TOOLS OF NORMATIVE ANALYSIS Chapter 3 Welfare Economics

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TOOLS OF NORMATIVE ANALYSIS Chapter 3

TOOLS OF NORMATIVE ANALYSIS Chapter 3

Welfare Economics Concerned with the social desirability of alternative economic states. 3 -2

Welfare Economics Concerned with the social desirability of alternative economic states. 3 -2

Consumption Economy • Edgeworth Box - an analytical device used to model welfare economic

Consumption Economy • Edgeworth Box - an analytical device used to model welfare economic theory • Depicts distribution of goods in a 2 -good/2 -person economy • Pareto Efficiency – an allocation of resources such that no person can be made better off without making another person worse off • Pareto Improvement – a reallocation of resources that makes at least one person better off without making anyone else worse off 3 -3

Edgeworth Box 2 person / 2 good economy y Eve 0’ Fig leaves per

Edgeworth Box 2 person / 2 good economy y Eve 0’ Fig leaves per year r v u w At “v”, how many apples and figs do Adam and Eve consume? 0 Adam s x Apples per year 3 -4

Indifference curves in Edgeworth Box Eve r 0’ E 1 Fig leaves per year

Indifference curves in Edgeworth Box Eve r 0’ E 1 Fig leaves per year E 2 E 3 A 2 0 Adam A 1 s Apples per year 3 -5

Beginning at Point g, how to make Adam better off without Eve becoming worse

Beginning at Point g, how to make Adam better off without Eve becoming worse off Eve r 0’ Fig leaves per year Eg g h A Pareto Efficient Allocation p Ap Ah Ag 0 Adam s Apples per year 3 -6

Beginning at Point g, how to make Eve better off without Adam becoming worse

Beginning at Point g, how to make Eve better off without Adam becoming worse off Eve r 0’ Fig leaves per year Eg g p Ep 1 A Pareto Efficient Allocation Ag 0 Adam s Apples per year 3 -7

Beginning at Point g how to make both Adam and Eve better off Eve

Beginning at Point g how to make both Adam and Eve better off Eve r 0’ Fig leaves per year Eg g • Pareto efficient • Pareto improvement Ep 2 p p 1 Ap 2 Ag 0 Adam s Apples per year 3 -8

Starting from a different initial point: Point k Eve 0’ r Fig leaves per

Starting from a different initial point: Point k Eve 0’ r Fig leaves per year Eg g k Ep 2 p 3 p 4 p p 2 p 1 Ap 2 Ag 0 Adam s Apples per year 3 -9

The Contract Curve Eve r Fig leaves per year Eg 0’ g The contract

The Contract Curve Eve r Fig leaves per year Eg 0’ g The contract curve – locus of all Pareto efficient points p 4 Ep 2 p p 3 p 1 Ap 2 Ag 0 Adam s Apples per year 3 -10

Pareto Efficiency in Consumption Adam MRSaf = MRSaf Eve Where MRS: -is the rate

Pareto Efficiency in Consumption Adam MRSaf = MRSaf Eve Where MRS: -is the rate at which an individual is willing to trade one good for another -is the absolute value of the slope of an indifference curve 3 -11

Production Economy • Analysis when supplies of 2 goods (applies and figs) are variable

Production Economy • Analysis when supplies of 2 goods (applies and figs) are variable rather than fixed • Production Possibilities Curve – Graph to model production economy – Maximum quantity of one output that can be produced given the amount of the other output 3 -12

Fig leaves per year Production Possibilities Curve C │Slope│ = marginal rate of transformation

Fig leaves per year Production Possibilities Curve C │Slope│ = marginal rate of transformation w y 0 C x z Apples per year 3 -13

Marginal Rate of Transformation • MRTaf = Marginal rate of transformation of apples for

Marginal Rate of Transformation • MRTaf = Marginal rate of transformation of apples for fig leaves • MRTaf = rate at which the economy can transform one good into another • MRTaf = Absolute value of slope of Production Possibilities Frontier • MRTaf = MCa/MCf 3 -14

