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Public Economics 1 > Mid-Semester Exam > Flashcards

Mid-Semester Exam Flashcards

1
Q

Define public economics.

A

The study of all aspects of government intervention in the economy.

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2
Q

What are the four questions of public economics according to Stiglitz and Rosengard?

A
  1. What is to be produced?
  2. How is it to be produced?
  3. For whom is it to be produced?
  4. How are these decisions made?
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3
Q

What happens in mixed economies?

A

Economic activity is undertaken by both private firms and the government.

This constitutes most modern economies in today’s day and age, other than North Korea and the Soviet Union.

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4
Q

The rise of the welfare state has coincided with…

A

An increase in public spending of roughly 10% of GDP in the 19th century, starting in the 1920s and accelerating in the 1960s.

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5
Q

How are goods produced?

A

By some combination of capital and labour.

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6
Q

What are rivalrous and non-rivalrous goods?

A

Rivalrous: a good that can only be consumed by one consumer.

Non-rivalrous: a good that can be consumed or possessed by multiple users.

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7
Q

What are excludable and non-excludable goods?

A

Excludable: goods that cost or have a barrier to their consumption.

Non-excludable: goods that are free to consume.

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8
Q

Define private goods and provide examples.

A

Excludable and rivalrous.

Examples: food, clothing, cars, personal electronics.

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9
Q

Define common goods and provide examples.

A

Non-excludable and rivalrous.

Examples: fish stocks, timber, coal.

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10
Q

Define club goods and provide examples.

A

Excludable and non-rivalrous.

Examples: cinemas, satellite TV.

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11
Q

Define public goods and provide examples.

A

Non-rivalrous and non-excludable.

Examples: air, national defense.

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12
Q

What measurements are used to compare public spending?

A

The best measurement is government expenditure as a percentage of GDP.

On the other hand, government expenditure per capita does not consider the wealth of economies and the distribution between them.

Example: USA has high expenditure per capita, but low as a share of GDP.

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13
Q

At a certain point, does the distribution of an economy have an effect on its size?

A

Yes.

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14
Q

What are the two main approaches to public economics?

A
  1. Causal (positive) approach: the relation between a first event and a second event, where the first event has caused the second event.

Example: Is Norway wealthy because of its public spending, or is Norway’s public spending high because of its wealth?

  1. Normative approach: the ideal standard that results from an action.

Example: what is the optimal level of public spending?

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15
Q

What is the new approach to public economics that is gaining popularity?

A

Policy evaluations: natural experiments that can be used to infer the causal impact of a policy on economic activity or other.

Example: the impact of minimum wage reforms has been used to assess employment.

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16
Q

What is falsification?

A

It holds that a theory cannot be true unless it can be proven false through deductive reasoning.

Example: the hypothesis that “all swans are white” can be falsified by observing a black swan, while inductive reasoning would state “all swans are white” and conclude it is probably true.

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17
Q

Why should the government intervene according to Musgrave?

A
  1. Allocation: to provide goods that markets fail to deliver.
  2. Distribution: change the distribution of goods among society’s members.
  3. Stabilisation: influence controls of the free market.
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18
Q

What does Adam Smith explain in the “Wealth of Nations”?

A

Smith explains that the decisions of individuals pursuing their private interests can, as led by the invisible hand, generate socially desirable outcomes.

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19
Q

What is the accurate interpretation of Adam Smith’s “invisible hand” metaphor?

A

Smith only mentioned it three times. In truth, Smith argued for a specific type of government intervention, which is mercantilist policy in trade - and does not dismiss government intervention.

However, it was repurposed by neoclassical economists in the 1950s and used as a rationale for market efficiency.

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20
Q

What is a Pareto improvement?

A

An allocation admits a Pareto improvement if there exists another feasible allocation such that: 1. At least one person would be better off; 2. Nobody would be worse off.

In other words, it exists if it is possible to increase the utility of at least one person without penalising others.

