Question

Using the Classical model with indifference curves (one factor and two goods), explain how free trade may affect the social utility level of an economy. (Assuming that the economy is completely specialized in production.) Explain how the change in welfare can be measured in terms of a change in national income. How can the change in welfare be disaggregated into the production gain and the consumption gain? What is the meaning of production gain and consumption gain? Draw diagram(s) to help you answer this question.

Answer 1

Using the Classical model with indifference curves (one factor and two goods), explain how free trade may affect the social utility level of an economy. (Assuming that the economy is completely specialized in production.)

Answer-

Economists use a vocabulary of maximizing utility to describe people’s preferences. In consumer choices, the level of utility that a person receives is described in numerical terms. The explanation below presents an alternative approach to describing personal preferences, called indifference curves, which avoids any need for using numbers to measure utility. By setting aside the assumption of putting a numerical valuation on utility—an assumption that many students and economists find uncomfortably unrealistic—the indifference curve framework helps to clarify the logic of the underlying model.

Indifference Curve?

People cannot really put a numerical value on their level of satisfaction. However, they can, and do, identify what choices would give them more, or less, or the same amount of satisfaction. An indifference curve shows combinations of goods that provide an equal level of utility or satisfaction. For example, Figure below presents three indifference curves that represent Peter’s preferences for the tradeoffs that he faces in his two main relaxation activities: eating doughnuts and reading paperback books. Each indifference curve (Ul, Um, and Uh) represents one level of utility. First we will explore the meaning of one particular indifference curve and then we will look at the indifference curves as a group.

Peter’s Indifference Curves. He would receive equal utility from all points on a given indifference curve. Any points on the highest indifference curve Uh, like F, provide greater utility than any points like A, B, C, and D on the middle indifference curve Um. Similarly, any points on the middle indifference curve Um provide greater utility than any points on the lowest indifference curve Ul.

The Shape of an Indifference Curve

The indifference curve Um has four points labeled on it: A, B, C, and D. Since an indifference curve represents a set of choices that have the same level of utility, Peter must receive an equal amount of utility, judged according to his personal preferences, from two books and 120 doughnuts (point A), from three books and 84 doughnuts (point B) from 11 books and 40 doughnuts (point C) or from 12 books and 35 doughnuts (point D). He would also receive the same utility from any of the unlabeled intermediate points along this indifference curve.

Indifference curves have a roughly similar shape in two ways: 1) they are downward sloping from left to right; 2) they are convex with respect to the origin. In other words, they are steeper on the left and flatter on the right. The downward slope of the indifference curve means that Peter must trade off less of one good to get more of the other, while holding utility constant. For example, points A and B sit on the same indifference curve Um, which means that they provide him with the same level of utility. Thus, the marginal utility that Peter would gain from, say, increasing her consumption of books from two to three must be equal to the marginal utility that he would lose if his consumption of doughnuts was cut from 120 to 84—so that his overall utility remains unchanged between points A and B. Indeed, the slope along an indifference curve is referred to as the marginal rate of substitution, which is the rate at which a person is willing to trade one good for another so that utility will remain the same.

Indifference curves like Um are steeper on the left and flatter on the right. The reason behind this shape involves diminishing marginal utility—the notion that as a person consumes more of a good, the marginal utility from each additional unit becomes lower. Compare two different choices between points that all provide Peter an equal amount of utility along the indifference curve Um: the choice between A and B, and between C and D. In both choices, Peter consumes one more book, but between A and B his consumption of doughnuts falls by 36 (from 120 to 84) and between C and D it falls by only five (from 40 to 35). The reason for this difference is that points A and C are different starting points, and thus have different implications for marginal utility. At point A, Peter has few books and many doughnuts. Thus, his marginal utility from an extra book will be relatively high while the marginal utility of additional doughnuts is relatively low—so on the margin, it will take a relatively large number of doughnuts to offset the utility from the marginal book. At point C, however, Peter has many books and few doughnuts. From this starting point, his marginal utility gained from extra books will be relatively low, while the marginal utility lost from additional doughnuts would be relatively high—so on the margin, it will take a relatively smaller number of doughnuts to offset the change of one marginal book. In short, the slope of the indifference curve changes because the marginal rate of substitution—that is, the quantity of one good that would be traded for the other good to keep utility constant—also changes, as a result of diminishing marginal utility of both goods.

The Field of Indifference Curves

Each indifference curve represents the choices that provide a single level of utility. Every level of utility will have its own indifference curve. Thus, Peter’s preferences will include an infinite number of indifference curves lying nestled together on the diagram—even though only three of the indifference curves, representing three levels of utility, appear on Figure. In other words, an infinite number of indifference curves are not drawn on this diagram—but you should remember that they exist.

Higher indifference curves represent a greater level of utility than lower ones. In Figure, indifference curve Ul can be thought of as a “low” level of utility, while Um is a “medium” level of utility and Uh is a “high” level of utility. All of the choices on indifference curve Uh are preferred to all of the choices on indifference curve Um, which in turn are preferred to all of the choices on Ul.

To understand why higher indifference curves are preferred to lower ones, compare point B on indifference curve Um to point F on indifference curve Uh. Point F has greater consumption of both books (five to three) and doughnuts (100 to 84), so point F is clearly preferable to point B. Given the definition of an indifference curve—that all the points on the curve have the same level of utility—if point F on indifference curve Uh is preferred to point B on indifference curve Um, then it must be true that all points on indifference curve Uh have a higher level of utility than all points on Um. More generally, for any point on a lower indifference curve, like Ul, you can identify a point on a higher indifference curve like Um or Uh that has a higher consumption of both goods. Since one point on the higher indifference curve is preferred to one point on the lower curve, and since all the points on a given indifference curve have the same level of utility, it must be true that all points on higher indifference curves have greater utility than all points on lower indifference curves.

