Public Economics Flashcards
1
Q
W1 - What is public economics?
A
The study of the role of the government in the economy.
2
Q
W1 - What are the four ways the government is instrumental the economy?
A
- In charge of regulatory structure.
- Taxes: 35% - 50% of National Income income in advanced economies are collected this way.
- Expenditures: Taxes fund PUBLIC GOODS and the WELFARE STATE.
- Macro-economic stabilisation through central bank, fiscal stimulus and bailout policies.
3
Q
W1 - What are some examples of public goods?
A
Infrastructure
Public Order & Safety, Defence
4
Q
W1 - What are some examples of the welfare state?
A
Education
Retirement Benefits
Health Care
Income support
5
Q
W1 - Examples of the macro-economic stabilisation through central banks?
A
Interest Rate
Inflation Control
6
Q
W1 - How would an economists (micro) perspective of individual behaviour limit us?
A
It focuses on purely self interested and economically rational agents.
It doesn’t take into account the role of social interactions
7
Q
W1 - Patrilocal?
A
A pattern of marriage in which the couple settle in the Husband’s home and community.
8
Q
W1 - Bigger View on Government - How do we bridge the gap between early historical social interactions and the government?
A
The government has adopted some of the roles of the community, such as taking care of the young (education), sick (health care) and old (retirement benefits).
9
Q
W1 - Economists View of Government?
Examples for:
Education
Retirement Benefits
Healthcare
A
Markets are not always the best replacement for social institutions.
Education is primarily government funded. Student loans work in theory but end up being a lifetime burden, with for-profit education tending to be a scam.
Retirement Benefits: In practice, saving for retirement works, but most are unable to do so.
Health care relies heavily on government/ community support everywhere. People are not able to afford or shop rationally for health care.
10
Q
W1 - What are the three overarching questions in public economics?
A
1) When should the government intervene in the economy?
2) Why do governments choose to intervene in the way that they do?
3) What is the effect of those interventions on economic out-comes?
11
Q
W1 - According to the traditional view of economists, when should governments intervene in the economy?
A
1) Market Failures: To prevent inefficient outcomes as a result of market forces.
(Thus increasing the size of the pie)
2) Redistribution: Markets tend towards inequality which is an issue as we are “social beings”.
People are willing to pool their resources (taxation and charitable donation) to help reduce inequality.
(Thereby changing the allocation of the pie)
12
Q
W1 - 4 Types of Market Failures with examples and how they are corrected?
A
1) Externalities
Example: Greenhouse Carbon Emissions.
Solution: Corrective Taxation for example.
2) Imperfect competition: Example: monopoly)
Solution: Requires regulation
3) Imperfect or Asymmetric Information
Example: Health
insurance markets are subject to death spirals.
Solution:
4) Individual failures
Example: People do not behave as \fully rational
individuals.
Example: Myopic people may not save enough for retirement.
13
Q
W1 - In terms of an individual and societal impact, what would the efficient outcome be?
When only individual impact is accounted for, what is this an example of?
A
The outcome that maximises the total social value (being value to the individual and society) at the given cost of this.
When only individual impact is accounted for, this is an example of a negative externality, a type of market failure.
14
Q
W1 - When is there a presence of efficiency costs?
Example?
A
If there is a tradeoff between efficiency for equity or another parameter.
Example: Redistribution through taxes and the reduced incentives to work, creating an equity-efficiency tradeoff.
15
Q
W1 -See BA 1. Analyse the graph.
A
The different parts of the distribution diverged from each other
Bottom 50%: their incomes are more or less CONSTANT (only 1% income growth!)
Despite the increase in average national income, we see that this gain is realised primarily by the top earners
16
Q
W1 - What are 4 ways the government might intervene to correct over or under production of goods or services?
A
1) Tax or Subsidize Private Sale or Purchase:
Tax goods that are overproduced (e.g. carbon tax) and subsidized goods underproduced (e.g.,
flu shots subsidies)
So tax and subsidise.
2) Restrict or Mandate Private Sale or Purchase:
Restrict the private sale or purchase of overproduced goods (e.g. fuel efficiency requirements), or mandate the private purchase of underproduced goods (e.g., auto insurance)
Restrict or mandate though quotas or laws.
3) Public Provision:
The government can provide the good directly, in order to potentially attain the level of consumption that maximizes social welfare (example is National Defence).
So government provision
4) Public Financing of Private Provision:
Government pays for the good but private sector supplies it (e.g., privately pro-vided health insurance paid for by US government in Medicare-Medicaid).
Public funding to private companies.
17
Q
W1 - What are the two types of effects that we look at with regards to government intervention?
Provide an explanation.
A
1) Direct Effects: The effects of government interventions
that would be predicted if individuals did not change their behaviour in response to the interventions.
Direct effects are are relatively easy to compute
2) Indirect Effects: The effects of government interventions that arise only because individuals change their behaviour in
response to the interventions. These are sometimes called unintentional effects.
These effects are estimated.
Both effects must be accounted when assessing the effectiveness of intervention.
18
Q
W1 - What are the effects of increasing top income tax rates.
A
Direct Effect: Mechanical raising of tax revenue.
Indirect Effect: Top earners might try to avoid/ evade taxes, reducing tax revenue relative to the mechanical outcome.
19
Q
W1 - Political Economy?
Example?
A
The theory of how the political process produces decisions that affect individuals and the economy.
Example: How the level of taxes and spending is set though voting and voters’ preferences.
20
Q
W1 - Public Choice?
Examples?
A
A sub-field of political economy.
From a Libertarian perspective, it focus on government failures.
Example: The failure of G in achieving its aims
I.e overaddressing issues (issues that aren’t there in the first place) OR using tools that do not productively address the issues at hand
21
Q
W1 - Normative Public Economics?
Example?
A
Normative Statements express a value judgment about whether a situation is desirable or undesirable. …
Normative statements are characterised by the modal verbs “should”, “would”, “could” or “must”.
Analysis of how things should be.
Should the government intervene in health insurance market?
How high should taxes be.
22
Q
W1 - Positive Public Economics?
A
Analysis of how things really are.
Does the government provided health care crowd out private health care insurance?
Do higher taxes reduce labour supply?
23
Q
W1 - The difference between normative and positive analysis?
A
Positive analysis is primarily empirical (data outputs) and normative analysis is primarily theoretical (theory).
24
Q
W1 - What are the 4 key facts about taxes and spending?
Hint:
- Growth
- Size
- Growth.
- Government spending and taxes.
A
1) Government Growth: Size of government relative to National Income grows dramatically over the process of development from less than 10% in less developed economies (similar to pre-industrialisation levels) to 30-50% in most advanced economies.
2) Government Size Stable in richest countries after 1980.
3) Government Growth is due to the expansion of the welfare state: (a) public education, (b) public retirement benefits, (c) public health insurance, (d) income support programs
4) Govt spending > Taxes: Most rich countries run deficits and have significant public debt (relative to GDP), particularly during Great Recession of 2008-10.
