Lecture 1 Flashcards
An allocation is an assignment or distribution of goods/financial resources and services. The market as an allocation
mechanism contains 3 elements. What 3 elements?
Demand, Supply & Price.
One element is the demand:
Demand represents the needs of market participants.
Or in other words: What are the market participants willing to pay for
One element is the supply:
The supply represents the willingness to produce goods.
The price is the ordering element:
The price determines if and when a good is produced, but at the same time if and when a good is consumed.
What is Pareto Optimum
Pareto Optimal: A situation is pareto optimal if no improvement in welfare can be achieved without making
someone else worse off.
Pareto optimal allocations do not allow any normative statements about distributional situations. If the cake is
100% in one hand, this can be a pareto optimal situation.
What does a Tax increase lead to?
The tax increase reduces the social
surplus for the producers and the
consumers by the red/white area β the
deadweight loss.
What foes Price fixing lead to
The fixed price increases the consumer return
for those who can purchase the goods. The
consumer return is shown in blue. The red
triangle is the deadweight loss. The gray area
represents the producer surplus.
The allocation mechanism is disturbed, not the
price alone, but other factors now lead to getting
the good. These factors can be personal
contacts or, for example, the first-come, firstserved principle.
Necessary Conditions for Perfect Markets?
Efficiency
* A price that contains all fundamental information
* All risk-free profits (arbitrage) have been used
* No manipulations are possible
Transparency
* Traceability of information linked to the service/goods
* Determination of the value of the good/service (supply and demand)
Number of market participants
* To prevent Oligopolies or monopolies are sufficient number of market participants is necessary
* No market entry barriers
What is First Fundamental Theorem of Welfare Economics?
The competitive equilibrium, where supply equals
demand, maximizes social efficiency.
What is Deadweight loss?
The reduction in social efficiency from preventing trades for which benefits exceed
costs.
What is Social Efficiency
Social efficiency represents the net gains to society from all trades that are made in a market, and it consists of the sum of two components:
consumer and producer surplus.
Also called total social surplus.
What is consumer and Producer Surplus
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.
We discuss the determination of welfare in two steps. Which 2 Steps?
First, we discuss the determinants of social efficiency, or the size of the economic pie.
Second, we consider how to integrate redistribution into this analysis so that we can measure the total
well-being of society, or social welfare.
Second Fundamental Theorem of Welfare Economics? Definition.
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.
Social Welfare function. Definition & Name 2!
Social Welfare Function (SWF): A function that combines the utility functions of all individuals into an
overall social utility function
The utilitarian social welfare function maximizes the sum of individual utility:
γπππππΉπΉγ^ππ=ππ_1+ππ_2+β¦+ππ_ππ
The Rawlsian social welfare function maximizes the utility of the worst-off member of society:
γπππππΉπΉγ^π
π
=minγ(ππ_1,ππ_2,β¦,ππ_ππ)γ
Social welfare functions reflect different possible equity criteria. What are the Criteria?
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.
Myths of Economic Markets
When more is demanded, the price goes down!
Correct would be: If more is demanded, the price rises!
If the state fixes the prices, everyone can afford this good!
Correct would be: If the state fixes the prices, it comes to overproduction or shortages.
If the state makes a law that controls the price, nobody can enrich itself and the society has more of it!
Correct would be: If the price is fixed, either the consumers or the producers profit more from it. The total yield for all decreases.
