Tools of normative analysis

1. Tools of normative analysis Lecture 2 Public Finance - Introductory

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 Public Finance - Introductory

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 Public Finance - Introductory

4. y v u w x Edgeworth Box2 person / 2 good economy Eve 0’ r Fig leaves per year 0 s Adam Apples per year Public Finance - Introductory

5. Individual preference 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 Public Finance - Introductory

6. E1 E2 E3 A3 A2 A1 Indifference curves in Edgeworth Box Eve r 0’ Fig leaves per year 0 s Adam Apples per year Public Finance - Introductory

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 ICs are tangent • Pareto improvement (Pareto superior move) → move from a situation where ICs are not tangent to one where they are tangent Public Finance - Introductory

8. Eg Ap Ah Ag Beginning at Point g, how to make Adam better off without Eve becoming worse off Eve r 0’ g h A Pareto Efficient Allocation Fig leaves per year p 0 s Adam Apples per year Public Finance - Introductory

9. Ep1 Eg Ag Beginning at Point g, how to make Eve better off without Adam becoming worse off Eve r 0’ g p Fig leaves per year p1 A Pareto Efficient Allocation s 0 Adam Apples per year Public Finance - Introductory

10. Ep2 Eg Ag Ap2 Beginning at Point g how to make both Adam and Eve better off Eve r 0’ g • Pareto efficient • Pareto improvement p Fig leaves per year p2 p1 0 s Adam Apples per year Public Finance - Introductory

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 ICs identifies MRS • Pareto efficiency implies Public Finance - Introductory

12. Eg Ep2 Ap2 Ag Starting from a different initial point: Point k Eve 0’ r g k p4 p3 p Fig leaves per year p2 p1 0 s Adam Apples per year Public Finance - Introductory

13. Eg Ep2 Ap2 Ag The Contract Curve Eve r 0’ g The contract curve –locus of all Pareto efficient points p4 p3 Fig leaves per year p p2 p1 0 s Adam Apples per year Public Finance - Introductory

14. Economics with production • Relax hypothesis of fixed quantities • Hypothesis: inputs (labour and capital) 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’ (often cited 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 Public Finance - Introductory

15. Production Possibilities Curve C │Slope│ = marginal rate oftransformation Fig leaves per year w y C 0 x z Apples per year Public Finance - Introductory

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 marginal cost (MC) of producing xz more (opportunity cost) • MRT is ratio of wy to xz, so that • To produce wy → more inputs must be reallocated from production of A to production of C → producton of A reduced by xz Public Finance - Introductory

17. Efficiency with variable production • Condition of Pareto efficiencybecomes (1) • Suppose MRSAdam=1/3 and MRT=2/3. • Adam wants 1 of bread in exchange of 3 croissants, butif he produces 3 croissants can obtain 2 of bread • Adam can be better off withoutanyonebeingworse off → alwayspossiblewhenMRS≠MRT • When MRS=MRT utility levelcannot be changed • Rearranging (1) Public Finance - Introductory

18. First Theorem of Welfare Economics - 1 • 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”) Public Finance - Introductory

19. First Theorem of Welfare Economics - 2 • Competition implies that all individuals face same prices • Under utility maximization, price ratio must be equal to individuals’ MRSs • On the production side, firm produces till P=MC. Setting prices equal to marginal costs • Price ratio is hence equal to MRT • This equation is equivalent to efficiency condition → perfect competition determines efficient allocation of resources Public Finance - Introductory

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 Public Finance - Introductory

21. The role of equity - 2 • On the contract curve UAdam and UEve 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 Public Finance - Introductory

22. Does society have to choose between p3 & q? Efficiency versus Equity Eve r 0’ p3 Fig leaves per year q p5 s 0 Adam Apples per year Public Finance - Introductory

23. Utility Possibilities CurveMaximum amount of one person’s utility given each level of another person’s utility Adam’s utility U p3 p5 q U Eve’sutility Public Finance - Introductory

24. Social Indifference CurveSociety’s willingness to trade off one person’s utility for another’s W = F(UAdam,UEve) Adam’s utility Increasingsocialwelfare Eve’sutility Public Finance - Introductory

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

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 Public Finance - Introductory

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 Public Finance - Introductory

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) Public Finance - Introductory