Chapter 2 An Introduction to Modeling, Efficiency and Equity Microeconomic Policy Analysis Lee S. Friedman Johnny Patta

Chapter 2 Chapter 2 An Introduction to Modeling, Efficiency and An Introduction to Modeling, Efficiency and

EquityEquityMicroeconomic Policy AnalysisMicroeconomic Policy Analysis

Lee S. FriedmanLee S. Friedman

Johnny PattaJohnny Patta

MAIN TOPICSMAIN TOPICS

A. General Discussion of ModelingA. General Discussion of Modeling

B. Standar Model of Consumer ChoiceB. Standar Model of Consumer Choice

C. Concept of an Efficient Allocation of C. Concept of an Efficient Allocation of Resources in an Economy and Resources in an Economy and IlustrationIlustration

D. Concept of Equitable Resource D. Concept of Equitable Resource Allocation and IlustrationAllocation and Ilustration

A. GENERAL DISCUSSION OF A. GENERAL DISCUSSION OF MODELINGMODELING

Modeling is a powerful technique used to predict the Modeling is a powerful technique used to predict the consequences of policies.consequences of policies.

A model is an abstraction intended to convey the essence A model is an abstraction intended to convey the essence of some particular aspect of the real world.of some particular aspect of the real world.

The usefulness of a model to its users depends on the The usefulness of a model to its users depends on the extent to which it increases knowledge or understanding extent to which it increases knowledge or understanding (and not on how much it leaves unexplained).(and not on how much it leaves unexplained).

Good economic models predict well enough to increase our Good economic models predict well enough to increase our understanding of certain situations, even though the may understanding of certain situations, even though the may not predict them perfectly and there may be related not predict them perfectly and there may be related situations in which the same models do not predict as well situations in which the same models do not predict as well as expected.as expected.

Model specification: the choice of a particular set of Model specification: the choice of a particular set of abstractions from reality are used to construct the modelabstractions from reality are used to construct the model

Models based on theory have been very successful in Models based on theory have been very successful in predicting.predicting.

Microeconomic policy analysis (MPA) rely on conventional Microeconomic policy analysis (MPA) rely on conventional theory as starting point and adapt it to account for theory as starting point and adapt it to account for circumstances specific to each problem.circumstances specific to each problem.

A fundamental analytic skill is to be able to identify A fundamental analytic skill is to be able to identify plausible alternative specifications relevant to a particular plausible alternative specifications relevant to a particular policy analysispolicy analysis

The point is to understand how heavily a policy conclusion The point is to understand how heavily a policy conclusion depends on specific assumptionsdepends on specific assumptions

Policy conclusions are often quite sensitive to variations in Policy conclusions are often quite sensitive to variations in the way policy itself modeled.the way policy itself modeled.

The reexamination of assumptions which are standard and The reexamination of assumptions which are standard and appropriate in many contexts often becomes the central appropriate in many contexts often becomes the central focus in a particular policy context. focus in a particular policy context.

B. STANDARD MODEL OF CONSUMER B. STANDARD MODEL OF CONSUMER CHOICECHOICE

A MODEL OF INDIVIDUAL RESOURCES ALLOCATION A MODEL OF INDIVIDUAL RESOURCES ALLOCATION DECISIONSDECISIONS

The general assumptions: economic man The general assumptions: economic man individual is individual is portrayed as a utility maximizerportrayed as a utility maximizer

It has four assumptions:It has four assumptions:1. Each consumer is assumed to have preference ordering1. Each consumer is assumed to have preference ordering2. Each consumer is non satiable2. Each consumer is non satiable3. Each consumer has strictly convex preferences or stated 3. Each consumer has strictly convex preferences or stated

informally, prefer diversity in consumption bundlesinformally, prefer diversity in consumption bundles4. Each consumer makes resource allocation choices in 4. Each consumer makes resource allocation choices in

accordance with his/her orderingaccordance with his/her orderingWe will explain those assumptions in the next slideWe will explain those assumptions in the next slide

