CHAPTER 3

TOOLS OF
NORMATIVE
ANALYSIS

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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

3-2
 Edgeworth Box
y Eve
r 0’
Fig leaves per year

v
u w

0 s
x
Adam
Apples per year
Edgeworth Box 3-3
 Indifference curves in Edgeworth Box Eve
r E1 0’

E2
Fig leaves per year

E3

A3

A2

A1
0 s
Adam
Apples per year
Edgeworth Box 3-4
 Making Adam better off without Eve
becoming worse off Eve
r 0’
g
Eg h A Pareto
Fig leaves per year

Efficient
Allocation

Ap

Ah

Ag
0 s
Adam
Apples per year
Edgeworth Box 3-5
 Making Eve better off without Adam
becoming worse off Eve
r 0’
g
Eg
Fig leaves per year

p
Ep1

p1
A Pareto
Efficient
Allocation
Ag
0 s
Adam
Apples per year
Edgeworth Box 3-6
 Making both Adam and Even better off Eve
r 0’
g
Eg
• Pareto efficient
Fig leaves per year

• Pareto improvement
Ep2
p
p2
p1

Ap2

Ag
0 s
Adam
Apples per year
Edgeworth Box 3-7
 Starting from a different initial point Eve
r 0’
g
Eg
k
Fig leaves per year

p4
Ep2
p3
p
p2
p1

Ap2

Ag
0 s
Adam
Apples per year
Edgeworth Box 3-8
 The Contract Curve Eve
r 0’
g
Eg
The
Fig leaves per year

p4 contract
Ep2 curve
p3
p
p2
p1

Ap2

Ag
0 s
Adam
Apples per year
Edgeworth Box 3-9
Pareto Efficiency in Consumption

Adam Eve

MRSaf = MRSaf

3-10
Production Possibilities Curve
Fig leaves per year

C
│Slope│ =
marginal rate of
transformation
w

C
0
x z Apples per year
3-11
Marginal Rate of Transformation
 MRTaf = Marginal rate of transformation of
apples for fig leaves
 MRTaf = MCa/MCf

3-12
Efficiency Conditions with Variable Production
Adam Eve
MRTaf = MRSaf = MRSaf
Adam Eve
MCa/MCf = MRSaf = MRSaf

3-13
The First Fundamental Theorem of Welfare
Economics
Adam
MRSaf = Pa/Pf
Eve
MRSaf = Pa/Pf
Adam Eve
MRSaf = MRSaf
MCa/MCf = Pa/Pf
MRTaf = Pa/Pf
Pa/Pf = MCa/MCf

3-14
 Efficiency versus Equity Eve
r 0’
Fig leaves per year

p3

p5 q

0 s
Adam
Apples per year
Edgeworth Box 3-15
Utility Possibilities Curve
Adam’s utility

p3

p5
q

U
Eve’s utility
3-16
Social Indifference Curve
W = F(UAdam, UEve)
Adam’s utility

Increasing
social
welfare

Eve’s utility
3-17
Maximizing Social Welfare
Adam’s utility

iii

ii

Eve’s utility
3-18
Market Failure
 Market Power
 monopoly
 Nonexistence of Markets
 asymmetric information
 externality
 public good

3-19
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?

3-20