Example: inmates doing social work.

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21
Q

Define Pareto Efficiency (or Optimality)?

A

An allocation where there is no room for further Pareto improvements.

In other words, if it is impossible to increase one’s utility without decreasing the utility of the other person.

It guarantees that no resources have been wasted, but does not take into account equity concerns, such as the inequality of a distribution of resources.

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22
Q

Identify and describe the key characteristic of competitive markets.

A

Price-taking behaviour: agents alone, be they consumers or firms, cannot influence prices.

It is an ambitious claim as it assumes agents have no market power.

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23
Q

Define competitive equilibrium.

A

It is a condition in which producers and consumers in competitive markets with freely determined prices arrive at an equilibrium price.

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24
Q

What are the three conditions of competitive equilibrium?

A
  1. Consumers maximise utility.
  2. Producers maximise profits.
  3. There is market clearing: the demand from consumers equals the supply provided by firms.
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25
Q

Define and explain the First Fundamental Theorem of Welfare Economics?

A

It states a competitive equilibrium is Pareto optimal.

Implication: there is no need for government intervention on efficiency grounds.

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26
Q

What three conditions must NOT exist for Pareto optimality?

A
  1. Externalities.
  2. Imperfect information.
  3. Public goods.
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27
Q

What are the two questions of public economics?

A
  1. How do governments affect the economy?
  2. How should government policies be designed to attain x, y, or z?
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28
Q

What have been the three main schools of thought in the history of public economics?

A
  1. 18th century: political economy thinkers (Smith, Mills).
  2. 19th century: public finance thinkers (German, Italian & Stockholm schools).
  3. 19th century onwards: welfare economics (Pareto, Walras).
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29
Q

What are the failures of the First Fundamental Theorem of Welfare Economics?

A
  • Market preconditions
  • Externalities
  • Imperfect competition
  • Asymmetric information
  • Correction of individual failures
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30
Q

What is the limit of the Second Fundamental Theory of Welfare Economics?

A

Redistributions may introduce distortions.

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31
Q

What are the four issues with government intervention?

A
  1. Collective choice problem: how to aggregate millions of choices?
  2. Commitment problem: lack of government credibility negatively affects the success of economic policies.
  3. Second-best policies: due to information constraints.
  4. Cycles: business and political.
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32
Q

What changes can shift the supply curve?

A
  • Production
  • Technology
  • Competition
  • Regulation / tax
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33
Q

What changes can shift the demand curve?

A
  • Consumer preferences & income
  • Population numbers
  • Price change in related goods
  • Consumer expectations for the future
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34
Q

What is consumer surplus?

A

The sum of all trades that could have happened because some consumers were willing to pay more than the equilibrium price, but benefited from a lower one.

It is the upper triangle: lies above the EQBM price and below the demand curve.

CS = WTP - P

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35
Q

What is producer surplus?

A

The difference between the production cost and the price received per unit.

It shows the marginal cost of production and the producer’s willingness to supply a particular good.

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36
Q

What is total welfare?

A

The sum of the consumer surplus and the producer surplus.

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37
Q

What are price ceilings or rent controls?

A

The mandated maximum price a producer is allowed to charge for a particular product.

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38
Q

What is deadweight loss?

A

The cost to society created by market inefficiency (when supply and demand are not in EQBM).

39
Q

What are indifference curves?

A

The various combinations of two goods with which a consumer is equally satisfied.

40
Q

What are the four properties of indifference curves?

A
  1. Never cross.
  2. Downwards-sloping.
  3. Convex.
  4. Further out = higher utility.
41
Q

Why are indifference curves downwards-sloping and never crossing?

A

Due to the non-satiation principle, an upward curve would mean that the consumer would be indifferent to a bundle with more of both goods and the extra utility.

42
Q

Why are indifference curves convex?

A

Due to diminishing marginal utility, the consumption of each individual unit of a good makes an individual less happy than the consumption of the previous unit.

