394 midterm Flashcards
what does the government do for its citizens?
6
- criminal justice system
- provides a stable trading environment
- provides defense, education, healthcare, infrastructure, utilities
- makes regulations
- taxes and subsidies
- redistributes wealth and provides for the underprivileged
what does the criminal justice system do?
rule of law: disincentivizes harmful behaviour and protects property rights
what is the role of law and macroeconomic policy in providing a stable trading environment?
role of law → enables enforcement of contracts
macroeconomic policy → setting int rates and making spending decisions
what types of regulations does the government provide?
labour law
env regulations
financial regulations → reduce fraud, protect investors
competition law
what is the purpose of taxes?
fund gov policies, reduce unwanted behaviour, encourage beneficial things like innovation
what are the costs of redistribution of wealth?
administration, loss to those taxed, cost of incentives
positive externality
policy response
benefit to someone who is not part of the transaction
incentivize → subsidies, tax benefits
ex. healthcare and education
negative externality
policy response
cost to someone who is not part of the transaction ; tax to disincentivize
acting rationally
selfishly maximizing your own anticipated utility
surplus
difference between utility of having the good and the utility of the transaction price
maximizing social welfare
how? whose job is it?
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
free market
transactions are voluntary
types of market failure
5; what do we need to fix mkt failure?
- imperfect competition
- information problems
- externalities
- public goods
- other situations (coordination problems)
institutions to fix mkt failure
problem with free markets
a rational agent participating in a free market may fail to maximize social welfare
institutions
what tradeoff do we have to make? what concerns exist?
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
policy
a set of rules, created and enforced by a governing body
normative analysis vs cost-benefit analysis
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
incentives
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
opportunity cost, willingness to pay
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
transfer seeking, team’s problem
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
laffer curve
more proportional tax = less incentive to make more money
parabolic curve of gov revenue against tax rate
marginalist principle
what if a resource has >1 potential use?
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
what is the paradox of value? what is its conclusion?
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
the law of unintended consequences, peltzman effect, the cobra effect
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
the invisible hand
conclusion
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
the first welfare theorem
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
management/production efficiency vs allocational/Pareto efficiency, X-inefficiency
examples
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
pareto efficiency
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?
pareto improvement, potential pareto improvement, deadweight loss
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
the second welfare theorem
relationship between pareto-optimal alloc. and social welfare?
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
trade vs transfer
trade = exchange goods
transfer = move goods
game theory
game, strategy, outcome
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
nash equilibrium
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
prisoner’s dilemma and its solutions
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
mkts can fail to achieve pareto efficiency bc of:
- imperfect competition
- public goods
- externalities
- informational mkt failure
types of mkt failure
imperfect competition
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
types of imperfect competition
5
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
monopsony
examples, policy response
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”
public goods
what defines them?
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
private good
commons good
club good
public good
policy response?
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.
real vs pecuniary externalities
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
regressive tax, pigovian tax
regressive tax: affects people of lower incomes disproportionately more; need to give alternatives
pigovian tax: tax so that MPC at eqm = MSC
imperfect info (asymmetric info)
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
calculate the expected price of a random car in the lemons problem
P of lemon * Vl + P of good car * Vg
adverse selection
calculate expected payoff w lemons
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]
reputation: multiple transactions
what happens if you are dishonest in a lemons transaction?
key assumption, cost of lying; how reps help
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
solutions to imperfect info problems
- reputations
- mkts for information
- labeling disclosure reqs → ex. food
- warranties and guarantees
- standards → set and enforced by gov, business, or professional orgs
moral hazard
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
distributive vs procedural fairness
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
fairness vs efficiency trade-offs
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
joseph stiglitz - the price of inequality
conclusions
- 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
thomas piketty - capital in the 21st century
conclusions; direct vs fiscal redistribution
- 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
piketty, capital in the 21st century
effects of fiscal redistribution
1
inequality increases bc return on capital growth will be faster than growth in the economy
fiscal federalism
solution to what problems? issues?
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
the social contract
hobbes vs rousseau
- 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
john rawls, the social contract and the theory of justice
horizontal equity, vertical equity
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
rawls
the veil of ignorance, maximin principle
- 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
individual sovereignty, economic freedom, consumer sovereignty
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
paternalism, internalities
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
should we maximise the social welfare of people alive right now or all of humanity?
+ challenges involved
- 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
