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Public Economics 1 > Final Exam > Flashcards

Final Exam Flashcards

1
Q

What is ‘first best’ taxation?

A

The 2nd Welfare Theorem: there is no conflict between equity and efficiency, when lump transfers are available.

Taxes can only enhance welfare in a first best environment.

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2
Q

What is ‘second best’ taxation?

A

Equity efficiency trade offs arise: people can react to taxes and lump transfers are not available.

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3
Q

What is a lump sum tax?

A

A lump sum tax is a tax whose value does not change and brings in the same level of revenue at all levels of GDP.

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4
Q

How are taxes justified?

A

First, taxes are justified on efficiency grounds. For example, it can alleviate a market failure; in the presence of externalities, the government can implement Pigouvian taxes.

Second, taxes can be justified on equity grounds. For example, redistributive taxes.

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5
Q

What is the marginal tax rate (MRT)?

A

How much an individual pays in tax for an additional dollar of income.

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6
Q

What is the key issue of optimal taxation?

A

People are unequal in their ability to acquire income. Under the common social welfare function, these inequalities should be compensated for.

However, the responses of individuals to taxes (distortions) can limit this degree of redistribution.

Therefore, optimal tax rates are those that balance the tradeoff between redistribution and distortion.

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7
Q

What is the price elasticity of demand?

A

The proportional change in the quantity demanded, relative to the proportional change in the price of the good.

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8
Q

What is the cross elasticity of demand?

A

The proportional change in the quantity demanded, relative to the proportional change in the price of another good.

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9
Q

What is the income elasticity of demand?

A

The proportional change in the quantity demanded, relative to the proportional change in income.

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10
Q

What is the price elasticity of supply?

A

The proportional change in the quantity supplied, relative to the proportional change in the price of a good.

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11
Q

What is the cross elasticity of supply?

A

The proportional change in quantity supplied, relative to the proportional change in the price of another good.

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12
Q

What are complements?

A

Goods that must be produced together.

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13
Q

What are substitutes?

A

Goods that use the same resources for production.

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14
Q

How are optimal design tax rates determined?

A

With the elasticity of taxable income

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15
Q

What is the elasticity of taxable income (ETI)?

A

The proportional change in tax rates, relative to the proportional change in taxable income.

It shows the distortion created by the tax, or how much revenue is lost because of people’s response to the tax.

The higher the ETI, the lower the optimal tax rates, because the more income responds to taxes, the less desirable taxes are.

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16
Q

Provide a method that ETI can be measured.

A

One of them includes the natural experiment where tax reforms only affect some taxpayers (treatment group) and not all (control group).

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17
Q

What is the inverse elasticity rule?

A

That optimal tax rates and price elasticity of demand should be inversely related.

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18
Q

What is the theory of optimal taxation?

A

The study of designing and implementing a tax that maximises a social welfare function subject to economic constraints.

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19
Q

How is the revenue potential of a tax calculated?

A

By combining estimate of the ETI with data on income distribution.

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20
Q

What should optimal tax rates take into account?

A

Revenue potential and the welfare loss of those paying taxes

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21
Q

What do basic optimal tax results imply that governments should do regarding the rich?

A

Tax them as much as possible!

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22
Q

What is capital income?

A

The increase in a capital asset’s value which is considered to be realised when the asset is sold.

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23
Q

What are the main limitations of ETI?

A
  1. Real responses: individuals change their economic decisions, including their levels of work, investments, and savings. This is difficult to mitigate.
  2. Avoidance responses: individuals manipulate their reported income to avoid taxes. Governments can mitigate this by making it more difficult to do so, such as reaching agreements on tax havens.
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24
Q

What is information asymmetry?

A

A situation where some parties have more information regarding an issue than others.

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25
Q

How is information asymmetry analysed?

A

Through the principal-agent relationship.

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26
Q

What is the principal-agent relationship?

A

It is an arrangement (or contract) in which the principal appoints an agent to act on its behalf, with some delegation of power. It often results in conflicts of interest.

