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CHAPTER 3

CHAPTER 3. TOOLS OF NORMATIVE ANALYSIS. Welfare Economics. Criteria for Evaluating Government Policy Welfare Economics – branch of economic theory concerned with the social desirability of alternative economic states. . Welfare Economics.

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CHAPTER 3

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  1. CHAPTER 3 TOOLS OF NORMATIVE ANALYSIS

  2. Welfare Economics Criteria for Evaluating Government Policy Welfare Economics – branch of economic theory concerned with the social desirability of alternative economic states.

  3. Welfare Economics • Welfare economics is the systematic method of evaluating the economic implications of alternative resource allocations. • Welfare analysis answers the following questions: • i) Is a given resource allocation efficient? • ii) Who gains and who loses under various allocations, and by how much?

  4. Economic Efficiency • An efficient allocation of resources is one in which it is impossible through any change in resource allocation to make 1 person better off without making someone worse off. • Also called PARETO OPTIMALITY

  5. Indifference Curves • Economic model of Preferences/Tastes • Do you prefer to have:  10 CCC and 2 pieces of CC or 8 CCC and 5 pieces of CC or Indifferent ? • Matter of taste

  6. Assumptions Behind Indifference Curves • Preferences are Complete: Consumers can compare and rank all market baskets. Given A & B, a consumer will either prefer A to B, B to A or be indifferent. Note that preferences ignore costs. • Preferences are Transitive: If prefer A to B and B to C, then prefer A to C. • More is preferred to Less: All goods are desirable such that without considering costs, consumers always prefer more to less.

  7. A consumer’s tastes are represented by her/his indifference curves. • Indifference Curve – represents all combinations of market baskets that provide the same level of satisfaction to a person. The consumer is indifferent (in terms of taste) among the baskets on the curve. • A collection of baskets, all of which the consumer considers equally desirable.

  8. Example: Graph of IC • Example: I am indifferent between the following combinations: • 10 CC and 4 CCC; 5CC and 8 CCC; 3 ½ CC and 14 CCC • Draw those points on the graph and connect: One of my indifference curves. • Indifference Map: describes a person’s preferences for all combinations of CCC & CC.

  9. Slope of IC • MRS • The rate at which the individual is willing to trade the y-axis good for the x-axis good. • Steeper IC: x-axis good is valuable to consumer • Flatter IC: x-axis good is not so valuable to consumer

  10. y v u w x Edgeworth BoxPossible distributions of 2 commodities (total available each year) between 2 people. Eve r 0’ Fig leaves per year s 0 Adam Apples per year Edgeworth Box

  11. 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

  12. Eg Ap Ah Ag Making Adam better off without Eve becoming worse off Eve r 0’ g h A Pareto Efficient Allocation p Fig leaves per year s 0 Adam Apples per year Edgeworth Box

  13. Eg Ep1 Ag Making Eve better off without Adam becoming worse off Eve r 0’ g p Fig leaves per year p1 A Pareto Efficient Allocation s 0 Adam Apples per year Edgeworth Box

  14. Ep2 Eg Ap2 Ag Making both Adam and Eve better off Eve r 0’ g • Pareto efficient • Pareto improvement p Fig leaves per year p2 p1 s 0 Adam Apples per year Edgeworth Box

  15. Ep2 Eg Ag Ap2 Starting from a different initial point Eve r 0’ g k p4 p3 p Fig leaves per year p2 p1 s 0 Adam Apples per year Edgeworth Box

  16. Ep2 Eg Ag Ap2 The Contract Curve Eve r 0’ g The contract curve p4 p3 p Fig leaves per year p2 p1 s 0 Adam Apples per year Edgeworth Box

  17. Contract Curve • Locus of all Pareto efficient points. • Any point in the Edgeworth Box in which Adam’s indifference curve is just touching (tangent to) Eve’s indifference curve is a Pareto efficient point.

  18. Pareto Efficiency in Consumption MRSaf = MRSaf Eve Adam

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

  20. What is Fair?

  21. Which Allocation is “Best”?Utility Possibilities Curve • A graph showing the maximum amount of one person’s utility given each level of utility attained by the other person. • All points on or below UPC attainable.

  22. Utility Possibilities Curve: From EB to UPC Adam’s utility U p3 p5 q U Eve’sutility

  23. UPC: Where Should Society Be? • Social Welfare Function: Similar to IC, except it embodies society’s views on the relative well-being of its members. • W=F(Uadam, Ueve) • Embodies society’s sense of “fairness”

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

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

  26. Practice • End of Chapter 3, p. 51, #4 • End of Chapter 3, p. 52, #9 • End of Chapter 3, p. 52, #11a, c • End of Chapter 3, p. 52, #13d • End of Chapter 3, p. 52, #14d

  27. Market Failure • Market Power • monopoly • Nonexistence of Markets • asymmetric information • externality • public good

  28. Buying into Welfare Economics • Individualistic outlook • merit goods • 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?

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