Public Economics 3 Summary Notes: Black Et Al, Chapter 5 Equity and Social Welfare

1
Public Economics 3
Summary notes: Black et al, Chapter 5
Equity and social welfare
Learning objective
 Distinguish between the Pareto and Bergson

criteria for a welfare improvement
 Discuss Nozick’s entitlement theory and its
relevance to the recent history of South Africa
 Explain how a redistribution of income can be
justified in terms of the theory of externalities
 Distinguish between the cardinal and ordinal
welfare functions
 Discuss the efficiency implications of policies
aimed at redistributing income from rich to
poor.
This chapter seeks to deal with the ‘problem’ of unequal

distributions of income and wealth.
The ‘black box’ nature of general equilibrium models is

considered, noting that predictions depend crucially on
initial assumptions. So if the initial distribution is
considered ‘unfair’, then so will the final distribution.
2
5.1 Introduction
The starting point once again is the two-good two-person

PC model. All points on the production possibility
frontier MoNo in Figure 5.1 are (technically) efficient.
Each point, however, corresponds to a different

distribution of income between the two participants.
Outcome S may be preferred to an actual outcome C.
Policy-induced movement from C to S will violate the

Pareto condition (making one person better off while
making another worse off is unacceptable).
By contrast, the Bergson criterion allows changes that

harm other individuals.
Section 5.2: Robert Nozick and his theory of entitlement
Section 5.3: Pareto criteria and theory of externalities
Section 5.4: Bergson criterion and welfare economics
Section 5.5: Equity-efficiency problem of redistribution

3
5.2 Nozick’s Theory of Entitlement
Associated with the libertarian school, this approach

rests on the proposition that individuals have a right not
to be coerced by others (negative freedom).
Laissez-faire system in which govt. role is to protect

individual freedom. Redistribution infringes on this
freedom.
Except under one special circumstance. The condition is

found by looking at Nozick’s three principles of justice:
1. Justice in acquisition. Individuals can acquire

things as long as they do not belong to someone
else, or no-one is made worse off than before.
2. Justice in transfer. Only voluntary transfers

between individuals are just (e.g. gifts, inheritances)
Violating either of these gives rise to the third principle:
3. Rectification of injustice in holdings. A

redistribution is potentially justified if either of the
above principles is violated.
How far back should one go? Is a San claim to the

Drakensberg valid?
See Box 5.1 on the TRC. March 1960 – Dec 1993

4
According to Nozick, rectification involves an analysis

of historical events that gave rise to the violation; and an
assessment of the distributional outcome in the absence
of the violation.
Extremely difficult to find answers to such questions.
Nozick’s principle is restricted to the redistribution of

capital and fixed property – not labour income (all of
those restrained from job advancement by the colour bar
would not qualify).
5.3 Other Pareto criteria
When externalities are present, there is a case for

modifying the strict Pareto criteria (that no-one may be
made worse off).
If the poor live in unsanitary conditions, engage in

crime, for example, they threaten the welfare of the rich.
(e.g. in SA, the poor imposing negative externalities on
the rich – are the rich now willing to do something about
poverty?)
The rich can increase their welfare by redistributing

income to the poor.
5
But no individual could solve the problem alone, so there

is a case for govt. action, for e.g. direct transfer
payments to poor, spending on health and basic services.
Another justification for redistribution arises from the

‘insurance motive’.
Individuals may view tax payments that go towards

setting up social security systems a cheaper way of
insuring themselves against possible loss of income
through unemployment or illness.
These schemes are usually redistributive – lower-paid

workers generally have higher claim propensities.
In both of the above cases rich people give up part of

their income (which is redistributed to the poor) because
they gain something material in return.
Redistribution can also be justified on Pareto grounds,

even if nothing material is gained, if individuals are
altruistic (concerned and generous).
An altruist, A, derives utility from her own income as

well as the utility of B, a non-altruist. B derives utility
only from his own income.
6
The condition for Pareto-efficiency under conditions

where there is a redistribution of income from A to B is
that:
The increase in A’s utility as a result of B’s higher

income must be greater than the decrease in A’s
utility loss resulting from the income sacrifice.
Real-life example? People give to charities, beggars.