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27
Q

What is an example of the principal-agent relationship?

A
  • Employers and employees
  • Doctors and patients
  • Shareholders and managers
  • Buyers and sellers
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28
Q

When does the principal-agent problem arise?

A
  • Different interests
  • Asymmetric information

The principal cannot directly ensure that the agent is acting within their best interest.

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29
Q

Who has more information in the principal-agent problem?

A

The agent.

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30
Q

What is the main cost of the principal-agent problem?

A

Agency costs, which arise from and requires payment to the agent who acts on behalf of the principal in some situations.

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31
Q

Why does the principal-agent relationship raise problems?

A
  • Different interests
  • Asymmetric information
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32
Q

What are the two types of information asymmetry? Define them.

A
  1. Moral hazard: a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full cost of that risk.
    - The principal wants to incentivise the agent to do the right action (hidden action).
  2. Adverse selection: a situation where buyers and sellers have different information.
    - The principal wants the agent to reveal their information (hidden knowledge).
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33
Q

What is the fundamental problem with adverse selection?

A

Market inefficiencies:
- Increases costs to attain information (exclusion)
- Decreases consumption
- Insurance does not work

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34
Q

What are the solutions to adverse selection?

A
  • Signals: when the agent credibly conveys some unobservable information about the good to the principle
  • Regulation
  • Screening
  • Statistical discrimination
  • Insurance

These solutions exist but entail costs that would not be supported if there was perfect information.

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35
Q

What is an example of adverse selection being solved?

A

Through the menu of contracts, insurers can propose several contracts and the choice of the contract will reveal the agent’s risk profile. It requires franchising.

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36
Q

What are the conditions for the signal to work?

A
  • Credibility through a trustworthy institution
  • Costly for only good-quality products to receive it (effort, time)
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37
Q

What is the market for lemons, according to Akerlof?

A

A situation where sellers are better informed than buyers about the quality of the goods for sale, like used cars.

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38
Q

When do incomplete markets occur?

A
  • When private markets fail to provide goods and services even though the cost of providing them is less than what individuals are willing to pay.
  • It provides rationale for government intervention.
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39
Q

Why are markets incomplete?

A
  • Not enough innovation
  • High transaction costs
  • Information asymmetry and enforcement costs
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40
Q

What are some markets that have been deemed incomplete markets?

A

Insurance and loan products in the United States.

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41
Q

Provide an example of where it can be difficult to distinguish between adverse selection and moral hazard.

A

Anti-poverty programs, as it is not clear whether poverty stems from a lack of productive skill (adverse selection) or a lack of effort from the poor who know they will get welfare assistance anyway (moral hazard).

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42
Q

Why would information asymmetry cause a death spiral in insurance markets?

A

If insurance is always offered at a fair price, it is a bad deal for healthy people and only high risk people will buy it.

As payout probability is higher, insurers will face losses and have to increase the premium price, meaning that no insurance contracts will be offered in the end.

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43
Q

How can a death spiral be solved?

A

Avoid pooling equilibrium, where insurance companies offer a contract based on average risk.

Target separating equilibrium, where insurance companies offer a menu of different contracts.

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44
Q

What happens at the market equilibrium of health insurance markets?

A
  • The premium equals the average payout per policy
  • Keep in mind, there may be multiple equilibria
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45
Q

What are some examples of health insurance?

A

Health industry, Global Financial Crisis

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46
Q

How do sovereign debt bailouts entail moral hazard?

A
  • Sovereign debt bailouts
  • Start-up financing
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47
Q

What are the effects of having unemployment benefits for a longer period?

A
  • It reduces the incentives to look for a job (moral hazard)
  • It increases the incentives to find higher-paying jobs
  • It increases the dissimilarity index (segregation)
  • It reduces over-education
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48
Q

What is the dissimilarity index?

A

It is a measure of segregation.

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49
Q

What is the Beveridge Curve?

