Efficiency and fairness

Question 1

Mention two goals of economic well-being:

Answer 1

efficiency and equity

Question 2

According to Musgrave, what are the functions of government?

Answer 2

allocation, redistribution, stabilization; efficiency, fairness, sustainable development

Question 3

What is efficiency?

Answer 3

In the absence of market failures, a free market is Pareto efficient = ‘the invisible hand’ !
– No-one is better off without making someone else worse- off

Question 4

What are the 2 fundamental theorems of welfare economics?

Answer 4

Two of the most important results of welfare economics describe the relationship between competitive markets and Pareto efficiency:

1. Every competitive economy is Pareto efficient.
2. Every Pareto efficient resource allocation can be attained through a decentralized competitive market mechanism, with the appropriate initial redistributions.-> It is not necessary to have a central planner (e.g. government),

Question 5

Types of Equity?

Answer 5

•End-results equity
–Is the outcome fair?
–eg is it fair that 50%+ income in US goes to 20%
of households?
•Horizontal equity
–equal treatment of equals
•Vertical equity
–treat unequals unequally
Process equity
–Are the rules that determine the process fair,
regardless of outcome.
–eg do children of wealthy families have an
advantage due to their family’s wealth?
•Equal opportunity or equal access
–the right to do what people are willing and able to do
•Social Mobility
–ability to move through income distributions

Question 6

What is Consumer surplus 1

Answer 6

Consumers’ surplus and producers’ surplus are a different set of tools to evaluate efficiency

The willingness to pay (the reservation price) of a consumer depends on his possibilities (e.g. income) and the utility he could gain from the good
If market price < reservation price, then the consumer buys
If market price > reservation price, then the consumer doesn’t buy
The price that he really has to pay is usually lower
The difference between the reservation price and the market price is called consumer’s surplus

Since the market demand curve shows the reservation prices of the consumers, if we sum the surpluses of each consumer, we get the area below the demand curve and above the market price

Question 7

What is Producer surplus?

Answer 7

A producer’s willingness to sell (the producer’s reservation price) depends on his cost structure
The producer’s reservation price is equal to the marginal cost
If market price > marginal cost, then the producer sells
If market price < marginal cost, then the producer doesn’t sell
The price that he really receives is usually higher
The difference between the market price and the producer’s marginal cost is called producer’s surplus

Since the market supply curve shows the marginal costs of producers, if we sum the surpluses of each producer, we get the area above the supply curve and below the market price

Question 8

Types of Social Welfare Function: A function that tries to aggregate the utility levels of each citizen

Answer 8

Utilitarian social welfare function : Focuses on welfare
consequentialist – end-oriented
ranking based on sums of utilities (the greatest utility sum of a community as objective – vs. egoism)
Rawlsian social welfare function: Social welfare should be highly egalitarian
•Distributive justice is biased by our position in life
- rich: will never favour re-distribution policies
- poor: will always do so
•Overcome bias to reach socially desirable outcome
–make decisions through a “veil of ignorance”
as if people do not know their true position in the income distribution and how that might affect future outcomes
Risk-averse: social welfare = utility of worst-off
WR = min(U1,U2 ,…,UH )