394 midterm

Question 1

what does the government do for its citizens?

6

Answer 1

1. criminal justice system
2. provides a stable trading environment
3. provides defense, education, healthcare, infrastructure, utilities
4. makes regulations
5. taxes and subsidies
6. redistributes wealth and provides for the underprivileged

Question 2

what does the criminal justice system do?

Answer 2

rule of law: disincentivizes harmful behaviour and protects property rights

Question 3

what is the role of law and macroeconomic policy in providing a stable trading environment?

Answer 3

role of law → enables enforcement of contracts

macroeconomic policy → setting int rates and making spending decisions

Question 4

what types of regulations does the government provide?

Answer 4

labour law
env regulations
financial regulations → reduce fraud, protect investors
competition law

Question 5

what is the purpose of taxes?

Answer 5

fund gov policies, reduce unwanted behaviour, encourage beneficial things like innovation

Question 6

what are the costs of redistribution of wealth?

Answer 6

administration, loss to those taxed, cost of incentives

Question 7

positive externality

policy response

Answer 7

benefit to someone who is not part of the transaction
incentivize → subsidies, tax benefits
ex. healthcare and education

Question 8

negative externality

policy response

Answer 8

cost to someone who is not part of the transaction ; tax to disincentivize

Question 9

acting rationally

Answer 9

selfishly maximizing your own anticipated utility

Question 10

surplus

Answer 10

difference between utility of having the good and the utility of the transaction price

Question 11

maximizing social welfare

how? whose job is it?

Answer 11

maximizing the sum of everyone’s utility
assumption: should be the role of gov to maximize everybody’s utility
can be increased through redistribution
trade in free markets will generally increase social welfare (in the absence of market failures) bc the buyer and seller will be better off (otherwise they wouldn’t agree to the transaction

Question 12

free market

Answer 12

transactions are voluntary

Question 13

types of market failure

5; what do we need to fix mkt failure?

Answer 13

1. imperfect competition
2. information problems
3. externalities
4. public goods
5. other situations (coordination problems)

institutions to fix mkt failure

Question 14

problem with free markets

Answer 14

a rational agent participating in a free market may fail to maximize social welfare

Question 15

institutions

what tradeoff do we have to make? what concerns exist?

Answer 15

govern how transactions take place and to redistribute wealth

creating institutions and implementing policies are both costly, and we have to trade off gains + costs of fixing mkt failures

institutions and policies may serve special interest groups, or self-serving bureaucrats

Question 16

policy

Answer 16

a set of rules, created and enforced by a governing body

Question 17

normative analysis vs cost-benefit analysis

Answer 17

normative analysis — what policy makers should do; ≠ what they actually do

cost-benefit analysis — tradeoff between benefit of additional social welfare against costs of implementing the policy

Question 18

incentives

Answer 18

when an agent’s utility is dependent on some action or outcome
people do more of something that is rewarded and less of something that is penalized

ex. R&D tax credits, demand curve (more expensive → less incentive → less demand), laffer curve

Question 19

opportunity cost, willingness to pay

Answer 19

opportunity cost — the utility of the next best alternative

willingness to pay — total utility an agent gets from a good, expressed in $
ex. monopoly price discrimination: charging everyone their willingness to pay to suck up all the surplus

Question 20

transfer seeking, team’s problem

Answer 20

transfer seeking — any activity that tries to increase one’s share of wealth without creating new wealth
ex. negotiating for a bigger piece of the pie

team’s problem — when a person who works hard provides a positive externality on the rest of the group, so there is an incentive to free-ride
type of moral hazard — people don’t get all the consequences of their actions, ex. insurance

Question 21

laffer curve

Answer 21

more proportional tax = less incentive to make more money

parabolic curve of gov revenue against tax rate

Question 22

marginalist principle

what if a resource has >1 potential use?

Answer 22

most activities are subject to diminishing MB and rising MC; the amount spent on the policy should be such that the benefit from the last dollar spent should be = the cost of raising that dollar (MB = MC)

if a resource has >1 potential use, it should be divided among those uses such that the MB are equal

Question 23

what is the paradox of value? what is its conclusion?

