The Economics of Climate Change C 175 The economics of climate change C 175 75 Christian Traeger g Part 2 Efficiency Public Goods Externalities Suggested background reading for emerging questions Kolstad Charles D 2000 Environmental Economics Oxford University Press New York York Varian Hal R any edition Intermediate Microeconomics a modern approach pp W W Norton Company p y New York Spring 09 UC Berkeley Traeger 2 Efficiency 1 The Economics of Climate Change C 175 A Brief Micro Review From Preferences to Efficiency Spring 09 UC Berkeley Traeger 2 Efficiency 2 The Economics of Climate Change C 175 Preferences Preferences Indifference Curves Budget Constraints and Choice Blackboard Spring 09 UC Berkeley Traeger 2 Efficiency 3 The Economics of Climate Change C 175 Utility From well behaved preferences we can build Mountains of Pleasure Blackboard No you have seen me drawing Antarctica and England Spring 09 UC Berkeley Traeger 2 Efficiency 4 The Economics of Climate Change C 175 Spring 09 UC Berkeley Traeger 2 Efficiency 5 The Economics of Climate Change C 175 Spring 09 UC Berkeley Traeger 2 Efficiency 6 The Economics of Climate Change C 175 Utility Each bundle is associated with a utility level U x y You can think of utility as a measure of pleasure or happiness or simply as representing preferences More utility preferred Indifference curves are the topo lines or contour lines of the utility mountain While of a lot of the analysis that we will do could be done right away with i h preferences f utility ili functions f i are a very convenient i tooll to make k things easier Spring 09 UC Berkeley Traeger 2 Efficiency 7 The Economics of Climate Change C 175 Utility Marginal utility MU of good x Change in utility U associated with a small change in the amount of good x x N t th Note thatt good d y iis k keptt constant t t MU d depends d on x level l l Discrete change MU x U U x x y U x y x x Infinitesimal change MU x U lim x 0 U x x y U x y x X Change in utility caused by a change x is then approximately U MUx x Spring 09 UC Berkeley Traeger 2 Efficiency 8 The Economics of Climate Change C 175 Utility More precisely marginal utility is itself a function of x and y MUx MUx x y Frequently met assumption Diminishing Marginal Utility The pleasure of an additional unit of consumption of good x decreases the more of good x I consume Spring 09 UC Berkeley Traeger 2 Efficiency 9 The Economics of Climate Change C 175 Aside on Cardinal vs Ordinal Utility An ordinal measure An ordinal utility function only ranks alternatives the value means nothing in absolute terms e g grades finishing position in race A cardinal measure A cardinal utility function Absolute measure allowing ranking and absolute comparison e g tons of carbon income For F describing d ibi market k outcomes we only l need d ordinal di l utility ili To aggregate utility over different individual we need cardinal utility necessary for most normative comparisons of market outcomes Spring 09 UC Berkeley Traeger 2 Efficiency 10 The Economics of Climate Change C 175 Marginal Rate of Substitution Marginal rate of substitution MRS Rate at which a consumer is just willing to substitute one good for the other Rate at which the consumer is just on the margin of being willing to pay some of good x in order to buy some more of good y Slope of indiffierence curve Note Generally negative what does that mean Formally U Y MU X MRS X U MU Y X Y This side is all about the consumer pX pY Here he hits the market Derive this from U MUx x MUy y 0 meaning U is constant Spring 09 UC Berkeley Traeger 2 Efficiency 11 The Economics of Climate Change C 175 Marginal Rate of Substitution Remark While MU is a cardinal measure MRS is an ordinal measure Frequently made assumption Diminishing marginal rate of substitution is responsible for max L U A X A Y A M p X X A pY Y A better bundles convex indifference curves Different perspective on convex indifference curves feasible bundles Averages are preferred Spring 09 UC Berkeley Traeger 2 Efficiency 12 The Economics of Climate Change C 175 Efficiency in consumption X vs Y For some Individual A The necessary condition Th di i ffor utility maximizing Individual utility maximisation max L U A X A Y A M p X X A pY Y A better bundles Max U X Y U X Y subject to px X py Y M given prices and income M are feasible bundles U A A p MRS A X A X U pY Y A and yield the generally efficient choices X and Y Spring 09 UC Berkeley Traeger 2 Efficiency 13 The Economics of Climate Change C 175 Pareto Efficiency ff One O off th the mostt iimportant t t economic i concepts t named d after ft the th Italian economist Vilfredo Pareto 1848 1923 Definition An allocation is Pareto optimal or Pareto efficient if it is not possible to reallocate the resources of the economy in a way such that at least one person is better off without making any other person worse off An A allocation ll ti iis inefficient i ffi i t if it is i possible ibl tto make k one member b off the th society better off without making any other member worse off Such a movement is called Pareto improvement Spring 09 UC Berkeley Traeger 2 Efficiency 14 The Economics of Climate Change C 175 Efficiency in consumption X vs Y Take a second consumer B Both consumers face same market prices and take them as given g Then efficiency requires U A U B A B p MRS A X A X X B MRS B U U pY Y A Y B What Wh t about b t the th efficiency ffi i off points a and b Edgeworth Box Consumer A s origin is the upper right corner and his utility i increases moving i tto the th lower l left l ft blue indifference curve Spring 09 UC Berkeley Traeger 2 Efficiency 15 The Economics of Climate Change C 175 Efficiency in consumption X vs Y Take a second consumer B Both consumers face same market prices and take them as given g Then efficiency requires U A U B A B p MRS A X A X X B MRS B U U pY Y A Y B Point P i a not Pareto P efficient ffi i point b is Pareto efficient Edgeworth Box Consumer A s origin is the upper right corner and his utility i increases moving i tto the th lower l left l ft blue indifference curve Spring 09 UC Berkeley Traeger 2 Efficiency 16 The Economics of Climate Change C 175 Efficiency in consumption X versus Y Note that there are infinitely many Pareto efficient allocations Which one …