25
W1 - What are the parts that make up the public welfare state?
(a) public education
(b) public retirement benefits
(c) public health insurance
(d) income support programs
26
W1 - BA 2. Analyse the graph.
Since 1980s, the size of the fiscal state is relatively stable
Q: interpret this graph (key features):
- -> very low levels of fiscal state before WWI
- -> almost identical across all countries
- -> increase in welfare state (spike in graph)
- -> leveling out since the 1980s
27
W1 - BA 3. Analyse the graph.
1870s: largely defensive expenditure
- this has stayed relatively stable over time as a fraction of GDP
- The other expenditure streams emerged after WWI and diverged into significant streams after WWII
NOTE: ageing society has lead to a larger fraction of income (GDP) being spent on pension premiums
28
OECD Anagram meaning?
Organisation of Economic Cooperation and Development.
29
Empirical Tools - Define Empirical Public Finance
The use of data and statistical methods to measure the impact of government policy on individuals and markets.
For example, how an incase of taxes affects work behaviour.
30
Empirical Tools - Correlation?
When two economic variables move together.
31
Empirical Tools - Causality?
Two economic variables are causally related if the movement of one causes movement of another.
32
Empirical Tools - What is the problem involving the distinction between correlation and causality called?
This is known as the identification problem.
33
Empirical Tools - Identification problem - What are the three ways that A and B could be correlated??
A is causing B
B is causing A (reverse causality)
A third factor is causing both.
34
Empirical Tools - What is a randomised trial?
The ideal type of experiments designed to test causality, whereby a group of individuals is randomly divided into a treatment group, which receives the treatment of interest, and a control group, which does not.
35
Empirical Tools - Bias definition in relation to correlation and causation.
Any source of difference between treatment and control groups that is correlated with the treatment but is not due to the treatment.
36
Empirical Tools - What are two examples of randomised trials?
Oestrogen Replacement Therapy
Welfare Reform. (TANF - Temporary Assistance For Needy Families)
37
Empirical Tools - Randomised Trials: Oestrogen Replacement Therapy Information?
A trial tracked over 16'000 women ages 50-79 who were recruited to participate in the trial of 40 clinical centres in the US. The trial was supposed to last 8.5 years but stopped after 5.2 as it was clear that ERT did in fact raise the risk of heart disease.
38
Empirical Tools - Randomised Trials: Welfare Reform?
Tests the effect of welfare reform on labour supply. These tests were implemented by a number of states.
39
Empirical Tools - What are the two reasons we need to beyond randomised trials?
Randomised trials can suffer from the following:
External Validity: The results are only valid for the sample of individuals who volunteer to be either treatments of controls, and this sample may be different from the population at large. (e/g. A trial in Sweden vs US may generate different results.
Attrition: Individuals may leave the extra experiment before it is complete. Reduction in the size of samples over time, which, if not random, can lead to bias estimates.
40
Empirical Tools - Observational Data?
Data generated by individuals behaviour observed in the real world, not in the context of deliberately designed experiments.
41
Empirical Tools - Time series analysis?
Analysis of the co-movement of two series over time.
42
Empirical Tools - Cross-sectional regression analysis?
Statistical analysis of the relationship between two or more variables exhibited by main individuals at one point in time.
43
Empirical Tools - What may two concerns be with randomised trials completed by the government with policy?
They can be expensive to implement and complete.
Ethical Concerns: If the policy has a positive societal impact, it may be unethical to neglect a group as it could be enhancing societal welfare.
44
Empirical Tools - BA 4. What are two ways this graph can be interpreted?
1. Maximum monthly benefit has fallen over time, increasing the opportunity cost of not working in the labour force --> hence, more hours worked by single mothers
2) more single mothers have been working in the labour force due to labour-market shifts (i.e. shift from production to services), hence fewer mothers are eligible for maximum monthly benefit --> reduction
45
Empirical Tools - Problems with Time Series (2)?
Causation.
When there is a general decline in a variable over time, is is difficult to infer causation.
Other factors can blur the causal interpretation.
46
Empirical Tools - When is time series analysis useful?
When there are sharp simultaneous changes in prices of a good.
For example, tobacco.
47
Empirical Tools - Regression line?
The line that measures the best linear approximation to the relationship between any two variables.
48
Empirical Tools - What can we say about OLS and its estimate of the coefficient of the independent variable β?
What are the implications if it is not true.
What needs to be included in the error term?
OLS regression estimates β without bias if the error term is not correlated with X.
"X causes Y" is not true if we do not have a strong control over factors that could impact X.
Any possible factors that could influence X and Y's comovement and X should be included in the error term.
49
Empirical Tools - β*hat* = .5(.1).
Interpret the above.
β*hat* is the estimated β.
Within the Parenthesis is the standard errors.
β*hat* = .5(.1) should be understood as β is in confidence interval (.5 - 2*.1), .5 + 2*.1) with a probability of 95%.
When the estimated coefficient is more than twice the standard error, we can conclude that it is significantly positive, i.e. is above zero with probability 95%.
50
Empirical Tools - How can we use control variables, Z, in cross-sectional regression analysis to be confident that the identification assumption holds?
Z can include factors that may be different between two groups being studied.
If, when we add Z variables, the β estimate changes a lot, we cannot be confident that the identification assumption holds.
51
Empirical Tools - What are Quasi-Experiments (Natural Experiments)?
Example
Changes in the environment that create nearly identical treatment and control goops for studying the effect of that environmental change.
This enables economists to take advantage of quasi-randomisation created by external forces.
Example: One state reduces welfare benefits whilst a comparable state does not.
52
Empirical Tools - Quasi-Experiments - Simple Difference Estimator?
D = Y [T, After] - Y [C, After]
It is the difference in average outcomes between the treatment and control after the change.
The above assumes that the C and T were identical before:
Y [T, Before] - Y [C, Before] = 0
When this is the case, we can be fairly confident that D estimates the causal effect.
53
Empirical Tools - Difference-In-Difference Estimator?
DD =
(Y[T, After] - Y[C, After] ) - (Y[T, Before] - Y[C, Before] )
This measures whether the difference between treatment and control changes after the policy change.
DD identifies the causal effect of the treatment if, absent the policy change, the difference between T and C would have stayed the same. This is known as the PARALLEL TREND ASSUMPTION.
54
Empirical Tools - What problems may exist with quasi-experiments?
1. No certainty of that all bias has been removed from the treatment-control comparison.
2. Robustness checks should be used to ensure the effect is causal, so for instance, going over other possibilities such as further policies implemented etc.
55
Empirical Tools - What are two examples of ideal quasi-experiments?
For and against DD.
1) Effects of Lottery winnings on labour supply. (Imbens, Rubin, Sacerdote)
Random assignment, conditional on playing. DD convincing.
