Midterm

Question 1

When do free markets work?

Answer 1

Efficiency is maximized when all possibility for mutually beneficial trade have been exhausted. First Theorem of Welfare Economics: a competitive market equilibrium is that which has maximized gains from trade.

Question 2

Maginal Utility

Answer 2

The incremental utility that accrues to a consumer from the consumption of one more unit of a particular good. Assumed to demonstrate diminishing returns.

Question 3

Indifference curves

Answer 3

Bundles of consumption of different good assumed to make an individually equally happy (i.e. provide equivalent amounts of utility).

Question 4

Marginal rate of substitution

Answer 4

Slope of individual’s indifference curve; shows rate at which individuals are willing to trade off one good for another to provide themselves utility. Under competitive equilibrium, all consumers will have equal MRS.

Question 5

Marginal Product

Answer 5

Impact on firm’s output from one additional unit of input; also assumed to show diminishing returns.

Question 6

Isoquants

Answer 6

Different combinations of firm’s inputs that can be combined to produce equivalent levels of output

Question 7

Marginal Rate of Technical Substitution

Answer 7

Slope of firm’s isoquant; assuming efficiency in production, firms will have equivalent MRTSs

Question 8

How do markets promote efficiency in product mix?

Answer 8

A profit-maximizing firm will choose a level of output such that price equals marginal cost, while a utility-maximizing consumer will choose output such that price equals MRS

Question 9

What are circumstances under which free market will not provide Pareto efficient outcomes

Answer 9

Existence of public goods; existence of externalities; full extension of property rights; full information; robust markets exist; perfect competition

Question 10

What do we mean by efficiency in allocation

Answer 10

Refers to conditions of Pareto optimality, the idea that it is not possible to make one party better off without making another party worse off. See previous notecard for circumstances in which this condition does not hold.

Question 11

In a 2 consumer, 2 input, 2 output economy, what conditions needs to be satisfied for an allocation to be deemed efficient?

Answer 11

With regard to consumers, would need to have allocation in which MRS across all consumers was equivalent (i.e. rate at which individuals are willing to trade off one good for another is the same). With regard to inputs, all firms must face equivalent input prices. With regard to output, must have profit-maximizing firms that are choosing output whereby price equals marginal cost, and utility-maximizing consumers that are choosing output such that price equals MRS.

Question 12

How can competitive markets help deliver allocative efficiency?

Answer 12

Competitive markets can help deliver allocative efficiency because they set the conditions in which consumers can send signals about their utility preferences, and firms can face equivalent input prices. This enables equivalence of marginal rate of substitution across consumers, and equivalence of MRTS across firms.

Question 13

Does allocative efficiency imply optimality?

Answer 13

Depends on how you define optimality. Two concerns: (1) you cannot have optimal allocations if the conditions for Pareto optimality do not hold and (2) efficiency is not necessarily the same things as equity (i.e. concern for social welfare).

Question 14

What is social welfare?

Answer 14

Refers to aggregation of individual utilities. With respect to individual utility, we are concerned only with efficiency (i.e. utility maximization), but we may have concern for equity when it comes to aggregating across all those individual utilities.

Question 15

Edgeworth Box

Answer 15

Diagram showing different allocations of goods Y and X across consumers A and B

Question 16

What is the rationale for discounting when it comes to intergenerational welfare?

Answer 16

Four reasons: (1) Opportunity cost of capital; (2) Time preference (i.e. we are impatient); (3) Risk; (4) Inflation

Question 17

What is the Ramsey Rule?

Answer 17

Provides us a means of determining the appropriate discount rate when we contemplate intergenerational welfare.

r=p+ng, where r=consumption discount rate, p=utility discount rate, n=elasticity of marginal utility of consumption, and g=per-capita growth rate in consumption

Question 18

IRR

Answer 18

“Internal rate of return.” Discount rate at which NPV for a particular project is equal to 0. IRR is typically compared against opportunity cost of capital.

Question 19

NPV

Answer 19

Difference between the present value of future cash inflows and future cash outflows, based on discounting. Project should always be rejected in those situations where NPV is negative.

Question 20

Why is NPV preferable to IRR?

Answer 20

Instances where IRR can prove misleading: (1) depending on timing associated with cash flows, can arrive at multiple IRRs; (2) project may have higher IRR but lower NPV; (3) in instances where firm is lending or borrowing upfront, projects may have equivalent IRR, even though NPV will indicate that lending is superior to borrowing

Question 21

Does welfare maximization require that total utilities of individuals be the same?

Answer 21

Not necessarily – depends on social welfare function that is specified.

Question 22

What are the components of total economic value?

Answer 22

Can be subdivided into “use values and non-use values.”

Use values include: (1) direct use value – value derived from consumption of a good, (2) indirect use value – functional benefits of a good (e.g. storm protection), (3) option value – future direct and indirect use values (e.g. biodiversity) and (4) bequest values – value derived from leaving thing to future generations

Non-use values include (1) existence values – utility derived from knowing a thing exists/will continue to exist

Question 23

Difficulties Associated with Causal Inference

Answer 23

(1) Omitted variables bias; (2) publication bias; (3) correlation does not equal causality; (4) measurement error

Question 24

What are the various approaches we can use to valuing changes in utility associated with changes to the environment?

