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TOOLS OF NORMATIVE ANALYSIS Chapter 3. Welfare Economics Concerned with the social desirability of alternative economic states. 3-2.

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Presentation on theme: "TOOLS OF NORMATIVE ANALYSIS Chapter 3. Welfare Economics Concerned with the social desirability of alternative economic states. 3-2."— Presentation transcript:

1 TOOLS OF NORMATIVE ANALYSIS Chapter 3

2 Welfare Economics Concerned with the social desirability of alternative economic states. 3-2

3 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 3-3

4 Edgeworth Box 2 person / 2 good economy Adam Eve 0 0’ s r Apples per year Fig leaves per year v wu y x At “v”, how many apples and figs do Adam and Eve consume? 3-4

5 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 3-5

6 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 AgAg AhAh ApAp EgEg g h p A Pareto Efficient Allocation 3-6

7 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 AgAg EgEg g p1p1 p E p1 A Pareto Efficient Allocation 3-7

8 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 AgAg EgEg g p1p1 p E p2 A p2 p2p2 Pareto efficient Pareto improvement 3-8

9 Starting from a different initial point: Point k Adam Eve 0 0’ s r Apples per year Fig leaves per year AgAg EgEg g p1p1 p E p2 A p2 p2p2 p3p3 p4p4 k 3-9

10 The Contract Curve Adam Eve 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 – locus of all Pareto efficient points 3-10

11 Pareto Efficiency in Consumption MRS af = MRS af 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 3-11

12 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 3-12

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

14 Marginal Rate of Transformation MRT af = Marginal rate of transformation of apples for fig leaves MRT af = rate at which the economy can transform one good into another MRT af = Absolute value of slope of Production Possibilities Frontier MRT af = MC a /MC f 3-14

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

16 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 3-16

17 The First Fundamental Theorem of Welfare Economics MRS af = P a /P f Consumption Side MRS af = P a /P f MRS af = MRS af MRS af = MRS af MC a /MC f = P a /P f Production Side MRT af = P a /P f P a /P f = MC a /MC f P a /P f = MC a /MC f Adam Eve Adam Eve 3-17

18 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 3-18

19 Efficiency versus Equity Adam Eve 0 0’ s r Apples per year Fig leaves per year q Does society have to choose between p 3 & q? p5p5 p3p3 3-19

20 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 p3p3 q p5p5 3-20

21 Social Indifference Curve Society’s willingness to trade off one person’s utility for another’s Eve’s utility Adam’s utility W = F(U Adam, U Eve ) Increasing social welfare 3-21

22 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) 3-22

23 Market Failures: Causes of Inefficiency Market Power – Monopoly Nonexistence of Markets – Asymmetric information – Externality – Public good 3-23

24 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? 3-24

25 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 – MRS i xy = MRT xy 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 3-25


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