1. CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. 3-2 Welfare Economics This chapter is about discussion of normative analysis in Public Finance. We will see that theoretical solutions to various questions involve normative analysis. Welfare Economics – branch of economic theory concerned with the social desirability of alternative economic states

3. 3-3 Welfare Economics What is the ideal income distribution. What is the optimal Tax rate. Why should we have social security system. The answer to these questions are subjective in nature. So, we will develop a framework which helps us understand consequences of various solutions.

4. 3-4 Edgeworth Box Edgeworh Box is a diagram that represents various distributions of resource in a simple 2 good 2 agents model.

5. 3-5 Edgeworth Box Adam Eve 0 0’0’ s r Apples per year Fig leaves per year v wu y x

6. 3-6 Indifference curves in Edgeworth Box Adam Eve 0 0’0’ s r Apples per year Fig leaves per year A1A1 A2A2 A3A3 E1E1 E3E3 E2E2

7. 3-7 Making Adam better off without Eve becoming worse off Adam Eve 0 0’0’ s r Apples per year Fig leaves per year AgAg AhAh ApAp EgEg g h p A Pareto Efficient Allocation

8. 3-8 Making Eve better off without Adam becoming worse off Adam Eve 0 0’0’ s r Apples per year Fig leaves per year AgAg EgEg g p1p1 p E p1 A Pareto Efficient Allocation

9. 3-9 Making both Adam and Eve better off Adam Eve 0 0’0’ s r Apples per year Fig leaves per year AgAg EgEg g p1p1 p E p2 A p2 p2p2 Pareto efficient Pareto improvement

10. 3-10 Starting from a different initial point Adam Eve 0 0’0’ s r Apples per year Fig leaves per year AgAg EgEg g p1p1 p E p2 A p2 p2p2 p3p3 p4p4 k

11. 3-11 The Contract Curve Adam Eve 0 0’0’ s r Apples per year Fig leaves per year AgAg EgEg g p1p1 p E p2 A p2 p2p2 p3p3 p4p4 The contract curve

12. 3-12 Pareto Efficiency in Consumption MRS af = MRS af Adam Eve

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

14. 3-14 Marginal Rate of Transformation MRT af = Marginal rate of transformation of apples for fig leaves MRT af = MC a /MC f

15. 3-15 Efficiency Conditions with Variable Production MRT af = MRS af = MRS af MC a /MC f = MRS af = MRS af AdamEve Adam Eve

16. 3-16 The First Fundamental Theorem of Welfare Economics MRS af = P a /P f MRS af = MRS af MC a /MC f = P a /P f MRT af = P a /P f P a /P f = MC a /MC f Adam Eve Adam Eve

17. 3-17 Efficiency versus Equity Adam Eve 0 0’0’ s r Apples per year Fig leaves per year q p5p5 p3p3

18. 3-18 Utility Possibilities Curve Eve’s utility Adam’s utility U U p3p3 q p5p5

19. 3-19 Social Indifference Curve Eve’s utility Adam’s utility W = F(U Adam, U Eve ) Increasing social welfare

20. 3-20 Maximizing Social Welfare Eve’s utility Adam’s utility i ii iii

21. 3-21 Market Failure Market Power –Monopoly Nonexistence of Markets –Asymmetric information –Externality –Public good

22. 3-22 Buying into Welfare Economics Individualistic outlook –Merit goods Results orientation Coherent framework for analyzing policy –Will it have desirable distributional consequences? –Will it enhance efficiency? –Can it be done at a reasonable cost?