A

A graphical representation between the unemployment and the job vacancy rate.

It offers an idea of how ‘tight’ the labour market is.

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50
Q

What does the slope of the Beveridge Curve indicate?

A

The steeper the curve is, the greater the growth or expansion.

The flatter the curve is, the recession is.

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51
Q

What causes an outwards shift in the Beveridge Curve?

A

A decline in match efficiency.

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52
Q

What is cyclical unemployment?

A

The component of overall unemployment that results directly from cycles of economic upturn and downturn.

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53
Q

What is the problem with situations of moral hazard?

A

Agents do not bear the risk or cost of their actions and make careful choices, because the cost is supported by the principal.

This may lead to an increase in risky behaviour and too much spending.

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54
Q

What is ‘too big to fail’ in the context of moral hazard?

A

If a big bank expects to be bailed out by the government in the event of a financial crisis, it can engage in riskier behaviour.

For example, Lehman Brothers in 2008. Mortgage brokers were encouraged to originate as many loans as possible to take commissions, regardless of the financial means of the borrower. When the borrowers could not repay their loans, the loans defaulted.

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55
Q

What happens when the proportion of the costs supported by the agent are increased?

A

It creates incentives to manage the cost of expenditures, but represents a higher risk for the agent.

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56
Q

What are the solutions to moral hazard?

A
  • Monetary incentives
  • Regulations or controls
  • Share the risks between parties
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57
Q

What is the second order equilibria, in the management of asymmetric information?

A

When asymmetric information is solved, but at some costs, called agency costs.

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58
Q

What is a market?

A

A market is where buyers and sellers can meet to facilitate the exchange or transaction of goods and services.

They can be physical, like a retail outlet, or virtual, like an e-retailer.

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59
Q

In practice, do purely competitive markets exist?

A

In practice, imperfect competition exists.

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60
Q

When does imperfect competition arise?

A

When an agent has the ability to influence prices.

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61
Q

What is a relevant market?

A

A set of products or services that are considered substitutes by consumers, both in terms or their characteristics and the geographic area where they are offered.

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62
Q

How does one know if products are substitutes?

A

Conduct an SSNIP test. See if consumers would switch to other suppliers in the hypothetical event of small but significant and non-transitory increases in prices or a product of service.

63
Q

What does a market structure describe?

A

The characteristics of the demand and supply in a given market and the variables determining the nature of competition on the market.

64
Q

What are the key elements to define a market structure?

A
  • The number of buyers and sellers
  • The extent of product suitability
  • Ease of entry and exit
65
Q

What are the four market structures? Define them.

A
  • Perfect competition: many sellers of a standardised product.
  • Monopolistic competition: many sellers of a differentiated product.
  • Oligopoly: a few sellers of a standardised or differentiated product.
  • Monopoly: a single seller of a product for which there is no close substitute.
66
Q

What are the characteristics of purely competitive markets?

A
  • No pricing power
  • Price competition
  • Very good substitutability
  • No barriers to entry
  • Many sellers
67
Q

What are the characteristics of monopolistic markets?

A
  • Some pricing power
  • Partial price competition
  • Good but differentiated substitutability
  • Low barriers to entry or exit
  • Many sellers
68
Q

What are some examples of competitive monopolistic markets?

A

Chocolate spread, with Nutella, Nutina, and many more.

69
Q

What are the main differences between perfect competition and monopolistic competition?

A
  • Firms look for differentiation or minor innovations
  • Prices are higher than the marginal cost
  • Monopolistic competitive firms waste resources on costs, such as marketing
70
Q

What are the characteristics of oligopolies?

A
  • Much pricing power
  • Partial price competition
  • Limited substitutability
  • High barriers to entry or exit
  • A few sellers
71
Q

What are some examples of oligopolies?

A

Smartphones, including Apple, Samsung, and Huawei.

72
Q

What is the difference between oligopolies and competitive markets?

A

Oligopolistic markets are less efficient: less competitive and higher prices.