2) Effects of the 1987 EITC expansion (tax credit for low income workers with kids.) on labour supply (Eissa and Liebman)
Compares singles mothers to single females. No compelling break in graph around 1987, DD not convincing.
56
Empirical Tools - Effects of the 1987 EITC expansion (tax credit for low income workers with kids.) on labour supply (Eissa and Liebman). problem with DD in this case?
The two groups are not comparable. Fertility is an outcome of the labour supply and it is a choice, so the difference is not confiding.
57
Empirical Tools - Structural Estimates?
Derived directly from theories.
Builds a theoretical model of individual behaviour and then estimates the parameters of the model. Estimates of the features that drive individual decisions, such as income and substitution effects or parameters of the utility.
Bad: These models may not be good for understanding causal estimates.
Good: Good for understanding policy variation.
58
Empirical Tools - Reduced form estimates?
Measures of the total impact of an independent variable on a dependent variable, without decomposing the source of that behaviour response in terms of underlying parameter of the utility functions.
59
Empirical Tools - Structural estimates vs reduced form estimates.
Reduced form estimates are more convincing and transparent but structural estimates are more directly useful to make predictions for alternative policies.
60
Empirical Tools - Conclusion of lecture.
Policy questions require us to establish if a causal relationship exists between the policy in question and the outcome of interest.
The best way to distinguish causality is through randomly assigning treatment and control group.
This approach is not always applicable, so we turn to time series, analysis, cross-sectional regression analysis and quasi-experimental analysis.
Each has its weaknesses, but careful consideration of the problem at hand can often lead to a sensible solution to the bias problem.
61
Theoretical Tools Definition?
The set of tools designed to understand the mechanisms behind economic decision making.
62
Empirical Tools Definition?
The set of tools designed to analyse data and answer questions raised by theoretical analysis.
63
Theoretical Tools - Utility Mapping of Preferences positives and negatives?
Economists model individuals' choices using the concepts of utility function maximisation subject to budget constraint.
This is a narrow view of human behaviour that works reasonably well for consumption choices, but likely less well for work behaviour.
64
Theoretical Tools - Utility function definition and equation?
A utility function is some mathematical function translating consumption into utility.
U = (X|1|, X|2|, X|3|, ...),
where X|n| are the is the quantity of good n.
65
Theoretical Tools - Indifference Curves definition and two assumptions?
A graphical representation of all bundles of goods that make an individual equally well off.
Assumptions:
1) Consumers prefer higher indifference curves.
2) Indifference curves are always downward sloping, representing DIMINISHING MARGINAL UTILITY.
66
Theoretical Tools - Marginal Utility Definition (and formula)?
The additional increment to utility obtained by consuming an additional unit of a good.
MU|1| = 𝛿u/𝛿X|1|
It is the derivative of utility with respect to X|1| keeping X|2| constant.
67
Theoretical Tools - Marginal Rate of Substitution (and formula)?
The MRS is equal to the (minus) slope of the indifference curve, being the rate at which the consumer will trade the good on the vertical axis for the good on the horizontal axis.
MRS|1,2| = MU|1| / MU|2|
The above shows the amount that the individual is indifferent between 1 unit of good 1 and MRS|1,2| of good 2. AKA how many x is required to give up 1 y.
It is the minus slope as we are staying how much more x we require to give up 1 y. It is expressed interims of y, which is decreasing (so is negative)
68
Theoretical Tools - Budget Constraint (and formula)?
A mathematical representation of all the combinations of goods an individual can afford to buy if they spend their entire income.
Y = p|1|X|1| + p|2|X|2|
where p|i| is the price of the good I, and Y is disposable income.
We can rearrange the above to attain:
X|2| = Y/ p|2| - p|1|/p|2| * X|1|,
where the slope of the budget contracts is -p|1|/p|2|
69
Theoretical Tools - Utility Maximisation?
With reference to budget constraint and utility preference.
Individuals maximize utility subject to the budget constraint, such that
MRS|1,2| = p1/p2
At this optimal, the individual is indifferent between buying 1 extra unit of good 1 for $ p|1| and buying p|1|/ p|2| extra units of good 2, also for $p|1|
70
Theoretical Tools - Utility Maximisation?
Implies that
| X|2|/X|1| = p|1|/ p|2|
71
Theoretical Tools - Demand Function?
Individual maximisation generates demand functions X|1|(p,Y)
72
Theoretical Tools - Income and Substitution Effects general?
Measures how X|1|(p,Y) (the demand functions) vary with p and Y.
73
Theoretical Tools - Income Effects?
The effect of giving extra income (Y) on the demand for goods.
How X|1|(p, Y) varies with y.
74
Theoretical Tools - Income Effects: Normal and Inferior goods explanations?
Normal goods: Goods for which demand increases as income Y rises: X|1|(p, Y) increases with Y (most goods are normal)
Inferior goods: Goods for which demand falls as income Y rises: X|1|(p, Y ) decreases with Y (example: you use public transportation less when you are rich enough to buy a car)
75
Theoretical Tools - Price Effects: Normal and Inferior goods explanations?
1) Substitution effect: Holding utility constant, a relative rise in the price of a good will always cause an individual to choose less of that good.
On a diagram, this amount will be the original amount of good 1 or two, minus the amount at the point along the same indifference curve with the new budget constraint transposed onto it.
2) Income effect: A rise in the price of a good will typically cause an individual to choose less of all goods because her income can purchase less than before.
On a diagram, this amount will be the substitution effect amount of good 1 or two, minus the amount where the indifference curve hits the new budget constraint.
76
Theoretical Tools - Price Effects?
How does X|1|(p, Y) vary with p|1|
77
Theoretical Tools - Aggregate Demand?
Each individual has a demand for each good dependent on price. Aggregating across all individuals, we get aggregate demand D(p) for the good.
78
Theoretical Tools - Elasticity of Demand (and mathematically)?
The % change in demand caused by a 1% incase in the price of a good.
ε^D = %Δ in quantity demanded / %Δ in price.
79
Theoretical Tools - What are the 5 properties of Elasticity of Demand?
1) Typically negative, since quantity demanded typically falls as price rises.
2) Typically not constant along a demand curve.
3) With vertical demand curve, demand is perfectly inelastic
( ε= 0).
4) With horizontal demand curve, demand is perfectly elastic
(ε = -∞).
5) The effect of one good's prices on the demand for another good is the cross-price elasticity. Typically, not zero.
80
Theoretical Tools - Elasticity of Supply mathematically?
ε^S = %Δ in quantity supplied / %Δ in price.
81
Theoretical Tools - Economic surplus?
The net gains to society from all trades in a particular market. It is the consumer surplus + the producer surplus.
82
Theoretical Tools - Consumer surplus and producer surplus?
The benefit that consumer/ producer derives from consuming/ producing a good above and beyond the cost of buying/ producing that good.
83
Theoretical Tools - First Fundamental Theorem of Welfare Economics (general)?