These arguments about the shapes of indifference curves and about higher or lower levels of utility do not require any numerical estimates of utility, either by the individual or by anyone else. They are only based on the assumptions that when people have less of one good they need more of another good to make up for it, if they are keeping the same level of utility, and that as people have more of a good, the marginal utility they receive from additional units of that good will diminish. Given these gentle assumptions, a field of indifference curves can be mapped out to describe the preferences of any individual.

Explain how the change in welfare can be measured in terms of a change in national income. How can the change in welfare be disaggregated into the production gain and the consumption gain? What is the meaning of production gain and consumption gain? Draw diagram(s) to help you answer this question.

Answer-

Pigou defines as “The range of our enquiry becomes restricted to that part of social (general) welfare that can be brought directly or indirectly into relation with the measuring rod of money.” Welfare is a state of the mind which reflects human happiness and satisfaction.

On the contrary, non-economic welfare is that part of social welfare which cannot be measured in money, for instance moral welfare. But it is not proper to differentiate between economic and non-economic welfare on the basis of money. Pigou also accepts it. According to him, non-economic welfare can be improved upon in two ways.

    (1) By the income earning method. Longer hours of working and unfavorable conditions will affect economic welfare adversely.

    (2) By the income spending method. It is assumed in economic welfare that expenditures incurred on different consumption goods provide the same amount of satisfaction.

Relation between Economic Welfare and National Income

The effect of national income can be studied in two ways.

1. Change in the size of National Income
2. Changes in Distribution of National Income

Changes in the Size of National Income

The change in the size of national income may be given positive or negative. The positive change in the national income increases its volume. Consequently, people consume more of goods and services. Which lead to increase in the economic welfare, whilst the negative change in national income results in reduction of its volume.

1. Changes in Prices

If the change in national income is due to change in prices, it will be difficult to measure the real changes in economic welfare. For instance, when the national income increases as a result of increase in prices, the increase in economic welfare is not possible for the reason that it is possible that the productivity of goods and services may not have increased. It is more likely that the economic welfare would decline as a result of increase in prices. It is only the real income in national income that increases economic welfare.

2. Working Conditions

It depends on the manner in which the increase in national income comes about. The economic welfare cannot be said to have increased, if the increase in national income is due to explanation of labour, for instance, hike in production by labourers for longer hours by paying them lesser wages than the minimum. Influencing to put their women and kids to work by not providing them with facilities of transport to and from the factories and residence, and that their residence in slums.

3. Per Capita Income

National income cannot be a reliable index of economic welfare, if per capita income is not kept in mind. It is possible that with the hike in national income, the population may increase at the same pace and thus the per capita income may not increase at all. In such a condition, the hike in national income will not result in hike in fiscal welfare and vice versa.

4. Method of Spending

The influence of hike in national income on fiscal welfare depends also on the method of spending adopted by the people. If with the increase in income people spend on such necessities and facilities as milk, butter, eggs etc. which hikes efficacy, the economic welfare will increase. But otherwise, the outlay in consuming alcohol, speculating etc. will decrease the economic welfare. Hence the increase and decrease of fiscal welfare depends on changes in the tastes of people.

Conclusion

It is unambiguous from the above study that although the national income and economic welfare are closely inter-related, yet it cannot be said with certainty that the economic welfare would increase with the increase in national income and per capita income. The increase or decrease in economic welfare as a consequence of increase in national income depends on a number of factors such as the rate of growth of population, the methods of earning income, the conditions of working, the method of spending, the fashions and tastes etc.

Gains from trade. In economics, gains from trade are the net benefits to economic agents from being allowed an increase in voluntary trading with each other. In technical terms, they are the increase of consumer surplus plus producer surplus from lower tariffs or otherwise liberalizing trade.

Production and Consumption Efficiency Gains from Free Trade

The aggregate welfare gains from free trade can be decomposed into two separate effects; production efficiency gains and consumption efficiency gains. In the adjoining figure we show the autarky and free trade equilibria for the US. The autarky production and consumption point occurs at the point A with a level of aggregate utility which corresponds to the indifference curve I_Aut. The US production and consumption points in free trade are P and C, respectively. In free trade the US realizes a level of aggregate utility which corresponds to the indifference curve I_FT. The free trade price ratio is given by the slope of the national income line which connects P and C.

The aggregate welfare gains from free trade corresponds to the difference in utility between I_FTand I_Aut. To decompose the aggregate effect we simply introduce a national income line with the same slope as the free trade price ratio and pass it through the original production point A. This income line is tangent to the indifference curve I_C. The utility level at I_C represents the level of aggregate welfare that would be realized if free trade prices prevailed and if there were no changes in domestic production. Thus, the difference between I_Cand I_Aut is the increase in welfare that arises solely due to the change in prices. This increase in welfare is the aggregate consumption efficiency gain from free trade.

The remaining gain from free trade corresponds to the difference between utility levels at I_FT and I_C. This increase in welfare arises due to the shift in production from point A to P. This shift represents the aggregate production efficiency gain from free trade.

Thus movements from autarky to free trade result in both aggregate production efficiency gains and aggregate consumption efficiency gains. One can conclude then that both producers and consumers benefit from free trade. This is true, in the aggregate. However, one cannot conclude that every individual producer and consumer will benefit from free trade. The aggregate gains conceal the redistributive effects of the movement to free trade.