CHAPTER 3

1. CHAPTER 3 TOOLS OF NORMATIVE ANALYSIS

2. Economic Analysis • Positive Analysis • Analysis Based on Fact • Normative Analysis • Analysis Based on Judgment

3. Welfare Economics Welfare Economics • branch of economic theory concerned with the social desirability of alternative economic states • Pareto Efficient Allocation • An allocation of resources such that no person can be made better off without making another person worse off.

4. y v u w x Edgeworth Box Eve r 0’ Fig leaves per year s 0 Adam Apples per year Edgeworth Box

5. y v u w x Edgeworth Box Eve r 0’ Fig leaves per year s 0 Adam Apples per year Edgeworth Box

6. y v u w x Edgeworth Box Eve r 0’ Fig leaves per year s 0 Adam Apples per year Edgeworth Box

7. E1 E2 E3 A3 A2 A1 Indifference curves in Edgeworth Box Eve r 0’ Fig leaves per year s 0 Adam Apples per year Edgeworth Box

8. Where is a Pareto Efficient Point?

9. Pareto Efficiency in Consumption • MRSaf • Marginal rate of substitution of apples for fig leaves • Ratio of Marginal Utilities • Slope of the Indifference Curve MRSaf = MRSaf Adam Eve

10. The First Fundamental Theorem of Welfare Economics Adam MRSaf = 1/3 MRSaf = 2/3 • 5 Minute Activity with Partner • Suppose we have the situation above, show that this is not Pareto efficient. • Hint: What kind of trade would happen in this situation? Eve

11. The First Fundamental Theorem of Welfare Economics Adam MRSaf = Pa/Pf MRSaf = Pa/Pf MRSaf = MRSaf Note: We can see this clearly from utility maximization. Eve Adam Eve

12. Production Possibilities Curve(Frontier) C Fig leaves per year │Slope│ = marginal rate oftransformation w y C 0 x z Apples per year

13. Marginal Rate of Transformation • MRTaf • Marginal rate of transformation of apples for fig leaves • MCa/MCf • MCa = cost of apples = Δ Figs • MC in the Picture (OCs!) • Slope of PPF

14. Efficiency Conditions with Variable Production Adam Eve MRTaf = MRSaf = MRSaf • 5 Minute Activity with Partner • Suppose we have the following: • MRS = ¼ vs. MRT = ¾ • Why is this not efficient? • i.e. How could a benevolent dictator make the situation better?

15. The First Fundamental Theorem of Welfare Economics MCa = Pa MCf = Pf MCa/MCf = Pa/Pf MRTaf = Pa/Pf Pa/Pf = MCa/MCf Note: We can see this clearly from utility maximization.

16. The First Fundamental Theorem of Welfare Economics • Assumptions: • Perfect Competition • Existing Markets • Pareto Efficient Allocation Naturally Emerges • Invisible Hand • Competitive Equilibrium is Pareto Efficient • Define Competitive Equilibrium

17. Efficiency versus Equity Eve r 0’ p3 iii q Fig leaves per year p5 s 0 Adam Apples per year Edgeworth Box

18. Utility Possibilities Curve Adam’s utility U p3 p5 q U Eve’sutility

19. Social Indifference Curve W = F(UAdam,UEve) Adam’s utility Increasingsocialwelfare Eve’sutility

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

21. Second Welfare Theorem • Pareto Efficient Allocations can be a Competitive Equilibrium with Transfers • Equity • Efficiency • We can pick any PE Allocation! • Problem?

22. Market Failure • Market Power • Monopoly/Monopolistic Competition • Violation?

23. Market Failure • Nonexistence of Markets • Asymmetric Information • Job Insurance • Moral Hazard

24. Market Failure • Nonexistence of Markets • Externality • Pa/Pf = MCa/MCf • Social MC > MC • Free Rider

25. Problems with Welfare Economics • Individualistic Outlook • Good Society = Happy Society Members • Subjective • Merit Goods • National Endowment for the Arts • Results Orientation • Not Process • Dictator?

26. Buying into Welfare Economics • Coherent framework for Analyzing Policy • Will it have desirable distributional consequences? • Will it enhance efficiency? • Can it be done at a reasonable cost? • If no, leave it alone!