43
Q

What is the Marginal Rate of Substitution (MRS)?

A

A model that illustrates how consumers make tradeoffs among competing products.

Principle: as the consumer has more of x, there is less willingness to give up y in order to get more of x.

MRS = change in good x / change in good y

44
Q

What are budget constraints?

A

The combination of goods a consumer can buy if they spend their entire income.

It defines a linear set of bundles that the consumer can afford with their income.

45
Q

Graphically, where are utility maximising bundles represented?

A

At the intersection of the highest possible indifference curve and the budget constraint line.

46
Q

What is the income effect?

A

How a change in income can change the quantity of goods that consumers will demand.

47
Q

What is the substitution effect?

A

How a change in prices can change the quantity of goods that consumers will demand.

48
Q

Define externalities.

A

The consequence of a given transaction on the market that is borne by an outsider who does not participate in the transaction.

49
Q

Define positive and negative externalities. Provide examples.

A

Positive: when consuming or producing a good causes a benefit to a third party.

Example: vaccination or taking public transport.

Negative externalities: when consuming or producing a good causes a cost to a third party.

Example: pollution or smoking in public.

50
Q

What do externalities cause?

A
  • Market failures via inefficient allocations
  • Meaning room for Pareto improvement and that self-interest does not align with socially desirable outcomes
51
Q

What do positive and negative externalities cause in terms of production?

A

Negative externalities cause overproduction.

Positive externalities cause underproduction

52
Q

What happens to the supply curve when there are externalities in the market?

A

It moves upwards (to the left) to account for social costs.

53
Q

What is the Tragedy of the Commons?

A

A situation in which individuals with access to a common good act in their own self-interest, and in doing so, deplete the resource.

Example: over-fishing.

54
Q

What are the two types of solutions to the Tragedy of the Commons?

A

Public solutions and private solutions.

55
Q

List and explain public solutions to the Tragedy of the Commons.

A

Quotas: restricts the quantity of goods that can be sold over a particular time period.
– Example: EU Common Fisheries Policy.
– Drawbacks: costly to control, assumes optimal quantities are known.

Pigouvian / Corrective taxes: a tax on a market transaction that creates a negative externality borne by individuals not directly involved in the transaction.
– Example: EU Carbon Border Adjustment Mechanism (CBAM).
– Drawbacks: costly to operate, and assumes marginal social costs are known.

56
Q

List and explain the private solutions to the Tragedy of the Commons.

A

Mergers: two firms that offer positive externalities to each other can enter into a contract together to make both parties better off.
– Drawbacks: coordination costs, risk of free-riding, and firm with negative externalities needs funds.

Coasian bargaining: through bargaining and a proper allocation of property rights, firms will find the most efficient solution and are able to solve externalities.
– Conditions: perfect information, free bargaining, property rights are well defined.
– Example: Vittel achieved a contractual agreement with farmers in 1990.
– The main drawback is that it has strong conditions. However, if there are transaction costs, the state can intervene and reduce them or implement efficient regulations.

Marketable permits: when the state issues permits allowing only a certain quantity of an externality to be produced.
– Example: EU Emissions Trading System.
– Drawbacks: decreases competitiveness of European firms and leads to carbon leakage.

57
Q

What is the double dividend?

A

Pigouvian taxes reduce the damage done to the environment and improve economic efficiency by using these revenues to reduce other taxes.

It is thus redistributive and a Pareto improvement.

58
Q

What is the internalisation of externalities?

A

When a firm or organisation takes charge of certain activities that third parties should not be involved in.

This can happen through market mechanisms, government regulations, or self-governing.

Example: carbon pricing.

59
Q

What are the two drawbacks of environmental policies and taxation?

A
  1. Perception - often perceived as a way of increasing public resources instead of fighting pollution.
  2. Unfair - disadvantage the least well-off households.
60
Q

How can an environmental tax be designed to be efficient and fair?

