CHAPTER
3
Tools of Normative Analysis
McGraw-Hill/Irwin
Copyright © 2010 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
y
Eve
0’
Fig leaves per year
r
v
u
w
0
Adam
s
x
Apples per year
3-3
Indifference curves in Edgeworth Box
Eve
r
0’
E1
Fig leaves per year
E2
E3
A3
A2
0
Adam
A1
s
Apples per year
3-4
Making Adam better off without Eve
becoming worse off
Eve
0’
r
Fig leaves per year
Eg
g
h
A Pareto
Efficient
Allocation
p
Ap
Ah
Ag
0
Adam
s
Apples per year
3-5
Making Eve better off without Adam
becoming worse off
Eve
r
0’
Fig leaves per year
Eg
g
p
Ep1
p1
A Pareto
Efficient
Allocation
Ag
0
Adam
s
Apples per year
3-6
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
0
Adam
s
Apples per year
3-7
Starting from a different initial point
Eve
0’
r
Fig leaves per year
Eg
g
k
p4
Ep2
p3
p
p2
p1
Ap2
Ag
0
Adam
s
Apples per year
3-8
The Contract Curve
Eve
r
0’
Fig leaves per year
Eg
g
The
contract
curve
p4
Ep2
p3
p2
p
p1
Ap2
Ag
0
Adam
s
Apples per year
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
Eve
• MCa/MCf = MRSaf = MRSaf
3-13
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
3-14
Efficiency versus Equity
Eve
0’
Fig leaves per year
r
p3
p5
q
s
0
Adam
Apples per year
3-15
Adam’s utility
Utility Possibilities Curve
U
p3
p5
q
U
Eve’s utility
3-16
Adam’s utility
Social Indifference Curve
W = F(UAdam, UEve)
Increasing
social
welfare
Eve’s utility
3-17
Adam’s utility
Maximizing Social Welfare
i
iii
ii
Eve’s utility
3-18
Market Failure
• Market Power
– Monopoly
• Nonexistence of Markets
– Asymmetric information
– Externality
– Public good
3-19
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?
3-20