The competitive equilibrium where supply equals demand maximises total economic surplus, sometimes called efficiency.
It is blind of distributional aspects and just focuses on maximising economic surplus.
84
Theoretical Tools - Deadweight Loss?
Diagrammatically?
The reduction in economic surplus from denying trades for which benefits exceed costs when quantity differs from the efficient quantity.
Key rule: Dead-weight loss triangle points to the efficient allocation and grows outward from there. It points the way the production and consumption levels should go.
85
Theoretical Tools - What are the 4 assumptions to ensure the 1st welfare theorem holds in private markets and is PARETO EFFICIENT?
1. No Externalities.
2. Perfect Competition (individual firms are price takers)
3. Perfect Information.
4. Agents are rational.
If any of the above do not hold, G intervention may be desirable.
86
Theoretical Tools - Pareto Efficiency?
Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be reallocated to make one individual better off without making at least one individual worse off.
87
Theoretical Tools - Drawback of Pareto Efficiency?
It is a weak requirement as a single person consuming everything is Pareto efficient.
88
Theoretical Tools - 2nd Welfare Theorem?
How to attain a Pareto Efficiency and solve for this?
Even with no market failures, free market outcomes might generate substantial inequality.
2nd Welfare Theorem:
Any Pareto efficient allocation can be reached by:
1. Suitable redistribution of initial endowments.
2. Then letting markets work freely.
There is no conflict between efficiency and equity.
89
Theoretical Tools - 2nd welfare theorem fallacy?
In reality, 2nd welfare theorem does not work because redistribution of initial endowments (as people can hide wealth) is not feasible (because initial
endowments cannot be observed by the government, e.g. inherence can be received in multiple ways.)
This would have led to the size of the pie being the same, but a redistribution though.
Instead, govt needs to use distortionary taxes and transfers based
on economic outcomes (such as income or working situation). This leads to the equity-efficiency tradeoff.
90
Theoretical Tools - Social Welfare Functions?
A function that combines the utility functions of all individuals into an overall social utility function.
Used to incorporate distributional aspects, instead of adding just $ of economic surplus.
91
Theoretical Tools - Utilitarian Social Welfare Function?
Max SWF = U1 +U2 + ... + U|n|
If marginal utilility of money decreases with income, utilitarian criterion values redistribution from rich to poor.
Transfers from rich to poor poor increase social welfare as a small reduction in utility for a income reduction will be transferred to an individual who attains a greater amount of satisfaction from that income.
92
Theoretical Tools - Rawlsian Welfare Function
Rawls proposed that society's goal should be to maximise the well-being of its worst-off member.
SWF = min(U1, U2, ..., U|n|)
Since social welfare is determined by the minimum utility in society, social welfare is maximised by maximising the well-being of the worst-off person in society.
It is more redistributive than utilitarian criterion.
Max utility derived from the greatest utility of the poorest in society.
93
Theoretical Tools - What are the three other social justice principles for welfare functions aside from utilitarianism and Rawlsian?
Just deserts: Individuals should receive compensation congruent with their contributions (Libertarian)
Commodity egalitarianism: Society should ensure that individuals meet a set of basic needs but that belong that point income distribution is irrelevant.
Equality of opportunity: society should ensure that all individuals have equal opportunities for success..
94
Theoretical Tools - What were the results of Saez-Stantchexa' 2016 online Survey?
Testing for social preferences.
1. People typically do not have "utilitarian" social justice principals (consumption lover not seen as more deserving than a frugal person.
2. People put weight on whether income has been earned though effort or not.
3. People put a lot of weight of what people would have done absent the government intervention (deserving poor vs free loaders)
95
Theoretical Tools - Actual social preferences. What are the conclusions with regards to redistribution?
People favour redistribution if they feel inequalities are "unfair" but views on what is fair differ.
Redistribution supported when people don't have control [eucation for children, health insurance etc]
Less support when people have some control [unemployment, being low income]
Less support when people don't "belong" [us vs them]
96
Theoretical Tools - What is the conservative view with regards to redistribution?
Individuals have control through personal responsibility. The government should
97
Theoretical Tools - What is the liberal view with regards to redistribution?
Many forces in society are beyond individuals' control. Society should therefore be nurturing.
98
W2 Externalities - Market Failures Definition?
A problem that violates one of the assumptions of the 1st welfare theorem and causes the market economy to deliver an outcome that does not maximise efficiency.
99
W2 Externalities - Negative Production Externality?
When a firm's production reduces the well-being of others who are not compensated by the firm.
100
W2 Externalities - PMC?
Private Marginal Cost: The direct cost to producers in production an additional unit of a good.
101
W2 Externalities - Marginal Damage?
MD: Any additional costs associated with the production of one extra unit of a good that are imposed on others but that the producers do not pay.
102
W2 Externalities - Social Marginal Cost?
SMC = PMC + MD
103
W2 Externalities - Visualise a graph with dead weight loss due to over production of a good with negative externalities?
y: Price of Steel
x: quantity of steel.
Plot the SMC, PMC, MD and PMB.
BA 5.
104
W2 Externalities - What externalities could there be for driving SUV's?
1. Environmental externalities: Compact cars get 25 miles/gallon, but SUVs get only 20.
2. Wear and tear on roads: Larger cars wear down
the roads more.
3. Safety externalities: The odds of having a fatal
accident quadruple if the accident is with a typical
SUV and not with a car of the same size.
105
W2 Externalities - Positive/ Negative Production Externality?
When a firm's production increases/ decreases the well-being of others but the firm/ individual is not compensated by those others.
e.g. Producition: Bees
Consumption: Private Gardens.
106
Visualise a graph with dead weight loss due to positive externalities?
y: Price of oil exploration
x: Q of oil exploration
Expenditure on oil exploration by any company have a positive externality because they offer more profitable opportunities for other companies. This leads to a social marginal cost that is below the private marginal cost and social optimum quantity that is greater than the competitive market equilibrium.
107
W2 Externalities - What does each point on a market supply curve represent?
The marginal cost of producing that unit of the good.
108
W2 Externalities - What curve shifts with the following externalities?
Negative production externality
Positive production externality
Negative consumption externality
Positive consumption externality
What is the intuition behind it?
Negative production externality: SMC curve lies above PMC curve.
Positive production externality: SMC curve lies below PMC curve.
Negative consumption externality: SMB curve lies below PMB curve.
Positive consumption externality: SMB curve lies above PMB curve.
SMC is the PMC + any additional cost to society. This is a good way to think about what is shifting in each instance. The negative and positive relate to the societal impact.
109
W2 Externalities - What two steps should one take into account when deciding what curve to shift for externalities?
1. Asses Sweater the externality is associated with producing a good or with consuming a good.
2. Assess whether the externality is positive or negative.
110
W2 Externalities - From a start point where PMC = SMC, which do the following lead to in terms of over or under production/ consumption?
