CHAPTER 3: NORMATIVE TOOLS
NORMATIVE ANALYSIS
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Normative Economics or Normative Analysis or
Welfare Economics: the study of how the economy should
work with a subjective representation of what has occurred,
what is happening, or what is expected to happen.
Welfare economics refers to the branch of economic theory
concerned with the social desirability of alternative
economic states.
Normative economics often is accompanied by tools of
positive analysis by interpreting results of econometric
models and then suggesting a policy prescription to achieve
some goal (i.e., what should be done).
Examples:
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BASIC TERMINOLOGY
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Pareto improvement:
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Pareto efficient or Pareto efficiency:
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This means there is no such reallocation possible to improve the welfare or utility
of one person without reducing the welfare or utility of another person.
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Pareto efficiency is one conventional standard for evaluating the optimal
allocation of resources.
Pareto efficiency, however, does NOT require any sort of “fair” distribution of resources.
Therefore, this is a positive tool of analysis. Ultimately, we will find a set of Pareto efficient
outcomes and then determine which is the “best” or most desirable. This is where the
normative approach comes in.
For practice purposes, a change in public policy may not meet such stringent criteria. In
many cases, some individual or business will be adversely affected by the policy.
TERMINOLOGY CONTINUED
3. Kaldor-Hicks Criterion suggests an alternative
approach to Pareto efficiency or Pareto Optimality.
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In this scenario,
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For example, a voluntary exchange that creates pollution
would be a Kaldor-Hicks improvement if the buyers and
sellers are still willing to carry out the transaction even if
they have to fully compensate the victims of the pollution.
In essence, a redistribution is possible such that there
are no losers; however, the actual compensation does
not have to take place
KALDOR-HICKS CONTINED
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This sets the stage for using cost-benefit analysis in
which we look at the “net benefits” or “benefits-costs” of
a project to see if it is worth undertaking.
 As long as the benefits outweigh the costs then the
project satisfies the Kaldor-Hicks criterion—the
benefits (dollars) can compensate or pay for the costs
(dollars).
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The criticism of such a technique is that the
distribution of such benefits and costs may be a
secondary consideration. Who receives the benefits?
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Additionally, aggregating the costs and benefits accruing to
different individuals is difficult (summing utility). Simplifying
assumptions are made to evaluate the dollar value of costs of
benefits. However, the marginal utility of a dollar may be
different for the rich and the poor. More concerns to address
later in the course!
4. Edgeworth Box: A device (a box) used to depict the
distribution of goods.
 Typically done in the most simplistic terms assuming two
goods and a two person economy.
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Edgeworth Box analysis uses indifference curves to
represent utility of different economic agents, and an initial
endowment point of resources.
 An endowment point shows the initial allocation or
resources.
We can use the Edgeworth Box to look at possible points of
Pareto improvement from an initial allocation and then a
set of Pareto efficient points resulting from different
endowment points.
Edgeworth Box analysis requires a basic understanding of
indifference curves. We will review this momentarily.
5. Contract Curve: within the context of the
Edgeworth Box is the contract curve. The
contract curve is…
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Given all points are efficient, we can then
compare the distribution of resources among the
various efficient choices in determining the “best”
allocation or distribution
THE NEXT SECTION OF
CHAPTER 3 WILL BE DONE
ON THE BLACKBOARD
First Fundamental Welfare Theorem and the
Second Fundamental Welfare Theorem.