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TOOLS OF NORMATIVE ANALYSIS. Welfare economics : Branch of economic theory concerned with the desirability of alternative economic states. Pure exchange economy Edgeworth box Conventionally shaped indifference curves.

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Tools of normative analysis

TOOLS OF NORMATIVE ANALYSIS

EC0 2006 PUBLIC SECTOR ECONOMICS


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

  • Pure exchange economy

  • Edgeworth box

  • Conventionally shaped indifference curves

EC0 2006 PUBLIC SECTOR ECONOMICS


  • 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.

EC0 2006 PUBLIC SECTOR ECONOMICS


  • 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 barely touching. The indifference curves must be tangent and their slopes equal.

  • MRS(Adam)= MRS(Eve)

EC0 2006 PUBLIC SECTOR ECONOMICS


  • 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 = MRS(Adam) = MRS(Eve)

EC0 2006 PUBLIC SECTOR ECONOMICS


  • The First Fundamental Theorem of Welfare Economics:

  • As long as

  • producers and consumers act as perfect competitors or price takers,

  • a market exists for each commodity,

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

EC0 2006 PUBLIC SECTOR ECONOMICS


EC0 2006 PUBLIC SECTOR ECONOMICS


  • Fairness: point where 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.

EC0 2006 PUBLIC SECTOR ECONOMICS


  • Utility possibilities curve point where is derived from the contract curve and it shows the maximum amount of one person’s utility given the other individual’s utility level.

  • All points on or below utility possibilities curve are attainable by society, all points above it are not attainable.

EC0 2006 PUBLIC SECTOR ECONOMICS


  • All points on utility possibilities curve are Pareto efficient but they represent very different distributions of real income between Adam and Eve.

  • To find which is best, a social welfare function which embodies society’s views on the relative deservedness of Adam and Eve must be postulated.

EC0 2006 PUBLIC SECTOR ECONOMICS


  • A social welfare function efficient but they represent very different distributions of real income between Adam and Eve. is a statement how society’s well-being relates to the 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.

EC0 2006 PUBLIC SECTOR ECONOMICS


  • 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.

EC0 2006 PUBLIC SECTOR ECONOMICS


  • The Second Fundamental Theorem of Welfare Economics of resources, government intervention may be necessary to achieve “fair” distribution of utility. :

  • society can attain any Pareto efficient allocation of resources by making a suitable assignment of individual endowments and letting people freely trade with each other 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 utility possibilities curve.

EC0 2006 PUBLIC SECTOR ECONOMICS


  • The issues of of resources, government intervention may be necessary to achieve “fair” distribution of utility. efficiency and distributional fairness can be separated.

  • If society determines that the current distribution of resources is unfair, without interfering with market prices and impairing efficiency, it needs only transfer resources among people in a way deemed to be fair.

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

EC0 2006 PUBLIC SECTOR ECONOMICS


  • Market Failure: of resources, government intervention may be necessary to achieve “fair” distribution of utility.

  • market power

  • inexistence of markets

  • asymmetric information

  • externality

  • public good

EC0 2006 PUBLIC SECTOR ECONOMICS


EC0 2006 PUBLIC SECTOR ECONOMICS


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