TOOLS OF NORMATIVE ANALYSIS Chapter 3

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

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

Edgeworth Box 2 person / 2 good economy Eve r 0’ v w u Fig leaves per year At “v”, how many apples and figs do Adam and Eve consume? Box and dimensions initially set 1st click – place point v 2nd click – draw horizontal line uw 3rd click – draw vertical line xy s Adam Apples per year

Indifference curves in Edgeworth Box Eve r A3 E1 0’ A2 E2 A1 E3 Fig leaves per year Box and dimensions initially set 1st click – Adam’s indifference curves 2nd click – Eve’s indifference curves s Adam Apples per year

A Pareto Efficient Allocation Beginning at Point g, how to make Adam better off without Eve becoming worse off Eve Ap r 0’ Ah g Ag Eg h A Pareto Efficient Allocation Fig leaves per year p Box and dimensions initially set 1st click – “A Pareto efficient allocation” and arrow s Adam Apples per year

A Pareto Efficient Allocation Beginning at Point g, how to make Eve better off without Adam becoming worse off Eve r 0’ Ag g Eg p Fig leaves per year Ep1 Box and dimensions initially set 1st click – “A Pareto efficient allocation” and arrow p1 A Pareto Efficient Allocation s Adam Apples per year

Beginning at Point g how to make both Adam and Eve better off Ap2 r 0’ g Ag Eg Pareto efficient Pareto improvement Ep2 p Fig leaves per year p2 p1 Box and dimensions initially set 1st click – Box with Pareto efficient and improvement within s Adam Apples per year

Starting from a different initial point: Point k Eve Ap2 0’ r g Ag Eg k p4 Ep2 p3 Fig leaves per year p p2 Box and dimensions initially set 1st click – p1 s Adam Apples per year

The Contract Curve Eve r 0’ g Eg Ap2 r 0’ g Ag Eg The contract curve –locus of all Pareto efficient points p4 Ep2 p3 Fig leaves per year p p2 Box and dimensions initially set 1st click – contract curve drawn from lower left to upper right and “The contract curve” and arrow appear p1 s Adam Apples per year

Pareto Efficiency in Consumption MRSaf = MRSaf 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 Adam Eve

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

Production Possibilities Curve │Slope│ = marginal rate of transformation Fig leaves per year w y Axes and labels 1st click – PPC and labels 2nd click – lines x and w 3rd click – lines z and y C x z Apples per year

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

Pareto Efficiency Conditions with Variable Production Adam Eve MRTaf = MRSaf = MRSaf MCa/MCf = MRSaf = MRSaf Adam Eve

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

The First Fundamental Theorem of Welfare Economics MRSaf = Pa/Pf Consumption Side MRSaf = Pa/Pf MRSaf = MRSaf MCa/MCf = Pa/Pf Production Side MRTaf = Pa/Pf Pa/Pf = MCa/MCf Adam Eve Adam Eve Each line wipes right after click

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

Efficiency versus Equity Eve Does society have to choose between p3 & q? r 0’ p3 Fig leaves per year Box and dimensions initially set 1st click – contract curve drawn from lower left to upper right and “The contract curve” and arrow appear q p5 s Adam Apples per year

Utility Possibilities Curve Maximum amount of one person’s utility given each level of another person’s utility Adam’s utility U p3 Axes and labels 1st click – Utility possibilities curve, p3 and p5 2nd click - q p5 q U Eve’s utility

Social Indifference Curve Society’s willingness to trade off one person’s utility for another’s W = F(UAdam, UEve) Adam’s utility Increasing social welfare Axes and labels 1st click – the arrow (speed: medium) and “Increasing social welfare” Eve’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) Adam’s utility i iii Axes, labels, and social indifference curves 1st click – utility possibilities curve and points ii Eve’s utility

Market Failures: Causes of Inefficiency Market Power Monopoly Nonexistence of Markets Asymmetric information Externality Public good

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?

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