Through the tax system in South Africa money is given
to the aged through the social pension. Well-targeted,
this transfer payment goes mostly to the very poor
(means tested).
5.4 Bergson criterion
A redistribution of income can be justified on welfare

grounds even if it makes someone worse off, in terms of
the Bergson criterion.
There are two approaches here, the first using a cardinal

or additive social welfare function, the second a more
generalised (ordinal) social welfare function that gives
rise to a set of social or community indifference
curves.
7
The cardinal or additive approach yields the following

social welfare function based on the sum of the utilities
of the individuals in the community:
W = Ua + Ub +…
Assume two individuals A, who is rich, and B who is

poor. W will increase if either Ua or Ub increases, or if
both increase, but also if, for e.g. Ua decreases and Ub
increases (so long as Ub increases by more than Ua
decreases).
Also, if the marginal utility of income diminishes as

income increases (an extra R10 means more to a poor
person than a rich one), redistribution from the rich to
the poor is justifiable.
If A and B’s marginal utility of income schedules are

identical (diminish at the same rate), it is a simple matter
to show algebraically that welfare is maximised if their
incomes are equalised.
The logical policy implications of this proposition is

radical redistribution of income (and wealth).
8
Getting around this awkwardness is achieved by
(a) denying that MUs of income decline at the same rate,

and/or
(b) showing that radical redistributions would cause total

welfare to fall because of the impact on A’s productive
effort
The ordinal stuff is much safer. Using a welfare

function of the type
W = W (Ua, Ub)
means that the usual ‘make the pie bigger, don’t change
the shape of the slices’ argument can safely be used.
Social indifference curves are required to display all of

the usual properties (i.e., to be well-behaved):
 Non-intersection
 Convex to the origin
 Diminishing marginal rates of substitution
Figure 5.2 (p.63) shows a set of such curves in relation

to a grand utility possibility frontier (the utility
combinations associated with all of the top-level
equilibrium points along a PPC)
9
Two crucial and related assumptions are made:
 It is assumed that the society in question is able to

choose between different points on the GUPF, say
H as opposed to G – how is the subject of much
debate (Chapter 6 gives one account of it)
 In selecting a particular point on the GUPF, society

is making an explicit value judgement about the
relative worthiness of individuals
10
By constructing suitable social indifference curves it is a

simple matter to show how society favours one or the
other group.
Look at Figure 5.3 (p.64). Re-label the vertical axis

‘White’ and the horizontal ‘Black’. The social
indifference curves W' illustrate the apartheid
dispensation. Those labelled W the democratic one (all
voices are heard).
Welfare levels at J and I are equal, but a case could be

made for the claim that W2 is superior to W'2.
11
Shifting from W'2 to W2 implies a shift in society’s

productive resources between sectors as well as between
individuals. Lets say at W'2 more resources are devoted
to the production of BMWs, good Y.
At W2, by contrast, there is a stronger preference for

goods used by poor people, say, bicycles, good X.
Can also be expressed mathematically (see equations 5.6

to 5.8a).
Noting that the very general welfare function Eq. 5.8a,
W = V (X, Y)
can be specified in many ways, Black et al observe that:
“… most such specifications will embody the above

value judgement, that is, that the community has to
make a judgement about the relative worthiness of
the two sectors and, by implication, of the two
individuals as well.” (p.64)
Figure 5.4 (p. 65) illustrates a society’s expressed desire

to move from a top-level competitive equilibrium point
C to the socially desired point S. Good Y and hence Ub
will be reduced.
12
Note that utility at W2 > utility at W1 (as usual).
Note as well that the axes of Figure 5.4 show quantities

of goods X and Y respectively, whereas those of Figure
5.3 show the utilities of individuals A and B.
This shows that the top-level condition, C, is a

necessary, but not sufficient condition for maximising
social welfare, S.
13
This gives rise to two questions:
 What kinds of policy are required to bring about

inter-sectoral and/or inter-personal redistributions
of income (movement from C to S)?
 What are the implications for economic efficiency

of such policies?
The answer to the first is the set of tax and expenditure

tools at the state’s disposal, which we will come to – the
attempt at answering the second is made in the last
section of this chapter.
5.5 Efficiency considerations
Most taxes and subsidies have distortionary effects on

markets.
Do the benefits from a particular policy justify the

distortions?
To illustrate, Black et al look at two distortions:
 The impact that taxes and subsidies might have

