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
3-2
Edgeworth Box
Eve
y
0’
Fig leaves per year
r
v
u
0
Adam
w
s
x
Apples per year
Edgeworth Box
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
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
3-5
Making Eve better off without Adam
becoming worse off
0’
r
Fig leaves per year
Eg
g
p
Ep1
p1
A Pareto
Efficient
Allocation
Ag
s
0
Adam
Eve
Apples per year
Edgeworth Box
3-6
Making both Adam and Even 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
3-7
Starting from a different initial point
Eve
0’
r
Fig leaves per year
Eg
g
k
p4
Ep2
p
p3
p2
p1
Ap2
Ag
s
0
Adam
Apples per year
Edgeworth Box
3-8
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
3-9
Pareto Efficiency in Consumption
Adam
MRSaf
Eve
= MRSaf
3-10
Fig leaves per year
Production Possibilities Curve
C
│Slope│ =
marginal rate of
transformation
w
y
0
C
x
z
Apples per year
3-11
Marginal Rate of Transformation

MRTaf = Marginal rate of transformation of
apples for fig leaves

MRTaf = MCa/MCf
3-12
Efficiency Conditions with Variable Production
Adam
Eve
MRTaf = MRSaf = MRSaf
Adam
MCa/MCf = MRSaf = MRSaf
Eve
3-13
Efficiency versus Equity
Eve
0’
Fig leaves per year
r
p3
p5
q
s
0
Adam
Apples per year
Edgeworth Box
3-14
Adam’s utility
Utility Possibilities Curve
U
p3
p5
q
U
Eve’s utility
3-15
Adam’s utility
Social Indifference Curve
W = F(UAdam, UEve)
Increasing
social
welfare
Eve’s utility
3-16
Adam’s utility
Maximizing Social Welfare
i
iii
ii
Eve’s utility
3-17
Market Failure

Market Power


monopoly
Nonexistence of Markets

asymmetric information

externality

public good
3-18
Buying into Welfare Economics

Individualistic outlook

merit goods

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?
3-19