3-tools of normative analysis.ppt

EC0 2006 PUBLIC SECTOR ECONOMICS1

TOOLS OF NORMATIVE ANALYSIS

Prof.Dr. Y.Kuştepeli


Welfare economics: Branch of economic theory concerned with the desirability of alternative economic states.

Pure exchange economy

Edgeworth box

Conventionally shaped indifference curves



A Pareto-efficient allocation is an allocation in which it is impossible to make someone better off without making anyone else worse off.

A Pareto-improvement is a reallocation of resources that makes one person better off without making anyone else worse off.

The locus of all Pareto-efficient points is called the contract curve.



For an allocation to be Pareto-efficient, it must a point at which indifference curves of two individuals are touching.

Indifference curves must be tangent and slopes equal.

MRS(Adam)= MRS(Eve)



Production Possibilities Curve: shows the maximum quantity of x that can be produced along with any given quantity of y.

MRT = MCx/MCy = slope of PPF

Pareto efficiency requires :

MRT = MRSAdam = MRSEve



First Fundamental Theorem of Welfare Economics

If1) producers & consumers are perfect competitors

or price takers, 2) a market exists for each commodity,

then under certain conditions, a Pareto efficient allocation of resources emerges. (Invisible hand).



A profit maximizing competitive firm produces up to the point where

MCx/MCy = Px/Py = MRT = MRSAdam = MRSEve

Competition along with maximizing behavior on part of all individuals leads to an efficient outcome.



Fairness: If properly functioning competitive markets allocate resources efficiently, what is the role of government in the economy?

Its main function would be to establish a setting in which property rights are protected so that competition can work.



Utility possibilities curve (UPC)Derived from contract curve,Shows maximum amount of one person’s

utility given other individual’s utility,All points on UPC are Pareto-efficient but they

represent different distributions of real income.

The best distribution of income is found by a social welfare function (contains society’s views on relative deservedness).



A social welfare function is a statement how society’s well-being relates to well-being of its members.

The First Fundamental Theorem of Welfare Economics indicates that a properly working competitive system leads to some allocation on the utility possibilities curve.

There is no reason that it is the particular point that maximizes social welfare.



Even if the economy generates a Pareto-efficient allocation of resources, government intervention may be necessary to achieve “fair” distribution of utility.

A second reason why the fundamental theorem imply more than a minimal government is that certain conditions required for its validity may not be satisfied by real world markets.



Second Fundamental Theorem of Welfare Economics

Society can attain any Pareto-efficient allocation by a suitable assignment of individual endowments and free trade as in Edgeworth box.

By distributing income suitably and then getting out of the way and letting markets work, the government can attain any point on the UPC.



The issues of efficiency and distributional fairness can be separated.

If society thinks that current distribution is unfair; without interfering with market prices and impairing efficiency, it needs only transfer resources among people in a fair way.

Government needs some way to allocate resources and the only way for doing so, may cause inefficiencies.



Market Failure:

1. market power

2. inexistence of markets

asymmetric information externality public good



The fact that the market generated allocation of resources is imperfect does not mean that government is capable of doing better.

In certain cases, the costs of setting up a government agency to deal with externality could exceed the cost of externality itself.


People’s preferences are at center stage in welfare economics. People know best what gives them satisfaction.

Musgrave (1959) developed the concept of “merit goods”: commodities that ought to be provided even if the members of the society do not demand them, e.g. Fine arts.

Prof.Dr. Y.Kuştepeli EC0 2006 PUBLIC SECTOR ECONOMICS16

Welfare economics impels us to ask three key questions when a government activity is proposed:

1.Will it have desirable distributional consequences?

2.Will it enhance efficiency?3.Can it be done at a reasonable cost?

If the answer to these questions are no, the market should be left alone.

Prof.Dr. Y.Kuştepeli EC0 2006 PUBLIC SECTOR ECONOMICS17

3-tools of normative analysis.ppt

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