on willingness to work (a static approach),
and
 The dynamic consequences of a policy

designed to redistribute from rich to poor.
14
The first of these poses questions about labour market

behaviour – specifically, does a tax or subsidy influence
either or both hours of work supplied and productivity
while at work - leading to a sub-optimal top-level
equilibrium.
Familiarity with the simple model of an individual’s

labour supply function is required here.
Depending on whether the substitution or the income

effect dominates, with a rise (fall) in taxes (subsidies),
hours of effort supplied may rise or fall.
Illustrating the productivity effect for an individual

worker is not so simple – evidence inconclusive.
Figure 5.5 (p. 66) looks at the economy as a whole. A

move from C0 under a redistributive policy (from sector
Y to X) would produce unambiguously superior results
at S and F. (Utility at W2 > utility at W1)
S is the policy target. Landing at F (sub-optimal

allocation) could be the result of a small disincentive
effect on labour productivity.
A stronger disincentive effect could land the economy at

E on W0, a clearly inferior position to the original point
C0.
15
The other efficiency consideration, the dynamic

consequences of taxing the rich and subsidising the poor,
have their principal effects on savings and investment
behaviour.
A tax on sector Y (individual B) may help the economy

reach point S. But it may also limit savings and
investment, and hence economic growth, keeping the
economy on M0N0.
16
Essentially the argument here is that at the socially sub-

optimal equilibrium C0, the incentives to save and invest
may be such as to move the economy from M0N0 to
M1N1.
If this happens, welfare level W3 becomes attainable.

From C0, if a position such as C1 is reached, this is
argued to be superior to S.
Black et al make the following concluding point:

a more equitable distribution may be desirable to
society– but costs and benefits need to be weighed up
against each other.
We will come back to this.

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1

Summary notes: Black et al, Chapter 5

Equity and social welfare

 Distinguish between the Pareto and Bergson

This chapter seeks to deal with the ‘problem’ of unequal

The ‘black box’ nature of general equilibrium models is

The starting point once again is the two-good two-person

Each point, however, corresponds to a different

Policy-induced movement from C to S will violate the

By contrast, the Bergson criterion allows changes that

Section 5.2: Robert Nozick and his theory of entitlement

Section 5.3: Pareto criteria and theory of externalities

Section 5.4: Bergson criterion and welfare economics

Section 5.5: Equity-efficiency problem of redistribution

5.2 Nozick’s Theory of Entitlement

Associated with the libertarian school, this approach

Laissez-faire system in which govt. role is to protect

Except under one special circumstance. The condition is

1. Justice in acquisition. Individuals can acquire

2. Justice in transfer. Only voluntary transfers

Violating either of these gives rise to the third principle:

3. Rectification of injustice in holdings. A

How far back should one go? Is a San claim to the

See Box 5.1 on the TRC. March 1960 – Dec 1993

According to Nozick, rectification involves an analysis

Extremely difficult to find answers to such questions.

Nozick’s principle is restricted to the redistribution of

5.3 Other Pareto criteria

When externalities are present, there is a case for

If the poor live in unsanitary conditions, engage in

The rich can increase their welfare by redistributing

But no individual could solve the problem alone, so there

Another justification for redistribution arises from the

Individuals may view tax payments that go towards

These schemes are usually redistributive – lower-paid

In both of the above cases rich people give up part of

Redistribution can also be justified on Pareto grounds,

An altruist, A, derives utility from her own income as

The condition for Pareto-efficiency under conditions

The increase in A’s utility as a result of B’s higher

Real-life example? People give to charities, beggars.

5.4 Bergson criterion

A redistribution of income can be justified on welfare

There are two approaches here, the first using a cardinal

The cardinal or additive approach yields the following

Assume two individuals A, who is rich, and B who is

Also, if the marginal utility of income diminishes as

If A and B’s marginal utility of income schedules are

The logical policy implications of this proposition is

Getting around this awkwardness is achieved by

(a) denying that MUs of income decline at the same rate,

(b) showing that radical redistributions would cause total

The ordinal stuff is much safer. Using a welfare

Social indifference curves are required to display all of

Figure 5.2 (p.63) shows a set of such curves in relation

Two crucial and related assumptions are made:

 It is assumed that the society in question is able to

 In selecting a particular point on the GUPF, society