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Reference Books

• Welfare Economics and Urban

Problems (Living
Environment), Bruce Walker–
May 18, 1981

• Urban Land Economics, Jack

Harvey and Ernie Jowsey,
Palgrave Macmillan, 2004

• Continuous Assessments:
(i) Assignment 1 (15%) due 26 April 20224
(ii) Assignment 2 (25%) due 21 June 2024
(iii) Final test (60%): Answer 3 Questions
• Part A: 2 Questions (Answer All)
Continuous • Part B: 2 Questions (Answer 1
question only)
Assessments • Just to share, the passing rate for last
Format semester is 95%
• Is this subject difficult??…No, but it requires
consistency, discipline and your
understanding of the subject matter.
• You need to understand the questions and
the scenario to answer the question and be
able to apply it to real estate!!

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Introduction to Welfare
Economics
Zarita Ahmad Baharum

What is Welfare Economics?

• The allocation of goods and resources to promote social
welfare is referred to as welfare economics.
• It is concerned with the economically efficient distribution of
resources for the benefit of the people.
• Welfare economists strive to direct public policy in such a
way that the distribution is economically and socially
beneficial to all segments of society.

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• Welfare economics is a branch of • The study's underlying

economics that studies the assumptions are the measurability
structure of the economy and the and comparability of social welfare
markets to achieve an efficient across various segments of
allocation of goods and resources society, as well as ethical and
in society. philosophical concerns about
• The goal of welfare economics is to social well-being.
improve society's overall well- • It entails employing utility theory in
being. economics. The value perceived by
• As a result, welfare economics society of the goods and services
entails evaluating economic offered to society is referred to as
policies and guiding public policies utility.
for the greater good of society. • According to the utility theory,
• The tools of cost-benefit analysis consumers will seek to maximise
and social welfare functions are their utility through their actions as
used in the study of welfare buyers and sellers in accordance
economics. with the laws of demand and
supply.

• There are various criteria for • Welfare economics seeks to

determining whether the welfare achieve a state that maximises
gains from a change in the a society's overall satisfaction
economy would outweigh any by maximising the producer and
losses. consumer surplus for the
• When looking at Pareto various markets that comprise
efficiency, resources cannot be the society.
allocated to make one person
better off without making one or
more people worse off.
• This cost-benefit analysis is
predicated on the assumption
that utility gains and losses can
be quantified in terms of money.

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• Real income has an impact on potential

consumption.
• Prospects for employment – the high cost of
Factors influencing unemployment
economic welfare • Job satisfaction – work satisfaction is as
important as income and wage.
(https://www.economicshel • Housing – Having a high income but being
unable to afford housing reduces economic
p.org/blog/1041/economics well-being.
/economic-welfare/) • Affordably priced housing is critical to
economic well-being.
• Education – opportunities to learn throughout
one's life that have an impact on one's well-
being.
• Life expectancy and quality of life – access to
healthcare, as well as healthy lifestyles, such
as obesity/smoking rates
• Happiness levels are normative assessments
of whether or not people are happy.
• Environment – Economic growth can lead to
increased pollution, which is harmful to one's
health and standard of living.
• Leisure time – high wages as a result of
working extremely long hours reduces
economic welfare. Leisure has monetary
value.

Welfare economics and the property

industry
• Land use and land values
• Policies of welfare (public goods etc.) will influence
the property industry as a whole
• Quality of life and the standard of living of the
society has a great influence on the property
industry (products, services, the development,
investment etc.)

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Why welfare economics?

