one or more persons better off without making at least one other person worse
off.
2. Conversely, an allocation is inefficient if it is possible to improve someone’s
position without worsening the position of anyone else.
3. A gain by one or more persons without anyone else suffering is known as a
Pareto improvement.
 4. When all such gains have been made, the resulting allocation is sometimes
referred to as Pareto optimal, or Pareto efficient.
5. A state in which there is no possibility of Pareto improvements is sometimes
referred to as being allocatively efficient, rather than just efficient, so as to
differentiate the question of efficiency in allocation from the matter of
technical efficiency in production.
6. Efficiency in allocation requires that three efficiency conditions are fulfilled
– efficiency in consumption, efficiency in production, and product-mix
efficiency.

Efficiency
1. An allocation of resources is efficient if it is not possible to make anyone
better off, without hurting at least one person in the economy.
2. In simpler terms, an efficient allocation is a ‘no-waste’ allocation i.e. all
resources have been fully employed such that any reallocation will necessarily
involve the worsening of the position of at least one economic agent.
3. Economic efficiency is characterized by efficiency in consumption, efficiency
in production, and product-mix efficiency.
Efficiency in Consumption
Given two individuals A and B, and their utility functions (assumed to be quasi-
concave and differentiable), an allocation that satisfies the condition of consumption
efficiency requires that the marginal rates of substitution for the two individuals be
equal. That is, we must have: MRS𝐴 = MRS𝐵 This means, in an Edgeworth box
framework, the indifference curves of the individuals should be tangential to each
other i.e. the slopes of the indifference curves must be equal at the efficiency points
(as at point ‘b’ in Figure 2.1). If the condition is not met i.e. if the indifference curves
are intersecting and not tangential, then it will be possible to increase one person’s
utility without hurting another person and such an allocation cannot be termed
‘efficient’ (point ‘a’ describes such an allocation in Figure 2.1). By drawing a line
through all such efficiency points (i.e. allocation points where the above condition
is met) we obtain the ‘consumption contract curve’ (the line CC in Figure 2.2) or the
‘Pareto efficient frontier’. Further, by plotting the utility levels attained at the
efficiency frontier, we obtain the utility possibility frontier (Figure 2.3). Note that
the two points of origin viz. 𝐴0 and 𝐵0 (in Figure 2.1) in the Edgeworth box lie on
the contract curve. These are two special allocations, one where individual A has
everything (𝐴0 ), and the other, where individual B has everything (𝐵0 ). Any
reallocation from these two points necessarily makes one person worse off; hence
these points are efficient.

Fig. 2.1: Edgeworth Box and Efficiency in Consumption

 Fig. 2.2: Consumption Contract Curve

Fig. 2.3: The Utility Possibility Frontier

Efficiency in Production

The condition for efficiency in production is similar to the one for efficiency in
consumption (or exchange). Consider an economy which produces goods X and Y
with a combination of inputs as capital (K) and labour (L). Efficiency in production
requires that the marginal rate of technical substitution be equal in the production of
both outputs. This means: MRTS𝑋 = MRTS𝑌 . Graphically, we can again represent
the condition as the point where two isoquants are tangent to each other in a
production Edgeworth box. The production Edgeworth box along with isoquants and
the efficient allocation is illustrated in Figure 2.4. If the above equality condition is
not satisfied, it would be possible to reallocate the inputs to increase the output of
one of the goods, without reducing the output of the other good. The locus of all
efficient allocations in the production Edgeworth box gives us the ‘production
contract curve’, which if represented in the output space, is simply the ‘production
possibilities frontier’ (shown in Figure 2.4 as the curve 𝑋𝑀 𝑌𝑀 ).

Fig. 2.4: Edgeworth Box and Efficiency in Production

Efficiency in Product-Mix

The product-mix efficiency condition is nothing but a combination of the above two
conditions involving both production and exchange. Given the production
possibilities frontier (PPF), the optimum allocation (i.e. the product mix where the
slope of the PPF equals the MRS of the individuals in the economy), is where we
achieve product mix-efficiency. Let us define MRT𝐿 as the increase in the output of
Y obtained by shifting a small amount of labor from use in the production of X to
use in the production of Y. Similarly, we shall define MRT𝐾 as the increase in the
output of Y obtained by shifting a small amount of capital from use in the production
of X to use in the production of Y. Using these two quantities, the condition for
product mix efficiency can be specified as:

