Economic Policy Analysis: Lecture 1

Theoretical Foundations of Economic Policy Analysis

Camille Landais

Stanford University

January 3, 2010
Outline

From Utility Maximization to Market Efficiency

Quick Review: Consumer Choice
Quick Review: Market Equilibrium
Application: TANF and Labor Supply
Application: TANF and Efficiency

Fundamental Theorems of WE

Conclusion
Imagine: Life after Stanford

I You graduate from Stanford and land a sweet job at the

California Health and Human Services Agency (HHS), which
oversees Temporary Assistance for Needy Families (TANF)
I The current governor is considering reducing TANF benefits,
in order to induce work among recipients
I The secretary of HHS disagrees, arguing that reduced benefits
will only hurt stay at home mothers
Economic Policy Analysis

You are asked to evaluate the situation:

I Theoretical Tools & Empirical Tools
I Positive Analysis: What will happen?
I Normative Analysis: What should happen?
Constrained Utility Maximization

I indifference curves = consumer preferences

I non-satiation
Consumers prefer higher indifference curves
Indifference Curves are downward sloping
Example: CDs and Movies
Figure 1: Indifference Curves & Marginal Rate of Substitution
Utility Functions

I U = f (X1 , X2 , ..., XN )
I marginal utility: the incremental utility gained by an
additional unit

∂U
MUX1 =
∂X1
I diminishing marginal utility
√
Example: U = QC × QM
Utility Functions

I Marginal Rate of Substitution (MRS): the rate at which

consumers are willing to trade one good for another
−MUM
MRS =
MUC

Example: CDs and Movies

Budget Constraints

I Key contribution of economics: resources are limited

I budget constraint: mathematical representation of all
affordable combinations of goods

Y = PC QC + PM QM

Example: CDs and Movies

Figure 2: Budget Constraint & Utility Maximization
Constrained Choice

I Using indifference curves and budget constraints, we model

consumer choice
I Optimal Bundle:
−MUM −PM
MRS = =
MUC PC

Example: CDs and Movies

Comparative Statics

I We can also analyze the effects of changes in prices or income

I A change in price creates a substitution effect and an
income effect
Example: CDs and Movies
Figure 3: Income & Substitution Effects
Demand Curves

I demand Curves: the quantity of a good consumed at each

price
I Using our analysis of consumer choice, we can predict
quantities consumed at different prices
I Key feature of demand curve is the elasticity of demand

Percent Change in QD −4Q/Q

εD = =
Percent Change in Price 4P/P

Elasticity is usually not constant

perfectly inelastic and perfectly elastic demand curves
cross price elasticities
Figure 4: Demand Curves
Supply Curves

I supply Curves: the quantity of a good agents (or firms) are

willing to supply at each price
I Built up from similar microfoundations of profit maximization
I Key concept is marginal productivity
I When this is diminishing, marginal costs will be increasing
I The supply curve in a competitive market is the marginal cost
curve, and will therefore be upward sloping
I Firms supply until price equals marginal cost
Market Equilibrium and Efficiency

I market demand and market supply are the horizontal sums

of individual curves
I market equilibrum: the combination of price and quantity
that satisfies both demand and supply
I competitive markets reach an equilibrium that is socially
efficient (size of the pie)
Consumer and Producer Surplus

I consumer surplus: benefit to consumers beyond what they

pay
I producer surplus: benefit to producers beyond the costs of
production
I price elasticity partly determines the amount of surplus
Figure 5: Consumer Surplus
From Surplus to Welfare
How can we link the effects of price changes to consumer’s
welfare? 3 key concepts
I Compensating variation (CV): what change in income would
restore the consumer’s well-being to what it was before the
price change

I Equivalent variation (EV): what change in the consumer’s

income would have an equal effect on the consumer’s
well-being as the price change

I Change in consumer’s surplus (∆CS): area to the left of the

demand curve between the before and after prices. We can go
from willingness-to-pay to surplus to welfare as well

These are 3 possible money metric measures of the effect of a price

change on welfare
Figure 6: Compensating Variation
Figure 7: Equivalent Variation
Figure 8: Consumer Surplus
Figure 9: Consumer Surplus and Preferences
From Surplus to Welfare (2)

I When no income effects, CV, EV and ∆CS are equivalent

ex: Quasi Linear Utility functions
∆Surplus=consistent dollar measures of the effect of the price
change on the well-being of the consumer

I Advantage of surplus analysis: only 2 parameters to estimate

(elasticity of demand, and elasticity of supply)