Problem of allocation; Problem of allocation;

1) Inefficiency 1) Static (point in time)

2) Optimally 2) Intertemporal (allocation

over time)

Efficiency and Optimality

Allocation of resources Thus,
1) what goods are produced 1) 2 person (A, B)
2) what quantities they are 2) 2 Goods ( X, Y)
produced 3) 2 Inputs (K – capital, L – labour)

2 Assumption Utility function

1) No externalities UA = UA(XA,YA)
2) all goods and services are UB= UB(XB,YB)
private goods
Production function
X = X(KX,LX)
Y= Y(KY,LY)

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Economic Efficiency
• Efficiency – not possible to make • A gain by one or more persons
one or more person better off without anyone else suffering =
without making at least one PARETO IMPROVEMENT
person worse off
• When all such gains have been
• Inefficient – possible to improve made the resulting allocation is
someone’s position without referred to as = PARETO
worsening the position of anyone OPTIMAL/PARETO EFFICIENT
else
• Efficiency in allocation requires 3
conditions;
1) efficiency in consumption
2) efficiency in production
3) product mix efficiency

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1) Efficiency in consumption
• MRUSa=MRUSb

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2) Efficiency in production
MRTSx=MRTSy

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3) Product mix efficiency

MRTL = MRTK = MRUSA = MRUSB

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An efficient allocation of resources is not

unique
• For an economy with given
quantities of available
resources, production functions
and utility functions, there will
be many efficient allocations of
resources. The criterion of
efficiency in allocation does
not, that is, serve to identify a
particular allocation.

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• So, there are many

combinations of X and Y output
levels that are consistent with
allocative efficiency, and for
any particular combination
there are many allocations as
between A and B that are
consistent with allocative
efficiency

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The social welfare function and optimality

• Figure 5.6 shows a social
welfare indifference curve WW
that has the same slope as the
utility possibility frontier at b,
which point identifies the
combination of UA and UB that
maximises the SWF.

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• While allocative efficiency is a

necessary condition for optimality, it is
not generally true that moving from an
allocation that is not efficient to one
that is efficient must represent a
welfare improvement.
• Such a move might result in a lower
level of social welfare.
• This possibility is illustrated in Figure
5.7. At C the allocation is not efficient,
at D it is.
• However, the allocation at C gives a
higher level of social welfare than
does that at D. Having made this
point, it should also be said that
whenever there is an inefficient
allocation, there is always some other
allocation which is both efficient and
superior in welfare terms.

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Compensation tests
• If there were a generally agreed SWF (social • However, there are two problems, at the level of
welfare frontier), there would be no problem, in principle, with this criterion.
principle, in ranking alternative allocations. One • First, as we have seen, the recommendation
would simply compute the value taken by the that all reallocations satisfying this condition be
SWF for the allocations of interest, and rank by undertaken does not fix a unique allocation.
the computed values. • Second, in considering policy issues there will
• An allocation with a higher SWF value would be very few proposed reallocations that do not
be ranked above one with a lower value. There involve some individuals gaining and some
is not, however, an agreed SWF. losing. It is only rarely, that is, that the welfare
• The relative weights to be assigned to the economist will be asked for advice about a
utilities of different individuals are an ethical reallocation that improves somebody’s lot
matter. Economists prefer to avoid specifying without damaging somebody else’s. Most
the SWF if they can. reallocations that require analysis involve
• Precisely the appeal of the Pareto winners and losers and are, therefore, outside of
improvement criterion – a reallocation is the terms of the Pareto improvement criterion.
desirable if it increases somebody’s utility • Given this, welfare economists have tried to
without reducing anybody else’s utility – is that devise ways, which do not require the use of a
it avoids the need to refer to the SWF to decide SWF, of comparing allocations where there are
on whether or not to recommend that winners and losers. These are compensation
reallocation. tests

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Welfare Theorems
• First theorem of welfare economics: A perfectly
competitive market with no “market failures”
reaches a “Pareto-efficient” allocation.
• Second theorem of welfare economics: Any
Pareto-efficient allocation is consistent with perfect
competition (with no market failures), given the
correct initial endowments.

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“Pareto Optimal” or “Pareto Efficient”

• “An allocation where the only way to make one
person better off is to make another person worse
off is Pareto Optimal.”
• A “Pareto Improvement” is a change that makes
one person better off without making anyone else
worse off.
• If a Pareto improvement is possible, the current
allocation is not Pareto efficient.

