The role of normative analysis in markets with hidden knowledge and hidden actions

When examining the economic impact of a change in policy regime, one may elect to conduct a positive analysis that considers the effect of such a policy change on the allocations supported as a market equilibrium. An alternative approach would be to perform a normative analysis that examines the effect of the regime change on the set of Pareto optimal allocations in the economy. In settings where the Fundamental Welfare Theorems hold, the isomorphism between equilibrium and Pareto efficient allocations implies that the choice of approach is largely a matter of convenience. When this isomorphism fails to hold, as in settings with hidden information or hidden actions, the equilibrium allocations may not be efficient so that a normative analysis of the alternative efficiency frontiers is required to determine whether the policy change is desirable in the sense of permitting potential Pareto improvements. If so, then an equilibrium analysis may be used to determine the extent to which such improvements may be realized by market participants.