73
Q

What is the main danger with oligopolies?

A

There is a risk of collusion.

This can take place by fixing a common price, reducing quantities, or sharing the market.

74
Q

What are some solutions to oligopolies?

A

Antitrust laws and competition authorities.

75
Q

What is the game theoretical outcome of collusion in oligopolies?

A

It is a Prisoner’s Dilemma: the optimum is to both collude, but the Nash equilibrium leads to no one colluding.

76
Q

What is a monopoly?

A
  • Significant pricing power
  • Advertising nature of competition
  • No substitutability
  • Very high barriers to entry
  • One seller
77
Q

What can a monopolist firm benefit from?

A
  • Large economies of scale
  • Large research and development budget
78
Q

What are the negative effects of having a monopoly?

A
  • High prices and low quantity of production
  • Little to no incentives to innovate, reduce costs, or offer good service to customers
79
Q

When can monopolies be beneficial?

A

When they are caused by innovation (patents) and natural monopolies (high fixed costs, eg. rail).

80
Q

How are all four types of market structures differentiated?

A
  • Perfect competition: identical products
  • Monopolistic competition: differentiated products
  • Oligopoly: few firms
  • Monopoly: one firm
81
Q

What is Cournot behaviour, in the context of oligopolies?

A

The use of quantity as a strategic variable.

82
Q

What is Bertrand behaviour, in the context of oligopolies?

A

The use of prices as a strategic variable.

83
Q

What is a monopsony?

A

A market with several sellers but only one buyer. For example, defence equipment.

84
Q

What is an oligopsony?

A

A market with several sellers and a few buyers. For example, farmers and major retailers.

85
Q

What are the three criteria of ‘competition’ in markets?

A
  • Contestability
  • Concentration
  • Collusiveness
86
Q

Under perfect competition, what happens to firms at equilibrium?

A

Each firm is producing the quantity for which MR = MC = ATC.

87
Q

What is the position of the demand curve under perfect competition?

A

Horizontal, as it is perfectly elastic.

88
Q

What is the position of the demand curve under monopolistic competition?

A

Downward sloping, as there is high elasticity because products are close substitutes.

89
Q

Why do monopolistic firms earn positive economic profits?

A

Because the market price is greater than the average total cost.

90
Q

What is the position of the demand curve under oligopolies?

A

Downward sloping and kinked to be steeper halfway down.

It assumes an increase in firms’ product price will not be followed by its competitors, but a decrease in price will.

91
Q

What is the position of the demand curve under monopolies?

A

Downward sloping.

92
Q

How do monopolies use price discrimination strategies?

A

By charging different consumers different prices for the same product or service; for example, at the movies, theatre, or museum based on age.

93
Q

What are some of the advantages of regulation or subsidies?

A
  • More consistent national policy
  • Clearer estimates of costs through subsidy schemes
  • Strong incentives still hold with regulation
94
Q

What are some of the disadvantages of regulation?

A
  • Costs to administering and enforcing
  • Government capacity for prudent implementation
  • Distortions, such as different behaviour from efficient, competitive equilibrium
95
Q

What are the two types of concerns that the government will not manage production efficiently?

A
  • Organisational causes: incentives; and personnel, procurement, budget restrictions.
  • Individual causes: bureaucratic competition, principal-agent problem, excessive risk aversion.
96
Q

Explain the rise of regulatory agencies.

A

It is a historical movement towards delegating regulation to independent authorities, to limit inefficiency associated with imperfect competition and avoid regulatory capture.

97
Q

What is the problem with regulatory agencies?

A

It makes coordinated policy making more challenging, and the public interest can suffer from a lack of consideration.

98
Q

What is an example of the rise of regulatory agencies?

A

In 1997, ART was established to coordinate the opening of the French monopoly over fixed telecom networks, in which a wave of mergers did not decrease competition.

99
Q

Define economies of scale.

A

When more units of a good or service can be produced on a larger scale with fewer input costs.

100
Q

What is the difference between a pure and impure public good?