The first and fourth assumptions model rationalityThe first and fourth assumptions model rationality The second and third assumptions are generalizations The second and third assumptions are generalizations

about preferencesabout preferences The first three assumptions are often represented by an The first three assumptions are often represented by an

ordinal utility functionordinal utility function The fourth assumption is equivalent to the consumer acting The fourth assumption is equivalent to the consumer acting

to maximize utilityto maximize utility


Each consumer is assumed to have preference orderingEach consumer is assumed to have preference ordering Consumer can compare any two possible bundles of goods and services Consumer can compare any two possible bundles of goods and services

and will prefer one to the other or be indifferent.and will prefer one to the other or be indifferent. Consumer is consistentConsumer is consistent

Each consumer is non satiableEach consumer is non satiable A property of consumer’s ordering is that more goods are preferred to A property of consumer’s ordering is that more goods are preferred to

less, other things equalless, other things equal The consumer is the judge of what things are “goods” as opposed to The consumer is the judge of what things are “goods” as opposed to

“bads”“bads” Consumer may commonly have limits for specific goods within any time Consumer may commonly have limits for specific goods within any time

period period there is always at least one good for which consumer is not yet there is always at least one good for which consumer is not yet satedsated

Each consumer has strictly convex preferences or stated informally, Each consumer has strictly convex preferences or stated informally,

prefer diversity in consumption bundlesprefer diversity in consumption bundles The consumer would prefer a more “balance” bundles to either of the The consumer would prefer a more “balance” bundles to either of the

extremesextremes Most people consume a diversity of goods rather than extreme quantities Most people consume a diversity of goods rather than extreme quantities

of only one or two itemsof only one or two items

Each consumer makes resource allocation choices in accordance Each consumer makes resource allocation choices in accordance with his/her orderingwith his/her ordering

The consumer is both self interested and informedThe consumer is both self interested and informed

Utility function as U(X1,X2,…,Xn)Utility function as U(X1,X2,…,Xn) There are n goods and services which can be in a bundleThere are n goods and services which can be in a bundle Xi tells us how much of the Xi tells us how much of the i i th goods and services in a bundleth goods and services in a bundle The value of the function tells us what utility level has been assigned to The value of the function tells us what utility level has been assigned to

any particular bundle consisting of X1, X2,…, Xnany particular bundle consisting of X1, X2,…, Xn

This utility function can be explained graphically by using This utility function can be explained graphically by using indifference curvesindifference curves


The Representation of preferences by indifference Curves

0 4 5

3

4

B

AC

UB

UA

MEAT

TOMATOES


MRS of a good T = MRSMRS of a good T = MRSM,TM,T

MRS is the maximum number of units of T a consumer is willing MRS is the maximum number of units of T a consumer is willing to give up in return for getting more unit of Mto give up in return for getting more unit of M

This keeps the consumer just indifferent between the initial This keeps the consumer just indifferent between the initial position and the proposed trade.position and the proposed trade.

MRSMRSM,TM,T is a measurable which can be compared for different is a measurable which can be compared for different consumersconsumers

MRSMRSM,TM,T is defined as the negative of the slope of the indifferent is defined as the negative of the slope of the indifferent curve (the slope is negative so the MRScurve (the slope is negative so the MRSM,TM,T is positive) is positive)

MRSMRSM,TM,T is diminishing from left to right is diminishing from left to right the more tomatoes the more tomatoes the consumer has, the less meat he will be willing to give up for the consumer has, the less meat he will be willing to give up for another pounds of tomatoes.another pounds of tomatoes.

The set of bundles which represent proportional combinations The set of bundles which represent proportional combinations of B and C correspond to the points on the straight line of B and C correspond to the points on the straight line between thembetween them

C. CONCEPT OF AN EFFICIENCY C. CONCEPT OF AN EFFICIENCY ALLOCATION OF RESOURCES IN AN ALLOCATION OF RESOURCES IN AN

ECONOMY AND ILLUSTRATIONECONOMY AND ILLUSTRATION

THE GENERAL CONCEPT OF EFFICIENCYTHE GENERAL CONCEPT OF EFFICIENCY

An efficient allocation of resources is one from which no An efficient allocation of resources is one from which no person can be made better off without making another person can be made better off without making another person worse off.person worse off.

