1. Chapter 2 An Introduction to Modeling, Efficiency and Equity Microeconomic Policy Analysis Lee S. Friedman Johnny Patta

2. MAIN TOPICS A. General Discussion of Modeling B. Standar Model of Consumer Choice C. Concept of an Efficient Allocation of Resources in an Economy and Ilustration D. Concept of Equitable Resource Allocation and Ilustration

3. A. GENERAL DISCUSSION OF MODELING

4. Modeling is a powerful technique used to predict the consequences of policies. Modeling is a powerful technique used to predict the consequences of policies. A model is an abstraction intended to convey the essence of some particular aspect of the real world. A model is an abstraction intended to convey the essence of some particular aspect of the real world. The usefulness of a model to its users depends on the extent to which it increases knowledge or understanding (and not on how much it leaves unexplained). The usefulness of a model to its users depends on the extent to which it increases knowledge or understanding (and not on how much it leaves unexplained). Good economic models predict well enough to increase our understanding of certain situations, even though the may not predict them perfectly and there may be related situations in which the same models do not predict as well as expected. Good economic models predict well enough to increase our understanding of certain situations, even though the may not predict them perfectly and there may be related situations in which the same models do not predict as well as expected. Model specification: the choice of a particular set of abstractions from reality are used to construct the model Model specification: the choice of a particular set of abstractions from reality are used to construct the model

5. Models based on theory have been very successful in predicting. Models based on theory have been very successful in predicting. Microeconomic policy analysis (MPA) rely on conventional theory as starting point and adapt it to account for circumstances specific to each problem. Microeconomic policy analysis (MPA) rely on conventional theory as starting point and adapt it to account for circumstances specific to each problem. A fundamental analytic skill is to be able to identify plausible alternative specifications relevant to a particular policy analysis A fundamental analytic skill is to be able to identify plausible alternative specifications relevant to a particular policy analysis The point is to understand how heavily a policy conclusion depends on specific assumptions The point is to understand how heavily a policy conclusion depends on specific assumptions Policy conclusions are often quite sensitive to variations in the way policy itself modeled. Policy conclusions are often quite sensitive to variations in the way policy itself modeled. The reexamination of assumptions which are standard and appropriate in many contexts often becomes the central focus in a particular policy context. The reexamination of assumptions which are standard and appropriate in many contexts often becomes the central focus in a particular policy context.

6. B. STANDARD MODEL OF CONSUMER CHOICE

7. A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS The general assumptions: economic man  individual is portrayed as a utility maximizer The general assumptions: economic man  individual is portrayed as a utility maximizer It has four assumptions: It has four assumptions: 1. Each consumer is assumed to have preference ordering 2. Each consumer is non satiable 3. Each consumer has strictly convex preferences or stated informally, prefer diversity in consumption bundles 4. Each consumer makes resource allocation choices in accordance with his/her ordering We will explain those assumptions in the next slide The first and fourth assumptions model rationality The first and fourth assumptions model rationality The second and third assumptions are generalizations about preferences The second and third assumptions are generalizations about preferences The first three assumptions are often represented by an ordinal utility function The first three assumptions are often represented by an ordinal utility function The fourth assumption is equivalent to the consumer acting to maximize utility The fourth assumption is equivalent to the consumer acting to maximize utility

8. A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS Each consumer is assumed to have preference ordering Each consumer is assumed to have preference ordering Consumer can compare any two possible bundles of goods and services and will prefer one to the other or be indifferent. Consumer can compare any two possible bundles of goods and services and will prefer one to the other or be indifferent. Consumer is consistent Consumer is consistent Each consumer is non satiable Each consumer is non satiable A property of consumer’s ordering is that more goods are preferred to less, other things equal A property of consumer’s ordering is that more goods are preferred to less, other things equal The consumer is the judge of what things are “goods” as opposed to “bads” The consumer is the judge of what things are “goods” as opposed to “bads” Consumer may commonly have limits for specific goods within any time period  there is always at least one good for which consumer is not yet sated Consumer may commonly have limits for specific goods within any time period  there is always at least one good for which consumer is not yet sated Each consumer has strictly convex preferences or stated informally, prefer diversity in consumption bundles Each consumer has strictly convex preferences or stated informally, prefer diversity in consumption bundles The consumer would prefer a more “balance” bundles to either of the extremes The consumer would prefer a more “balance” bundles to either of the extremes Most people consume a diversity of goods rather than extreme quantities of only one or two items Most people consume a diversity of goods rather than extreme quantities of only one or two items Each consumer makes resource allocation choices in accordance with his/her ordering Each consumer makes resource allocation choices in accordance with his/her ordering The consumer is both self interested and informed The consumer is both self interested and informed