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(1) Pareto Efficiency

Definition of Pareto Efficiency

• Pareto efficiency is said to occur

when it is impossible to make one
party better off without making
someone worse off.
• It is an economic state where
resources are distributed in the
most efficient way.
• Pareto efficiency will occur on a
production possibility frontier. When
an economy is operating on a
simple production possibility
frontier, (e.g. at Point A) it is not
possible to increase output of
Goods without reducing output of
Services

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• at Point C (12 goods and 17 services) It is Examples of Pareto Efficiency

possible to increase either without leading
to a decline in the output of the other. Thus • To build a new airport may lead to a
to be at point C would be classed as greater increase in social benefit than
Pareto inefficient, and this is generally social cost.
considered to be bad for the economy. • Therefore, there is a net gain to
• Pareto efficiency is related to the concept society.
of productive efficiency. • However, those people living near the
• Productive efficiency is concerned with the new airport will lost out.
optimal production of goods which occurs • Therefore this is not a pareto
at the lowest point on the short run improvement.
average cost curve and occurs on a PPF. • However, if the people living nearby
were compensated for extra noise,
• Pareto efficiency is also concerned with then it is possible to have a pareto
allocative efficiency. improvement.
• To be pareto efficiency the distribution of • In practise there are often practical
resources needs to be at a point where it is difficulties and high frictional costs in
impossible to make someone better off compensating losers from a particular
without making someone worse off. project.

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(2) Kaldor–Hicks Efficiency

Definition of Kaldor–Hicks Example of Kaldor Hicks
efficiency
• Suppose building a new airport
• Pareto efficiency occurs when led to a net utility of 100 units
one party benefits from a to the wider society.
decision, but others aren’t • However, building a new airport
made worse off. In other words, would make local residents
no one loses out. worse off (air pollution, noise
• Kaldor Hicks states that a pollution). This welfare loss
decision can be more efficient might be calculated at 10 units.
as long as in theory, everyone • Therefore, in theory the new
can be compensated to offset airport could be efficient
any potential costs. according to Kaldor-Hicks by
compensating local residents
from some of the net gain.

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• Under Kaldor Hicks, the key Problems of Kaldor Hicks

principle is the idea that in
theory people could be
compensated. • Just because in theory,
compensation may be given
• This compensation doesn’t to those who lose out, in
actually have to occur. practice it may not.
• Whereas under pareto • This can lead to an increase
efficiency, this compensation in inequality and be
would have to occur through perceived as unfair.
voluntary agreements
between two parties. • For example, those under
flight path may feel it is
• Kaldor-Hicks criteria may be unfair they have been left
used to judge the out to have to put up with an
effectiveness of a Cost- airport nearby.
Benefit Analysis scheme.

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(3) Scitovsky Efficiency

• The Scitovsky paradox is a theory which states that in welfare
economics there is no increase in social welfare by a return to the
original part of the losers.
• Thus, if an allocation A is deemed superior to another allocation B by
the Kaldor Hicks compensation criteria, by a subsequent set of
moves by the same criteria, it can prove that B is also superior to A.
• The paradox occurs when the gainer from the change of allocation A
to allocation B can compensate the loser for making the change, but
the loser could also then compensate the gainer for going back to the
original position.

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Market Failure
Definition of Market Failure
• This occurs when there is an inefficient allocation of
resources in a free market.

Types of market failure:

i) Externalities
ii) Public Goods
iii) Natural Monopoly
iv) Moral hazard
v) Asymmetric information
vi) Transaction costs

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(i) Externalities
• Private market activities create so-called spillovers
or externalities that affect the third party.
• They include any cost or benefit not accounted for
in the price of goods or services.