Negative production externality
Positive production externality
Negative consumption externality
Positive consumption externality
If the costs are incorporated, then there will be under production/ consumption. If they are not, there will be over production/ consumption.
Negative production externality: Over Production
Positive production externality: Under Production
Negative consumption externality: Over Consumption
Positive consumption externality: Under Consumption.
111
W2 Externalities - What was Ronald Coase's key question?
Why won't the market simply compensate the affected parties for externalities?
112
W2 Externalities - What is the idea behind Coase's Theorem?
Use the example of the Fisherman and an Steel Plant producing sludge
To internalise externalities using property rights through market mechanisms. Relies on costless bargaining. Posits that the government has a limited but crucial role in establishing and enforcing property rights, then the private market will do the rest.
Plant produces sludge that is fed into the river.
Fisherman down the river sell fish that they collect from their land.
This reduces the number of fish, thereby reducing the Fishermans salary.
From the perspective of the Fisherman, the only way to reduce sludge to pre factory levels is for the factory to close.
The owners can internalise the externally by agreeing an amount to pay to the fisherman per unit of sludge, thereby paying the marginal damages.
113
W2 Externalities - What are the two parts of Coase's Theorem?
1. When there are well defined property rights and costless bargaining, then negotiations between the party creating the externally and the party affected by the externality can bring about the socially optimum market quantity.
2. The efficient solution to an externally does not depend on which party is assigned the property rights, as long as someone is assigned the rights.
114
W2 Externalities - Coase's Theorem: Why does it only need to be the case that one party has property rights?
Use the Fisherman, steel plant example.
If the Fisherman have the property rights, they will be willing to accept a given amount per unit of sludge to compensate them (being the Marginal Damage (MD)).
If the Steel Plant have the property rights of the river, they will be willing to accept an amount per unit of sludge from the fisherman in order to limit production.
Plant produces sludge that is fed into the river.
Fisherman down the river sell fish that they collect from their land.
This reduces the number of fish, thereby reducing the Fishermans salary.
From the perspective of the Fisherman, the only way to reduce sludge to pre factory levels is for the factory to close.
The owners can internalise the externally by agreeing an amount to pay to the fisherman per unit of sludge, thereby paying the marginal damages.
115
W2 Externalities - Coase's Theorem - Why would the property rights holder charge or take the MD rather than something different?
If the price was above the MD, the negative benefactor would want to sell an extra unit and incur the associated costs.
MD is the equilibrium efficient price in the newly created pollution market.
116
W2 Externalities - Coase's Theorem - 3 Problems?
1. The Assignment Problem:
In cases where externalities affect many agents, e.g. global warming, assigning property rights is difficult.
2. The holdout problem: Shared ownership of property rights fives each owner power over all the others (because joint owners have to all agree to the Cousin Solution). This will equally be increased by the assignment problem.
3. Transactions costs and negotiating problems:
The Cousian approach ignores the fundamental problem that it is hard to negotiate as the number of each individuals on each party increases (n). The transaction costs and negotiating costs increase with n.
117
W2 Externalities - Coase's Theorem - Summary.
Ronald Coase's insight that externalities can sometimes be internalised was useful as it provides a competitive market model which can internalise some small scale, localised externalities to an efficient outcome.
It does not help on large scale, global externalities. This would require the government to successfully aggregate the interests of al individuals suffering from the externality.
118
W2 Externalities - How does public policy resolve the problems associated with negative externalities?
(2)
1. Price Policy: Corrective tax or subsidy equal to the marginal damage per unit.
2. Quantity Regulation: Government forces firms to produce the socially efficient quantity.
These would be 1 and 2 on a previous BA. Namely, Tax and subsidise or prohibit and mandate.
119
W2 Externalities - What would the effect on the cost curve be for a tax and subsidy?
A tax will shift the curve up and subsidy will shift the curve down.
120
W2 Externalities - Pigouvian Taxation?
Pigovian tax (also spelled Pigouvian tax) is a tax on any market activity that generates negative externalities (costs not included in the market price).
121
W2 Externalities - Public Sector Remedies: What is preferred out of pigouvian taxation and regulation (e.g. limiting pollution)?
In an ideal world they would be identical
Traditionally regulation has been used but taxes are more direct and effective at addressing regularities.
A tax may not be efficient for firm that have different mc of reducing pollution. It may be better to allow a market to develop in which firms with a high cost of reducing production pay other firms with a lower cost to ensure MSC = MSB. They can trade pollution permits.
122
W2 Externalities - Heterogenous Costs of Pollution Reduction - Formula and Intuition.
Firm H has a high cost of pollution reduction and L a low one.
Blanket tax vs permits
c|H|(q): 1.5q^2 ---- c
MC|H|(q): c'|H|(q) = 3q
c|L|(q): .75q^2
MC|L|(q): c'|L|(q) = 1.5q
See BA 7
Each maximises according to its quantity minus the cost of reducing cost * quantity.
When a blanket tax is used, each firm will maximise
q - c(q)
This will be where the MC = Taxation.
When permits are used:
Firms maximise:
pq - c(q)
q: Amount of pollution reduction
c(q) cost of pollution reduction * amount
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W2 Externalities - Tradable permits vs a corrective tax?
When is each best?
When permits are sold to firms, permits will have exactly the same effect as a tax.
If sold, it will look like a tax but also a transfer to firms that are are polluting initially.
Uncertainty of MC of reducing pollution: tax cannot target a specific quantity whilst permits can.
Taxes are therefore preferred when MD curve is flat or close to flat. (because a change in quantity does not have a large effect
Tradable permits are preferable when MD curve is steep.
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W2 Externalities - Which of the following lead to efficient outcomes?
Policy Option 1: Quantity Regulation
Policy Option 2: Price Regulation Through a Corrective Tax
Policy Option 3: Quantity Regulation with Tradable Permits
Policy Option 1: Quantity Regulation (not efficient unless quantity can be based on actual reduction cost for each firm).
MC can be lower by allowing firms that have a lower MC increasing q more.
Policy Option 2: Price Regulation Through a Corrective Tax (efficient)
Policy Option 3: Quantity Regulation with Tradable Permits (efficient)
125
W2 Externalities - When would MD be flat?
What about steep (example).
When the are no diminishing returns to the increase in the reduction of something.
Global warming will be relatively flat as a reduction even in one country will not have any great effect on the overall level of warming.
Steep when the MC of any increase causes a significant social cost. e.g. nuclear material leakage.
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W2 Externalities - How would quantity regulation work? (two plants producing pollution)
Permits allow the level of pollution that is required.
Each plant will get the same number of permits, entitling it to produce one unit of pollution.
When able to trade, the plant that has higher mc in reducing pollution will buy the permits from the other firm for a cost greater than MC|B| but less than MC|A| (at the given quantities), making it profitable for both firms.
Anything past this level will ensure the cost of purchasing a new
127
W2 Externalities - What about when there is uncertainty about reducing the cost of pollution?
Flat vs Steep MD Curve
BA 8.
