Chapter 3: Normative Tools

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Chapter 3 Normative Tools
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Normative Analysis

• Normative Economics or Normative Analysis or
  Welfare Economics the study of how the economy
  should work with a subjective representation of
  what has occurred, what is happening, or what is
  expected to happen.
• Welfare economics refers to the branch of
  economic theory concerned with the social
  desirability of alternative economic states.
• Normative economics often is accompanied by tools
  of positive analysis by interpreting results of
  econometric models and then suggesting a policy
  prescription to achieve some goal (i.e., what
  should be done).
• Examples

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BASIC TERMINOLOGY

• Pareto improvement
• Pareto efficient or Pareto efficiency
• This means there is no such reallocation possible
  to improve the welfare or utility of one person
  without reducing the welfare or utility of
  another person.
• Pareto efficiency is one conventional standard
  for evaluating the optimal allocation of
  resources.
• Pareto efficiency, however, does NOT require any
  sort of fair distribution of resources.
  Therefore, this is a positive tool of analysis.
  Ultimately, we will find a set of Pareto
  efficient outcomes and then determine which is
  the best or most desirable. This is where the
  normative approach comes in.
•  
• For practice purposes, a change in public policy
  may not meet such stringent criteria. In many
  cases, some individual or business will be
  adversely affected by the policy.

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TERMINOLOGY CONTINUED

• 3. Kaldor-Hicks Criterion suggests an alternative
  approach to Pareto efficiency or Pareto
  Optimality.
• In this scenario,
• For example, a voluntary exchange that creates
  pollution would be a Kaldor-Hicks improvement if
  the buyers and sellers are still willing to carry
  out the transaction even if they have to fully
  compensate the victims of the pollution.
• In essence, a redistribution is possible such
  that there are no losers however, the actual
  compensation does not have to take place 

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KALDOR-HICKS CONTINED

• This sets the stage for using cost-benefit
  analysis in which we look at the net benefits
  or benefits-costs of a project to see if it is
  worth undertaking.
• As long as the benefits outweigh the costs then
  the project satisfies the Kaldor-Hicks
  criterionthe benefits (dollars) can compensate
  or pay for the costs (dollars).
• The criticism of such a technique is that the
  distribution of such benefits and costs may be a
  secondary consideration. Who receives the
  benefits?
• Additionally, aggregating the costs and benefits
  accruing to different individuals is difficult
  (summing utility). Simplifying assumptions are
  made to evaluate the dollar value of costs of
  benefits. However, the marginal utility of a
  dollar may be different for the rich and the
  poor. More concerns to address later in the
  course!

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• 4. Edgeworth Box A device (a box) used to
  depict the distribution of goods.
• Typically done in the most simplistic terms
  assuming two goods and a two person economy.
• Edgeworth Box analysis uses indifference curves
  to represent utility of different economic
  agents, and an initial endowment point of
  resources.
• An endowment point shows the initial allocation
  or resources.
• We can use the Edgeworth Box to look at possible
  points of Pareto improvement from an initial
  allocation and then a set of Pareto efficient
  points resulting from different endowment points.
• Edgeworth Box analysis requires a basic
  understanding of indifference curves. We will
  review this momentarily.

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• 5. Contract Curve within the context of the
  Edgeworth Box is the contract curve. The contract
  curve is
• Given all points are efficient, we can then
  compare the distribution of resources among the
  various efficient choices in determining the
  best allocation or distribution

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THE NEXT SECTION OF CHAPTER 3 WILL BE DONE ON THE
BLACKBOARD

• First Fundamental Welfare Theorem and the Second
  Fundamental Welfare Theorem.