TOOLS OF NORMATIVE
ANALYSIS
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
1

Welfare economics: Branch of economic
theory concerned with the desirability of
alternative economic states.

Pure exchange economy

Edgeworth box

Conventionally shaped indifference curves
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
2

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
3

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)
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
4

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)
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
5

The First Fundamental Theorem of
Welfare Economics:

1)
As long as
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).
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
6

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
7

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
8

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
9

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
10

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
11

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
12

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
13

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
14

Market Failure:
1.
market power
2.
inexistence of markets

asymmetric information
externality
public good


Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
15

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.
Assoc. Prof. Y.Kuştepeli
ECN 2042 PUBLIC ECONOMICS
16