CHAPTER 3
TOOLS OF
NORMATIVE
ANALYSIS
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Welfare Economics

Welfare Economics – branch of economic
theory concerned with the social desirability
of alternative economic states.

Welfare economics relies heavily on certain
basic economic tools.

Indifference curves represent customer
preferences for certain products.
3-2
Edgeworth Box
Eve
y
0’
Fig leaves per year
r
v
u
0
Adam
w
s
x
Apples per year
Edgeworth Box (it depicts distribution of
products between customers)
3-3
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
3-4
Indifference Curve

Adam is happier on indifference curve A3
than on A2 or A1.

Eve is happier on indifference curve E3 than
on E2 or E1.

In general, Eve’s utility increases as her
position moves toward southwest while
Adam’s utility increases as he moves toward
northeast.
3-5
Making Adam better off without Eve
becoming worse off
0’
r
Eg
Fig leaves per year
Eve
g
h
A Pareto
Efficient
Allocation
p
Ap
Ah
Ag
s
0
Adam
Apples per year
Edgeworth Box
3-6
Pareto Efficient



Pareto Efficient allocation occurs when no
person can be made better off without making
another person worse off.
Pareto Efficiency requires that each person’s
marginal rate of substitution between two
commodities equal the marginal rate of
transformation.
Pareto Efficiency is the economist’s
benchmark of efficient performance for an
economy.
3-7
Pareto Efficient

Despite its appeal, Pareto Efficiency has no
obvious claim as an ethical norm.

Society may prefer as inefficient allocation on
the basis of equity or some other criterion.

This provides one possible reason for
governmental intervention in the economy.

A second reason for the government
intervention is the market failure.
3-8
Pareto Improvement

Pareto Improvement is a reallocation of
resources that makes one person better off
without making anyone else worse off.
3-9
Making Eve better off without Adam
becoming worse off
r
0’
Fig leaves per year
Eg
g
p
Ep1
p1
A Pareto
Efficient
Allocation
Ag
s
0
Adam
Eve
Apples per year
Edgeworth Box
3-10
Making both Adam and Eve better off
Eve
0’
r
Fig leaves per year
Eg
g
• Pareto efficient
• Pareto improvement
Ep2
p
p2
p1
Ap2
Ag
s
0
Adam
Apples per year
Edgeworth Box
3-11
Starting from a different initial point
Eve
r
0’
Fig leaves per year
Eg
g
k
p4
Ep2
p
p3
p2
p1
Ap2
Ag
s
0
Adam
Apples per year
Edgeworth Box
3-12
The Contract Curve
Eve
0’
r
Fig leaves per year
Eg
g
The
contract
curve
p4
Ep2
p
p3
p2
p1
Ap2
Ag
s
0
Adam
Apples per year
Edgeworth Box
3-13
The Contract Curve

The contract curve refers to the locus of all of
the pareto efficient points.
3-14
Pareto Efficiency in Consumption


The production possibilities curve: It shows the
maximum quantity of one good that can be produced
along with any given quantity of another good.
Marginal Rate of Substitution (MRS): It is the
absolute value of the slope of the indifference curve
indicates the rate at which the individual is willing to
trade one good for an additional amount of another.
Adam
MRSaf
Eve
= MRSaf
3-15
Fig leaves per year
Production Possibilities Curve
C
│Slope│ =
marginal rate of
transformation
w
y
0
C
x
z
Apples per year
3-16
Marginal Rate of Transformation

MRTaf = Marginal rate of transformation of
apples for fig leaves

Marginal Cost (MC): It is the incremental
production cost of one more unit of output.

MRTaf = MCa/MCf
3-17
Efficiency Conditions with Variable Production
Adam
Eve
MRTaf = MRSaf = MRSaf
Adam
MCa/MCf = MRSaf = MRSaf
Eve
3-18
The First Fundamental Theorem of Welfare
Economics
Adam
MRSaf = Pa/Pf
Eve
MRSaf = Pa/Pf
Adam
Eve
MRSaf = MRSaf
MCa/MCf = Pa/Pf
MRTaf = Pa/Pf
Pa/Pf = MCa/MCf
3-19
Efficiency versus Equity
Eve
Fig leaves per year
r
0’
p3
p5
q
s
0
Adam
Apples per year
Edgeworth Box
3-20
Adam’s utility
Utility Possibilities Curve
U
p3
p5
q
U
Eve’s utility
3-21
Social Welfare Function

Social Welfare Function is simply a statement of
how society’s well-being relates to the well-being of
its members.

Just as an individual’s welfare depends on the
quantities of commodities he/she consumes,
society’s welfare depends on the utilities of each of
its members.

Even if the economy generates a Pareto efficient
allocation of resources, government intervention
may be necessary to achieve “fair” distribution of
utility.
3-22
Adam’s utility
Social Indifference Curve
W = F(UAdam, UEve)
Increasing
social
welfare
Eve’s utility
3-23
Adam’s utility
Maximizing Social Welfare
i
iii
ii
Eve’s utility
3-24
Market Failure

Market Power


monopoly
Nonexistence of Markets



Asymmetric information: One party in a transaction has
information that is not available to another; e.g. poverty.
Externality: A situation in which one person’s behavior
affects the welfare of another in a way that is outside the
existing markets; e.g. clean air.
Public good: A commodity that is non-rival in
consumption – the fact that one person consumes it does
not prevent anyone else from doing so as well; e.g.
electricity.
3-25
Buying Problems into Welfare Economics

Individualistic outlook

merit goods: It describes commodities that ought to be
provided even if the members of society do not demand
them.

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?
Any “no” answer means market should be left alone.
3-26