Pareto optimality
Who profits from the oil? The Norwegian oil fund, the budget rule, and the politics of distribution.
Image source: Aker BP
When the oil company British Petroleum found large amounts of oil under the Norwegian part of the North Sea, the Norwegian authorities had a problem. The oil that came out from the sea floor would lead to large financial surpluses. A good problem to have, but a problem nonetheless.
Since oil is a natural resource that in principle belongs to the Norwegian people (or so Norwegian law and tradition has decided), it was seen as natural that the surplus from extracting and selling the oil should benefit Norwegian society as a whole and not just to the oil companies that extract the oil. Norway therefore worked to set up a frameworks that would try give oil companies incentives to invest and a fair return for building out oil fields. At the same time as the wealth generated by oil extraction should benefit the society as a whole.
A central element of this frameworks was a natural resource tax of 50% of profits. This was in addition to the normal company tax on profits that in combination led to a marginal rate of income taxation on oil companies of close to 80%. But on the other hand, the Norwegian tax code also has generous provisions for writing down costs, which gives companies an incentive to invest despite high taxes. You could look at it as if the state was taking an 80% ownership position in all firms: Providing financing for investments, but also taking 80% of the profits.
In addition to the tax policy, Norway also established a state-owned oil company - Statoil (now Equinor) that initially would be a co-owner in all fields on the Norwegian shelf. The profits from Equinor would go directly to the Norwegian state budget. (Eventually, about 49% of the shares of Statoil were listed on public markets.)
50 years of oil extraction on the Norwegian Continental Shelf has shown this to be a mostly succesful recipe for managing petroleum wealth. Oil companies were given a stable frameworks for operating on the Norwegian Continental Shelf, while still ensuring that most of the proceeds went to the Norwegian people by way of extra funds for the national budget.
The system put in place could be seen as being what an economist would call a pareto improvement. Compared to before petroleum was produced, mostly everyone was at least as well off as before.
In the 1990's, the Norwegian government set up the Norwegian Pension Fund Abroad, otherwise known as The Oil Fund. The idea was that the proceeds from petroleum production that went to the state would be put into this fund that would invest in stocks and bonds abroad.
At the same time, a budget rule was established that said the government should limit it's extraction from the oil fund to a maximum of on average 4% of the value of the fund. Why 4%? Because that was the expected long-term return of the fund. In theory then, if the government was disciplined in following the budget rule, the principal put into the fund would be maintained indefinetly and the proceeds from limited Norwegian petroleum resources would benefit not just the current generation of Norwegians but also future generations.
The establishment of both the oil fund and the budget rule are broadly seen as smart ways of managing natural resource wealth and a fair way of distributing the proceeds across generations. But these policies do not represent pareto improvement. In order to distribute proceeds from Norwegian petroleum wealth to future generations, you necessarily have to limit how much current generations can benefit from the wealth. The Oil Fund is not a pure win-win.
In this lesson we look closely at the idea of pareto improvements and pareto optimality. But keep in mind, even if something is not pareto optimal and a pareto improvement, it can still be worthwhile policy.
Distributions and pareto optimality
Distribution and welfare
Here we have a simple example of a distribution problem. Let us say that our university establishes a fund of 300,000 Euro in welfare funds to be distributed between students and faculty.
We begin by drawing in a budget line where each corner represents an extreme, where 300,000 Euro goes entirely either to students or to faculty. The line between these two points represents all possible distributive combinations that use up all the funds.
We start at a point under the budget line. 100,000 goes to the students and 80,000 goes to the faculty. What points on the figure represent a pareto improvement?
The light blue triangle represents all the distributions where we improve the welfare of either students, faculty (or both), without someone losing anything. We say that all these points pareto dominate the original point. Everyone is at least equally happy compared to the original point.
Press the Increase faculty funds button or the Increase student funds button a few times so that you end up on the budget line. After you are on the budget line, and you continue to press either button, what happens?
Once we have reached the budget line, in order to give more to one of the groups, you have to take from the other.
Remember, pareto optimality says nothing about fairness. A distribution where 300,000 goes to the faculty can be pareto optimal without being in the least bit fair.
Pareto optimality is an important concept in economics because a transaction on a well-functioning market (in other words that someone buys something) should be a pareto improvement. The buyer gets something that they value more than what they pay (otherwise, they wouldn't have paid for it), and the seller gets more money that what it cost to produce--the marginal cost (otherwise they wouldn't have sold it.)
But it is not always the case that a market transaction is a pareto improvement. Problems happend when a transaction has a loser. For example, when someone buys a product that has lower quality than they initially though. This can happen because of what economists call information assymmetry. This is a fancy term for when a buyer has less information about a product than the seller.
An other example of a market transaction which is not a pareto improvement is when there is a third party that loses something. This is what economists call an externality. This means there is a cost (and sometimes) a benefit that comes from a transaction but which does not directly affect the buyer or producer. Pollution is a good example of this. If a factory can spew pollution for free into the air or water, this definetly has a cost, but not one that the company needs to include in their price.