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• A positive externality is the Positive • Negative externalities such as air

effect or benefit realized by a third pollution occur when the producer
party resulting from a transaction in cannot be charged all the costs.
which they had no direct involvement. • Since the external costs do not enter
In financial transactions, a positive the calculations the producer makes,
externality provides benefits to the producer manufactures more of
individuals in the form of a "spillover". the good than is socially beneficial.
For example, higher wages and
improved health benefits for • With both positive and negative
workers is a positive externality of a externalities, market outcomes need
company merger. some kind of regulation to be more
• Other example would be research efficient.
and development that yields benefits
to society (e.g., employment in
industry) that the producer cannot
capture.
• Thus, the producer's incentive is to
under-invest in the activity unless
government subsidized or protect it.
• With positive externalities, too little of
the good in question is produced.
• With negative ones too much is
made.

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(ii) Public Goods

• A pure public good is one whose • Public goods have two characteristics:
consumption by one person does not – Non-rivalry: This means that when a
reduce its availability for others. good is consumed, it doesn’t reduce
the amount available for others.
• When a person consumes a private
- E.g. benefiting from a street light
good such as an apple, it is not doesn’t reduce light for others, but
available for consumption by others. eating an apple would.
• When a person consumes a good – Non-excludability: This occurs when
such as national defense or a radio it is not possible to provide a good
broadcast, however, the amount of the without it being possible for others to
good available for consumption by enjoy. E.g erecting a dam to stop
others is not diminished. flooding, or providing law and order.
• Public goods can be supplied by the
private sector.
• Radio and television broadcasts are
provided by private enterprises subject
only to non-economic regulation.

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• A fundamental problem with either • For example, not allowing satellite-

private or public provision centers on dish ownership free reception of cable
television induces customers to pay
the "revelation of preferences" for for the service.
public goods. • Fire protection for the properties of a
• If those who benefit from a public good local public good is typically supplied
are asked to contribute an amount by municipalities and paid for by the
taxes of the beneficiaries.
reflecting their valuations, an individual • It can be provided privately, though, if
may decide not to pay and hence, exclusion can be practiced.
become free ride on the payments of • Example: Ali’s house caught fire. He
others. called the firefighters. They
• Because of the free-rider problem, responded to his call. When they got
to the house, they asked if the house
public provision may be warranted. were covered by the fire protection
• This, however, does not resolve the plan. Ali, who had not paid the RM25
problem of determining the public's fee, said, "No". The firefighters asked
if there were anyone inside. When Ali
aggregate valuation of the good and replied "No", they drove away, letting
thus whether it should be supplied. the house burn to the grounds.
• If individuals could be excluded from
consuming the public good the
revelation and free-rider problem could
be resolved - at least in principle.

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(iii) Natural Monopoly

• A monopoly is natural if one firm can • An example is the water company. It is
produce a given set of goods or services inefficient for 2 firms to spend all the
at lower cost than can any other number money to connect pipes to your house,
of firms. because you'll only end up choosing
• A natural monopoly results when costs are one of them, and there would be a
decreasing in the scale of a firm (economy higher price charged by each firm to
of scale) or in the scope of its products or make up for the fact that half of their
services (economy of scope). pipes would earn no revenue.
• In natural monopoly situations the • Another characteristic is a low marginal
monopolists will raise his costs and tariffs cost.
because he likes incentives for efficiency • Once the company has built the pipes, it
and is interested in the maximization of doesn't cost much to run the water
profit. through them.
• A natural monopoly is a market structure • Thus, the monopoly has to charge
in which there is so much capital above marginal cost to make up for the
investment required that it is inefficient for investment.
more than one firm to do it.

