EC325 MT

Question 1

When and why should government interfere?

Answer 1

1. Create framework of law in which markets operate (property rights, prohibition of some markets)
2. Correct market failures, eg Limited rationality, externalities & Public goods, Asymmetric information, imperfect competition
3. Paternalistic concerns (individuals being irrational), eg impatience, overconfidence, default options, inattention
4. Redistribution (equity efficiency tradeoff)

Question 2

Utility assumptions

Answer 2

1. Non satiation - more is better: U’(X) > 0

2. Diminishing marginal utility: U’‘(X) <0

Question 3

Compensating variation

Answer 3

What change in income would restore the consumers well-being to what it was before the price change

Question 4

Equivalent variation

Answer 4

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

Question 5

Consumer Surplus

Answer 5

Area to the left of the demand curve between the before and after prices: he difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).

Question 6

First Fundamental of Welfare Economics

Answer 6

Competitive Markets reach a pareto efficient equilibrium

ASSUMPTIONS:

1. Perfect competition (producers and consumers are price takers)
2. Complete markets (markets exist for all commodities)
3. Perfect information
4. No externalities (perfectly defined property rights)

FFTW implies little role for government, however efficiency may not be only goal for society

Question 7

Second fundamental of welfare economics

Answer 7

We can reach any pareto efficient allocation by altering initial endowments of resources - just have to redistribute income/wealth and from there the market will do the rest

Thus in theory, efficiency and equity issues can be addressed separately. In practice, these lump sum transfers aren’t feasible so there is efficiency-equity tradeoff

Question 8

Rawlsian Social Welfare Function

Answer 8

Min(Ua, Ub, Uc…)

Question 9

Kaldor Hicks Efficiency

Answer 9

Pareto efficiency hard to come by in real world, reallocation is kaldor-hicks improvement if the winners can compensate the losers:

Sum of CV >/= 0

After the compensation, there is a pareto improvement, this maximises utilitarian social welfare

Question 10

Remedies to externalities

Answer 10

Coasian Bargaining (private solution)
Pigouvian taxation
Regulation
Cap and Trade/ Permits

Question 11

Coasian Bargaining and its limits

Answer 11

Coase theorem: If transaction costs are low and sources of damages can be identified, once property rights are completely defined, private bargaining will restore efficiency irrespective of initial assignments of property rights.

LIMITS:
Costs of bargaining:
- EG Air pollution, would require millions of agents to coordinate and bargain
- To reduce transaction costs, need association (eg government) to represent agents

Cost of enforcement:

• High costs of monitoring
• Often hard to identify precise source of damage

Question 12

Pigouvian taxation + Limits

Answer 12

Impose tax t equal to marginal cost of the externality to an activity that generates negative externalities, such that t=s (s=Marginal damage by externality).

makes a firm’s marginal cost c’(x) + t = c’(x) + s = MSC

LIMIT: Must know marginal damage function which is unrealistic

Question 13

Regulation + advantages + disadvantages

Answer 13

Legally mandating/capping a certain level of consumption/production of an activity that generates externality. If we know efficient quantity with certainty, this will have same effect as pigouvian taxation

PROS:
- Easy to enforce, Salience + Political expedience

Cons:

• no incentive for innovation
• Allocative inefficiency with heterogeneity in cost of pollution reduction

Question 14

Cap and Trade permits

Answer 14

Hybrid of coasian bargaining and regulation:

Cap total amount of pollution and allow firms to trade permits to pollute.

Useful when private costs of carbon usage unknown so carbon tax is unfeasible.

The market mechanism embedded in this system ensures that costs of reducing emissions are borne efficiently.

Question 15

Public good features

Answer 15

• Non Rival in consumption: one person’s consumption of a good will not affect another’s opportunity to consume the good
• Non excludable: cannot deny individuals opportunity to consume a good
• Suffer from free rider problem -> inefficient private provision -> first welfare theorem breaks down

Question 16

Free Riding

Answer 16

When investment has a personal cost but common benefit/s, individuals underinvest. Thus there is market under-provision compared to the Samuelson rule

Question 17

Limitations of Samuelson Rule

Answer 17

Difficult to implement public intervention properly:

• Govt needs to know preferences or have mechanism to reveal preferences
• Issue of how to finance the public good if only distortionary taxes available
• Samuelson analysis is a first best benchmark