Sometimes efficiency is referred to Pareto OptimalitySometimes efficiency is referred to Pareto Optimality

Any allocation of resources which is not efficient is called Any allocation of resources which is not efficient is called inefficient.inefficient.

The achievement of efficiency typically requires The achievement of efficiency typically requires coordination among the different economic agentscoordination among the different economic agents

EFFICIENCY WITH AN INDIVIDUALISTIC INTERPRETATIONEFFICIENCY WITH AN INDIVIDUALISTIC INTERPRETATION

The definition of efficiency refers to individuals being either The definition of efficiency refers to individuals being either better off or worse offbetter off or worse off

To apply it on any practical problem, we need a method of To apply it on any practical problem, we need a method of deciding whether someone’s well being has improved or deciding whether someone’s well being has improved or detoriateddetoriated

One way to develop such method is by using the One way to develop such method is by using the principle of principle of consumer sovereignty, consumer sovereignty, which means that which means that each person is the each person is the sole judge of his/her own welfare.sole judge of his/her own welfare.

Efficiency would be judged under consumer sovereignty Efficiency would be judged under consumer sovereignty unless it is explicitly stated otherwise.unless it is explicitly stated otherwise.

In using the consumer sovereignty principle, it is important In using the consumer sovereignty principle, it is important to distinguish between consumer judgments and consumer to distinguish between consumer judgments and consumer actions. actions.

EFFICIENCY IN A MODEL OF EXCHANGE ECONOMYEFFICIENCY IN A MODEL OF EXCHANGE ECONOMY

A pure exchange economy in which there are only two utility A pure exchange economy in which there are only two utility maximizing consumers and two different goods.maximizing consumers and two different goods.

The allocation of resources in an economy is efficient in exchange The allocation of resources in an economy is efficient in exchange if and only if the MRS of one good for another is the same for each if and only if the MRS of one good for another is the same for each persons consuming both of the two goods.persons consuming both of the two goods.

If MRSIf MRSSS ≠ ≠ MRSMRSJJ there would be “room for a deal” there would be “room for a deal” inefficient inefficient

Efficiency requires that MRS between two goods in the economy Efficiency requires that MRS between two goods in the economy must be the same for all consumers of the two goods.must be the same for all consumers of the two goods.

Consumer can increase their utility level by tradngConsumer can increase their utility level by tradng

Equilibrium position of efficiency will be reached because of Equilibrium position of efficiency will be reached because of diminishing MRSdiminishing MRS

Efficiency requires only that we adequate the comparable MRS Efficiency requires only that we adequate the comparable MRS values of each consumer at their margin, we don’t have to know values of each consumer at their margin, we don’t have to know individual preferences in an absolute sense individual preferences in an absolute sense


What if actual world consists of a great many consumers What if actual world consists of a great many consumers and a very large number of different goods and services??and a very large number of different goods and services??

Price is one simple coordinating mechanism to Price is one simple coordinating mechanism to accomplished the taskaccomplished the task

If each good has one price, consumers pay to buy the good If each good has one price, consumers pay to buy the good or receive when they sell it. Then each consumer can be or receive when they sell it. Then each consumer can be thought of as having a budget constraint.thought of as having a budget constraint.

A budget constraint derived by multiplying the quantity of A budget constraint derived by multiplying the quantity of each good in the initial endowment by its price and each good in the initial endowment by its price and summing over all the goods in the endowment. summing over all the goods in the endowment.

The consumer will then try to allocate his budget for x and The consumer will then try to allocate his budget for x and y goods that are brought:y goods that are brought:

MRSMRSX,YX,Y= P= PXX/ P/ PYY


For utility to be maximized, any consumer of both goods must For utility to be maximized, any consumer of both goods must have same MRShave same MRSM,TM,T. Since all consumers face the same prices, . Since all consumers face the same prices, all try to achieve the same MRSall try to achieve the same MRSM,TM,T if they are successful, the if they are successful, the resulting allocation is efficient.resulting allocation is efficient.

