Tools of Normative Analysis

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Tools of Normative Analysis
How do we assess the desirability of various
government actions? Welfare economics is
concerned with the social desirability of
alternative economic states. We will use welfare
economics to determine cases in which markets
fail to produce desirable results, producing a
role for government action. A simple economy
Two people, Alina and Stephanie. Two goods,
parkas and fried cheese curds. We use an
Edgeworth box to describe the distribution of
parkas and curds between them. to graph
construct an Edgeworth box with indifference
curves An allocation like point p on the graph,
at which the only way to make one person better
off is to make another worse off, is Pareto
efficient. Is Pareto efficiency is a desirable
condition for an economy? Why? In general, when
economists talk about efficiency they are
referring to the Pareto efficiency concept. Is
point 0 on the graph Pareto efficient? What may
be undesirable about point 0? Is Pareto
efficiency a fairness concept?
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A movement from point g to point p on the graph
(or away from any Pareto inefficient point on the
graph as long as someone is made better off and
no one worse off) is a Pareto improvement. We
could have made a move from g that would make
both Alina Stephanie better off. There are, in
fact, many Pareto efficient points that make both
people happier than they were at g, and in
general many Pareto efficient points in the
Edgeworth box. Try starting from another point,
k. The locus of all the Pareto efficient points
is the contract curve, and is mm in our
graph. Points in the contract curve are points of
tangency, i.e. points at which the slope of
Alinas indifference curve the slope of
Stephanies indifference curve. The absolute
value of the indifference curve slope is the rate
at which the individual is willing to trade off
one good for another, the marginal rate of
substitution. Pareto efficiency, therefore, is
where Production In the Edgeworth box, amounts
of available goods are fixed. What if the gods
are produced using inputs like labor hours, and
the amounts produced can change? to graph PPF
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The production possibilities curve shows the max
quantity of cheese curds that our inputs can
produce for a given amount of parkas produced. We
can increase parka production from Ox to Oz, a
distance xz, but wed have to give up distance wy
of curds to do so. wy/xz (curds given up over
parkas gained) is the marginal rate of
transformation of parkas for curds .
is the absolute value of the
slope of the production possibilities curve. We
can express the MRT as the marginal cost of parka
production in terms of curds over the marginal
cost of curd production in terms of parkas,
or Efficiency Conditions with Variable
Production With variable production of parkas and
curds, the condition for Pareto efficiency
becomes Why? Suppose Stephanies MRS of parkas
for curds is 1/3 and the MRT of p for c is 2/3.
How many parkas is Stephanie willing to give up
for 1 curd? By def. MRT, how many would she have
to give up to make a curd? Is she willing to do
that? Does any of this hurt Alina? Was MRS 1/3
for Stephanie MRT 2/3 efficient?
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Using our rule for MRT and marginal cost, it is
also true that is a necessary condition for
Pareto efficiency. The First Fundamental Theorem
of Welfare Economics (Efficiency) Assume (1)
All producers and consumers act as perfect
competitors no producer or consumer has market
power (i.e. no one can act independently to
change prices) (2) A market exists for every
commodity Then the first fundamental theorem
states that a Pareto-efficient allocation of
goods will emerge from an unfettered private
market. (Adam Smiths invisible hand) The
intuition behind the proof of the FFT The price
of parkas is . The price of cheese curds
is . Alinas utility-maximizing bundle is
such that
. Stephanies utility-maximizing bundle is such
that
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On the production side, we remember that
profit-maximizing competitive firms will produce
until P MC, so Recalling that the MRT of
parkas for curds the MC of parkas / the MC of
curds, we see that the conditions on Stephanies
utility-maximizing purchases, Alinas
utility-maximizing purchases and the producers
profit-maximizing output together imply our
condition for Pareto optimality. Thus we have
demonstrated that under assumptions (1) (2)
free markets will yield Pareto efficient
allocations of goods. Questions Does the FFT
imply that under (1) (2) free markets will
yield all-around good allocations? What amount of
government intervention is required if (1) (2)
hold and the only goal is efficiency? The Second
Fundamental Theorem of Welfare Economics
(Fairness) Efficiency may not be the only
criterion by which society judges
allocations. Returning to our graph, compare
points p5 and q. Which of these points is
efficient? Would all societies prefer it? Note
that the contract curve tells us the maximum
amount of utility Stephanie can have for each
level of Alinas utility.
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In utility space (in which Alinas utility is on
the horizontal axis and Stephanies on the
vertical), we can plot utility possibilities
curve UU, which expresses the maximum amount of
one persons utility given the others (and the
available resources and productive
capability). graph UU Note that p5 is on UU
and reflects a much higher utility for Louise
than for Ananth, and that q lies below UU but
represents a more even balance of utility between
Louise and Ananth. Which points on UU are Pareto
efficient? Which is best?
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• To answer this question, we construct a social
  welfare function, which represents societys
  preferences over the happiness of Alina and
  Stephanie.
• Societys welfare function yields a set of
  indifference curves across members utilities,
  just as an individuals utility function yields
  indifference curves across consumption goods.
• to graph of social indifference curves
• Social welfare increases to the northeast, as
  individual utilities increase.
• Superimposing social indifference curves on UU
  allows us to determine societys preferred
  allocation, which will necessarily be efficient,
  but will also incorporate social concerns about
  fairness.

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Does the government have to impose the preferred
allocation (iii) for it to be obtained? The
Second Fundamental Theorem of Welfare Economics
states that society can attain any Pareto
efficient allocation by suitably redistributing
income (or initial resources) and letting people
trade freely until the efficient allocation is
reached. Importance This means that the issues
of fairness and efficiency can be separated
government need not interfere with markets in
order to attain a fair distribution of
resources, it need only transfer resources among
its people in a way deemed fair.
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• Market Failure
• So our minimal government that achieves
  efficiency might not be so great if we also care
  about fairness.
• Another reason that the minimal government we
  decided achieves efficiency when (1) (2) hold
  might not work in reality is that (1) (2) dont
  always hold.
• Market power If some producers have power to
  affect prices in their markets, then they are
  likely to follow their own interests and not the
  consumers by raising price above marginal cost.
  This interferes with our stated condition for
  Pareto Efficiency.
• A Monopoly is a single firm that holds all of the
  power in its market. An Oligopoly is a small
  group of firms that does the same. In each case,
  the producer with market power lowers output
  (implicitly raising the price) so that P gt MC and
  the resulting allocation is inefficient.
• Nonexistence of markets The FFT assumes that a
  market exists for every good (2). If markets
  dont exist for some goods, can we expect the
  invisible hand to allocate them efficiently?

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There are some insurance goods for which markets
dont exist. Consider poverty insurance no firm
would sell it to you because youd be likely to
quit working and collect your insurance. You and
the insurer have asymmetric information about
your efforts to avoid poverty, and this
information problem destroys the market for
poverty insurance. Externalities Additionally,
market failure may arise due to the existence of
positive or negative externalities. What are some
examples? Does government intervene in these
cases? Public goods Finally, markets failure
occurs in the case of public goods. What are
some examples? Does government intervene in these
cases?