MRT𝐿 = MRT𝐾 = MRS𝑋 = MRS𝑌

At such an allocation, the economy is simultaneously satisfying the conditions for

production efficiency, consumption efficiency and product mix efficiency. This is
called as ‘a fully efficient static allocation of resources. The allocation at which
product-mix efficiency is being achieved is depicted at point ‘b’ in Figure 2.6. The
locus 𝑋𝑀 𝑌𝑀 depicts the production possibilities frontier where the slope is equal to
the marginal rate of transformation (MRT) between goods X and Y. At the three
points denoted by a, b and c (all points lying on the frontier in general) the production
efficiency condition is being satisfied i.e. we have MRTS𝑋 = MRTS𝑌 at each of these
points. The society’s ‘indifference curve’ (denoted by the curve marked I in Figure
𝐴 𝐵
2.6), has a slope of 𝑀𝑅𝑆𝑋,𝑌 = 𝑀𝑅𝑆𝑋,𝑌 at point b. Since the slope of the production
possibilities frontier MRT can be rewritten as the ratio of the marginal rates of
transformation of labor and capital, the above condition implies that at the point of
allocation satisfying the product mix efficiency, the slope of the production
possibilities frontier (MRT) should be equal to the slope of the indifference curves
of the agents (MRS).
 Fig. 2.6: Product-mix efficiency

EQUITY AND OPTIMALITY

In addition to efficiency, a desirable allocation of resources should fulfill the

condition of equity as well.

While no ‘general’ definition of equity exists, equity being a normative concept, it

is often understood as ‘fairness’.

In the context of consumption and exchange, an allocation is considered equitable if

no agent prefers another agent’s bundle i.e. agent A does not ‘envy’ agent B’s bundle.

To take the simplest possible example, consider the two origins in the Edgeworth
box.

It was earlier explained that both these allocations are efficient.

However, it is easy to see that these allocations are not equitable because, at either
of these two allocations, one agent has none of the two goods.

Note that equity is not the same as equality i.e. an equal distribution of resources
need not always be equitable unless the preferences of the two individuals are
identical.
Optimality/ The social welfare function and optimality

Combining the two concepts of efficiency and equity we can get the notion of social
optimality i.e. the maximization of society’s welfare.

Naturally, if we are to maximize social welfare, we first need to define a function

that represents society’s welfare.

This is clearly the ‘aggregate social welfare function’ representing society’s

aggregate preferences.

Since due to Arrow’s impossibility result this is not possible to achieve, to proceed
further, we need the assumption that such an aggregation of preference is somehow
possible.

With this assumption, the social welfare function can translate the utility levels of
all the members of the society to a number in such a manner that the welfare function
gives higher values of utility to the more socially desirable functions (e.g. health and
education).

The social welfare function, 𝑊 = 𝑊(𝑈𝐴 , 𝑈𝐵 ) can take different functional forms,
although the typical restriction on the function is that it should be non-decreasing in
𝜕𝑊 𝜕𝑊
the utility of each agent. This means: ≥ ≥0
𝜕𝑈𝐴 𝜕𝑈𝐵

The choice of a welfare function determines what the society considers desirable as
the choice necessarily entail value judgments.

Thus, given a utility possibilities frontier, the highest social welfare function that is
tangent to it provides the social optimal (i.e. point ‘b’ in Fig. 2.7).

The locus WW is one of the ‘level curves’ of the social welfare function where its
‘indifference curves’ are assumed to be continuous and bowed inward.
The tangency of the indifference curve with the utility possibilities frontier (i.e. the
bowed-out curve in Fig. 2.7) is at point ‘b’.

At this tangency, since welfare is maximized, all three efficiency conditions (i.e.
consumption efficiency, production efficiency and product-mix efficiency) are
satisfied.

Further, the slope of the indifference curve and the utility possibilities frontier are
equalized.

Clearly, given the shape of the social welfare indifference curves, points ‘a’ and ‘c’
would not maximize welfare and hence are not optimal.

Fig. 2.7: Maximization of Social Welfare

ALLOCATION IN A MARKET ECONOMY

Efficiency given ideal conditions

A variety of institutional arrangements might be employed to allocate resources,

such as dictatorship, central planning and free markets.
Any of these can, in principle, achieve an efficient allocation of resources.

Here, we are particularly interested in the consequences of free-market resource

allocation decisions.

The great attraction of free markets as a way of organizing economic activity is that
they do not require that any institution or agent have such knowledge.

Our concentration on markets – they are decentralized information-processing

systems of great power. The modern welfare economics that is the basis for
environmental and resource economics takes it that markets are the way economies
are mainly organized.

Environmental and resource issues are studied, that is, as they arise in an economy
where markets are the dominant social institution for organizing production and
consumption.

The market economy is now the dominant mode of organizing production and
consumption in human societies.