A

A pure public good is non-rival and non-excludable, whereas an impure private good verifies only one of those conditions.

101
Q

How is the optimal provision of a good determined?

A
  • How valuable it is to customers, through the marginal benefit or utility
  • How costly it is to produce the good, through the marginal cost of production
102
Q

What is the optimal provision of a private good?

A

According to the First Welfare Theorem, it is on the market and at the price equilibrium, where the MB = MC.

103
Q

What is the Samuelson rule for the provision of public goods?

A

Sum of MB = MC.

Logic: If the production of the public unit is increased by one unit, P = MC. While this is the same for private goods, an additional unit of public goods benefits all consumers, which means the MC = sum of MB.

104
Q

If public goods were sold on the market, why would there be an under-provision of the good?

A

Because markets do not incorporate the collective benefit of the production of public goods.

105
Q

Why do public goods create market failures?

A

Free-riding causes the underprovision of public goods, because competitive markets do not take into account the collective benefit.

106
Q

Define the free-rider problem.

A

A type of market failure that occurs when those who benefit from public goods do not pay for them.

107
Q

How is government intervention justified?

A

In the presence of a market failure, governments can intervene on efficiency grounds to reach the social optimum in the case of underproduction.

108
Q

How can common pool resources be dealt with to avoid the tragedy of the commons?

A
  • Privatisation
  • State regulations
  • Common ownership and regulation through social norms
109
Q

Other than the main four market structures (and the two others), what other market structures exist?

A

Two-sided markets.

110
Q

When do two-sided markets occur?

A

When two user groups (buyers and sellers) interact through an intermediary platform to the benefit of both parties. For example, Amazon, AirBnB, Uber and LinkedIn.

111
Q

Who are the two user groups (supply and demand) in two-sides market structures?

A

They are interdependent through network effects.

112
Q

What are network effects?

A

When the value of a product or service depends on a number of buyers, sellers or users who leverage it.

113
Q

What is the snowball effect?

A

More buyers creates value to sellers, which creates more sellers, which creates value to buyers, which creates more buyers, and so on.

114
Q

What problems do two-sided markets raise?

A

They rapidly dominate the market because they are hard to compete with.

115
Q

Why does imperfect competition call for regulation?

A

To avoid negative practices for the consumers.

116
Q

What is competition law?

A

The field of law that promotes or seeks to maintain market competition by regulating anti-competitive conduct by companies.

117
Q

Who is in charge of the implementation of competition law?

A

The European Commission, together with the national competition authorities, directly enforces EU competition rules.

118
Q

What is the competition law authority in France?

A

Autorité de la concurrence.

119
Q

What are the main functions of competition authorities?

A

Fighting collusion and abusive behaviour (predatory pricing), and supervising mergers and acquisitions to avoid monopolies.

120
Q

Provide an example of a decision made by competition authorities.

A

In 2019, the European Commission prohibited Siemens’ acquisition of Alstom – the two largest suppliers of railway and signalling systems.

121
Q

Why have natural monopolies been regulated more than others?

A

They are often related to some essential services, including energy, telecommunications, transport and water.

122
Q

Seeing that natural monopolies set their own prices, how do they decide on them?

A
  • Pricing at marginal cost: replicates perfect competition but leads to high deficits.
  • Pricing at the average cost: good for financial equilibrium but prices are high.
  • Ramsey pricing: the price increase over MC is inverse to the price elasticity of demand.
123
Q

Why are natural monopolies opened to competition?

A
  • Offer people a better service at lower costs
  • Have more innovation through competition
  • Give consumers opportunities to choose their supplier
124
Q

How are natural monopolies opened to competition?

A
  • Activities are separated
  • Only the management of the infrastructure is kept under monopoly
  • Other activities are opened to competition
125
Q

Provide an example of a natural monopoly that was opened up to competition.

A

SNCF, or French rail transportation.

126
Q

When a natural monopoly is opened up to competition, why is there a need for a regulatory body to be created?

