One period model Flashcards
Exogenous variables
Determined outside the model (G and Z)
Endogenous variables
Determined inside the model (C and h)
4 things needed for competitive equilibrium
Consumer optimises given market prices
Firm optimises profit
Labour market clears
Government budget (G=T)
Pareto optimality with equation
MRS = MRT = MPN = W
Allocation that is chosen by a fictitious social planner. Cannot be improved without making someone in the economy worse off
First welfare theorem
Competitive equilibrium is pareto optimal
Second welfare theorem
A pareto optimum is a competitive equilibrium
Effect of an increase in government spending
Akin to a pure negative income effect as G=T therefore higher taxes
consumption and leisure fall
GS crowds out private consumption
However due to the negative income effect, HH supply more labour so crowding out is only partial
Effect of a decrease in government spending
Akin to a pure positive income effect
Consumption and leisure rise
However due to HHs being wealthier the labour supply reduces
An increase in TFP or z
Both an IE and SE
Increases the MPN, hence the real wage. Increase in W always increases consumption. However effect on leisure is ambiguous because an increase in W implies more expensive therefore more work but also better off less work
Why market economies don’t achieve efficiency
Distortionary taxes
Firms may not be price takers
Externalities no measured
Effect of distortionary taxes
instead of W, is now W(1-t) Consumer sets MRS = W(1-t) Firm sets MPn = W Therefore MRS < MPn Overall the tax creates a wedge.
Effect of distortionary tax on pareto optimum
First welfare theorem does not hold
Laffer curve
Shows the effect of a tax rate on tax revenue
Decrease in TFP or z
Due to lower MPN, it reduces the wage, consumption falls.
Leisure is ambiguous because lower wages mean less attractive to work. However households are poorer so work more
Can the government run a deficit in the one period model
No G must equal T
