Tools of normative analysis Lecture 2 Public Finance - Introductory

Public Finance - Introductory Welfare economics Need of tools to evaluate desirability of alternative policies (“states of the world”) WE helpful to understand when markets work or fail Microeoconomic approach Fundamental tool for government advisors Public Finance - Introductory

Public Finance - Introductory Pure exchange Edgeworth box 2 goods (A and C), 2 individuals (groups), here Adam and Eve Total goods quantities given, set equal to 1 What Adam does not have is owned by Eve 2 origins Point v, endowment → distribution before exchange Public Finance - Introductory

Edgeworth Box 2 person / 2 good economy Eve r 0’ v w u Fig leaves per year Box and dimensions initially set 1st click – place point v 2nd click – draw horizontal line uw 3rd click – draw vertical line xy s Adam Apples per year Public Finance - Introductory

Individual preference and Pareto-optimality Individual preferences described by indifference curves (IC) Begin with endowment point at intersection of IC Lens is domain of exchange (Pareto set) Pareto set denotes distributions that individuals may freely choose because One is better off and none is worse off Both are better off Points within Pareto set are Pareto optimal Public Finance - Introductory

Indifference curves in Edgeworth Box Eve r A3 E1 0’ A2 E2 A1 E3 Fig leaves per year Box and dimensions initially set 1st click – Adam’s indifference curves 2nd click – Eve’s indifference curves s Adam Apples per year Public Finance - Introductory

Public Finance - Introductory Pareto efficiency - 1 A Pareto efficient/optimal distribution: impossible to improve the situation of one individual without making another worse off (e.g. point p) In Pareto efficient distributions individual ICs are tangent Pareto improvement (Pareto superior move) → move from a situation where ICs are not tangent to one where they are tangent Public Finance - Introductory

Beginning at Point g, how to make Adam better off without Eve becoming worse off Ap r 0’ Ah g Ag Eg h A Pareto Efficient Allocation Fig leaves per year p Box and dimensions initially set 1st click – “A Pareto efficient allocation” and arrow s Adam Apples per year Public Finance - Introductory

Beginning at Point g, how to make Eve better off without Adam becoming worse off 0’ Ag g Eg p Fig leaves per year Ep1 Box and dimensions initially set 1st click – “A Pareto efficient allocation” and arrow p1 A Pareto Efficient Allocation s Adam Apples per year Public Finance - Introductory

Beginning at Point g how to make both Adam and Eve better off Ap2 r 0’ g Ag Eg Pareto efficient Pareto improvement Ep2 p Fig leaves per year p2 p1 Box and dimensions initially set 1st click – Box with Pareto efficient and improvement within s Adam Apples per year Public Finance - Introductory

Public Finance - Introductory Pareto efficiency - 2 Point p not only optimal point Conditional on original endowment Contract curve is locus of all Pareto optimal points Locus of tangency points Slope of ICs identifies MRS Pareto efficiency implies Public Finance - Introductory

Starting from a different initial point: Point k Eve Ap2 0’ r g Ag Eg k p4 Ep2 p3 Fig leaves per year p p2 Box and dimensions initially set 1st click – p1 s Adam Apples per year Public Finance - Introductory

Public Finance - Introductory The Contract Curve Eve Ap2 r 0’ g Ag Eg The contract curve –locus of all Pareto efficient points p4 Ep2 p3 Fig leaves per year p p2 Box and dimensions initially set 1st click – contract curve drawn from lower left to upper right and “The contract curve” and arrow appear p1 s Adam Apples per year Public Finance - Introductory

Economics with production Relax hypothesis of fixed quantities Hypothesis: inputs (labour and capital) can be re-allocated between production of goods If inputs are efficiently employed, producing more of good A shifts inputs from the production of good C Production of C will decrease ‘Production possibility frontier’ (often cited by Hitler: Do you want more butter or more guns?) denotes the maximal quantity of good A that can be produced at any given quantity of good C Public Finance - Introductory

Production Possibilities Curve │Slope│ = marginal rate of transformation Fig leaves per year w y Axes and labels 1st click – PPC and labels 2nd click – lines x and w 3rd click – lines z and y C x z Apples per year Public Finance - Introductory

Marginal rate of transformation To produce more C, from quantity 0x to 0z, one needs to produce less A, from 0w to 0y Segment wy is marginal cost (MC) of producing xz more (opportunity cost) MRT is ratio of wy to xz, so that To produce wy → more inputs must be reallocated from production of A to production of C → producton of A reduced by xz Public Finance - Introductory