Answer 23

why are diamonds worth more than water if water is a necessity?

prices are determined on the margin bc each unit of a good is used differently

Question 24

the law of unintended consequences, peltzman effect, the cobra effect

Answer 24

law of unintended consequences — policies often fail to help their intended beneficiaries bc of perverse incentives
ex. policies to help employees can cause companies to switch to contractors

peltzman effect — people adjust their behaviour to a regulation in ways that counteract the intended effect of the regulation; a type of moral hazard
ex. the safer they make cars, the more risks the driver is willing to take

the cobra effect — rewards people for making the issue worse

Question 25

the invisible hand

conclusion

Answer 25

need to make a good product in order to compete so as to maximize your own benefit
1. mkts are very effective at providing sophisticated goods which give us significant utility
2. very little role for gov intervention in competitive business
3. “why can’t the private sector do it?” → main question for any public policy proposal
4. gov needs to reduce monopoly power and provide public goods such as national defense, parks, and roads

Question 26

the first welfare theorem

Answer 26

under perfect competition, markets achieve pareto efficiency:
prices are set by the mkt
entry of new firms drive profits to 0
buyers and sellers have all relevant info

Question 27

management/production efficiency vs allocational/Pareto efficiency, X-inefficiency

examples

Answer 27

management/production efficiency — lowest input usage

allocational/Pareto efficiency — appropriate amount of each good is being produced
more emphasis on this bc we assume that mkt competition ensures that firms minimize costs or else they go out of business

X-inefficiency = management inefficiency
ex. monopoly, subsidies, high differentiation

Question 28

pareto efficiency

Answer 28

when it’s impossible to reallocate the resources among a group of people in a way that makes at least 1 person better off without making anybody else worse off
best possible outcome for everybody
no DWL

how do we increase social welfare?

Question 29

pareto improvement, potential pareto improvement, deadweight loss

Answer 29

pareto improvement — when at least one person is made better off while no one is made worse off

potential pareto improvement — if a reallocation of resources allows indiv who are net gainers to fully compensate the net losers and still be better off
ex. removing rent control
net gain for everybody > net loss for everybody

deadweight loss (DWL) — measures deviation from pareto efficiency
wasteful bc money was left on the table; mutually beneficial transactions were not realized
usually triangles

pareto impr and potential pareto impr increase social welfare

Question 30

the second welfare theorem

relationship between pareto-optimal alloc. and social welfare?

Answer 30

social welfare can be maximized through redistribution of endowments
pareto improvements
policy economists think of themselves as benevolent social planners → maximizing social welfare

maximizing social welfare = pareto efficient

a pareto improvement must increase social welfare, but a net increase in social welfare isn’t necessarily a pareto improvement

Question 31

trade vs transfer

Answer 31

trade = exchange goods
transfer = move goods

Question 32

game theory

game, strategy, outcome

Answer 32

game — players, actions, and payoffs

strategy — complete contingent plan; for every action of another player, you know in advance what action you would take

outcome — specified in terms of the strategies of the players

Question 33

nash equilibrium

Answer 33

nash equilibrium — each player chooses the action that maximizes their utility, given the other player’s action
strategies are in eqm when every strategy is a best response to every other strategy
actions are made simultaneously

Question 34

prisoner’s dilemma and its solutions

Answer 34

selfish dominant strategy makes you worse off than the pareto optimum

solutions to the prisoner’s dilemma:
1. when the game is repeated, tit for tat (punish in the next round), grim (punish forever) > can incentivise players to cooperate
2. institutions that enforce rules (ex. antidoping in sports)
3. outside intervention to restructure the payoffs (mob boss kills anyone who talks)
4. signaling
5. trust or social conventions

Question 35

mkts can fail to achieve pareto efficiency bc of:

Answer 35

1. imperfect competition
2. public goods
3. externalities
4. informational mkt failure

Question 36

types of mkt failure

imperfect competition

Answer 36

mkt structures where the assumptions of perfect competition break down
buyers and/or sellers exert some control over pieces
entry/exit is blocked
some sellers/buyers have mkt power
outcome → firms produce too little + prices are too high

