EC0 2006 PUBLIC SECTOR ECONOMICS1

TOOLS OF NORMATIVE

ANALYSIS

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS2

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

Pure exchange economy

Edgeworth box

Conventionally shaped indifference curves

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS3

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.

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS4

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)

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS5

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)

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS6

The First Fundamental Theorem of Welfare Economics:

As long as 1) producers and consumers act as 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).

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS7

A profit maximizing competitive firm produces up to the point where

MCx/MCy = Px/Py = MRT = MRS(Adam) = MRS(Eve)

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

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS8

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.

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS9

Utility possibilities curve 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.

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS10

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.

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS11

A social welfare function 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.

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS12

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.

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS13

The Second Fundamental Theorem of Welfare Economics:

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.

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS14

The issues of 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.

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS15

Market Failure:

1. market power

2. inexistence of markets

asymmetric information externality public good

Prof.Dr. Y.Kuştepeli

EC0 2006 PUBLIC SECTOR ECONOMICS16

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.

Prof.Dr. Y.Kuştepeli