L2: Theoretical Tools of Public Finance

Question 1

how consumers make choices

Answer 1

represent preferences with a utility function

show how to represent preferences graphically

model budget constraints that individuals face

show how individuals maximise utility given their budget constraints

Question 2

utility function

Answer 2

mathematical function which translates well-being from different consumption bundles into units that can be compared in order to determine choice

Question 3

indifference curve

Answer 3

graphical representation of all bundles of goods that make an individual equally well off

Question 4

2 key properties of indifference curves

Answer 4

consumers prefer higher indifference curves
- moving up from the origin as you increase consumption of either good

indifference curves are always downwards-sloping
- convexity
- tendency to not choose extreme versions of a basket between two goods

Question 5

marginal utility

Answer 5

increment to utility obtained by consuming an additional unit of a good

Question 6

marginal rate of substitution

Answer 6

rate at which the consumers will trade off the good on the vertical axis for that on the horizontal axis

slope of the indifference curve

Question 7

budget constraint

Answer 7

mathematical representation of all combinations of goods one can buy using all income

fact that individuals have limited resources

Question 8

substitution effect

Answer 8

holding utility constant, a relative rise in the price of a good will always cause an individual to choose less of that good

changing relative price but keeping the individual on the same indifference curve

Question 9

income effect

Answer 9

rise in the price of a good will typically cause an individual to choose less of all goods because income can purchase less than before

changing income but not relative prices

Question 10

normal goods

Answer 10

goods for which demand increases as income rises

Question 11

inferior goods

Answer 11

goods for which demand decreases as income rises

Question 12

elasticity of demand

Answer 12

% change in demand caused by a 1% change in price

typically negative, since demand falls as price rises

not constant along a demand curve but defined at a particular point

Question 13

cross-price elasticity

Answer 13

how responsive demand for good 1 is to price of good 2

Question 14

horizontal demand curve

Answer 14

perfectly elastic demand

Question 15

vertical demand curve

Answer 15

perfectly inelastic demand

Question 16

marginal cost

Answer 16

incremental cost to a firm of producing one more unit of a good

Question 17

elasticity of supply

Answer 17

% change in supply for a 1% increase in price

Question 18

social efficiency

Answer 18

net gains to society from all trades that are made in a market

sum of consumer and producer surplus

Question 19

consumer surplus

Answer 19

benefit consumers derive from consuming a good, above and beyond the price they pay for the good

Question 20

producer surplus

Answer 20

benefit producers derive from selling a good, above and beyond the cost of producing that good

Question 21

first fundamental theorem of welfare economics

Answer 21

competitive equilibrium, where supply equals demand, maximises social efficiency

holds with no failures

results in pareto efficiency

Question 22

deadweight loss

Answer 22

reduction in social efficiency from preventing trades for which benefits exceed costs

Question 23

pareto efficiency

Answer 23

not possible to make someone better off without making someone else worse off

desirable but says nothing about how well-being is distributed

Question 24

second fundamental theorem of welfare economics

Answer 24

any pareto efficient outcome can be reached by
- redistribution of initial endowments (individualised lump-sum taxes based on characteristics but not actual behaviour)
- letting markets work efficiently thereafter

Question 25

social welfare function

Answer 25

aggregates individual utility functions

meant to represent social preferences for redistribution from the rich to the poor

reflects social values, not economic analysis

Question 26

utilitarian social welfare function

Answer 26

if marginal utility declines with income, we are willing to give up more than $1 from the rich to provide $1 to the poor

Question 27

rawlsian social welfare function

Answer 27

willing to give up any amount from anyone else to help the poorest a little

very redistributive

Question 28

egalitarianism

Answer 28

greater equality is better even if no one is better off and some worse off

Question 29

specific egalitarianism

Answer 29

some things should be allocated equally even if there is general inequality

access to housing, healthcare, food, etc. as a human right so certain commodities for which inequality of consumption is unacceptable

Question 30

equality of opportunity

Answer 30

redistribution avoided except to the extent of providing equality of opportunity

Question 31

equal sacrifice

Answer 31

should evaluate the amount given up rather than the final outcome

those with higher utility and lower marginal utility should give up more

Question 32

reference groups

Answer 32

people care about who gets redistribution - deserving poor vs. freeloaders