Tools of normative analysis

Transcription

1 Tools of normative analysis Lecture 2 1

2 Welfare economics Need of tools to evaluate desirability of alternative policies ( states of the world ) WE helpful to understand when markets work or fail Microeoconomic approach Fundamental tool for government advisors 2

3 Pure exchange Edgeworth box 2 goods (A and C), 2 individuals (groups), here Adam and Eve Total goods quantities given, set equal to 1 What Adam does not have is owned by Eve 2 origins Point v, endowment distribution before exchange 3

4 Edgeworth Box 2 person / 2 good economy r y Eve 0 Fig leaves per year u v w 0 Adam x Apples per year s 3-4

5 Individual preferences and Pareto-optimality Individual preferences described by indifference curves (IC) Begin with endowment point at intersection of IC Lens is domain of exchange (Pareto set) Pareto set denotes distributions that individuals may freely choose because One is better off and none is worse off Both are better off Points within Pareto set are Pareto optimal 5

6 Indifference curves in Edgeworth Box r E 1 Eve 0 E 2 Fig leaves per year E 3 A 3 A 2 0 Adam A 1 Apples per year s 3-6

7 Pareto efficiency - 1 A Pareto efficient/optimal distribution: impossible to improve the situation of one individual without making another worse off (e.g. point p) In Pareto efficient distributions individual IC are tangent Pareto improvement (Pareto superior move) move from a situation where IC are not tangent to one where they are tangent 7

8 Beginning at Point g, how to make Adam better off without Eve becoming worse off r Eve 0 Fig leaves per year E g g h p A Pareto Efficient Allocation A p A h 0 A g s Adam Apples per year 3-8

9 Beginning at Point g, how to make Eve better off without Adam becoming worse off Eve r E g g 0 Fig leaves per year E p1 p 1 p 0 A Pareto Efficient Allocation A g s Adam Apples per year 3-9

10 Beginning at Point g how to make both Adam and Eve better off Eve r 0 Fig leaves per year E g E p2 g p 1 p 2 p Pareto efficient Pareto improvement A p2 0 A g s Adam Apples per year 3-10

11 Pareto efficiency - 2 Point p not only optimal point Conditional on original endowment Contract curve is locus of all Pareto optimal points Locus of tangency points Slope of IC identifies MRS Pareto efficiency implies MRS = Adam AC MRS Eve AC 11

12 Starting from a different initial point: Point k Eve Fig leaves per year r E g E p2 g p 1 p 2 p k p 3 p 4 0 A p2 0 A g s Adam Apples per year 3-12

13 The Contract Curve Eve r E g g 0 Fig leaves per year E p2 p 1 p 2 p p 3 p 4 The contract curve locus of all Pareto efficient points A p2 0 A g s Adam Apples per year 3-13

14 Economics with production Relax hypothesis of fixed quantities Hypothesis: inputs (L and K) can be re-allocated between production of goods If inputs are efficiently employed, producing more of good A shifts inputs from the production of good C Production of C will decrease Production possibility frontier (oftencited by Hitler: Do you want more butter or more guns?) denotes the maximal quantity of good A that can be produced at any given quantity of good C 14

15 Production Possibilities Curve Fig leaves per year w C Slope = marginal rate of transformation y 0 x z C Apples per year 3-15

16 Marginal rate of transformation To produce more C, from quantity 0x to 0z, one needs to produce less A, from 0w to 0y Segment wy is MC of producing xz more ( opportunity cost) MRT is ratio of wy to xz, so that MCA MRT AC = MCC To produce wy more inputs must be reallocated from production of A to production of C producton of A reduced by xz 16

17 Efficiency with variable production Condition of Pareto efficiency becomes (1) MRT = MRS = AC Adam AC MRS Suppose MRS Adam =1/3 and MRT=2/3. Adam wants 1 of bread in exchange of 3 croissants if he produces 3 croissants can obtain 2 of bread Adam can be better off without anyone being worse off always possible when MRS MRT When MRS=MRT utility level cannot be changed Rearranging (1) MCA Adam Eve = MRS AC = MRS AC MC C Eve AC 17

18 First Theorem of Welfare Economics First Theorem of Welfare Economics: if producers and consumers are perfectly competitive (price takers) under certain conditions (to be explained later) they will always reach a PE distribution of resources ( laissez faire) FTWE shows that competitive markets authomatically allocate resources in the most efficient way, without need of government intervention (Adam Smith s invisible hand ) 18

19 Conditions under which FTWE holds Competitionimplies that all individuals face same prices Under utility maximization, price ratio must be equal to individuals MRS P A Adamo MRS AC P = = C MRS On the production side, firm produces till P=MC. Setting prices equal to marginal costs MC A P = A MC P C C Eva AC Price ratio is hence equal to MRT P A = P C MRT AC This equation is equivalent to efficiency condition perfect competition determines efficient allocation of resources 19

20 Role of equity - 1 If markets produce efficient use of resources, government has no economic role Efficiency not the only criterion to evaluate the employ of resources In the diagram p3 is efficient and q is not, but q is characterized by a more equal distribution of resources 20

21 Efficiency versus Equity Eve r 0 Fig leaves per year p 5 q p 3 0 Does society have to choose between p 3 & q? s Adam Apples per year 3-21

22 The role of equity - 2 On the contract curve U Adam and U Eve are in trade off the higher the utility of Adam, the lower that of Eve Utility possibilities frontier Locus of maximal utility levels on the contact curve Which is the best point? Social welfare function: equivalent for society of an individual IC iii is optimum of optima 22

23 Utility Possibilities Curve Maximum amount of one person s utility given each level of another person s utility Adam s utility U p 3 p 5 q U Eve s utility 3-23

24 Social Indifference Curve Society s willingness to trade off one person s utility for another s Adam s utility W = F(U Adam, U Eve ) Increasing social welfare Eve s utility 3-24

25 Maximizing Social Welfare Adam s utility i iii If society values a more equitable distribution of goods - embodied in Social Indifference Curves, fairness and efficiency are possible (iii) ii Eve s utility 3-25

26 Role of equity - 3 SWF is seducing side of WE no scientific underpinnings! Heavily influenced by value judgements Slope of SWF is MRS between individual utilities How to assess that one individual is more important of another (Egalité, etc )? Problem of ethics (but an unsolved/unsolvable one) Efficiency has empirical dimensions and can be evalated with tools of economic analysis 26

27 Violations of FTWE - 1 Market power or non-existing markets P>MC: market economy produces inefficient results violation of FTWE Asymmetric information Market does not emerge (Akerlof s market for lemons ) government may intervene Externalities Activity of one individual affects the utility of others without going through price system (market) government may intervene Public good Good whose consumption is non rival individual has no incentive to reveal her MU MU P 27

28 Violations of FTWE - 2 The fact that markets fail to produce efficient allocations does not mean that governments can do better It s a possibility, which depends on many issues There are also government failures One of the subject matters of Public Choice FTWE helps thinking rigorously about merits of government intervention Are distributive consequences desirable? Are there efficiency improvements? Are costs reasonable? When the answer to any of these questions is no better to opt for market alternative Government intervention might be demanded for reasons of general interest (e.g. equity) but become in fact a special advantage (lobbies, bureaucracy) 28