I When income effects are small (IO cases for instance), rely on
surplus for welfare analysis is fine

I When income effects are potentially big (cf. UI, taxes, etc.),
rely on utility and try to estimate parameters of the utility
function.
Figure 10: Market Efficiency
Back to TANF

I TANF created in 1996 after overhaul of ”cash welfare”

programs
I Monthly support to low-income families (about $679 in 2003)
I Use micro tools to analyize TANF
I Need to model labor supply, using leisure as a good
Back to TANF

I Consider Amy who makes $10/hr

I TANF supplies $5,000 gaurantee
I Benefit reduced at a rate of 50% (implicit tax)
I What happens if benefit guarantee is cut to $3,000?
Effect of Change in TANF

I Remember income and substitution effects

I Depends on previous earnings
I What will the magnitude of the effect be?
I Consider Amy and Natalia

UAmy = 100 × ln (C ) + 175 × ln (L)

UNatalia = 75 × ln (C ) + 300 × ln (L)
Figure 11: Labor Supply 1
Figure 12: Labor Supply 2
Figure 13: Labor Supply 3
Figure 14: Labor Supply 4
Figure 15: Labor Supply 5
Beyond the Effects of TANF Change

I Once we have decided what happens as a result of a change in

TANF, we want to know the net gain or loss of this change
I This will take us from the realm of positive analysis to
normative analysis
Effect of TANF on Market

I Workers are the suppliers of labor

I Firms are the buyers of labor
I The wage is the price paid for a unit of labor
Example: Introducing TANF and Reducing TANF
I Net social gain due to efficiency
I Need to consider equity
Figure 16: Efficiency Gains from TANF Reduction
Outline

From Utility Maximization to Market Efficiency

Fundamental Theorems of WE
Efficiency
Equity

Conclusion
Fundamental Theorems of Welfare Economices

I Simple intuition of the 2 theorems in a basic Edgeworth

framework
I Discuss implications for public intervention
I See how welfare function approach can fit in
Figure 17: Edgeworth Box
Figure 18: Edgeworth Box
Figure 19: Edgeworth Box
Figure 20: Pareto Efficiency
Figure 21: Pareto Efficiency
Figure 22: Pareto Efficiency
Pareto Efficiency

I At a Pareto Efficient allocation indifference curves are

tangent, and therefore:

Will Jada
MRSST = MRSST
I There are multiple Pareto efficient allocations along the
contract curve
Figure 23: The Contract Curve
Figure 24: The Contract Curve
Figure 25: The Contract Curve
Figure 26: The Contract Curve
Production Economy

I In a simple Edgeworth box the amount of goods are fixed or

exogenously determined
I Alternatively, the economy may use inputs to produce turkey
burgers and smoothies
I The production technology will be captured by the
production possibilities curve and the marginal rate of
transformation (MRS)
Figure 27: Production Possibility Curve
Pareto Efficiency with Production

I The marginal rate of transformation is the ratio of marginal

costs of producing an additional unit of each good:
MCS
MRTST =
MCT
I At a Pareto efficient allocation, the marginal rate of is aligned
with the marginal rates of substitution:
Will Jada
MRTST = MRSST = MRSST
Pareto Efficiency with Production

I The marginal rate of transformation is the ratio of marginal

costs of producing an additional unit of each good:
MCS
MRTST =
MCT
I At a Pareto efficient allocation, the marginal rate of is aligned
with the marginal rates of substitution:
Will Jada
MRTST = MRSST = MRSST
First Fundamental Theorem of Welfare Economics
(FFTWE)

I A competitive market will reach a Pareto efficient allocation

of goods if:
1. All producers and consumers are price takers
2. Markets are complete (i.e. a market exist for all commodities)
First Fundamental Theorem of Welfare Economics

I From consumer theory we have:

Will PS Jada PS
MRSST = and MRSST =
PT PT
I From producer theory we have:
PS
MRTST =
PT
I Therefore, we have:

Will Jada PS MCS

MRTST = MRSST = MRSST =⇒ =
PT MCT
I So, should government just get out of the way?
First Fundamental Theorem of Welfare Economics

I From consumer theory we have:

Will PS Jada PS
MRSST = and MRSST =
PT PT
I From producer theory we have:
PS
MRTST =
PT
I Therefore, we have:

Will Jada PS MCS

MRTST = MRSST = MRSST =⇒ =
PT MCT
I So, should government just get out of the way?
First Fundamental Theorem of Welfare Economics

I From consumer theory we have:

Will PS Jada PS
MRSST = and MRSST =
PT PT
I From producer theory we have:
PS
MRTST =
PT
I Therefore, we have:

Will Jada PS MCS

MRTST = MRSST = MRSST =⇒ =
PT MCT
I So, should government just get out of the way?
First Fundamental Theorem of Welfare Economics

I From consumer theory we have:

Will PS Jada PS
MRSST = and MRSST =
PT PT
I From producer theory we have:
PS
MRTST =
PT
I Therefore, we have:

Will Jada PS MCS

MRTST = MRSST = MRSST =⇒ =
PT MCT
I So, should government just get out of the way?
Fairness versus Efficiency

I The FFTWE may imply that there is little role for government
in the economy
I Competitive markets lead to Pareto efficient allocations
I However, efficiency may not be the only goal for society
I We may also have a desire for some sort of equitable
distribution of goods
Figure 28: Distribution and Pareto efficiency
Second Fundamental Theorem of Welfare Economics
(SFTWE)

I How do we arrive at different efficient allocations

I The SFTWE states that we can reach any Pareto efficient
allocation by altering the initial endowments of resources. In
other words, we just have to redistribute income and from
there the market will do the rest.
I Thus, in theory, efficiency and equity issues can be addressed
separately
I In practice, these ”lump sum” redistributions are not feasible,
leaving us with an efficiency-equity trade-off
I In that case, we need a framework for deciding how much of a
trade-off society should make
Utility Possibility Curve

I The contract curve defines a set of possible utility

combinations
I We can plot these combinations on the utility possibility
curve (upc)
I Note that this curve serves much the same purpose as a
production possibilities curve or budget constraint, capturing
the trade-off inherent in different utility outcomes
Figure 29: Utility Possibility Curve
Social Welfare Function

I How do we rank the possible utility outcomes?

I One way is to define a Social Welfare Function (SWF):

W = f (UWill, UJada )

I The SWF behaves as a utility function for society, and, for

example, has indifference curves
I This combined with the upc directs us toward the social
optimum
Figure 30: SWF Maximization
Social Welfare Function
I What are the features of the SWF?
I Typically the SWF is an increasing function of all of its
arguments:
∂W
>0
∂UWill
I A Utilitarian SWF is linear in form:

WUtilitarian = UWill + UJada

I A Rawlsian SWF places more weight on society’s worse off:

WRawlsian = min (UWill, UJada )

I Concavity in the SWF leads to a preference for equality

I Usually it is not possible to build up a coherent SWF using
individual’s utilities (Arrow’s Impossibility Theorem)
Outline

From Utility Maximization to Market Efficiency

Fundamental Theorems of WE

Conclusion
Violations of the FFTWE and Public Policies

I Aside from distributional concerns, there are other reason why

one might consider a larger role for government intervention
I When the assumptions underlying the FFTWE breakdown, we
have what is called Market Failures
I There are three major types of breakdowns
1. Market Power: The assumption of perfect competition may
not always hold. In that case, firm may not set price equal to
marginal costs, violating our conditions of Pareto Efficiency
2. Under or overprovision of goods because of positive or
negative externalities
3. Non provision of goods:It may not be the case that a market
exists for every commodity. Some examples include:
Asymmetric information and the collapse of insurance markets
Public good for that no one entity is willing to supply to the
market
Violations of the FFTWE and Public Policies

I Aside from distributional concerns, there are other reason why

one might consider a larger role for government intervention
I When the assumptions underlying the FFTWE breakdown, we
have what is called Market Failures
I There are three major types of breakdowns
1. Market Power: The assumption of perfect competition may
not always hold. In that case, firm may not set price equal to
marginal costs, violating our conditions of Pareto Efficiency
2. Under or overprovision of goods because of positive or
negative externalities
3. Non provision of goods:It may not be the case that a market
exists for every commodity. Some examples include:
Asymmetric information and the collapse of insurance markets
Public good for that no one entity is willing to supply to the
market
Violations of the FFTWE and Public Policies

I Aside from distributional concerns, there are other reason why

one might consider a larger role for government intervention
I When the assumptions underlying the FFTWE breakdown, we
have what is called Market Failures
I There are three major types of breakdowns
1. Market Power: The assumption of perfect competition may
not always hold. In that case, firm may not set price equal to
marginal costs, violating our conditions of Pareto Efficiency
2. Under or overprovision of goods because of positive or
negative externalities
3. Non provision of goods:It may not be the case that a market
exists for every commodity. Some examples include:
Asymmetric information and the collapse of insurance markets
Public good for that no one entity is willing to supply to the
market