9. Utility function as U(X1,X2,…,Xn) Utility function as U(X1,X2,…,Xn) There are n goods and services which can be in a bundle There are n goods and services which can be in a bundle Xi tells us how much of the i th goods and services in a bundle Xi tells us how much of the i th goods and services in a bundle The value of the function tells us what utility level has been assigned to any particular bundle consisting of X1, X2,…, Xn The value of the function tells us what utility level has been assigned to any particular bundle consisting of X1, X2,…, Xn This utility function can be explained graphically by using indifference curves This utility function can be explained graphically by using indifference curves A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS The Representation of preferences by indifference Curves

10. A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS MRS of a good T = MRS M,T MRS of a good T = MRS M,T MRS is the maximum number of units of T a consumer is willing to give up in return for getting more unit of M MRS is the maximum number of units of T a consumer is willing to give up in return for getting more unit of M This keeps the consumer just indifferent between the initial position and the proposed trade. This keeps the consumer just indifferent between the initial position and the proposed trade. MRS M,T is a measurable which can be compared for different consumers MRS M,T is a measurable which can be compared for different consumers MRS M,T is defined as the negative of the slope of the indifferent curve (the slope is negative so the MRS M,T is positive) MRS M,T is defined as the negative of the slope of the indifferent curve (the slope is negative so the MRS M,T is positive) MRS M,T is diminishing from left to right  the more tomatoes the consumer has, the less meat he will be willing to give up for another pounds of tomatoes. MRS M,T is diminishing from left to right  the more tomatoes the consumer has, the less meat he will be willing to give up for another pounds of tomatoes. The set of bundles which represent proportional combinations of B and C correspond to the points on the straight line between them The set of bundles which represent proportional combinations of B and C correspond to the points on the straight line between them

11. C. CONCEPT OF AN EFFICIENCY ALLOCATION OF RESOURCES IN AN ECONOMY AND ILLUSTRATION

12. THE GENERAL CONCEPT OF EFFICIENCY THE GENERAL CONCEPT OF EFFICIENCY An efficient allocation of resources is one from which no person can be made better off without making another person worse off. An efficient allocation of resources is one from which no person can be made better off without making another person worse off. Sometimes efficiency is referred to Pareto Optimality Sometimes efficiency is referred to Pareto Optimality Any allocation of resources which is not efficient is called inefficient. Any allocation of resources which is not efficient is called inefficient. The achievement of efficiency typically requires coordination among the different economic agents The achievement of efficiency typically requires coordination among the different economic agents

13. EFFICIENCY WITH AN INDIVIDUALISTIC INTERPRETATION EFFICIENCY WITH AN INDIVIDUALISTIC INTERPRETATION The definition of efficiency refers to individuals being either better off or worse off The definition of efficiency refers to individuals being either better off or worse off To apply it on any practical problem, we need a method of deciding whether someone’s well being has improved or detoriated To apply it on any practical problem, we need a method of deciding whether someone’s well being has improved or detoriated One way to develop such method is by using the principle of consumer sovereignty, which means that each person is the sole judge of his/her own welfare. One way to develop such method is by using the principle of consumer sovereignty, which means that each person is the sole judge of his/her own welfare. Efficiency would be judged under consumer sovereignty unless it is explicitly stated otherwise. Efficiency would be judged under consumer sovereignty unless it is explicitly stated otherwise. In using the consumer sovereignty principle, it is important to distinguish between consumer judgments and consumer actions. In using the consumer sovereignty principle, it is important to distinguish between consumer judgments and consumer actions.

14. EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY A pure exchange economy in which there are only two utility maximizing consumers and two different goods. A pure exchange economy in which there are only two utility maximizing consumers and two different goods. The allocation of resources in an economy is efficient in exchange if and only if the MRS of one good for another is the same for each persons consuming both of the two goods. The allocation of resources in an economy is efficient in exchange if and only if the MRS of one good for another is the same for each persons consuming both of the two goods. If MRS S ≠ MRS J  there would be “room for a deal”  inefficient If MRS S ≠ MRS J  there would be “room for a deal”  inefficient Efficiency requires that MRS between two goods in the economy must be the same for all consumers of the two goods. Efficiency requires that MRS between two goods in the economy must be the same for all consumers of the two goods. Consumer can increase their utility level by tradng Consumer can increase their utility level by tradng Equilibrium position of efficiency will be reached because of diminishing MRS Equilibrium position of efficiency will be reached because of diminishing MRS Efficiency requires only that we adequate the comparable MRS values of each consumer at their margin, we don’t have to know individual preferences in an absolute sense Efficiency requires only that we adequate the comparable MRS values of each consumer at their margin, we don’t have to know individual preferences in an absolute sense

15. EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY What if actual world consists of a great many consumers and a very large number of different goods and services?? What if actual world consists of a great many consumers and a very large number of different goods and services?? Price is one simple coordinating mechanism to accomplished the task If each good has one price, consumers pay to buy the good or receive when they sell it. Then each consumer can be thought of as having a budget constraint. If each good has one price, consumers pay to buy the good or receive when they sell it. Then each consumer can be thought of as having a budget constraint. A budget constraint derived by multiplying the quantity of each good in the initial endowment by its price and summing over all the goods in the endowment. A budget constraint derived by multiplying the quantity of each good in the initial endowment by its price and summing over all the goods in the endowment. The consumer will then try to allocate his budget for x and y goods that are brought: The consumer will then try to allocate his budget for x and y goods that are brought: MRS X,Y = P X / P Y

16. EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY For utility to be maximized, any consumer of both goods must have same MRS M,T. Since all consumers face the same prices, all try to achieve the same MRS M,T if they are successful, the resulting allocation is efficient. For utility to be maximized, any consumer of both goods must have same MRS M,T. Since all consumers face the same prices, all try to achieve the same MRS M,T if they are successful, the resulting allocation is efficient. If a policy results in at least one consumer of a good being charged a price different from the price charged other consumers of the good, the policy will generally be inefficient. If a policy results in at least one consumer of a good being charged a price different from the price charged other consumers of the good, the policy will generally be inefficient. Different price for the same good  MRS A ≠ MRS B  inefficient Different price for the same good  MRS A ≠ MRS B  inefficient The conclusion that Price discrimination is inefficient comes from applying the utility maximizing model of behavior to the definition of efficiency. The conclusion that Price discrimination is inefficient comes from applying the utility maximizing model of behavior to the definition of efficiency. The equilibrium prices are the ones which allow the consumers in the above example actually to achieve efficiency, any other prices will results in some consumers not being able to buy the quantities necessary to maximize their utility. The equilibrium prices are the ones which allow the consumers in the above example actually to achieve efficiency, any other prices will results in some consumers not being able to buy the quantities necessary to maximize their utility.

17. A GEOMETRIC REPRESENTATION OF THE MODEL A GEOMETRIC REPRESENTATION OF THE MODEL The Edgeworth Box

18. A GEOMETRIC REPRESENTATION OF THE MODEL A GEOMETRIC REPRESENTATION OF THE MODEL Every possible allocation of two goods between Smith and Jones is represented by one point in the Edgeworth Box Every possible allocation of two goods between Smith and Jones is represented by one point in the Edgeworth Box The gray area represents all allocations of meats and tomatoes whereby both Smith and Jones would consider themselves better off than at initial allocation. The gray area represents all allocations of meats and tomatoes whereby both Smith and Jones would consider themselves better off than at initial allocation. For every point like A, through which the indifferent curves intersect, improvements by trading are possible. For every point like A, through which the indifferent curves intersect, improvements by trading are possible. B is an efficient allocation; from it; it is impossible to find a trade which will make one person better off without making the other worse off  MRS S M,T = MRS J M,T  tangent B is an efficient allocation; from it; it is impossible to find a trade which will make one person better off without making the other worse off  MRS S M,T = MRS J M,T  tangent Contract curve illustrated that there are many possible resource allocation which are efficient Contract curve illustrated that there are many possible resource allocation which are efficient

19. A GEOMETRIC REPRESENTATION OF THE MODEL A GEOMETRIC REPRESENTATION OF THE MODEL Lower Left Corner of the Edgeworth Box G is not tangent but efficient G is not tangent but efficient There can not be any mutual satisfactory trades at point G There can not be any mutual satisfactory trades at point G Thus G is efficient  there’s a limit imposed by the boundaries Thus G is efficient  there’s a limit imposed by the boundaries

20. A GEOMETRIC REPRESENTATION OF THE MODEL A GEOMETRIC REPRESENTATION OF THE MODEL Economic model has now been constructed in two forms: Economic model has now been constructed in two forms: Verbal description Verbal description Geometric representation Geometric representation Modeling is a way for the model builder to learn, but it is also a way to communicate with others Modeling is a way for the model builder to learn, but it is also a way to communicate with others The main point of doing policy analysis is to learn The main point of doing policy analysis is to learn If policy analysis is to influence policy, it is particularly important to communicate it effectively If policy analysis is to influence policy, it is particularly important to communicate it effectively Presenting two different forms of an elementary economic model makes it easier to understand the analytic process that connects consumer choice to their efficiency consequences Presenting two different forms of an elementary economic model makes it easier to understand the analytic process that connects consumer choice to their efficiency consequences