If a policy results in at least one consumer of a good being If a policy results in at least one consumer of a good being charged a price different from the price charged other charged a price different from the price charged other consumers of the good, the policy will generally be inefficient. consumers of the good, the policy will generally be inefficient. Different price for the same good Different price for the same good MRS MRSAA ≠ ≠ MRSMRSBB inefficient inefficient The conclusion that Price discrimination is inefficient comes from The conclusion that Price discrimination is inefficient comes from

applying the utility maximizing model of behavior to the definition applying the utility maximizing model of behavior to the definition of efficiency.of efficiency.

The equilibrium prices are the ones which allow the consumers The equilibrium prices are the ones which allow the consumers in the above example actually to achieve efficiency, any other in the above example actually to achieve efficiency, any other prices will results in some consumers not being able to buy prices will results in some consumers not being able to buy the quantities necessary to maximize their utility.the quantities necessary to maximize their utility.

A GEOMETRIC REPRESENTATION OF THE MODELA GEOMETRIC REPRESENTATION OF THE MODEL

MEAT

TOMATOES

S3S2

J1

SE

S1

JE

J3

J2

A

D

H

B

C

G

MS

E

TS

E TJ

E

MJ

E

OS

OJ

F

The Edgeworth Box


Every possible allocation of two goods between Smith and Every possible allocation of two goods between Smith and Jones is represented by one point in the Edgeworth BoxJones is represented by one point in the Edgeworth Box

The gray area represents all allocations of meats and The gray area represents all allocations of meats and tomatoes whereby both Smith and Jones would consider tomatoes whereby both Smith and Jones would consider themselves better off than at initial allocation.themselves better off than at initial allocation.

For every point like A, through which the indifferent curves For every point like A, through which the indifferent curves intersect, improvements by trading are possible.intersect, improvements by trading are possible.

B is an efficient allocation; from it; it is impossible to find a B is an efficient allocation; from it; it is impossible to find a trade which will make one person better off without making trade which will make one person better off without making the other worse off the other worse off MRS MRSSS

M,TM,T = = MRSMRSJJM,T M,T tangent tangent

Contract curve illustrated that there are many possible Contract curve illustrated that there are many possible resource allocation which are efficientresource allocation which are efficient


Lower Left Corner of the Edgeworth Box

TOMATOES

MEAT

G

S’

J’

Os`

G is not tangent but efficientG is not tangent but efficient There can not be any mutual satisfactory trades at point GThere can not be any mutual satisfactory trades at point G Thus G is efficient Thus G is efficient there’s a limit imposed by the boundaries there’s a limit imposed by the boundaries


Economic model has now been constructed in two forms:Economic model has now been constructed in two forms: Verbal descriptionVerbal description Geometric representationGeometric representation

Modeling is a way for the model builder to learn, but it is Modeling is a way for the model builder to learn, but it is also a way to communicate with othersalso a way to communicate with others

The main point of doing policy analysis is to learnThe main point of doing policy analysis is to learn

If policy analysis is to influence policy, it is particularly If policy analysis is to influence policy, it is particularly important to communicate it effectivelyimportant to communicate it effectively

Presenting two different forms of an elementary economic Presenting two different forms of an elementary economic model makes it easier to understand the analytic process model makes it easier to understand the analytic process that connects consumer choice to their efficiency that connects consumer choice to their efficiency consequencesconsequences

RELATIVE EFFICIENCYRELATIVE EFFICIENCY

The pareto concept of efficiency is an absolute oneThe pareto concept of efficiency is an absolute one

We wish to know whether one allocation is relatively more We wish to know whether one allocation is relatively more efficient than another or whether an allocative change increases efficient than another or whether an allocative change increases efficiencyefficiency

One allocation is defined as Pareto superior to another if and One allocation is defined as Pareto superior to another if and only if it makes at least one person better off and no one worse only if it makes at least one person better off and no one worse offoff

Test for efficiency/ pareto optimality does not depend on Test for efficiency/ pareto optimality does not depend on whether someone has been made worse off; it depends only on whether someone has been made worse off; it depends only on whether it is possible to make someone better off without whether it is possible to make someone better off without making anyone else worse off.making anyone else worse off.