128
W2 Externalities - Corrective taxes vs tradable permits - When are taxes preferred and when are tradable permits preferred?
Taxes preferred when the curve is flat. (as movements along the MD curve won't change much for quantities)
With setting a amount, the DWL can be large.
Tradable permits are preferable when MD curve is steep.
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W2 Externalities - 1970 Clean Air Act?
Landmark federal legislation that first regulated acid rain-causing emissions by setting maximum standards for atmospheric concentrations of various substances, including SO2
130
W2 Externalities - Implications of quantity based or regulation vs price regulation.
Long
Quantity
Price
Summary (application to policy)
The instrument choice depends on whether the government wants to get the amount of pollution
reduction right or whether it wants to minimize costs. Quantity regulation
assures there is as much reduction as desired, regardless of the cost. So, if it is critical to get the amount exactly right, quantity regulation is the best way to go. This is why the efficiency cost of quantity regulation under uncertainty is so much lower with the nuclear leakage case in panel (b). In this case, it is critical to get the reduction close to optimal; if we end up costing firms extra money in
the process, so be it. For global warming, getting the reduction exactly right
isn’t very important; so it is inefficient in this case to mandate a very costly
option for firms.
Price regulation through taxes, on the other hand, assures that the cost of
reductions never exceeds the level of the tax, but leaves the amount of reduction uncertain. That is, firms will never reduce pollution beyond the point at which reductions cost more than the tax they must pay (the point at which
the tax intersects their true marginal cost curve, MC2). If marginal costs turn
out to be higher than anticipated, then firms will just do less pollution reduction.
This is why the deadweight loss of price regulation in the case of global
warming is so small in panel (a): the more efficient outcome is to get the exact
reduction wrong but protect firms against very high costs of reduction. This is
clearly not true in panel (b): for nuclear leakage, it is most important to get the
quantity close to right (almost) regardless of the cost to firms.
In summary, quantity regulations ensure environmental protection, but at a variable cost to firms, while price regulations ensure the cost to the firms, but at a variable level of environmental protection. So, if the value of getting the environmental protection close to right is high, then quantity regulations will
be preferred; but if getting the protection close
131
W2 Externalities - The 1990 Amendments and Emissions Trading
SO2 allowance system: The feature of the 1990 amendments to the Clean Air Act that granted plants permits to emit SO2
in limited quantities and allowed them to trade those permits.
132
W2 Externalities - Key study into the clean air act and SO2 effecting health?
Chay and Greenstone
133
W2 Externalities - According to Wagner-Weitzman 2015), what are the four factors that make addressing CO2 emissions and climate change challenging?
What is their plea?
1) Global: Emissions in one country affect the full world
2) Irreversible: Atmospheric CO2 has long life (centuries)
[absent carbon capture tech breakthrough]
3) Long-term: Costs of global warming are decades/centuries away [how should this be discounted?]
4) Uncertain: Great uncertainty in costs of global warming [mitigation or amplifying feedback loops]
How fast should we start reducing emissions? [Stern-Weitzman want a fast reduction, Nordhaus advocates a slower path]
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W2 Externalities - 4 main costs of global warming?
1) Sea rise which will
flood low lying coasts and major population centers (e.g., Miami, Florida; value of real estate subject
to regular fooding has dropped)
2) Impact on bio-diversity (mass extinctions)
3) Agricultural production could be disrupted by climate change and the increased weather variability it generates: demand for food is very inelastic in the short-run ) Spikes in prices if agricultural output falls ) disruption/famines possible in low income countries
4) Droughts and heat waves will make many places less livable.
135
W2 Externalities - Why is estimating the costs of global warming tricky?
Example: heat waves and mortality analysis of Barreca et al. (2016)
Society will adapt and reduce costs.
e. g.
1) The mortality eect of an extremely hot day (80oF+) declined by about 75% between 1900-1959 and 1960-2004.
2) Adoption of residential air conditioning (AC) explains the entire decline
3) Worldwide adoption of AC will speed up the rate of climate change (if fossil fuel powered)
136
W2 Externalities - Kyoto Treaty (1997)
Kyoto 1997: 35 industrialized nations (but not US) agreed to reduce their emissions of greenhouse gases to 5% below (depends on country) 1990 levels by the year 2012
Industrialized countries are allowed to trade emissions rights
among themselves, as long as the total emissions goals are met [=quantity regulation with trading permits]
Developing countries are not in the treaty even though it is
cheaper to use fuel eciently as you develop an industrial base than it is to \retrot" an existing industrial base
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W3 Public Goods - Pure public good?
What are the two conditions?
Goods that are perfectly Non-Rival in consumption and Non-Excludable.
An individual's consumption of a good does not affect another's opportunity to consume the food and individuals cannot deny each other the opportunity to consume the good.
146
W3 Public Goods - What is an impure public good?
Goods that satisfy the two public good conditions (Non rival and non-excludable) to some degree, but not fully.
147
W3 Public Goods - Provide an example of an impure public good?
1. Non excludable and rivalrous
2. Non Rivalrous but excludable.
1. Crowded sidewalk (the more people that access the good, the less it can be accessed by others.
2. Cable Tv. (everyone can receive the signal but some people may not be given permission to join.
148
W3 Public Goods - Numéraire Good?
A good for which price is set at 1 in order to model choice between goods, which depends on relative, not absolute prices.
It will be on the x axis.
We care about the demand of goods relative to other goods, so this is useful in modelling.
149
W3 Public Goods - Marginal rate of substitution definition?
What is the formula?
How many units of good y must be given up in order to attain an extra unit of good x whilst staying at the same rate of utility.
It will be the negative of the slope of the indifference curve (so you get a positive number.
MRS|x,y| = -[MU|x| / MU|y|] = -dy/dx
MUy/MUx would be the amount of x the individual is willing to give up for one extra unit of y.
150
W3 Public Goods - For an indifference curve, what optimality conditions must hold for two individuals (A and B) and two goods?
Think demand and supply side.
Assume Good X is the numeraire.
Demand Side:
MU(B)|y|/ MU(B)|x|= MRS(A)|y,x| = MRS(B)|y,x| = Py/ Px = Py
The individuals optimal choice is found at the tangency of their indifference curve and budget constraint. This will occur where the MRS|y,x| equals the ratio of the price of the two goods (the slope of the budget constraint)
Py is basically the gradient of the cost line.
Supply side:
MCy = Py
Where Py is the marginal benefit for the firm producing the ice cream.
151
W3 Public Goods - How would we find the optimal provision of private goods?
Summate all the Marginal benefit curves if individuals to create the market demand and find the intercept with market supply.
152
W3 Public Goods - How would we find the optimal provision of public goods?
For one unit of a public good, we add up the MRS of each individual, creating the societal MRS.
MRS(A)|x,y| + MRS(B)|x,y| = MC.
We then set the combines MRS equal to the marginal cost.