Question 18

Lindahl Pricing + Constraints

Answer 18

How to achieve pareto efficiency through decentralised mechanism
- Set for each person the price ( t^h) as his willingness to pay (at efficient level of Public good G):
t^h = u^h(G)
- If everyone identical, set same level of tax for everybody
- With heterogeneity, efficiency can only be achieved with public goods through individual specific prices

CONSTRAINTS:

• must be able to exclude consumer from using goods so only works with non rival, excludable goods (country club, public pool…)
• Must know individuals preferences to set prices (individuals have incentive to underreport)

Question 19

2 Social Choice problems

Answer 19

Preference revelation

Preference aggregation

Question 20

Preference revelation:

Answer 20

In public goods, preference revelation through private markets is unfeasible - people have incentives to underreport value of public good (free rider problem)

Question 21

Aggregating preferences SC Problem

Answer 21

Consistent aggregation needs to fulfil 3 conditions:
- Pareto criterion: if all voters prefer a to be then the social choice should rank a above b

• Transitivity
• Independence of irrelevant alternatives: if A>B, and C is added to the choice set but not picked, then A should still be chosen over B

Question 22

Arrow’s impossibility theorem

Answer 22

The only social choice rule that satisfies Pareto Criterion, transitivity and IIA is dictatorship

Question 23

Median voter theorem

Answer 23

with single peaked preferences, majority voting produces equilibrium, which is the preferred level of the individual who is at the median of the distribution of preferred spending G

generally, median voter equilibrium is not pareto efficient - does not satisfy the samuelson rule

Question 24

Gibbard - Satterthwaite Theorem

Answer 24

A voting rule is a rule for selecting single option given the stated (but potentially untrue) preferences of a group of individuals.

GS Theorem: for any voting rule, one of following must hold:

• Only 2 options considered (and others eliminated before voting)
• Rule is susceptible to strategic voting
• Rule is dictatorial

Question 25

New Contract Theory purpose

Answer 25

Emphasises importance of ownership for incentives to invest:

• to reduce costs
• to improve quality and innovate
• Key problem is non contractible quality, such as learning by students in school or standard of living

Question 26

New Contract Theory: case for privatisation

Answer 26

Stronger when:

• innovation is important
• Quality reducing cost reductions can be controlled by contract
• Government suffers from inefficiency or patronage

eg mail service

Question 27

New contract theory: case for public provision

Answer 27

When:

• Cost reductions likely to lead to non-contractible reductions of quality
• Innovation is relatively unimportant, competition is weak

eg police

Question 28

Social insurance and types of SI

Answer 28

Government intervention to provide insurance against adverse events. Citizens ‘buy’ the insurance through taxes or mandatory contributions

Types of SI:

• Unemployment Insurance
• Disability Insurance
• Health insurance
• Social security

Question 29

Why is SI valuable?

Answer 29

Due to risk aversion resulting from diminishing marginal utility, so U(E[X]) > E[U(x)]

Individuals desire consumption smoothing over uncertain outcomes

Question 30

Adverse selection problem and how it leads to government intervention

Answer 30

Asymmetric information is not realistic. Individuals’ risk types best known to them. If insurers can’t observe risk type, they have to offer coverage at higher price. This leads to adverse selection:

At a given premium, those most likely to buy insurance are those with worst risks

This means not everyone will get full insurance so outcome isn’t socially efficient.v

Adverse selection leads to scope for government intervention. Government faces same information constraint but can compel individuals to participate via mandation or taxes so can ensure full insurance for everyone at actuarily fair price for whole population, this can create a PARETO IMPROVEMENT.

Question 31

Problems with SI

Answer 31

1. Crowding out: SI may crowd out existing forms of private insurance
2. Moral Hazard: adverse and unobservable actions taken by individuals in response to insurance. 4 types of MH:
   - Reduced precaution against entering adverse state
   - Increasing propensity of claiming the worse state
   - Increased expenditures when in adverse state
   - Supplier responses to insurance against adverse state

Cost of moral hazard: 2 types of externalities:

• Higher premium/taxes for all insured individuals
• Reduced tax revenue for other productive uses

3. Classification errors type 1 and 2:
   - Type 1: a truly eligible individual applies for benefits but is rejected
   - Type 2: a truly ineligible individual applies for benefits and is accepted

