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CHAPTER 3 TOOLS OF NORMATIVE ANALYSIS McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Economic Analysis Positive Analysis Analysis Based on Fact Normative Analysis Analysis Based on Judgment 3-2 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. 3-3 Edgeworth Box Eve y 0’ Fig leaves per year r v u 0 Adam w s x Apples per year Edgeworth Box 3-4 Edgeworth Box Eve y 0’ Fig leaves per year r v u 0 Adam w s x Apples per year Edgeworth Box 3-5 Edgeworth Box Eve y 0’ Fig leaves per year r v u 0 Adam w s x Apples per year Edgeworth Box 3-6 Indifference curves in Edgeworth Box r Eve 0’ E1 Fig leaves per year E2 E3 A3 A2 A1 s 0 Adam Apples per year Edgeworth Box 3-7 Where is a Pareto Efficient Point? 3-8 Pareto Efficiency in Consumption MRSaf Marginal rate of substitution of apples for fig leaves Ratio of Marginal Utilities Slope of the Indifference Curve Adam MRSaf Eve = MRSaf 3-9 The First Fundamental Theorem of Welfare Economics Adam MRSaf = 1/3 Eve 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? 3-10 The First Fundamental Theorem of Welfare Economics Adam MRSaf = Pa/Pf Eve MRSaf = Pa/Pf Adam Eve MRSaf = MRSaf Note: We can see this clearly from utility maximization. 3-11 Fig leaves per year Production Possibilities Curve(Frontier) C │Slope│ = marginal rate of transformation w y 0 C x z Apples per year 3-12 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 3-13 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? 3-14 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. 3-15 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 3-16 Efficiency versus Equity Eve 0’ Fig leaves per year r q iii p5 s 0 Adam p3 Apples per year Edgeworth Box 3-17 Adam’s utility Utility Possibilities Curve U p3 p5 q U Eve’s utility 3-18 Adam’s utility Social Indifference Curve W = F(UAdam, UEve) Increasing social welfare Eve’s utility 3-19 Adam’s utility Maximizing Social Welfare i iii ii Eve’s utility 3-20 Second Welfare Theorem Pareto Efficient Allocations can be a Competitive Equilibrium with Transfers Equity Efficiency We can pick any PE Allocation! Problem? 3-21 Market Failure Market Power Monopoly/Monopolistic Competition Violation? 3-22 Market Failure Nonexistence of Markets Asymmetric Information Job Insurance Moral Hazard 3-23 Market Failure Nonexistence of Markets Externality Pa/Pf = MCa/MCf Social MC > MC Free Rider 3-24 Problems with Welfare Economics Individualistic Outlook Good Society = Happy Society Members Merit Goods Subjective National Endowment for the Arts Results Orientation Not Process Dictator? 3-25 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! 3-26