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(iv) Asymmetric information

• If people have different (private) information • Information, however, can remain
at the time they act, markets may not under-supplied because it is the self-
perform efficiently, even when there are interest of its possessor not to supply it.
advantageous trades that could be made. • Manufacturers are understandably
• When market participation have incomplete reluctant to release negative
information and acquiring information is information about potential hazards
costly, markets may not function efficiently. associated with their products because
• The mandated provision of information doing so may reduce demand.
through regulation may then be warranted. • Consequently, consumers may be
• Regulation may not be warranted in all poorly informed about hazards.
situations involving asymmetric information, • Similarly, an employee may be
however, Information has value, so there is incompletely informed about possible
a demand for it. health and safety hazards in the
• More generally, individuals may invest in workplace. In such situations, the
information acquisition or hire agents who liability system may serve as partial
are more knowledgeable than they are. alternative to regulation.

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(v) Moral Hazards

• Moral hazard refers to the presence of • Regulation is one response to moral
incentives for individuals to act in ways hazard problems, but regulation can
that incur costs that they do not have to also cause moral hazard making
bear. regulation itself less effective.
• For example, in medical care, a fully • The principal means of dealing with
insured individual has an effectively moral hazards is to structure
unlimited demand for medical care, since incentives so that the induced
she/he doesn't bear the cost of the care behavior is taken into account.
they receive. • In the case of medical insurance, co-
• In addition, the individual may not have the payments can be required and
proper incentive to take socially efficient reimbursement limits imposed.
preventive measures, since she/he knows • Moral hazard can also be addressed
that the cost of any illness or accident will by monitoring the behavior of
be covered by insurance. individuals to increase the likelihood
• Similarly, the provision of federally funded that they take proper care.
flood insurance encourages people to live • Fine for not wearing a set belt is an
in areas prone to flooding and can lead to example of monitoring.
socially inefficient local decision.
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(vi) Transaction Costs

• Market failures can also result from • Example: a common problem in markets is
costs associated with making market the incentive for sellers to reduce the quality
transactions. of the goods or services they sell.
• To the extent consumers and • When quality can only be observed through
producers incur costs in becoming use, a seller may have an incentive to
informed about market opportunities reduce it.
and completing market transactions, • As long as a high quality good is more costly
markets will not perform efficiently. to produce than a low-quality good and a
• Regulation to reduce those consumer cannot tell the difference until
transactions costs then can improve after it is purchased, the seller's strategy can
efficiency. be to cut back on quality.
• For example, in the auto industry • Markets however can resolve some of these
global auto emissions standards can problems.
enhance efficiency, as auto producers • For example, If consumers can tarnish the
would not have to produce different reputation of the firm by informing other
models for different states. consumers that the firm reduce the quality,
consumers will not purchase from that firm.

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Overcoming Market Failure

i. Taxation
ii. Subsidies
iii. Regulation, standards and legal controls
iv. Tradable permits

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(i) Taxation (ii) Subsidies

• Some of the tax revenue is used • It is used to encourage
to finance merit goods and public
goods, such as education and production and consumption
health. which is particularly relevant in
• Indirect tax is used to discourage the case of merit goods and
production of demerit goods and
others services that produce products that generate positive
negative externalities. externalities.
• Polluter pays tax where the • Examples : rural bus subsidies,
polluter pays explicitly for the
pollution caused. (it is hard to fuel payment, education and so
measure the exact amount of tax , on.
as it is hard to estimate the cost of
negative externality; again, the tax
can be shared with consumers;
the price elasticity of demand for
many demerit good is inelastic;
better quality information might be
used to further reduce
consumption.)

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(iii) Regulation, standards and (iv) Tradable permits

legal controls

• The use of demerit goods : • Tradable emissions permits are used

in an environmental regulatory
restrictions on the sales of scheme where the sources of the
tobacco products and alcohol. pollutant to be regulated (most often
an air pollutant) are given permits to
• It plays an important role in release a specified number of tons of
reducing many forms of the pollutant.
environmental pollution that • The government issues only a limited
would otherwise have been number of permits consistent with the
desired level of emissions.
unavoidable. • The owners of the permits may keep
them and release the pollutants, or
reduce their emissions and sell the
permits.
• The fact that the permits have value
as an item to be sold gives the owner
an incentive to reduce their
emissions.

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