A

Efficient: the price signal must be safeguarded (producers should assume the cost of pollution in their production costs).

Fair: there must be a fair allocation of the cost of decarbonisation.

61
Q

At the collective level, how effective are Pareto improvements for policymakers?

A

They are rare and may cause policy paralysis.

62
Q

What is the Kaldor-Hicks Criterion?

A

A change is welfare-improving if those who gain from the change could theoretically fully compensate those who lose, with at least one of the beneficiaries still better off.

63
Q

Why are both Pareto Efficiency and the Kaldor-Hicks Criterion individualistic?

A

– Absolute measure of welfare
– Negative view of liberty

64
Q

Competitive economies must satisfy what three aspects of Pareto Efficiency?

A

Exchange efficiency: goods have to go to the individuals who value them the most.
– All individuals have the same MRS.
– Shown by the Edgeworth-Bowley Box.

Production efficiency: given a fixed set of resources, the production of good A cannot be increased without decreasing the production of good B.
– Shown by replacing the budget constraint with an isocost line, where slope equals relative price.

Product mix efficiency: goods produced correspond to those desired by individuals.
– Assuming that all consumers have identical preferences, utility is maximised at the point where the indifference curve is tangential to the production possibilities schedule, where MRT = MRS = price ratio.

65
Q

What is the utility possibilities frontier?

A

The maximum level of utility that can be achieved by two consumers.

If an economy is Pareto efficient, it must be operating along the curve.

66
Q

When assessing the tradeoff between fairness and efficiency, what two questions will government intervention ask?

A
  1. How much efficiency must be forgone to have more equity?
  2. What is the relative value that should be assigned to a decrease in inequality compared to a decrease in efficiency?
67
Q

How does the utility possibilities frontier represent social choices?

A

It shows the highest utility attainable by an individual, given the levels of utility attainable by others.

68
Q

Why does the utility possibilities frontier have a concave shape?

A

Due to the MRS, which implies that as the production of one good increases, its opportunity cost increases.

69
Q

In economics, what is a social welfare function?

A

A function that ranks social states as less desirable, more desirable, or indifferent for every possible pair of social states.

70
Q

Describe the three types of social welfare functions.

A
  1. Utilitarianism: sums the utility of each individual in order to obtain society’s overall welfare.
    – All people are the same regardless of their initial level of utility.
    – Example: one additional unit of utility for a starving individual is not seen to be greater than an additional unit of utility for a millionaire.
  2. Rawlsian: welfare is the greatest when the utility of individuals that have the least, is the greatest.
    – There can be no increase in social welfare unless it improves the position of the individual that is the worst off.
  3. Weighted utilitarianism: measures how much social welfare improves when an individual’s utility decreases.
71
Q

What are the two limits to social welfare functions?

A
  1. Interpersonal comparisons:
    – Utilitarian: assumes that the utilities of individuals can be compared in a meaningful way, but it is difficult to objectively compare their value.
    – Rawlsian: avoids comparing utilities and their distributional share amongst people, which means economists are better off using a mere description of winners and losers of policies.
  2. Uncertain representation: calculating social welfare functions of a heterogeneous democracy is a challenge (as opposed to authoritarian regimes).
72
Q

If a particular policy is not a Pareto improvement, what must governments look at?

A

Efficiency (net gains/losses) and equity (measure of inequality) effects

73
Q

When do governments use social welfare functions?

A

When a policy has net positive gains, but losses in equity measures.

74
Q

What is the net efficiency of a policy?

A

The difference between the total WTP and the total costs of a policy.

75
Q

What are three tools to assess distributional effects or equity of a policy?

A
  1. The poverty line
  2. Gini coefficient
  3. Lorenz curve
76
Q

What happens when the total WTP exceeds the total costs, but the costs borne by some exceed their WTP?

A

Compensation principle: if the aggregate willingness to pay exceeds the cost, the policy should proceed.

