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TOOLS OF NORMATIVE ANALYSIS
Chapter 3
Welfare Economics
Concerned with the social desirability of alternative economic states.
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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
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Edgeworth Box
2 person / 2 good economy
Adam
Eve
0
0’
s
r
Apples per year
Fig leaves per year
v
w
u
y
x
At “v”, how many apples and figs do Adam and Eve consume
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Indifference curves in Edgeworth Box
Adam
Eve
0
0’
s
r
Apples per year
Fig leaves per year
A1
A2
A3
E1
E3
E2
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Beginning at Point g, how to make Adam better off without Eve becoming worse off
Adam
Eve
0
0’
s
r
Apples per year
Fig leaves per year
Ag
Ah
Ap
Eg
g
h
p
A Pareto Efficient Allocation
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Beginning at Point g, how to make Eve better off without Adam becoming worse off
Adam
Eve
0
0’
s
r
Apples per year
Fig leaves per year
Ag
Eg
g
p1
p
Ep1
A Pareto Efficient Allocation
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Beginning at Point g how to make both Adam and Eve better off
Adam
Eve
0
0’
s
r
Apples per year
Fig leaves per year
Ag
Eg
g
p1
p
Ep2
Ap2
p2
Pareto efficient
Pareto improvement
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Starting from a different initial point: Point k
Adam
Eve
0
0’
s
r
Apples per year
Fig leaves per year
Ag
Eg
g
p1
p
Ep2
Ap2
p2
p3
p4
k
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The Contract Curve
Adam
Eve
0
0’
s
r
Apples per year
Fig leaves per year
Ag
Eg
g
p1
p
Ep2
Ap2
p2
p3
p4
The contract curve –locus of all Pareto efficient points
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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
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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
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Production Possibilities Curve
Apples per year
Fig leaves per year
C
C
0
w
y
x
z
│Slope│ = marginal rate of transformation
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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
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Pareto Efficiency Conditions with Variable Production
MRTaf = MRSaf = MRSaf
MCa/MCf = MRSaf = MRSaf
Adam
Eve
Adam
Eve
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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
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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
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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
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Efficiency versus Equity
Adam
Eve
0
0’
s
r
Apples per year
Fig leaves per year
q
Does society have to choose between p3 & q
p5
p3
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Utility Possibilities Curve
Maximum amount of one person’s utility given each level of another person’s utility
Eve’s utility
Adam’s utility
U
U
p3
q
p5
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Social Indifference Curve
Society’s willingness to trade off one person’s utility for another’s
Eve’s utility
Adam’s utility
W = F(UAdam, UEve)
Increasing social welfare
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Maximizing Social Welfare
Eve’s utility
Adam’s utility
i
ii
iii
If society values a more equitable distribution of goods - embodied in Social Indifference Curves, fairness and efficiency are possible (iii)
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Market Failures: Causes of Inefficiency
Market Power
Monopoly
Nonexistence of Markets
Asymmetric information
Externality
Public good
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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
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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
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