21. RELATIVE EFFICIENCY RELATIVE EFFICIENCY The pareto concept of efficiency is an absolute one The pareto concept of efficiency is an absolute one We wish to know whether one allocation is relatively more efficient than another or whether an allocative change increases efficiency We wish to know whether one allocation is relatively more efficient than another or whether an allocative change increases efficiency One allocation is defined as Pareto superior to another if and only if it makes at least one person better off and no one worse off One allocation is defined as Pareto superior to another if and only if it makes at least one person better off and no one worse off Test for efficiency/ pareto optimality does not depend on whether someone has been made worse off; it depends only on whether it is possible to make someone better off without making anyone else worse off. Test for efficiency/ pareto optimality does not depend on whether someone has been made worse off; it depends only on whether it is possible to make someone better off without making anyone else worse off. Efficiency is a matter of whether there is a room for improvement, and one might wish that measures of efficiency indicated only the scarcity of the available room for improvement Efficiency is a matter of whether there is a room for improvement, and one might wish that measures of efficiency indicated only the scarcity of the available room for improvement

22. RELATIVE EFFICIENCY RELATIVE EFFICIENCY

24. D. CONCEPT OF AN EQUITABLE RESOURCE ALLOCATION AND ILLUSTRATION

25. EQUALITY OF OUTCOME IS ONE CONCEPT OF EQUITY EQUALITY OF OUTCOME IS ONE CONCEPT OF EQUITY Equity is a fairness in the distribution of goods and services among the people in an economy Equity is a fairness in the distribution of goods and services among the people in an economy Distibutions in the “middle” of the contract curve represent more equal outcomes than those at extremes Distibutions in the “middle” of the contract curve represent more equal outcomes than those at extremes If equality of well being or satisfaction is the objective, then it is the share of utility which should be of equal size. If equality of well being or satisfaction is the objective, then it is the share of utility which should be of equal size. But since the utility is neither measurable nor interpersonally comparable, we use income or wealth But since the utility is neither measurable nor interpersonally comparable, we use income or wealth

26. EQUALITY OF OPPORTUNITIES IS ANOTHER CONCEPT OF EQUITY EQUALITY OF OPPORTUNITIES IS ANOTHER CONCEPT OF EQUITY The process must be fair The process must be fair INTEGRATING EQUITY-EFFICIENCY EVALUATION IN A SOCIAL WELFARE FUNCTION INTEGRATING EQUITY-EFFICIENCY EVALUATION IN A SOCIAL WELFARE FUNCTION Social welfare function is a relation between a distribution of utility levels among society’s members and a judgment about the overall social satisfaction achieved by that distribution Social welfare function is a relation between a distribution of utility levels among society’s members and a judgment about the overall social satisfaction achieved by that distribution W = W(U 1, U 2,…, U m ) W = W(U 1, U 2,…, U m ) U i = utility level of the individual I = 1,2,…,m individuals in the economy To clarify the meaning of social welfare function, consider Smith and Jones as two person economy. The social welfare function will be: To clarify the meaning of social welfare function, consider Smith and Jones as two person economy. The social welfare function will be: W = W(U S, U J )

27. ALTERNATIVES SOCIAL WELFARE FUNCTIONS W B = social welfare functions which considers relative efficiency but is indifferent to the degree of equality Transfer units between Smith and Jones does not affect the level of social welfare, whether or not, the transfer increases or decreases the equality of distribution W = U S + U J W R = social welfare can be increased by raising the utility level of both people A change like the point A to point E improves welfare Benthamite function, but decreases it by Rawlsian standards because the minimum utility level, the worst off person declines W = min (U S + U J ) W M = a a middle of the road function that lies between Rawlsian and Benthamite ideals For any given level of agregate utility, social welfare increases with greater equality

28. SOCIAL WELFARE AND THE UTILITY POSSIBILITIES FRONTIER Maximum social welfare that can be achieved is on point C, social welfare tangent to utility possibilities frontier W D is not feasible because the resource is limited By this welfare function, society prefers more equality to less Two limitations to the use of social welfare functions in policy analysis: Utility is neither measurable for interpersonally comparable There’s no agreement or consensus in what “ proper” social welfare function is

29. Thank You