Answer 24

(1) Dose-response – in essence, how do lab animals and, in some cases, people seem to respond to exposure to, e.g. a chemical? Considered a “non-demand curve based approach.”
(2) Contingent valuation – survey-based technique for the valuation of non-market based resources. Basically going around and asking people how much they value particular goods. Issues include that question order, question wording makes a difference, transitivity doesn’t seem to hold up very well.
(3) Hedonic pricing – indirect method of valuing environmental good by evaluating changes in price of goods in related market (i.e. change in housing prices for living next to a coal plant). Issue here is confounding variables.
(4) Travel cost – attempts to calculate how much people value a good by estimating how much people are paying to go see that good. Issue here is that it assumes people only value a good if they have access to it, difficult to account for opportunity cost, and availability of substitutes will tend to bear on this.

Question 25

What is the difference between Marshallian and Hicksian demand?

Answer 25

Marshallian – utility maximization subject to budget constraint

Hicksian – expenditure minimization subject to utility constraint

Question 26

What is the difference between Willingness-to-Pay (WTP) and Willingness-to-Accept (WTA)?

Answer 26

WTP – maximum amount a person is willing to pay in order to obtain a good or avoid something undesired (e.g. pollution)

WTA – minimum amount a person will accept in order to give up a good or accept something undesired (e.g. pollution)

Historically, assumption has been that WTP should be close or equivalent to willingness to WTA, but behavioral economist have cast doubt on whether this is true. WTA>WTP

Question 27

What is the difference between CV and EV?

Answer 27

CV – ex-post change in income that would “compensate” consumer for change in price

EV – ex-ante change in income that would be equivalent to proposed price price change

Question 28

Types of quasi-experimental approaches

Answer 28

(1) Regression discontinuity design – assignment to treatment is determined by whether or not an individual falls above or below a certain threshold
(2) Instrumental variables approach – deploying an instrument that is correlated with the treatment but not correlated with that outcome
(3) Fixed effects – multiple observations of units (e.g. states) over a given period of time

Question 29

How can costs associated with regulation be estimated?

Answer 29

(1) Survey approach – ask firms how much it will cost them to comply with regulation. Obvious issue here is tendency for firms to underreport.
(2) Economic approach – team of third-party economists uses economic analysis. Question here is whether to use partial or general equilibrium model.

Question 30

Why might it pay for firms to “go green?”

Answer 30

Hypothesis on the part of Michael Porter

“Going green” may: motivate innovation, provide signal that resources are being used inefficiently, raise corporate awareness.

Question 31

What is the difference between stock and flow pollutants?

Answer 31

Stock – environment has relatively little absorptive capacity, so pollutant builds up in the atmosphere, and amount of damage is a function of the amount of accumulation. E.g. heavy metals. Important implication is that what is done today will have ramifications on all future generations.

Flow – environment has some absorptive capacity, such that pollution damage only occurs after pollution reaches particular level. E.g. carbon dioxide. Implication here is that, from societal perspective, need to determine what absorptive capacity of system is, and how to keep pollution below that level.

Question 32

What determines the efficient level of pollution?

Answer 32

Flow – choose level of pollution that maximizes net benefits (i.e. has a marginal benefit equivalent to marginal damage). This, in turn, will minimize sum of total abatement and damage costs.

Stock – still set marginal benefit equal to marginal damages, but marginal damages are now a perpuity, with a decay rate of alpha.

IMPORTANT NOTE: In instances where pollution is not uniformly mixed, regulators should set marginal benefit of a polluter equal to the marginal damage, but here calculated as the marginal damage to the receptors of the pollution.

Question 33

Coase Theorem

Answer 33

Idea that by extending property rights to an individual/set of parties, those parties can bargain with one another in order to find an optimal social outcome. The effectiveness of this approach will depend on the robustness of the extension of property rights as well as the degree of transaction costs associated with it.

Question 34

Types of Command and Control (CAC) Regulation

Answer 34

(1) input-based; (2) technology-based; (3) output; (4) outright prohibition

Question 35

What is a “double dividend?

Answer 35

Refers to situations where you can raise taxes on “bads” (e.g. pollution) in order to lower taxes on “goods” (e.g. labor). Not clear that there is, in all situations, net benefit to this approach, however. Depends on general equilibrium effects, as in if firm is forced to raise prices as a consequence of pollution tax.

Question 36

Choice of policy instruments under uncertainty

Answer 36

If there is uncertainty about marginal abatement costs (MAC), then it does matter whether you use permits as opposed to Pigouvian taxes (Weitzman). In this case, if marginal social cost (MSC) is steeper, then use a price instrument (i.e. taxes). If, by contrast, marginal social benefit is steeper, then use a quantity instrument (i.e. permits).

Question 37

Definition of public good

Answer 37

Good that is both non-excludable and non-rival. Non-rival – my use of a good does not interfere with your ability to use it. Non-excludable – I cannot prevent you from using the good.