CHAPTER 3 NORMATIVE TOOLS NORMATIVE ANALYSIS Normative Economics

CHAPTER 3: NORMATIVE TOOLS

NORMATIVE ANALYSIS Normative Economics or Normative Analysis or Welfare Economics: the study of how the economy should work with a subjective representation of what has occurred, what is happening, or what is expected to happen. Welfare economics refers to the branch of economic theory concerned with the social desirability of alternative economic states. Normative economics often is accompanied by tools of positive analysis by interpreting results of econometric models and then suggesting a policy prescription to achieve some goal (i. e. , what should be done). Examples:

BASIC TERMINOLOGY Pareto improvement: Pareto efficient or Pareto efficiency: This means there is no such reallocation possible to improve the welfare or utility of one person without reducing the welfare or utility of another person. Pareto efficiency is one conventional standard for evaluating the optimal allocation of resources. Pareto efficiency, however, does NOT require any sort of “fair” distribution of resources. Therefore, this is a positive tool of analysis. Ultimately, we will find a set of Pareto efficient outcomes and then determine which is the “best” or most desirable. This is where the normative approach comes in. For practice purposes, a change in public policy may not meet such stringent criteria. In many cases, some individual or business will be adversely affected by the policy.

TERMINOLOGY CONTINUED 3. Kaldor-Hicks Criterion suggests an alternative approach to Pareto efficiency or Pareto Optimality. In this scenario, For example, a voluntary exchange that creates pollution would be a Kaldor-Hicks improvement if the buyers and sellers are still willing to carry out the transaction even if they have to fully compensate the victims of the pollution. In essence, a redistribution is possible such that there are no losers; however, the actual compensation does not have to take place

KALDOR-HICKS CONTINED This sets the stage for using cost-benefit analysis in which we look at the “net benefits” or “benefits-costs” of a project to see if it is worth undertaking. As long as the benefits outweigh the costs then the project satisfies the Kaldor-Hicks criterion—the benefits (dollars) can compensate or pay for the costs (dollars). The criticism of such a technique is that the distribution of such benefits and costs may be a secondary consideration. Who receives the benefits? Additionally, aggregating the costs and benefits accruing to different individuals is difficult (summing utility). Simplifying assumptions are made to evaluate the dollar value of costs of benefits. However, the marginal utility of a dollar may be different for the rich and the poor. More concerns to address later in the course!

4. Edgeworth Box: A device (a box) used to depict the distribution of goods. Typically done in the most simplistic terms assuming two goods and a two person economy. Edgeworth Box analysis uses indifference curves to represent utility of different economic agents, and an initial endowment point of resources. An endowment point shows the initial allocation or resources. We can use the Edgeworth Box to look at possible points of Pareto improvement from an initial allocation and then a set of Pareto efficient points resulting from different endowment points. Edgeworth Box analysis requires a basic understanding of indifference curves. We will review this momentarily.

5. Contract Curve: within the context of the Edgeworth Box is the contract curve. The contract curve is… Given all points are efficient, we can then compare the distribution of resources among the various efficient choices in determining the “best” allocation or distribution

THE NEXT SECTION OF CHAPTER 3 WILL BE DONE ON THE BLACKBOARD First Fundamental Welfare Theorem and the Second Fundamental Welfare Theorem.