Transcript Chapter 2 An Introduction to Modeling, Efficiency and Equity

Chapter 2
An Introduction to Modeling, Efficiency and Equity
Microeconomic Policy Analysis
Lee S. Friedman
Johnny Patta
MAIN TOPICS
A. General Discussion of Modeling
B. Standar Model of Consumer Choice
C. Concept of an Efficient Allocation of
Resources in an Economy and Ilustration
D. Concept of Equitable Resource Allocation
and Ilustration
A. GENERAL DISCUSSION OF MODELING
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Modeling is a powerful technique used to predict the consequences
of policies.
A model is an abstraction intended to convey the essence of some
particular aspect of the real world.
The usefulness of a model to its users depends on the extent to
which it increases knowledge or understanding (and not on how
much it leaves unexplained).
Good economic models predict well enough to increase our
understanding of certain situations, even though the may not
predict them perfectly and there may be related situations in which
the same models do not predict as well as expected.
Model specification: the choice of a particular set of abstractions
from reality are used to construct the model
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Models based on theory have been very successful in predicting.
Microeconomic policy analysis (MPA) rely on conventional theory as
starting point and adapt it to account for circumstances specific to
each problem.
A fundamental analytic skill is to be able to identify plausible
alternative specifications relevant to a particular policy analysis
The point is to understand how heavily a policy conclusion depends
on specific assumptions
Policy conclusions are often quite sensitive to variations in the way
policy itself modeled.
The reexamination of assumptions which are standard and
appropriate in many contexts often becomes the central focus in a
particular policy context.
B. STANDARD MODEL OF CONSUMER
CHOICE
A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS
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The general assumptions: economic man  individual is portrayed
as a utility maximizer
It has four assumptions:
1. Each consumer is assumed to have preference ordering
2. Each consumer is non satiable
3. Each consumer has strictly convex preferences or stated informally,
prefer diversity in consumption bundles
4. Each consumer makes resource allocation choices in accordance with
his/her ordering
We will explain those assumptions in the next slide
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The first and fourth assumptions model rationality
The second and third assumptions are generalizations about
preferences
The first three assumptions are often represented by an ordinal
utility function
The fourth assumption is equivalent to the consumer acting to
maximize utility
A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS
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Each consumer is assumed to have preference ordering
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Each consumer is non satiable
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A property of consumer’s ordering is that more goods are preferred to less, other
things equal
The consumer is the judge of what things are “goods” as opposed to “bads”
Consumer may commonly have limits for specific goods within any time period 
there is always at least one good for which consumer is not yet sated
Each consumer has strictly convex preferences or stated informally, prefer
diversity in consumption bundles
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Consumer can compare any two possible bundles of goods and services and will
prefer one to the other or be indifferent.
Consumer is consistent
The consumer would prefer a more “balance” bundles to either of the extremes
Most people consume a diversity of goods rather than extreme quantities of only
one or two items
Each consumer makes resource allocation choices in accordance with
his/her ordering
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The consumer is both self interested and informed
A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS
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Utility function as U(X1,X2,…,Xn)
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There are n goods and services which can be in a bundle
Xi tells us how much of the i th goods and services in a bundle
The value of the function tells us what utility level has been assigned to any
particular bundle consisting of X1, X2,…, Xn
This utility function can be explained graphically by using indifference
curves
TOMATOES
C
A
4
3
UA
B
UB
0
4
5
MEAT
The Representation of
preferences by indifference
Curves
A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONS
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MRS of a good T = MRSM,T
MRS is the maximum number of units of T a consumer is willing to
give up in return for getting more unit of M
This keeps the consumer just indifferent between the initial position
and the proposed trade.
MRSM,T is a measurable which can be compared for different
consumers
MRSM,T is defined as the negative of the slope of the indifferent
curve (the slope is negative so the MRSM,T is positive)
MRSM,T is diminishing from left to right  the more tomatoes the
consumer has, the less meat he will be willing to give up for another
pounds of tomatoes.