153
W3 Public Goods - Social Efficiency maximising condition for a public good?
MRS(A)|x,y| + MRS(B)|x,y| = MC.
We sum vertically, being the amount that society is willing to pay for the next unit of the public good.
See BA 9 for the graphs.
Social efficient is maximised when the MC is set equal to the sim of the MRS(Sum), rather than being set equal to each individual MRS.
The MRS is the demand side, representing the amount the individual is willing to pay for an extra unit. The MC is the supply side of how much it costs to produce a further unit. It will be the summation of the willingness to pay for all of society and all of society benefit from all the units.
MRS public good, y = Py
This is known as the Samuelson Rule (Samuelson, 1954).
154
W3 Public Goods - Given the marginal benefit of two individuals, graphically show the Social marginal benefit and cost of a public good.
See BA 9.
155
W3 Public Goods - What causes public goods to be oversupplied in a private market with no free riders? q
Each individual will set their MRS|public good, B| to be equal to their marginal benefit. Public goods are, by nature, non rivalrous. Therefore, if each individual neglects to acknowledge other individuals purchase of the public good, they will end up with far more of it overall. They should therefore sum the MRS wit society and pay equally.
156
W3 Public Goods - Free rider problem and its implications on the provision of such goods.
What about in terms of externalities?
When an investment has a personal cost but a common benefit, individuals (on average) will underinvest.
In a private market, public goods are under provided.
A public good provides a positive externality and is therefore undersupplied by the market.
157
W3 Public Goods - What are three reasons that help private provision of public goods work better?
1. Some individuals care more than others about the public good.
2. Altruism: individuals value the benefits and costs to others in making their consumption choices.
3. Warm Glow: Model of public goods provision in which individuals care about both the total amount of the public food and their particular contribution as well.
158
W3 Public Goods - Marwell and Ames 1981?
- 10 repetitions for each game
- In each game, group of 5 people, each with 10 tokens to allocate between
cash and public good.
- If take token in cash, get $1 in cash for yourself. If contribute to common
good, get $.5 to each of all ve players.
Nash equilibrium: get everything in cash
Socially optimal equilibrium: contribute everything to public good.
In the lab, subjects contribute about 50% to public good, but public good
contributions fall as game is repeated (Isaac, McCue, and Plott, 1985)
Explanations: people are willing to cooperate
This should be taken into account with policies implemented by the government.
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W3 Public Goods - Charitable giving?
5 examples.
The government incentivisation
and reasons for donating?
A private provision of a public good.
Examples include:
1. Religious activities.
2. Education.
3. Human Services
4. Health
5. Art
This is encouraged by the government through deduction in income tax purposes.
Reason:
1. Warm Glow (name on building)
2. Reciprocity (alumni)
3. Social pressure (churches)
4. Autism (poverty relief).
160
W3 Public Goods - Empircal Evidence of Crowd Out in Charitable Donations?
Government spending can crowd out private donations though:
1. Willingness to donate.
2. Fundraising.
Panel Data (following the same organisation over time) had the following results:
$1000 increase in government grant leads to $250 reduction in
private fundraising
Suggests that crowdout could be non-trivial if fundraising is a powerful
source of generating private contributions
Subsequent study by Andreoni and Payne confirms this
Find that $1 more of government grant to a charity leads to 56 cents less private contributions
70 percent ($0.40) due to the fundraising channel
Suggests that individuals are relatively passive actors
161
W3 Public Goods - Randomised Field Experiment to test reciprocity?
Falk (2007) conducted a eld experiment to investigate the relevance of reciprocity in charitable giving
In collaboration with a charitable organization, sent 10,000 Christmas solicitation letters for funding schools for street children in Bengladesh to potential donors (in Switzerland)
randomized into 3 groups
1) 1/3 of letters contained no gift (control group)
2) 1/3 contained a small gift: one post-card (children drawings)+one-
envelope (treatment 1)
3) 1/3 contained a larger gift: 4 post-cards (children drawings)+4-envelopes
(treatment 2)
Likelihood of giving: 12% in control, 14% in treatment 1,
21% in treatment 2
"large gift" was very eective (even relative to cost)
19
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W3 Public Goods - Empirical Evidence of Social Pressure.
Dellavigna-List-Malmendier '12 design a door-to-door fundraiser randomized experiment:
Control: no advance warning of fund-raiser visit
Treatment group 1:
flyer at doorknob informs about the exact time of
solicitation (hence can seek/avoid fund-raiser)
Treatment group 2: same as treatment 1 but
flyer has a check box \Do
not disturb"
Results (relative to control):
Treatment group 1: 9-25% less likely to open door for fund-raiser, same
(unconditional) giving
Treatment group 2: a number of people opt out and (unconditional) giving
is 28-42% lower)
Social pressure is an important determinant of door-to-door giving and door-to-door fund-raising campaigns lower utility of
potential donors
163
W3 Public Goods - Social Prices?
What does evidence show?
A policy instrument that focuses on setting a social costs on goods with negative externalities and a a social reward on goods with positive externalities.
By making people care about social norms, we can get to a socially optimum level of consumption of a good.
164
W3 Public Goods - Civil Duty Mailing?
Hawthorne Mailing?
Self Mailing?
Neighbours Mailing?
Civil Duty Mailing: Sending a letter to individuals to encourage them to do something, for instance vote. e.g. "It is your civil duty to vote"
Hawthorne Mailing: Encouraging people to vote by saying they are in a study. e.g. "you are being studied"
Self Mailing: A letter is sent to the household that alert them if they voted or not. A letter is sent before the vote to inform them of this.
Neighbours Mailing: People are alerted that their neighbours will be alerted as to whether they voted and vice versa.
165
W3 Public Goods - Of the following, what had the biggest effect on voter turn out (rank order)?
1. Control
2. Self Mailing
3. Hawthorne Mailing
4. Neighbours Mailing
5. Civil Duty Mailing
Lowest: Control (29.7%)
Civil Duty Mailing (31.5%)
Hawthorne Mailing (32.2%)
Self Mailing (34.5%)
Highest: Neighbours Mailing (37.8%)
166
W3 Public Goods - Should social pricing be used on top of standard pricing through corrective taxes or tradable permits?
Use the use of SUVs and electric cars as examples.
Social Pricing is relatively ineffective compared to a gas tax. It destroys welfare without bringing tax revenue.
Social pricing for electric cars is efficient relative to gas tax: adds welfare as energy efficient cars become more enjoyable to drive.
Social costs can be useful when it is hard to enforce a rule, such as littering.
167
W3 Public Goods - For pure public goods, what is the optimal level of provision?
The point where the sum of marginal benefits across all recipients equals the mc.
168
W3 Public Goods - What 3 reasons make it difficult to measure preference for public goods?
Preference revelation: Individuals may hide their true preferences and true value under the knowledge that they may be charged more for a good.
Preference Knowledge: Individuals may not know their true valuation since they have little experience pricing certain public goods.