Question 32

Unemployment Insurance

Answer 32

UI Schemes provide cash benefits to workers suffering job losses. Benefits are function of pre-unemployment income. Typically given by previous earnings*replacement rate up to a maximum cap and duration

Moral Hazard on UI can be:

• Effect on incidence on unemployment
• Effect on duration of unemployment

Evidence of moral hazard is that job finding rate is constant and then drastically increases around the time limit of the UI

Question 33

Estimating Effects of UI

Answer 33

Problem as UI schemes are usually national so empirical identification is difficult, however in US UI is a state programme with large variation so can use state reforms as NATURAL EXPERIMENTS with treatments (those affected by reform) and controls (those not affected)

• Johnston and Mas estimate that a one month reduction in UI leads to a 0.45 month reduction in UI claiming spells and 0.25 month reduction in unemployment duration

Question 34

UI: Moral Hazard vs Job Search Friction

Answer 34

Increases in UI length cause negative fiscal externalities via moral hazard but with labour market imperfections may also improve job quality.

Idea is that with longer on benefits people will wait longer to find a better match.

Most evidence doesn’t support this but recently Nekoei and Weber found evidence of this in Austria

Question 35

Retirement Pensions: why should the government intervene?

Answer 35

• Individual failures: people may not save adequately for retirement on their own
• Market failures: adverse selection in annuitization market
• Redistribution - within generations or across generations

Question 36

Fully funded pension schemes

Answer 36

Savings used to pay future benefits. Contributions are invested in assets and returns credited to scheme’s fund. Dependent on stock market performance

Question 37

PAYGO pension schemes

Answer 37

Contributions from today’s workers pay benefits for today’s retirees. Contractarian in nature and run/dependant on the state.

Legacy debt: first generation receives benefits without contributing. Not a huge problem as debt is carried.

If rate of pop growth > interest rates then every generation receives more than it contributes

Question 38

PAYGO pension schemes balanced budget condition

Answer 38

TtNt,workers = BtNt,retirees

where Tt = tax, Bt = benefits Nt = number of workers or retirees

balanced budget occurs as long as growth its stable.

If dependancy ratio increases (Nt,ret/Nt,work) this puts stress on pension schemes

Question 39

Healthcare around the world facts

Answer 39

• USA spends most per capita on healthcare out of OECD countries
• Spending on healthcare as % of GDP is increasing for most countries
• USA spends least through public finance out of OECD countries (heavy private sector)
• Japan has highest life expectancy out of OECD countries
• USA has highest infant morality rate out of OECD countries

Question 40

Healthcare Intervention: Redistributive arguments

Answer 40

2 dimensions of inequality:

• Inequality in income driven by varying market abilities
• Inequality in health outcomes driven by varying health risks

Because premiums don’t depend on underlying health risks, healthcare programmes redistribute from healthy to sick. If they are means tested they can redistribute from rich to poor as well.

Why should we link redistribution to specific goods rather than just give cash transfers?

• Counter argument is consumer sovereignty: utility gain from healthcare is never higher than its corresponding cash value
• However this argument applies to individuals not program as a whole
• In kind transfers enhance targeting of redistributive systems and thus improves the equity-efficiency tradeoff

Question 41

Potential healthcare instruments

Answer 41

Price Subsidies (USA)

Government Mandates (USA)

Government provision (European countries)

Question 42

Health insurance generosity

Answer 42

Most generous plan is first dollar coverage

Can be less generous by involving some sort of patient payments:

• Deductibles: insurees pay full cost up to a limit beyond which insurer pays the rest
• Co-payment: fixed payment whenever individuals use a health good or service
• Coinsurance: individual pays a share of each bill

Optimal generosity determined by trading off social benefits from alleviating market failures and improving equity against the social costs from the moral hazard

Moral hazard such as excessive use of healthcare under insurance creates a deadweight loss (DWL depends on price elasticity of healthcare)

Question 43

Why is healthcare spending rising

Answer 43

• rising costs per unit of care
• Quality improving technical change: more expensive and effective treatments available, interacts toxically with moral hazard as more expensive treatments used when cheaper ones adequate
• as income grows, share of income spent on health grows (healthcare is a luxury good)
• More old people

Question 44

Kahneman and Tversky Behavioural Economics findings

Answer 44

Main points:

losses loom larger than gains:

• Relies on a reference point against which losses and gains are determined
• Reference points can also be manipulated though

low probability possibilities are often over weighted in decision making, such as health