The set of bundles which represent proportional combinations of B
and C correspond to the points on the straight line between them
C. CONCEPT OF AN EFFICIENCY
ALLOCATION OF RESOURCES IN AN
ECONOMY AND ILLUSTRATION
THE GENERAL CONCEPT OF EFFICIENCY
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An efficient allocation of resources is one from which no person can
be made better off without making another person worse off.
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Sometimes efficiency is referred to Pareto Optimality
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Any allocation of resources which is not efficient is called inefficient.
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The achievement of efficiency typically requires coordination among
the different economic agents
EFFICIENCY WITH AN INDIVIDUALISTIC INTERPRETATION
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The definition of efficiency refers to individuals being either better
off or worse off
To apply it on any practical problem, we need a method of deciding
whether someone’s well being has improved or detoriated
One way to develop such method is by using the principle of
consumer sovereignty, which means that each person is the sole
judge of his/her own welfare.
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Efficiency would be judged under consumer sovereignty unless it is
explicitly stated otherwise.
In using the consumer sovereignty principle, it is important to
distinguish between consumer judgments and consumer actions.
EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY
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A pure exchange economy in which there are only two utility maximizing
consumers and two different goods.
The allocation of resources in an economy is efficient in exchange if and
only if the MRS of one good for another is the same for each persons
consuming both of the two goods.
If MRSS ≠ MRSJ  there would be “room for a deal”  inefficient
Efficiency requires that MRS between two goods in the economy must be
the same for all consumers of the two goods.
Consumer can increase their utility level by tradng
Equilibrium position of efficiency will be reached because of diminishing
MRS
Efficiency requires only that we adequate the comparable MRS values of
each consumer at their margin, we don’t have to know individual
preferences in an absolute sense
EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY
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What if actual world consists of a great many consumers and a very
large number of different goods and services??
Price is one simple coordinating mechanism to accomplished the
task
If each good has one price, consumers pay to buy the good or
receive when they sell it. Then each consumer can be thought of as
having a budget constraint.
A budget constraint derived by multiplying the quantity of each
good in the initial endowment by its price and summing over all the
goods in the endowment.
The consumer will then try to allocate his budget for x and y goods
that are brought:
MRSX,Y= PX/ PY
EFFICIENCY IN A MODEL OF EXCHANGE ECONOMY
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For utility to be maximized, any consumer of both goods must have
same MRSM,T. Since all consumers face the same prices, all try to
achieve the same MRSM,T if they are successful, the resulting
allocation is efficient.
If a policy results in at least one consumer of a good being charged
a price different from the price charged other consumers of the
good, the policy will generally be inefficient.
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Different price for the same good  MRSA ≠ MRSB  inefficient
The conclusion that Price discrimination is inefficient comes from
applying the utility maximizing model of behavior to the definition of
efficiency.
The equilibrium prices are the ones which allow the consumers in
the above example actually to achieve efficiency, any other prices
will results in some consumers not being able to buy the quantities
necessary to maximize their utility.
A GEOMETRIC REPRESENTATION OF THE MODEL
TOMATOES
MJE
OJ
S3
S2
F
SE
D
A
TS
TJE
E
H
S1
B
JE
C
G
OS
J1
J2
J3
MSE
The Edgeworth Box
MEAT
A GEOMETRIC REPRESENTATION OF THE MODEL
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Every possible allocation of two goods between Smith and Jones is
represented by one point in the Edgeworth Box
The gray area represents all allocations of meats and tomatoes
whereby both Smith and Jones would consider themselves better off
than at initial allocation.
For every point like A, through which the indifferent curves
intersect, improvements by trading are possible.