Question 37

types of imperfect competition

5

Answer 37

monopoly — mkts with a single seller
policy responses to natural monopoly: public corporation (ex. BC hydro) or regulation (ex. fortis)
cartels — multiple sellers who collude on price
oligopoly — small number of sellers compete, recognizing they are large enough to affect the price
monopolistic competition — lg number pf sellers of diff. varieties of the same product
entry/exit costs ar below
each firm has a mini monopoly on its style, flavour, or brand
monopsony — mkts where there is a single buyer

Question 38

monopsony

examples, policy response

Answer 38

inefficiently low prices → lower than eqm
ex. labour mkt with a single major employer
ex. single-payer health insurance system, like MSP
walmart, amazon, starbucks are not true monopsonists but they appear to have significant bargaining power w suppliers
policy response: minimum wage, unions, “fair trade”

Question 39

public goods

what defines them?

Answer 39

non-rival – benefits obtained by one consumer don’t affect the benefits obtained by others
some goods are non-rival up to a congestion point
non-excludable — it is prohibitively costly to selectively prevent people from using it
not just bc it’s provided free to the public or provided by publicly owned enterprise!

underprovided by the private sector

Question 40

private good
commons good
club good
public good

policy response?

Answer 40

private good: rival and excludable
commons good: rival, non-excludable
club good: nonrival, excludable
public good: nonrival, nonexcludable

policy response: private and club goods are normally left to mkt, public goods are often provided by the gov.

Question 41

real vs pecuniary externalities

Answer 41

real externalities — activity by-products that generate non-priced costs or benefits affecting 3rd parties
3rd party = not the buyer or seller
pecuniary externalities — externality is incorporated into the price

Question 42

regressive tax, pigovian tax

Answer 42

regressive tax: affects people of lower incomes disproportionately more; need to give alternatives

pigovian tax: tax so that MPC at eqm = MSC

Question 43

imperfect info (asymmetric info)

Answer 43

exchange is guaranteed to be mutually beneficial only if both parties are rational and well-informed
when both parties have the same amount of uncertainty, there is not necessarily a market failure
market failure arises from asymmetric information — mainly when the seller knows product char. that the buyer does not
can also be from buyer knowing more than seller
if consumers can’t distinguish before buying, the existence of bad products can drive good ones out of the mkt

Question 44

calculate the expected price of a random car in the lemons problem

Answer 44

P of lemon * Vl + P of good car * Vg

Question 45

adverse selection

calculate expected payoff w lemons

Answer 45

buyer knows more; ex. insurance

lemons have the greatest incentive to buy the policy → leads to adverse selection
insurance firms are risk neutral and clients at risk-averse
adverse selection pushes prices up!

price - [P(L) * P(sickness) * 1000] - [P(G) * P(sickness) * 1000]

Question 46

reputation: multiple transactions

what happens if you are dishonest in a lemons transaction?

key assumption, cost of lying; how reps help

Answer 46

ppl don’t like you > can’t make future sales

economists assume that rational agents tel the truth only if falsehood is costsly to them
cost from lying = cost of not being able to sell another good used car

therefore reputations can mitigate information asymmetries and lead to pareto-optimal allocations

Question 47

solutions to imperfect info problems

Answer 47

1. reputations
2. mkts for information
3. labeling disclosure reqs → ex. food
4. warranties and guarantees
5. standards → set and enforced by gov, business, or professional orgs

Question 48

moral hazard

Answer 48

when an agent’s behaviour changes bc they don’t bear all the costs of their actions; take more risk than they would otherwise
adverse selection is a type of moral hazard
ex. bankers undertaking high risk investments knowing that the gov will bail them out in the event that they fail

Question 49

distributive vs procedural fairness

Answer 49

distributive fairness — final allocation of benefits/goods across individuals is just
any policy that increases distributive fairness → has incentive costs
complete equality of outcomes (equal shares) is not optimal
ex. free medical care, unemployment insurance, disaster relief programs, progressive taxation

procedural fairness – rules are just (morally defensible) regardless of the final allocation
non-coercion: no individual is forced to take an action they don’t want to take
equality of opportunity
everyone has to have the same starting point though → unrealistic