Pareto Efficiency Conditions with Variable Production Adam • MRTaf = MRSaf Adam Eve •

Pareto Efficiency Conditions with Variable Production Adam • MRTaf = MRSaf Adam Eve • MCa/MCf = MRSaf Eve 3 -15

The First Fundamental Theorem of Welfare Economics • Given: – All producers and consumers

The First Fundamental Theorem of Welfare Economics • Given: – All producers and consumers are perfect competitors – A market exists for every commodity • Then a Pareto Efficient allocation of resources emerges – A competitive economy allocates resources efficiently out any need for centralized direction 3 -16

The First Fundamental Theorem of Welfare Economics Adam • MRSaf = Pa/Pf Consumption Side

The First Fundamental Theorem of Welfare Economics Adam • MRSaf = Pa/Pf Consumption Side Eve • MRSaf = Pa/Pf Adam • MRSaf = MRSaf Eve • MCa/MCf = Pa/Pf Production Side • MRTaf = Pa/Pf • Pa/Pf = MCa/MCf 3 -17

Fairness and Second Fundamental Theory of Welfare Economics • Addresses equity concerns in allocations

Fairness and Second Fundamental Theory of Welfare Economics • Addresses equity concerns in allocations of goods • Second Fundamental Theory of Welfare Economics states that society can attain any Pareto efficient allocation of resources – one that is more equitable – by redistributing the initial allocation of resources and then letting people freely trade • Interference with market prices, which impairs efficiency, is unnecessary 3 -18

Efficiency versus Equity Eve Fig leaves per year r 0’ p 3 p 5

Efficiency versus Equity Eve Fig leaves per year r 0’ p 3 p 5 q Does society have to choose between p 3 & q? 0 Adam s Apples per year 3 -19

Utility Possibilities Curve Adam’s utility Maximum amount of one person’s utility given each level

Utility Possibilities Curve Adam’s utility Maximum amount of one person’s utility given each level of another person’s utility U p 3 p 5 q U Eve’s utility 3 -20

Social Indifference Curve Adam’s utility Society’s willingness to trade off one person’s utility for

Social Indifference Curve Adam’s utility Society’s willingness to trade off one person’s utility for another’s W = F(UAdam, UEve) Increasing social welfare Eve’s utility 3 -21

Adam’s utility Maximizing Social Welfare If society values a more equitable distribution of goods

Adam’s utility Maximizing Social Welfare If society values a more equitable distribution of goods embodied in Social Indifference Curves, fairness and efficiency are possible (iii) i ii Eve’s utility 3 -22

Market Failures: Causes of Inefficiency • Market Power – Monopoly • Nonexistence of Markets

Market Failures: Causes of Inefficiency • Market Power – Monopoly • Nonexistence of Markets – Asymmetric information – Externality – Public good 3 -23

Buying into Welfare Economics: The Controversies • Underlying outlook is individualistic – Merit goods:

Buying into Welfare Economics: The Controversies • Underlying outlook is individualistic – Merit goods: commodities that output to be provided even if people do not demand it. • Results orientation rather than the process used to arrive at the results • However, coherent framework for analyzing policy – Will it have desirable distributional consequences? – Will it enhance efficiency? – Can it be done at a reasonable cost? 3 -24

Chapter 3 Summary • Welfare economics is the study of the desirability of different

Chapter 3 Summary • Welfare economics is the study of the desirability of different economic states – Based on individualist social philosophy • Pareto efficiency occurs when no person can be made better off without making another person worse off – MRSixy = MRTxy i=persons i…. n • First Fundamental Theory of Welfare Economics: Competitive markets result in Pareto efficiency • Second Fundamental Theory of Welfare Economics: Society can attain any Pareto Efficient outcome with reassignment of initial endowments and free trade 3 -25