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CHAPTER 3. TOOLS OF NORMATIVE ANALYSIS. Welfare Economics. Criteria for Evaluating Government Policy Welfare Economics – branch of economic theory concerned with the social desirability of alternative economic states. . Welfare Economics.

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CHAPTER 3


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chapter 3

CHAPTER 3

TOOLS OF NORMATIVE ANALYSIS

welfare economics
Welfare Economics

Criteria for Evaluating Government Policy

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

welfare economics1
Welfare Economics
  • Welfare economics is the systematic method of evaluating the economic implications of alternative resource allocations.
  • Welfare analysis answers the following questions:
  • i) Is a given resource allocation efficient?
  • ii) Who gains and who loses under various allocations, and by how much?
economic efficiency
Economic Efficiency
  • An efficient allocation of resources is one in which it is impossible through any change in resource allocation to make 1 person better off without making someone worse off.
  • Also called PARETO OPTIMALITY
indifference curves
Indifference Curves
  • Economic model of Preferences/Tastes
  • Do you prefer to have: 

10 CCC and 2 pieces of CC

or

8 CCC and 5 pieces of CC

or

Indifferent ?

  • Matter of taste
assumptions behind indifference curves
Assumptions Behind Indifference Curves
  • Preferences are Complete: Consumers can compare and rank all market baskets. Given A & B, a consumer will either prefer A to B, B to A or be indifferent. Note that preferences ignore costs.
  • Preferences are Transitive: If prefer A to B and B to C, then prefer A to C.
  • More is preferred to Less: All goods are desirable such that without considering costs, consumers always prefer more to less.
a consumer s tastes are represented by her his indifference curves
A consumer’s tastes are represented by her/his indifference curves.
  • Indifference Curve – represents all combinations of market baskets that provide the same level of satisfaction to a person. The consumer is indifferent (in terms of taste) among the baskets on the curve.
  • A collection of baskets, all of which the consumer considers equally desirable.
example graph of ic
Example: Graph of IC
  • Example: I am indifferent between the following combinations:
  • 10 CC and 4 CCC; 5CC and 8 CCC;

3 ½ CC and 14 CCC

  • Draw those points on the graph and connect:

One of my indifference curves.

  • Indifference Map: describes a person’s preferences for all combinations of CCC & CC.
slope of ic
Slope of IC
  • MRS
  • The rate at which the individual is willing to trade the y-axis good for the x-axis good.
  • Steeper IC: x-axis good is valuable to consumer
  • Flatter IC: x-axis good is not so valuable to consumer
edgeworth box possible distributions of 2 commodities total available each year between 2 people

y

v

u

w

x

Edgeworth BoxPossible distributions of 2 commodities (total available each year) between 2 people.

Eve

r

0’

Fig leaves per year

s

0

Adam

Apples per year

Edgeworth Box

indifference curves in edgeworth box

E1

E2

E3

A3

A2

A1

Indifference curves in Edgeworth Box

Eve

r

0’

Fig leaves per year

s

0

Adam

Apples per year

Edgeworth Box

making adam better off without eve becoming worse off

Eg

Ap

Ah

Ag

Making Adam better off without Eve becoming worse off

Eve

r

0’

g

h

A Pareto Efficient Allocation

p

Fig leaves per year

s

0

Adam

Apples per year

Edgeworth Box

making eve better off without adam becoming worse off

Eg

Ep1

Ag

Making Eve better off without Adam becoming worse off

Eve

r

0’

g

p

Fig leaves per year

p1

A Pareto Efficient Allocation

s

0

Adam

Apples per year

Edgeworth Box

making both adam and eve better off

Ep2

Eg

Ap2

Ag

Making both Adam and Eve better off

Eve

r

0’

g

  • Pareto efficient
  • Pareto improvement

p

Fig leaves per year

p2

p1

s

0

Adam

Apples per year

Edgeworth Box

starting from a different initial point

Ep2

Eg

Ag

Ap2

Starting from a different initial point

Eve

r

0’

g

k

p4

p3

p

Fig leaves per year

p2

p1

s

0

Adam

Apples per year

Edgeworth Box

the contract curve

Ep2

Eg

Ag

Ap2

The Contract Curve

Eve

r

0’

g

The contract curve

p4

p3

p

Fig leaves per year

p2

p1

s

0

Adam

Apples per year

Edgeworth Box

contract curve
Contract Curve
  • Locus of all Pareto efficient points.
  • Any point in the Edgeworth Box in which Adam’s indifference curve is just touching (tangent to) Eve’s indifference curve is a Pareto efficient point.
efficiency versus equity
Efficiency versus Equity

Eve

r

0’

p3

Fig leaves per year

q

p5

s

0

Adam

Apples per year

Edgeworth Box

which allocation is best utility possibilities curve
Which Allocation is “Best”?Utility Possibilities Curve
  • A graph showing the maximum amount of one person’s utility given each level of utility attained by the other person.
  • All points on or below UPC attainable.
utility possibilities curve from eb to upc
Utility Possibilities Curve: From EB to UPC

Adam’s utility

U

p3

p5

q

U

Eve’sutility

upc where should society be
UPC: Where Should Society Be?
  • Social Welfare Function: Similar to IC, except it embodies society’s views on the relative well-being of its members.
  • W=F(Uadam, Ueve)
  • Embodies society’s sense of “fairness”
social indifference curve
Social Indifference Curve

W = F(UAdam,UEve)

Adam’s utility

Increasingsocialwelfare

Eve’sutility

maximizing social welfare
Maximizing Social Welfare

i

Adam’s utility

iii

ii

Eve’sutility

practice
Practice
  • End of Chapter 3, p. 51, #4
  • End of Chapter 3, p. 52, #9
  • End of Chapter 3, p. 52, #11a, c
  • End of Chapter 3, p. 52, #13d
  • End of Chapter 3, p. 52, #14d
market failure
Market Failure
  • Market Power
    • monopoly
  • Nonexistence of Markets
    • asymmetric information
    • externality
    • public good
buying into welfare economics
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?