Tradeoffs across measures: if the aggregate benefit is positive, the poor are beneficiaries, and the rich are net losers – the project increases efficiency and equity.

Weighted net benefits: in some situations, middle-class individuals may be better off.

77
Q

What are the two ways to measure poverty?

A
  1. Monetary: the poverty line lies at 60% of the median income.
  2. Living conditions: in France, there are 27 indicators of material deprivation and if 8 indicators are met, it is considered poverty.
78
Q

What are the issues with the assessment of poverty?

A
  • Shifts in consumption patterns, meaning the poverty line should be higher.
  • Blind to in-kind benefits (food stamps).
  • Difficulties integrating non-cash expenditures, such as healthcare.
79
Q

How is inequality defined?

A

Definitions are varied and consider income, wealth, living conditions, and access to public goods, between countries, within countries and between generations and other demographic groups.

These measure centile or decile ration, Gini coefficient, and the Lorenz curve.

80
Q

What is inequality convergence?

A

The idea that inequality is falling in countries with initially high inequality, or vice versa.

81
Q

By what means of allocation do governments redistribute wealth?

A

Between age groups or socioeconomic groups within the same cohort.

It can be done through monetary transfers or through subsidised access to public services.

82
Q

What does the “Great Gatsby” curve plot?

A

It plots the Gini coefficient and intergenerational income elasticity, and shows a strong correlation between income inequality and intergenerational income elasticity.

This means that countries with a high degree of inequality have less economic mobility across generations.

83
Q

What does the Second Fundamental Theorem of Welfare Economics state?

A

Any Pareto optimum can be supported as a competitive equilibrium for some initial set of endowments.

84
Q

What are the main implications and drawbacks of the Second Fundamental Theorem of Welfare Economics?

A

A fair Pareto optimum can be achieved through decentralised, competitive markets, and there is no need for government intervention except for the distribution of initial wealth.

The main drawback is that it lump-sum transfers are distortive, because they affect the amount of resources available and change the amount to be distributed.
– This causes a tradeoff between equity and efficiency.
– Also, agents can modify the amount of resources to be distributed.

85
Q

What is the relationship between the First and Second Fundamental Theorems of Welfare Economics?

A

The 2nd Theorem is a converse of the 1st Theorem, as competitive equilibrium equals Pareto optimum – and vice versa.

The 1st Theorem is about efficiency, while the 2nd Theorem is about equity.

86
Q

What are the four requirements of perfect competition?

A
  1. Many buyers and sellers
  2. No barriers to entry
  3. Informational symmetry
  4. Price taking
87
Q

In an ideal world, what are the steps to maximise equity and efficiency?

A
  1. Redistribute wealth endowments to address equity concerns.
  2. Let actors trade in competitive markets.

This will achieve the Pareto optimum and efficiency.

88
Q

What is utility used to describe?

A

Wellbeing at an individual level.

89
Q

Social welfare functions provide a way of solving…

A

… equity-efficiency tradeoffs, depending on value judgements.

But in practice, governments do not explicitly refer to them, and rather use direct and empirically meaningful measures of equity and efficiency.

90
Q

How is the efficiency gain of a policy measured?

A

The difference between consumer surplus and the cost for government.

Limit: doesn’t account for gains or losses at the individual level because consumer surplus is an aggregate.

91
Q

How is WTP measured?

A

Surveys.

92
Q

What is the difference between WTP and the EQBM price?

A

Consumer surplus.

93
Q

How much efficiency, in dollar measurements, should we give up to curb inequality?

A

Weighted benefit approach: the more gains are located at the bottom of the distribution, the more desirable the policy is.

94
Q

What are the seven reasons for which governments intervene in economies?

A

Distribution,
Imperfect competition,
Absence of futures and Insurance markets,
Failure to attain full equilibrium,
Public goods,
Merit wants, and
Externalities.

Public Economics 1 (2 decks)

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