1. McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 3 TOOLS OF NORMATIVE ANALYSIS

2. 3-2 Welfare Economics  Welfare Economics – branch of economic theory concerned with the social desirability of alternative economic states.  Welfare economics relies heavily on certain basic economic tools.  Indifference curves represent customer preferences for certain products.

3. 3-3 Edgeworth Box Edgeworth Box (it depicts distribution of products between customers) Adam Eve 0 0’ s r Apples per year Fig leaves per year v wu y x

4. 3-4 Indifference curves in Edgeworth Box Edgeworth Box Adam Eve 0 0’0’ s r Apples per year Fig leaves per year A1A1 A2A2 A3A3 E1E1 E3E3 E2E2

5. 3-5 Indifference Curve  Adam is happier on indifference curve A3 than on A2 or A1.  Eve is happier on indifference curve E3 than on E2 or E1.  In general, Eve’s utility increases as her position moves toward southwest while Adam’s utility increases as he moves toward northeast.

6. 3-6 Making Adam better off without Eve becoming worse off Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year AgAg AhAh ApAp EgEg g h p A Pareto Efficient Allocation

7. 3-7 Pareto Efficient  Pareto Efficient allocation occurs when no person can be made better off without making another person worse off.  Pareto Efficiency requires that each person’s marginal rate of substitution between two commodities equal the marginal rate of transformation.  Pareto Efficiency is the economist’s benchmark of efficient performance for an economy.

8. 3-8 Pareto Efficient  Despite its appeal, Pareto Efficiency has no obvious claim as an ethical norm.  Society may prefer as inefficient allocation on the basis of equity or some other criterion.  This provides one possible reason for governmental intervention in the economy.  A second reason for the government intervention is the market failure.

9. 3-9 Pareto Improvement  Pareto Improvement is a reallocation of resources that makes one person better off without making anyone else worse off.

10. 3-10 Making Eve better off without Adam becoming worse off Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year AgAg EgEg g p1p1 p E p1 A Pareto Efficient Allocation

11. 3-11 Making both Adam and Eve better off Edgeworth Box 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

12. 3-12 Starting from a different initial point Edgeworth Box 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

13. 3-13 The Contract Curve Edgeworth Box 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

14. 3-14 The Contract Curve  The contract curve refers to the locus of all of the pareto efficient points.

15. 3-15 Pareto Efficiency in Consumption  The production possibilities curve: It shows the maximum quantity of one good that can be produced along with any given quantity of another good.  Marginal Rate of Substitution (MRS): It is the absolute value of the slope of the indifference curve indicates the rate at which the individual is willing to trade one good for an additional amount of another. MRS af = MRS af Adam Eve

16. 3-16 Production Possibilities Curve Apples per year Fig leaves per year C C 0 w y xz │Slope│ = marginal rate of transformation

17. 3-17 Marginal Rate of Transformation  MRT af = Marginal rate of transformation of apples for fig leaves  Marginal Cost (MC): It is the incremental production cost of one more unit of output.  MRT af = MC a /MC f

18. 3-18 Efficiency Conditions with Variable Production MRT af = MRS af = MRS af MC a /MC f = MRS af = MRS af AdamEve AdamEve

19. 3-19 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 AdamEve

20. 3-20 Efficiency versus Equity Edgeworth Box Adam Eve 0 0’ s r Apples per year Fig leaves per year q p5p5 p3p3

21. 3-21 Utility Possibilities Curve Eve’s utility Adam’s utility U U p3p3 q p5p5

22. 3-22 Social Welfare Function  Social Welfare Function is simply a statement of how society’s well-being relates to the well-being of its members.  Just as an individual’s welfare depends on the quantities of commodities he/she consumes, society’s welfare depends on the utilities of each of its members.  Even if the economy generates a Pareto efficient allocation of resources, government intervention may be necessary to achieve “fair” distribution of utility.

23. 3-23 Social Indifference Curve Eve’s utility Adam’s utility W = F(U Adam, U Eve ) Increasing social welfare

24. 3-24 Maximizing Social Welfare Eve’s utility Adam’s utility i ii iii

25. 3-25 Market Failure  Market Power monopoly  Nonexistence of Markets Asymmetric information: One party in a transaction has information that is not available to another; e.g. poverty. Externality: A situation in which one person’s behavior affects the welfare of another in a way that is outside the existing markets; e.g. clean air. Public good: A commodity that is non-rival in consumption – the fact that one person consumes it does not prevent anyone else from doing so as well; e.g. electricity.

26. 3-26 Buying Problems into Welfare Economics  Individualistic outlook merit goods: It describes commodities that ought to be provided even if the members of society do not demand them.  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? Any “no” answer means market should be left alone.