Question 50

fairness vs efficiency trade-offs

Answer 50

policies that promote distributional fairness have a cost of reduced efficiency
evening out the outcomes removes or distorts incentives
people who make diff levels of effort still get the same payoffs, so less reason to exert effort/do less desirable activities
if prices moved away from comp eqm to benefit buyers/sellers, there will be DWL
ex. rent control, min wage

Question 51

joseph stiglitz - the price of inequality

conclusions

Answer 51

• significant cause of inequality is through “rent seeking” by the wealthy
• the wealthy wield political power that shapes monopolies, obtain favourable treatment, and ensure low taxes
• inequality is self-perpetuating; transfers across gen since wealth is inherited
• not only arguably unfair (lg diff in starting allocations) but also hurts productivity by suppressing aggregate demand

Question 52

thomas piketty - capital in the 21st century

conclusions; direct vs fiscal redistribution

Answer 52

• clear evidence of high levels of inequality
• if capital and labour are inputs, assuming substitution between labour and capital, there are 2 policy responses:
• direct distribution (increasing wages)
• fiscal redistribution (tax on capital)
• fiscal redistribution preferable since increasing cost of labour through dir dist increases unemployment, whereas taxing capital doesn’t

Question 53

piketty, capital in the 21st century

effects of fiscal redistribution

1

Answer 53

inequality increases bc return on capital growth will be faster than growth in the economy

Question 54

fiscal federalism

solution to what problems? issues?

Answer 54

diff initial allocations of capital are unfair, however taxing capital has problems; capital is internationally mobile and tax competition makes capital highly elastic

solution is fiscal federalism — a progressive global tax on wealth

issues with fiscal federalism:
* what if a country refuses?
* how to divide up global revenue?
* differences in federal spending + tax levels around the world

Question 55

the social contract

hobbes vs rousseau

Answer 55

• ideas developed by 17th and 18th cent philosophers concerning the legitimacy of the state over the individual
• individuals consent, either explicitly or tacitly, to surrender some of their freedoms and submit to the authority of the state, in exchange for protection of their remaining rights
• changes over time, based on lvl of economic activity, laws, conflicts
• Hobbes refers to the state of nature where life is solitary, poor, nasty, brutish, and short
• individuals voluntarily give up their natural freedom to obtain benefits of the political order
• rousseau argued that democracy (self-rule) was the best way of ensuring the general welfare while maintaining individual freedom under the rule of law

Question 56

john rawls, the social contract and the theory of justice

horizontal equity, vertical equity

Answer 56

horizontal equity — people that are alike in relevant ways should be treated the same; “equals should be treated equally and unequals unequally”
ex. workplace discrimination

vertical equity — people who differ in relevant ways should be treated differently
differences that justify diff treatment: need, deservedness, contribution, effort
ex. wealth redistribution, crime, participation

Question 57

rawls

the veil of ignorance, maximin principle

Answer 57

• use empathy to put yourself in the shoes of the disadvantaged, then design rules around that so that the rules are fair
• maximin principle — preference for the welfare of the least advantaged

Question 58

individual sovereignty, economic freedom, consumer sovereignty

Answer 58

individual sovereignty — philosophical construct key to the notion of private enterprise; includes:

economic freedom — the freedom to enter into voluntary economic agreements

consumer sovereignty — the right to one’s own tastes and preferences
* implies the ultimate determiner of what will be made and sold and consumed is the consumer

Question 59

paternalism, internalities

Answer 59

paternalism — placing limits on a person’s liberty or autonomy for their own good; may be against their will
* ex. restrictions on narcotics, activity of minors, seatbelts

utility functions might not be rational and include internalities — LT cost/benefit to an individual they don’t consider when making the decision to consume a good (ex. health concerns)
* might not be able to trust people to maximize their own LR utility

Question 60

should we maximise the social welfare of people alive right now or all of humanity?

+ challenges involved

Answer 60

• we tend to undervalue humanity’s future
• might want to be paternalistic about the whole of humanity
• can use cost/benefit analyis to help us decide what we should sacrifice now in order to increase the social welfare of humanity
• however there are significant challenges → accounting for uncertainty, choosing discount rates