Chapter 2 Flashcards
Theoretical Tools of Public Finance
Theoretical Tools
The set of tools designed to understand the mechanics behind economic decision making.
Empirical Tools
The set of tools designed to analyze data and answer questions raised by theoretical analysis.
Utility Function
A mathematical function representing an individual’s set of preferences, which translates her well-being from different consumption bundles into units that can be compared in order to determine choice.
Constrained Utility Maximization
The process of maximizing the well-being (utility) of an individual, subject to her resources (budget constraint).
Models
Mathematical or graphical representation of reality.
Indifference Curve
A graphical representation of all bundles of goods that make an individual equally well off. Because these bundles have equal utility, an individual is indifferent as to which bundle he consumes.
Marginal Utility
The additional increment to utility obtained by consuming an additional unit of a good.
Marginal Rate of Substitution (MRS)
The rate at which a consumer is willing to trade one good for another. The MRS is equal to slope of the indifference curve, the rate at which the consumer will trade the good on the vertical axis for the good on the horizontal axis.
Budget Constraint
A mathematical representation of all the combinations of goods an individual can afford to buy if she spends her entire income.
Opportunity Cost
The cost of any purchase is the next best alternative use of that money, or the forgone opportunity.
Substitution Effect
Holding utility constant, a relative rise in the price of a good will always cause an individual to choose less of that good.
Income Effect
A rise in the price of a good will typically cause an individual to choose less of all goods because her income can purchase less than before.
Normal Goods
Goods for which demand increases as income rises.
Inferior Goods
Goods for which demand falls as income rises.
Welfare Economics
The study of the determinants of well-being, or welfare, in society.
Demand Curve
A curve showing the quantity of a good demanded by individuals at each price.
Elasticity of Demand
The percentage change in the quantity demanded of a good caused by each 1% change in the price of that good.
Supply Curve
A curve showing the quantity of a good that firms are willing to supply at each price.
Marginal Productivity
The impact of a one-unit change in any input, holding other inputs constant, on the firm’s output.
Marginal Cost
The incremental cost to a firm of producing one more unit of a good.
Profit
The difference between a firm’s revenues and costs, maximized when marginal revenues equal marginal costs.
Market
The arena in which demanders and suppliers interact.
Market Equilibrium
The combination of price and quantity that satisfies both demand and supply, determined by the interaction of the supply and demand curves.
Consumer Surplus
The benefit that consumers derive from consuming a good, above and beyond the price they paid for the good.
Producer Surplus
The benefit that producers derive from selling a good, above and beyond the cost of producing that good.
Total Social Surplus (Social Efficiency)
The sum of consumer surplus and producer surplus.
First Fundamental Theorem of Welfare Economics
The competitive equilibrium, where supply equals demand, maximizes social efficiency.
Deadweight Loss
The reduction in social efficiency from preventing trades for which benefits exceed costs.
Social Welfare
The level of well-being in society.
Second Fundamental Theorem of Welfare Economics
Society can attain any efficient outcome by suitably redistributing resources among individuals and then allowing them to freely trade.
Equity-efficiency Trade-off
The choice society must make between the total size of the economic pie and its distribution among individuals.
Social Welfare Function (SWF)
A function that combines the utility functions of all individuals into an overall social utility function.
Commodity Egalitarianism
The principle that society should ensure that individuals meet a set of basic needs, but that beyond that point income distribution is irrelevant.
Equality of Opportunity
The principle that society should ensure that all individuals have equal opportunities for success but not focus on the outcomes of choices made.