A
  • To ensure fair and non-discriminatory access to the infrastructure
  • To supervise negotiations between applicants and infrastructure managers

Example: CRE – independent administrative body in charge of regulating electricity and gas markets.

127
Q

What are five events for which public intervention is needed?

A
  • Externalities
  • Asymmetric information
  • Public goods
  • Anti-competitive behaviour of firms
  • Social / equity reasons
128
Q

What is the supply and demand for regulation? What about the market price?

A
  • Supply: legislative bodies, regulatory bodies
  • Demand: consumers, firms, industries
  • Market price: campaign financing, bribery
129
Q

What is regulatory capture?

A

The process through which a regulatory agency, created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry it is meant to regulate.

130
Q

What are revolving door deals?

A

When high-level regulators and other officials leave government and find high-level jobs in the same industry that they had been responsible for regulating.

131
Q

What is capture theory?

A

The idea that regulated firms will earn higher rates on average than non-regulated firms. For example, bank regulation.

132
Q

In debates on the justification of public intervention, such as market failures versus state failures, what are some solutions?

A

More conditions to have independent regulatory bodies and high sanctions on briberies.

133
Q

Who is the main economist that justified public intervention?

A

Joseph Stiglitz

134
Q

What is a point to make against public intervention?

A

Public choice theory: bureaucrats and politicians are also utility maximisers, and not benevolent.

135
Q

How are publicly-provided private goods rationed?

A
  • User charges and fees; eg. airline ticket tax, funding airport facilities
  • Uniform provisional; eg. primary education
  • Queuing; eg. healthcare
136
Q

What are the benefits of the provision of public goods at the EU-level?

A
  • Economies of scale
  • Policy spillovers
  • Preference heterogeneity
137
Q

Put simply, what are the two objectives of government spending?

A
  • Efficiency: to correct market failures
  • Equity: to perform redistribution
138
Q

How are public expenditures financed?

A

Through taxes or debt

139
Q

What is the central definition of public debt?

A

General government debt: central government + local administration and social security funds.

140
Q

What is the main indicator of public finances tracked by financial markets and institutions?

A

Debt-to-GDP ratio, or public debt over GDP.

141
Q

What is the simplified accounting equation for public debt?

A

Evolution of debt = interest payments - primary balance

142
Q

Under what scenario would public debt increase, even with a surplus?

A

If interests are too high, public debt can surpass the sum of the surplus.

143
Q

What percentage should primary deficits not exceed?

A

3% of GDP.

144
Q

What is the primary balance?

A

The fiscal balance, excluding net interest payments on public debt.

145
Q

What are the main drivers of public debt?

A

Trade deficit, international oil prices, FDI and domestic investment.

146
Q

When is public debt considered sustainable?

A

If the government is able to meet all its current and future payment obligations without exceptional financial assistance or going into default.

147
Q

How can a country avoid creditors believing their debt is not sustainable, and causing a surge in interest rates to trigger a debt crisis?

A

Credible policies, that include the ability to collect taxes, manage public spending or foster economic growth.

148
Q

What do austerity measures target?

A

Primary surpluses, through deficit reductions. Its effectiveness is uncertain.

149
Q

How can debt-to-GDP ratios be reduced?

A
  • Austerity measures
  • Structural reforms
  • Sovereign debt
  • Inflation
150
Q

What do structural reforms target?

A

Fostering GDP growth, through deregulation and competition policies.

151
Q

What happens when a sovereign default occurs?

A

It mechanically decreases public debt, but it undermines the credibility of the government to pay its future debt payments.

It often leads to an increase in interest rates or a recession.

152
Q

Is public debt labelled in real or nominal terms?

A

Nominal – it does not take into account inflation.

153
Q

What happens when GDP is greater than the interest rate on public debt?

A

Public debt can remain or increase sustainably. Put bluntly, public debt may have no fiscal cost.

154
Q
A

Public Economics 1 (2 decks)

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