Transcript TOOLS OF NORMATIVE ANALYSIS

TOOLS OF NORMATIVE
ANALYSIS
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
1
• Welfare economics: Branch of economic
theory concerned with the desirability of
alternative economic states.
• Pure exchange economy
• Edgeworth box
• Conventionally shaped indifference curves
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
2
• A pareto efficient allocation is an allocation in which it
is impossible to make someone better off without making
anyone else worse off.
• A Pareto improvement is a reallocation of resources that
makes one person better off without making anyone else
worse off.
• The locus of all Pareto efficient points is called the
contract curve. For an allocation to be pareto efficient it
must a point at which indifference curves of two
individuals are barely touching. The indifference curves
must be tangent and their slopes equal.
• MRS(Adam)= MRS(Eve)
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
3
• Production Possibilities Curve: shows
the maximum quantity of x that can be
produced along with any given quantity of
y.
• MRT = MCx/MCy = slope of PPF
• Pareto efficiency requires
MRT = MRS(Adam) = MRS(Eve)
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
4
• The First Fundamental Theorem of Welfare
Economics:
• As long as 1) producers and consumers act as perfect
competitors or price takers, 2) a market exists for each
commodity, then under certain conditions a Pareto
efficient allocation of resources emerges. (Invisible
hand).
• A basic result from economic theory is that a profit
maximizing competitive firm produces output up to the
point where
• MCx/MCy = Px/Py = MRT = MRS(Adam) = MRS(Eve)
• Competition along with maximizing behavior on part of
all individuals leads to an efficient outcome.
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
5
• Fairness: If properly functioning competitive markets
allocate resources efficiently, what is the role of
government in the economy?
• Its main function would be to establish a setting in which
property rights are protected so that competition can work.
• Utility possibilities curve is derived from the contract
curve and it shows the maximum amount of one person’s
utility given the other individual’s utility level.
• All points on or below utility possibilities curve are
attainable by society, all points above it are not attainable.
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
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• All points on utility possibilities curve are Pareto efficient
but they represent very different distributions of real
income between Adam and Eve. To find which is best, a
social welfare function which embodies society’s views
on the relative deservedness of Adam and Eve must be
postulated.
• A social welfare function is a statement how society’s
well-being relates to the well being of its members.
• The First Fundamental Theorem of Welfare Economics
indicates that a properly working competitive system
leads to some allocation on the utility possibilities curve.
There is no reason that it is the particular point that
maximizes social welfare.
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
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• Even if the economy generates a Pareto efficient
allocation of resources, government intervention
may be necessary to achieve “fair” distribution of
utility.
• A second reason why the fundamental theorem
need not imply a minimal government is that
certain conditions required for its validity may not
be satisfied by real world markets. When these
conditions are absent, the free market allocation
of resources may be inefficient.
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
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• The Second Fundamental Theorem of
Welfare Economics: society can attain
any Pareto efficient allocation of resources
by making a suitable assignment of
individual endowments and letting people
freely trade with each other as in
Edgeworth box.
• By distributing income suitably and then
getting out of the way and letting markets
work, the government can attain any point
on the utility possibilities curve.
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
9
• The issues of efficiency and distributional
fairness can be separated. If society
determines that the current distribution of
resources is unfair, without interfering with
market prices and impairing efficiency, it
needs only transfer resources among
people in a way deemed to be fair.
• Government needs some way to allocate
resources and the only way for doing so
(taxes) may cause inefficiencies.
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
10
• Market Failure:
1. market power
2. unexistence of markets
• asymmetric information
• externality
• public good
• The fact that the market generated allocation of
resources is imperfect does not mean that
government is capable of doing better. In certain
cases, the costs of setting up a government
agency to deal with externality could exceed the
cost of externality itself.
Assoc. Prof. Y.Kuştepeli
ECN 242 PUBLIC ECONOMICS
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