Welfare economics theory points to a set of circumstances such that a system of free
markets would sustain an efficient allocation of resources. The ‘institutional
arrangements’, as we shall call them, include the following:

1. Markets exist for all goods and services produced and consumed.

2. All markets are perfectly competitive.

3. All transactors have perfect information.

4. Private property rights are fully assigned in all resources and commodities.

5. No externalities exist.

6. All goods and services are private goods. That is, there are no public goods.
7. All utility and production functions are ‘well behaved’.

An efficient allocation would be the outcome in a market economy populated

entirely by maximisers and where all of these institutional arrangements were in
place. Before explaining why and how this is so, a few brief comments are in order
on these conditions required for a market system to be capable of realizing allocative
efficiency. First, note that, as we shall see in later sections of this chapter where we
discuss public goods and externalities, arrangements 5 and 6 are really particulars of
4. Second, note that 4 is necessary for 1 – markets can only work where there are
private property rights and a justice system to enforce and protect such rights. Third,
that an important implication of 2 is that buyers and sellers act as ‘price-takers’,
believing that the prices that they face cannot be influenced by their own behaviour.
No agent, that is, acts in the belief that they have any power in the market. Finally,
note that these are a very stringent set of conditions, which do not accurately describe
any actual market economy. The economy that they do describe is an ideal type, to
be used in the welfare analysis of actual economies as a benchmark against which to
assess performance, and to be used to devise policies to improve the performance,
in regard to efficiency criteria, of such actual economies. We now explain why a
market allocation of resources would be an efficient allocation in such ideal
circumstances. A more formal treatment is provided in Appendix 5.2. Consider, first,
individuals and their consumption of produced commodities. Any one individual
seeks to maximise utility given income and the, fixed, prices of commodities. Figure
5.8, familiar from introductory microeconomics, refers to an individual in a two-
commodity economy. The line YmaxXmax is the budget constraint. Ymax is the
amount of Y available if all income is spent on Y, Xmax is consumption if all income
is spent on X. The slope of the budget constraint gives the price ratio PX/PY.
Utility maximization requires consumption X* and Y* corresponding to point b on
the indifference curve U*U*. Consumption at points on YmaxXmax to the left or
right of b, such as a and c, would mean being on a lower indifference curve than
U*U*. Consumption patterns corresponding to points to the northeast of Ymax
Xmax are not attainable with the given income and prices. The essential
characteristic of b is that the budget line is tangential to an indifference curve. This
means that the slope of the indifference curve is equal to the price ratio. Given that
the slope of the indifference curve is the MRUS, we have:

𝑃𝑋
𝑀𝑅𝑈𝑆 =
𝑃𝑌

In the ideal conditions under consideration, all individuals face the same prices. So,
for the two individual, two-commodity market economy, we have
𝑃𝑋
𝑀𝑅𝑈𝑆 𝐴 = 𝑀𝑅𝑈𝑆 𝐵 = (5.8)
𝑃𝑌

Comparison of equation 5.8 with equation 5.3 shows that the consumption efficiency
condition is satisfied in this ideal market system. Clearly, the argument here
generalizes to many-person, multi-commodity contexts. Now consider firms. To
begin, instead of assuming that they maximize profits, we will assume that they
minimize the costs of producing a given level of output. The cost-minimization
assumption is in no way in conflict with the assumption of profit maximization. On
the contrary, it is implied by the profit maximization assumption, as, clearly, a firm
could not be maximizing its profits if it were producing whatever level of output that
involved at anything other than the lowest possible cost. We are leaving aside, for
the moment, the question of the determination of the profit-maximizing level of
output, and focusing instead on the prior question of cost minimization for a given
level of output. This question is examined in Figure 5.9, where X*X* is the isoquant
corresponding to some given output level X*. The straight lines K1L1, K2L2, and
K3L3 are iso cost lines. For given prices for inputs, PK and PL , an isocost line
shows the combinations of input levels for K and L that can be purchased for a given
total expenditure on inputs. K3 L3 represents, for example, a higher level of
expenditure on inputs, greater cost, than K2 L2.

The slope of an isocost line is the ratio of input prices, PK/PL. Given production of
X*, the cost-minimizing firm will choose the input combination given by the point
b. Any other combination, such as a or c, lying along X*X* would mean higher total
costs. Combinations represented by points lying inside K2 L2 would not permit of
the production of X*. The essential characteristic of b is that an isocost line is
tangential to, has the same slope as, an isoquant. The slope of an isoquant is the
MRTS so that cost-minimizing choices of input levels must be characterized by:

𝑃𝐾
𝑀𝑅𝑇𝑆 =
𝑃𝐿

In the ideal circumstances under consideration, all firms, in all lines of production,
face the same PK and PL, which means that

