Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS1 TOOLS OF NORMATIVE ANALYSIS

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS2 Welfare economics: Branch of economic theory concerned with the desirability of alternative economic states. Pure exchange economy Edgeworth box Conventionally shaped indifference curves

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS3 A pareto efficient allocation is an allocation in which it is impossible to make someone better off without making anyone else worse off. A Pareto improvement is a reallocation of resources that makes one person better off without making anyone else worse off. The locus of all Pareto efficient points is called the contract curve. For an allocation to be pareto efficient it must a point at which indifference curves of two individuals are barely touching. The indifference curves must be tangent and their slopes equal. MRS(Adam)= MRS(Eve)

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS4 Production Possibilities Curve: shows the maximum quantity of x that can be produced along with any given quantity of y. MRT = MCx/MCy = slope of PPF Pareto efficiency requires MRT = MRS(Adam) = MRS(Eve)

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS5 The First Fundamental Theorem of Welfare Economics: As long as 1) producers and consumers act as perfect competitors or price takers, 2) a market exists for each commodity, then under certain conditions a Pareto efficient allocation of resources emerges. (Invisible hand). A basic result from economic theory is that a profit maximizing competitive firm produces output up to the point where MCx/MCy = Px/Py = MRT = MRS(Adam) = MRS(Eve) Competition along with maximizing behavior on part of all individuals leads to an efficient outcome.

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS6 Fairness: If properly functioning competitive markets allocate resources efficiently, what is the role of government in the economy? Its main function would be to establish a setting in which property rights are protected so that competition can work. Utility possibilities curve is derived from the contract curve and it shows the maximum amount of one person’s utility given the other individual’s utility level. All points on or below utility possibilities curve are attainable by society, all points above it are not attainable.

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS7 All points on utility possibilities curve are Pareto efficient but they represent very different distributions of real income between Adam and Eve. To find which is best, a social welfare function which embodies society’s views on the relative deservedness of Adam and Eve must be postulated. A social welfare function is a statement how society’s well-being relates to the well being of its members. The First Fundamental Theorem of Welfare Economics indicates that a properly working competitive system leads to some allocation on the utility possibilities curve. There is no reason that it is the particular point that maximizes social welfare.

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS8 Even if the economy generates a Pareto efficient allocation of resources, government intervention may be necessary to achieve “fair” distribution of utility. A second reason why the fundamental theorem need not imply a minimal government is that certain conditions required for its validity may not be satisfied by real world markets. When these conditions are absent, the free market allocation of resources may be inefficient.

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS9 The Second Fundamental Theorem of Welfare Economics: society can attain any Pareto efficient allocation of resources by making a suitable assignment of individual endowments and letting people freely trade with each other as in Edgeworth box. By distributing income suitably and then getting out of the way and letting markets work, the government can attain any point on the utility possibilities curve.

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS10 The issues of efficiency and distributional fairness can be separated. If society determines that the current distribution of resources is unfair, without interfering with market prices and impairing efficiency, it needs only transfer resources among people in a way deemed to be fair. Government needs some way to allocate resources and the only way for doing so (taxes) may cause inefficiencies.

Assoc. Prof. Y.KuştepeliECN 242 PUBLIC ECONOMICS11 Market Failure: 1. market power 2. unexistence of markets asymmetric information externality public good The fact that the market generated allocation of resources is imperfect does not mean that government is capable of doing better. In certain cases, the costs of setting up a government agency to deal with externality could exceed the cost of externality itself.