CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All...

20
CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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Page 1: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

CHAPTER 3

Tools of Normative Analysis

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Page 2: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-2

Welfare Economics

• Welfare Economics – branch of economic theory concerned with the social desirability of alternative economic states

Page 3: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-3

Edgeworth Box

Adam

Eve

0

0’

s

r

Apples per year

Fig

leav

es p

er y

ear

vwu

y

x

Page 4: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-4

Indifference curves in Edgeworth Box

Adam

Eve

0

0’

s

r

Apples per year

Fig

leav

es p

er y

ear

A1

A2

A3

E1

E3

E2

Page 5: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-5

Making Adam better off without Eve becoming worse off

Adam

Eve

0

0’

s

r

Apples per year

Fig

leav

es p

er y

ear

Ag

Ah

Ap

Eg

gh

p

A Pareto Efficient

Allocation

Page 6: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-6

Making Eve better off without Adam becoming worse off

Adam

Eve

0

0’

s

r

Apples per year

Fig

leav

es p

er y

ear

Ag

Egg

p1

pEp1

A Pareto Efficient

Allocation

Page 7: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-7

Making both Adam and Eve better off

Adam

Eve

0

0’

s

r

Apples per year

Fig

leav

es p

er y

ear

Ag

Eg

g

p1

p

Ep2

Ap2

p2

• Pareto efficient

• Pareto improvement

Page 8: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-8

Starting from a different initial point

Adam

Eve

0

0’

s

r

Apples per year

Fig

leav

es p

er y

ear

Ag

Eg

g

p1

p

Ep2

Ap2

p2

p3

p4

k

Page 9: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-9

The Contract Curve

Adam

Eve

0

0’

s

r

Apples per year

Fig

leav

es p

er y

ear

Ag

Eg

g

p1

p

Ep2

Ap2

p2

p3

p4

The contract curve

Page 10: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-10

Pareto Efficiency in Consumption

MRSaf = MRSaf

Adam Eve

Page 11: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-11

Production Possibilities Curve

Apples per year

Fig

leav

es p

er y

ear

C

C0

w

y

x z

│Slope│ = marginal rate oftransformation

Page 12: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-12

Marginal Rate of Transformation

• MRTaf = Marginal rate of transformation of apples for fig leaves

• MRTaf = MCa/MCf

Page 13: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-13

Efficiency Conditions with Variable Production

• MRTaf = MRSaf = MRSaf

• MCa/MCf = MRSaf = MRSaf

Adam Eve

Adam Eve

Page 14: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-14

The First Fundamental Theorem of Welfare Economics

• MRSaf = Pa/Pf

• MRSaf = Pa/Pf

• MRSaf = MRSaf

• MCa/MCf = Pa/Pf

• MRTaf = Pa/Pf

• Pa/Pf = MCa/MCf

Adam

Eve

Adam Eve

Page 15: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-15

Efficiency versus Equity

Adam

Eve

0

0’

s

r

Apples per year

Fig

leav

es p

er y

ear

qp5

p3

Page 16: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-16

Utility Possibilities Curve

Eve’s utility

Ada

m’s

util

ity

U

U

p3

q

p5

Page 17: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-17

Social Indifference Curve

Eve’s utility

Ada

m’s

util

ity

W = F(UAdam, UEve)

Increasingsocialwelfare

Page 18: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-18

Maximizing Social Welfare

Eve’s utility

Ada

m’s

util

ity

i

ii

iii

Page 19: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-19

Market Failure

• Market Power– Monopoly

• Nonexistence of Markets– Asymmetric information– Externality– Public good

Page 20: CHAPTER 3 Tools of Normative Analysis Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

3-20

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?


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