TOOLS OF NORMATIVE

ANALYSIS

EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

Welfare economics: Branch of economic

theory concerned with the desirability of

alternative economic states.
Pure exchange economy
Edgeworth box
Conventionally shaped indifference curves

EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

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.
The locus of all Pareto-efficient points is called

the contract curve.

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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

For an allocation to be Pareto-efficient, it must

a point at which indifference curves of two

individuals are touching.
Indifference curves must be tangent and slopes

equal.
MRS(Adam)= MRS(Eve)

EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

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 = MRSAdam = MRSEve

EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

First Fundamental Theorem of Welfare

Economics
If
1) producers & consumers are 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).
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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

A profit maximizing competitive firm

produces up to the point where

MCx/MCy = Px/Py = MRT = MRSAdam = MRSEve
Competition along with maximizing behavior

on part of all individuals leads to an efficient

outcome.

EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

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.

EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

Utility possibilities curve (UPC)

Derived from contract curve,
Shows maximum amount of one persons

utility given other individuals utility,

All points on UPC are Pareto-efficient but they
represent different distributions of real income.
The best distribution of income is found by a

social welfare function (contains societys

views on relative deservedness).
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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

A social welfare function is a statement how

societys well-being relates to 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.

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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

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.

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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

Second Fundamental Theorem of Welfare

Economics
Society can attain any Pareto-efficient

allocation by a suitable assignment of

individual endowments and free trade 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
UPC.

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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

The issues of efficiency and distributional

fairness can be separated.

If society thinks that current distribution is

unfair; without interfering with market prices

and impairing efficiency, it needs only transfer
resources among people in a fair way.
Government needs some way to allocate

resources and the only way for doing so, may

cause inefficiencies.
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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

 Market Failure:
1. market power
2. inexistence of markets
asymmetric information
externality
public good

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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

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.

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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

Peoples preferences are at center stage in

welfare economics. People know best what

gives them satisfaction.
Musgrave (1959) developed the concept of

merit goods: commodities that ought to be

provided even if the members of the society do
not demand them, e.g. Fine arts.

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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli

Welfare economics impels us to ask three key

questions when a government activity is proposed:

1. Will it have desirable distributional consequences?
2. Will it enhance efficiency?
3. Can it be done at a reasonable cost?
If the answer to these questions are no, the market

should be left alone.

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EC0 2006 PUBLIC SECTOR ECONOMICS

Prof.Dr. Y.Kutepeli