B is an efficient allocation; from it; it is impossible to find a trade
which will make one person better off without making the other
worse off  MRSSM,T = MRSJM,T  tangent
Contract curve illustrated that there are many possible resource
allocation which are efficient
A GEOMETRIC REPRESENTATION OF THE MODEL
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G is not tangent but efficient
There can not be any mutual satisfactory trades at point G
Thus G is efficient  there’s a limit imposed by the boundaries
TOMATOES
J’
S’
G
Os`
MEAT
Lower Left Corner of the
Edgeworth Box
A GEOMETRIC REPRESENTATION OF THE MODEL
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Economic model has now been constructed in two forms:
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Verbal description
Geometric representation
Modeling is a way for the model builder to learn, but it is also a way
to communicate with others
The main point of doing policy analysis is to learn
If policy analysis is to influence policy, it is particularly important to
communicate it effectively
Presenting two different forms of an elementary economic model
makes it easier to understand the analytic process that connects
consumer choice to their efficiency consequences
RELATIVE EFFICIENCY
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The pareto concept of efficiency is an absolute one
We wish to know whether one allocation is relatively more efficient
than another or whether an allocative change increases efficiency
One allocation is defined as Pareto superior to another if and only if
it makes at least one person better off and no one worse off
Test for efficiency/ pareto optimality does not depend on whether
someone has been made worse off; it depends only on whether it is
possible to make someone better off without making anyone else
worse off.
Efficiency is a matter of whether there is a room for improvement,
and one might wish that measures of efficiency indicated only the
scarcity of the available room for improvement
RELATIVE EFFICIENCY
US
PARETO SUPERIOR
D
SE
H
A
R
Pareto superior which are feasible in
the economy
B
Utility possibilities frontier
JE
UJ
RELATIVE EFFICIENCY
US
Constant agregate utility
D
H
F
SE
B
A
Utility possibilities frontier
JE
UJ
D. CONCEPT OF AN EQUITABLE
RESOURCE ALLOCATION AND
ILLUSTRATION
EQUALITY OF OUTCOME IS ONE CONCEPT OF EQUITY
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Equity is a fairness in the distribution of goods and services among the
people in an economy
Distibutions in the “middle” of the contract curve represent more equal
outcomes than those at extremes
If equality of well being or satisfaction is the objective, then it is the share of
utility which should be of equal size.
But since the utility is neither measurable nor interpersonally comparable, we
use income or wealth
TOMATOES
OJ
C
B
T/2
A
G
F
OS
D
M/2
MEAT
EQUALITY OF OPPORTUNITIES IS ANOTHER CONCEPT OF EQUITY
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The process must be fair
INTEGRATING EQUITY-EFFICIENCY EVALUATION IN A SOCIAL
WELFARE FUNCTION
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Social welfare function is a relation between a distribution of utility
levels among society’s members and a judgment about the overall
social satisfaction achieved by that distribution
W = W(U1, U2,…, Um)
Ui= utility level of the individual
I = 1,2,…,m individuals in the economy
To clarify the meaning of social welfare function, consider Smith and
Jones as two person economy. The social welfare function will be:
W = W(US, UJ)
ALTERNATIVES SOCIAL WELFARE FUNCTIONS
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WB = social welfare functions which
considers relative efficiency but is
indifferent to the degree of equality
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US
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E
D
C
WR = social welfare can be increased by
raising the utility level of both people
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WR
A
WB
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WM
UJ
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Transfer units between Smith and Jones
does not affect the level of social welfare,
whether or not, the transfer increases or
decreases the equality of distribution
W = US + UJ
A change like the point A to point E
improves welfare Benthamite function, but
decreases it by Rawlsian standards because
the minimum utility level, the worst off
person declines
W = min (US + UJ)
WM = a a middle of the road function that
lies between Rawlsian and Benthamite
ideals
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For any given level of agregate utility, social
welfare increases with greater equality
SOCIAL WELFARE AND THE UTILITY POSSIBILITIES FRONTIER
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US
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A
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Maximum social welfare that can be
achieved is on point C, social welfare
tangent to utility possibilities frontier
WD is not feasible because the resource is
limited
By this welfare function, society prefers
more equality to less
Two limitations to the use of social welfare
functions in policy analysis:
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C
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B
WD
WC
E
WE
WA
UJ
Utility is neither measurable for
interpersonally comparable
There’s no agreement or consensus in what
“ proper” social welfare function is
Thank You