𝑀𝑅𝑇𝑆𝑋 = 𝑀𝑅𝑇𝑆𝑌 5.9

which is the same as equation 5.4, the production efficiency condition for allocative
efficiency – cost minimizing firms satisfy this condition. The remaining condition
that needs to be satisfied for allocative efficiency to exist is the product mix
condition, equation 5.5, which involves both individuals and firms. In explaining
how this condition is satisfied in an ideal market system we will also see how the
profit-maximizing levels of production are determined. Rather than look directly at
the profit-maximizing output choice, we look at the choice of input levels that gives
maximum profit. Once the input levels are chosen, the output level follows from the
production function. Consider the input of labor to the production of X, with
marginal product XL. Choosing the level of XL to maximize profit involves
balancing the gain from using an extra unit of labor against the cost of so doing. The
gain here is just the marginal product of labor multiplied by the price of output, i.e.
PXXL. The cost is the price of labor, i.e. PL. If PL is greater than PXXL, increasing
labor use will reduce profit. If PL is less than PXXL, increasing labor use will
increase profit. Clearly, profit is maximized where PL = PXXL. The same argument
applies to the capital input, and holds in both lines of production. Hence, profit
maximization will be characterized by

𝑃𝑋 𝑋𝐿 = 𝑃𝐿
 𝑃𝑋 𝑋𝐾 = 𝑃𝐾

𝑃𝑌 𝑌𝐿 = 𝑃𝐿

𝑃𝑌 𝑌𝐾 = 𝑃𝐾

which imply

𝑃𝑋 𝑋𝐿 = 𝑃𝑌 𝑌𝐿 = 𝑃𝐿

and

𝑃𝑋 𝑋𝐾 = 𝑃𝑌 𝑌𝐾 = 𝑃𝐾

Using the left-hand equalities here, and rearranging, this is

𝑃𝑋 𝑌𝐿
= (5.10a)
𝑃𝑌 𝑋𝐿

𝑃𝑋 𝑌𝐾
and = (5.10b)
𝑃𝑌 𝑋𝐾

Now, the right-hand sides here are MRTL and MRTK, as they are the ratios of
marginal products in the two lines of production and hence give the terms on which
the outputs change as labour and capital are shifted between industries. Given that
the lefthand sides in equations 5.10a and 5.10b are the same we can write
𝑃𝑋
𝑀𝑅𝑇𝐿 = 𝑀𝑅𝑇𝐾 = (5.11)
𝑃𝑌
showing that the marginal rate of transformation is the same for labour shifting as
for capital shifting. Referring back to equation 5.8, we can now write

𝑃𝑋
𝑀𝑅𝑇𝐿 = 𝑀𝑅𝑇𝐾 = = 𝑀𝑅𝑈𝑆 𝐴 = 𝑀𝑅𝑈𝑆 𝐵
𝑃𝑌

showing that the profit-maximizing output levels in the ideal market economy satisfy
the product mix condition for allocative efficiency, equation 5.5. This completes the
demonstration that in an ideal market system the conditions necessary for allocative
efficiency will be satisfied. We conclude this section by looking briefly at profit-
maximizing behavior from a perspective that will be familiar from an introductory
microeconomics course. There, students learn that in order to maximize profit, a firm
which is a price-taker will expand output up to the level at which price equals
marginal cost. Figure 5.10 refers. For output levels below X*, price exceeds marginal
cost so that increasing output will add more to receipts than to costs, so increasing
profit as the difference between receipts and costs. For output levels greater than X*,
marginal cost exceeds price, and reducing output would increase profit. This is in no
way inconsistent with the discussion above of choosing input levels so as to
maximize profit. It is just a different way of telling the same story. In order to
increase output, assuming technical efficiency, more of at least one input must be
used. In thinking about whether or not to increase output the firm considers
increasing the input of capital or labor, in the manner described above. For the case
of labor in the production of X, for example, the profit-maximizing condition was
seen to be PL = PXXL, which can be written as
𝑃𝐿
= 𝑃𝑋
𝑋𝐿

which is just marginal cost equals price, because the left-hand side is the price of an
additional unit of labor divided by the amount of output produced by that additional
unit. Thus, if the wage rate is £5 per hour, and one hour’s extra labor produces 1
tonne of output, the left-hand side here is £5 per tonne, so the marginal cost of
expanding output by one tonne is £5. If the price that one tonne sells for is
greater(less) than £5 it will pay in terms of profit to increase(decrease) output by one
tonne by increasing the use of labor. If the equality holds and the output price is £5,
profit is being maximized. The same argument goes through in the case of capital,
and the marginal cost equals price condition for profit maximization can also be
written as
𝑃𝐾
= 𝑃𝑋
𝑋𝐾