Efficiency with variable production Condition of Pareto efficiency becomes (1) Suppose MRSAdam=1/3 and MRT=2/3. Adam wants 1 of bread in exchange of 3 croissants, but if he produces 3 croissants can obtain 2 of bread Adam can be better off without anyone being worse off → always possible when MRS≠MRT When MRS=MRT utility level cannot be changed Rearranging (1) Public Finance - Introductory

First Theorem of Welfare Economics - 1 First Theorem of Welfare Economics: if producers and consumers are perfectly competitive (price takers) under certain conditions (to be explained later) they will always reach a PE distribution of resources (→ laissez faire) FTWE shows that competitive markets authomatically allocate resources in the most efficient way, without need of government intervention (Adam Smith’s “invisible hand”) Public Finance - Introductory

First Theorem of Welfare Economics - 2 Competition implies that all individuals face same prices Under utility maximization, price ratio must be equal to individuals’ MRSs On the production side, firm produces till P=MC. Setting prices equal to marginal costs Price ratio is hence equal to MRT This equation is equivalent to efficiency condition → perfect competition determines efficient allocation of resources Public Finance - Introductory

Public Finance - Introductory Role of equity - 1 If markets produce efficient use of resources, government has no economic role Efficiency not the only criterion to evaluate the employ of resources In the diagram p3 is efficient and q is not, but q is characterized by a more equal distribution of resources Public Finance - Introductory

Public Finance - Introductory The role of equity - 2 On the contract curve UAdam and UEve are in trade off → the higher the utility of Adam, the lower that of Eve Utility possibilities frontier Locus of maximal utility levels on the contact curve Which is the ‘best point’? Social welfare function: equivalent for society of an individual IC iii is optimum of optima Public Finance - Introductory

Efficiency versus Equity Eve Does society have to choose between p3 & q? r 0’ p3 Fig leaves per year Box and dimensions initially set 1st click – contract curve drawn from lower left to upper right and “The contract curve” and arrow appear q p5 s Adam Apples per year Public Finance - Introductory

Public Finance - Introductory Utility Possibilities Curve Maximum amount of one person’s utility given each level of another person’s utility Adam’s utility U p3 Axes and labels 1st click – Utility possibilities curve, p3 and p5 2nd click - q p5 q U Eve’s utility Public Finance - Introductory

Public Finance - Introductory Social Indifference Curve Society’s willingness to trade off one person’s utility for another’s W = F(UAdam, UEve) Adam’s utility Increasing social welfare Axes and labels 1st click – the arrow (speed: medium) and “Increasing social welfare” Eve’s utility Public Finance - Introductory

Maximizing Social Welfare If society values a more equitable distribution of goods - embodied in Social Indifference Curves, fairness and efficiency are possible (iii) Adam’s utility i iii Axes, labels, and social indifference curves 1st click – utility possibilities curve and points ii Eve’s utility Public Finance - Introductory

Public Finance - Introductory Role of equity - 3 SWF is “seducing” side of WE – no scientific underpinnings! Heavily influenced by value judgements Slope of SWF is MRS between individual utilities How to assess that one individual is more important of another (Egalité, etc…)? Problem of ethics (but an unsolved/unsolvable one) Efficiency has empirical dimensions and can be evalated with tools of economic analysis Public Finance - Introductory

Public Finance - Introductory Violations of FTWE - 1 Market power or non-existing markets P>MC: market economy produces inefficient results → violation of FTWE Asymmetric information Market does not emerge (Akerlof’s ‘market for lemons’) → government may intervene Externalities Activity of one individual affects the utility of others without going through price system (market) → government may intervene Public good Good whose consumption is non rival → individual has no incentive to reveal her MU → MU≠P Public Finance - Introductory

Public Finance - Introductory Violations of FTWE - 2 The fact that markets fail to produce efficient allocations does not mean that governments can do better It’s a possibility, which depends on many issues There are also government failures One of the subject matters of Public Choice FTWE helps thinking rigorously about merits of government intervention Are distributive consequences desirable? Are there efficiency improvements? Are costs reasonable? When the answer to any of these questions is no → better to opt for market alternative Government intervention might be demanded for reasons of general interest (e.g. equity) but become in fact a special advantage (lobbies, bureaucracy) Public Finance - Introductory