Efficiency is a matter of whether there is a room for Efficiency is a matter of whether there is a room for improvement, and one might wish that measures of efficiency improvement, and one might wish that measures of efficiency indicated only the scarcity of the available room for indicated only the scarcity of the available room for improvementimprovement


UJ

US

SE

JE

A

DH

B

R

PARETO SUPERIOR

Pareto superior which are feasible in the economy

Utility possibilities frontier


UJ

US

SE

JE

A

DH

B

Utility possibilities frontier

F

Constant agregate utility

D. CONCEPT OF AN EQUITABLE D. CONCEPT OF AN EQUITABLE RESOURCE ALLOCATION AND RESOURCE ALLOCATION AND

ILLUSTRATIONILLUSTRATION

EQUALITY OF OUTCOME IS ONE CONCEPT OF EQUALITY OF OUTCOME IS ONE CONCEPT OF EQUITYEQUITY

Equity is a fairness in the distribution of goods and services among Equity is a fairness in the distribution of goods and services among the people in an economythe people in an economy

Distibutions in the “middle” of the contract curve represent more Distibutions in the “middle” of the contract curve represent more equal outcomes than those at extremesequal outcomes than those at extremes

If equality of well being or satisfaction is the objective, then it is the If equality of well being or satisfaction is the objective, then it is the share of utility which should be of equal size.share of utility which should be of equal size.

But since the utility is neither measurable nor interpersonally But since the utility is neither measurable nor interpersonally comparable, we use income or wealthcomparable, we use income or wealth

OJ

OS

TOMATOES

MEAT

G

F D

A

C

B

M/2

T/2

EQUALITY OF OPPORTUNITIES IS ANOTHER CONCEPT OF EQUALITY OF OPPORTUNITIES IS ANOTHER CONCEPT OF EQUITYEQUITY

The process must be fairThe process must be fair

INTEGRATING EQUITY-EFFICIENCY EVALUATION IN A SOCIAL INTEGRATING EQUITY-EFFICIENCY EVALUATION IN A SOCIAL WELFARE FUNCTIONWELFARE FUNCTION

Social welfare function is a relation between a distribution of Social welfare function is a relation between a distribution of utility levels among society’s members and a judgment about utility levels among society’s members and a judgment about the overall social satisfaction achieved by that distributionthe overall social satisfaction achieved by that distribution

W = W(UW = W(U11, U, U22,…, U,…, Umm))

UUii= utility level of the individual= utility level of the individual

I = 1,2,…,m individuals in the economy I = 1,2,…,m individuals in the economy

To clarify the meaning of social welfare function, consider To clarify the meaning of social welfare function, consider Smith and Jones as two person economy. The social welfare Smith and Jones as two person economy. The social welfare function will be:function will be:

W = W(UW = W(USS, U, UJJ))

CD

E

A

US

UJ

WR

WM

WB

ALTERNATIVES SOCIAL WELFARE FUNCTIONSALTERNATIVES SOCIAL WELFARE FUNCTIONS WB = social welfare functions which

considers relative efficiency but is indifferent to the degree of equality

Transfer units between Smith and Jones does not affect the level of social welfare, whether or not, the transfer increases or decreases the equality of distribution

W = US + UJ

WR = social welfare can be increased by raising the utility level of both people

A change like the point A to point E improves welfare Benthamite function, but decreases it by Rawlsian standards because the minimum utility level, the worst off person declines

W = min (US + UJ) WM = a a middle of the road function

that lies between Rawlsian and Benthamite ideals

For any given level of agregate utility, social welfare increases with greater equality

SOCIAL WELFARE AND THE UTILITY POSSIBILITIES FRONTIERSOCIAL WELFARE AND THE UTILITY POSSIBILITIES FRONTIER

Maximum social welfare that can be achieved is on point C, social welfare tangent to utility possibilities frontier

WD is not feasible because the resource is limited

By this welfare function, society prefers more equality to less

Two limitations to the use of social welfare functions in policy analysis:

Utility is neither measurable for interpersonally comparable

There’s no agreement or consensus in what “ proper” social welfare function is

C

B

A

E

US

UJ

WD

WC

WE

WA

Thank YouThank You

Documents

Chapter 2 An Introduction to Modeling, Efficiency and Equity Microeconomic Policy Analysis Lee S. Friedman Johnny Patta