Chapter 5: Normative Economics PDF

**Chapter 5: Normative Economics** Welfarism is based on theories of institutions which start from the normative premise that individual welfare, and only individual welfare, should matter for an evaluation of institutions. Individual welfare is measured in terms of the subjective wellbeing of indi...

**Chapter 5: Normative Economics** Welfarism is based on theories of institutions which start from the normative premise that individual welfare, and only individual welfare, should matter for an evaluation of institutions. Individual welfare is measured in terms of the subjective wellbeing of individuals, utility. Individuals follow their interests, so, to make sure that individual and social interests are aligned, one has to make sure that individual interests are channeled in the right way, by means of adequately designed institutions. Mainstream economics has mostly, if not exclusively, focused on welfaristic theories of just institutions and is, in this respect, normative. Economists' self-perception is that they are no experts in normative theories and that they focus on what could be seen as a minimum criterion for a society: the criterion of *Pareto effiency.* The idea goes back to the Italian economist Vilfredo Pareto. He wanted to understand under which conditions institutions are able to cope with the problem of scarcity in order to avoid waste. Waste, in this sense, is not the peel of a carrot, but a specific property of the allocation of goods, services and resources. **Efficiencies of allocations** An allocation is a technical term for the distribution of resources, goods and services among the individuals in a society. An allocation would be **inefficient** if it were possible to redistribute the available goods and services in a way that makes at least one individual better off without making any other individual worse off. Efficiency in production: an allocation of given quantities of resources is efficient in production, if it is not possible to reallocate the resources among the producers in such a way as to increase the production of at least one good without reducing the production of another good. Efficiency in consumption: an allocation of given quantities of goods and services is efficient in consumption, if it is not possible to reallocate the goods and services among the consumers in such a way as to increase the well-being of at least one consumer without reducing the well-being of another. Pareto efficiency requires both efficiency in production and consumption. However, Pareto efficiency may easily be at odds with one's ethical institutions about just or fair distribution of goods and services. According to welfarist theories, seeking Pareto improvements is necessary, but may not be sufficient for justice. **Graphical representations** A consumer's willingness to buy is the point at which the consumer is indifferent between buying and not buying. The difference between one's maximum willingness to pay and one's actual payment is **consumer surplus**. Given a market demand function for some good [*i*, *x*~*i*~(*p*~*i*~)]{.math.inline}, and a market price [*p*~*i*~]{.math.inline}, let [*P*~*i*~(*x*)]{.math.inline} be the inverse demand function and define as x([*p*~*i*~)]{.math.inline} the demand where the price equals the willingness to pay. The consumer surplus is the aggregate difference between the customers' willingness to pay and their actual payment, \ [CS(*x*(*p*~*i*~))= ∫~*x* = 0~^*x*(*p*~*i*~^(*P*~*i*~(*x*) − *p*~*i*~)*dx*]{.math.display}\ **Producer surplus:** Given a market supply function for some good [*i*, *y*~*i*~(*p*~*i*~), *and* *a* *market* *price* *p*~*i*~]{.math.inline}, let [*Q*~*i*~(*y*)]{.math.inline} the inverse supply function and define as [*y*(*p*~*i*~)]{.math.inline} the supply where the price equals the willingness to sell. The producer surplus is the aggregate difference between the market price and the firms' willingness to sell, [PS]{.math.inline} [(*y*(*p*~*i*~))= ∫~*y* = 0~^*y*(*p*~*i*~)^(*p*~*i*~−*Q*~*i*~(*y*))*dy*]{.math.inline} The sum of the consumer and producer surpluses is the community surplus and is a measure of the gains from trade made possible by this market. **First Theorem of Welfare Economics:** Every equilibrium on competitive markets is Pareto-efficientn **Second Theorem of Welfare Economics:** Assume that there are endowments of goods and resources, and that demand and supply fulfill certain conditions of regularity. Then, every Pareto-efficient allocation can be reached as a competitive equilibrium by means of reallocating endowments. - To enforce redistributive policies mentioned in the second theorem, the agency in charge requires sufficient independence and coercive power. Independence means no politicians on the payrolls of the rich, no lobbying, etc\... Coercive power means no complicated tax-avoidance strategies, trusts, etc... **Hidden willingness to pay** The *theory of revealed preference* makes the point that the true, normatively relevant preferences of a person can be elicited from his market behavior. Whether or not the observed willingness to pay is a reliable measure for the actual preferences of the individuals is a highly controversial question, as people suffer from behavioral biases (gap between the actual and revealed interests of people): - anchoring (suggesting random associations to influence people's estimates) - ego depletion (people with depleted ego due to cognitive tasks are more prone to overspending and impulsive purchases) Thus, there are areas of life where people seem to display less than perfect rationality - usually, the hardest decisions are those requiring a minimum degree of financial literacy, far-sightedness and commitment. If the revealed-preference paradigm becomes harder to defend, we can no longer assume that consumer and producer surplus are an adequate measure of welfare. **Markets** The complicated network of markets ensures that signals about relative scarcity are transmitted in a way that guides resources towards their most efficient uses. First Theorem of Welfare Economics: Every market equilibrium is Pareto-efficient. Second Theorem of Welfare Economics: Any Pareto-optimum can be decentralized as a market equilibrium by a reallocation of resources (though more restrictive assumptions are needed!) The ceteris-paribus condition: the analysis of a relationship under the assumption that all relevant variables, except one, are held constant. **Resource allocation:** - is [productively efficient] if, for given resource endowments, it is impossible to reallocate resources to increase the production of one good without decreasing the production of at least one other good. - is [allocatively efficient] if, for given quantities of goods, it is impossible to reallocate goods to make one individual better off without making another worse off. - is [Pareto efficient], if it is both productively and allocatively efficient (sum of producer and consumer surplus are maximized). Immagine che contiene animale, pianta Descrizione generata automaticamente 1. **Demand** **Willingness to pay:** The maximal amount of money that a consumer is willing to pay for a given quantity of a good. **Consumer surplus**: Difference between the willingness to pay and the price actually paid. Corresponds to the area under the demand curve and above the price.  2. **Supply** **Willingness to sell**: The minimum price at which a supplier is willing to sell a good. (=opportunity costs) Producer Surplus: The difference between the price actually received and the willingness to sell. Corresponds to the area under the price and above the supply function. Immagine che contiene screenshot, mappa, testo Descrizione generata automaticamente