Preference Aggregation: How can the government effectively put together the preferences of millions of citizens in order to decide on the value of a public project.
169
Week 4 Social Insurance - Social Insurance Definition and examples (3)?
Government interventions in the provision of insurance against adverse events.
1. Health Insurance (NHS, private insurance)
2. Retirement and liability insurance (Social Security)
3. Unemployment Insurance.
Growth in the government in the 20th century is mostly due to the growth of social insurance.
170
Week 4 Social Insurance - Insurance Premium?
The amount of money paid for an insurance policy.
171
Week 4 Social Insurance - Expected Utility Model?
Individuals wish to maximise expected utility defined as the weighted sum of utilities across sates of the world, where the weights are the probabilities of each state occurring.
172
Week 4 Social Insurance - What can be said of U(consumption)?
the Utility Function is increase in c at a decreasing rate (concave)
U'(c) > 0
U''(c) < 0.
173
Week 4 Social Insurance - How would we factor in an adverse event into the EU equation? (wordy version with q being the chance of an adverse event)
EU= (1-q)(Consumption with no adverse event) + q(Consumption with adverse events)
174
Week 4 Social Insurance - Actuarially fair premium?
The insurance premium that is set equal to the insurer's expected payout (so no costs to insurers)
175
Week 4 Social Insurance - What would be the expected utility of an individual with the probability of being sick 'q', medical costs when sick 'd', premium of insurance policy 'p', payout 'b' if sick and wealth 'W'?
What will be the expected profits for insurers?
EU : q x U(W - p - d + b) +
(1-q) x U(W - p)
Expected Profits of Insurers: p - q.b
The actuality fair insurance when EP = 0 will be
b = p/q
176
Week 4 Social Insurance - How will individuals choose their premium level?
See BA 10.
p = d.q
177
Week 4 Social Insurance - graphically represent the EU of an insured and uninsured risk avers e individuals with and without insurance.
See BA 11.
178
Week 4 Social Insurance - How would we account for heterogeneity (with symmetric information) in the insurance market using the example of healthy and unhealthy types?
What are the implications on the insurance market?
See BS 12.
Each price will be actuarily fair.
Private insurance companies do not equalise incomes across types, only within types.
Pre-existing condition will lead to inequality in insurance premiums and welfare but no failure in the insurance market.
179
Week 4 Social Insurance - How would we account for heterogeneity (with asymmetric information) in the insurance market using the example of healthy and unhealthy types?
See BS 13.
The insurance company cannot differentiate between types.
Everybody will opt for the cheaper insurance, known as adverse selection.
180
Week 4 Social Insurance - What equilibrium possibilities exist with heterogeneity (with asymmetric information) in the insurance market using the example of healthy and unhealthy types?
Pooling Equilibrium: Insurance companies offer a contract based on average risk - Good deal for sickly, mediocre deal for healthy but still better than no insurance.
Separating Equilibrium: Insurance companies offer two contacts: one expensive contact with full insurance for the sickly and a cheap contract with partial insurance for the healthy, leading to selection.
Outcome not efficient here as healthy are underinsured.
181
Week 4 Social Insurance - Adverse Selection?
When individuals know more about their risk level than the insurer and hence individuals with high risk are more likely to purchase insurance.
182
Week 4 Social Insurance - How does adverse selection cause a death spiral in the insurance market?
This occurs due to asymmetric information.
Insurance is offered at average fair price, bad deal for low risk people so they don't buy it, so insurers make losses. Insurers raise the price further. only very high risk people buy it. Insurers make losses again. No insurance contract is offered at all even though everybody wants full actuarially fair insurance.
183
Week 4 Social Insurance - What government intervention would correct the insurance market market failure?
Mandate: everybody required to buy insurance, leading to low risk people subsidising high risk people.
From a societal perspective, being high risk is rarely a consequence of individual choices, so society may wish to compensate for this.
This explains why OECD countries, bar the US, have opted for universal healthcare.
184
Week 4 Social Insurance - What are the social reasons for social insurance? (5)
All income level families should have access to high quality healthcare.
Redistribution: Private insurers cannot provide insurance against pre-existing conditions, leading to higher risk individuals paying more.
Externalities: An individuals lack of insurance can lead to negative physical externalities (such as flu shots).
Individual Failures: Individuals may not appropriately insure themselves against risk if the government does not force them to do so.
Administrative Costs: Medicare admin costs are 2% of claims paid. Administration costs of private insurance average 12%. Healthy individuals are poached by insurance companies and unhealthy people screened.
185
Week 4 Social Insurance - Moral Hazard? Provide an example
Adverse actions taken by insured individuals in response to insure nave against adverse outcomes.
e.g. someone receiving unemployment benefits may not search for a new job.
186
Week 4 Social Insurance - What is the central trade-off of social insurance?
Moral hazard problems (disincentive effects) create the central trade-off:
Insurance is desirable for consumption smoothing (benefit) but can create moral hazard (Drawback).
This is similar to the equity efficiency tradeoff in taxation.
187
Week 4 Social Insurance - What determines moral hazard?
How hard it is to observe whether the adverse event has occurred.
How easy it is to change behaviour away from the adverse event.
188
Week 4 Social Insurance - When examining insurance, what are the three main types of moral hazard involved?
1. Reduced Precaution: against entering the averse state (car insurance).
2. Increased odds of staying in the adverse state (e.g. unemployment insurance). Adverse behaviour more likely.
3. Increased expenditures when in the adverse state (e.g. health insurance)
Outcome: increased cost of providing insurance.
189
Week 4 Social Insurance - Concluding Points?
Asmymetric information in the private insurance market has two implication:
1. Adverse selection, hence the need for social insurance.
2. Moral Hazard, hence a need to LIMIT GENEROSITY of insurance.
Asymmetric information is a requirement for rationale behind government intervention whilst simultaneously serving to undercut it.
190
Week 4 Social Security and Retirement - Early Retirement Model?
People would work until they dies before 20th century, but poverty rate among elderly high before Social Security.
191
Week 4 Social Security and Retirement - What graph can be used to show the Life Cycle Model?
BA 14.
192
Week 4 Social Security and Retirement - What actual retirement programmes are in place broadly?
All OECD (GDP around 6-10%, with US around 5%)
Individuals pay social security contributions (payroll taxes) while working and receive retirement benefits when they stop working until the end of their life.
193
Week 4 Social Security and Retirement - What is the public retirement programme called in the UK and what are the requirements?
(New) State Pension.
Requires 35 qualifying years with complete NI contributions.
Max amount: £168.60/ week.
Triple Lock: Pensions rise by the max of the following:
Annual inflation, average earnings growth or 2.5%
194
Week 4 Social Security and Retirement - What are the two main pension types and two do they work (funding)?
Unfunded (pay-as-you-go): benefits of current retirees are paid out of contributions from current workers
Current benefits = current contributions.
Implicit return on taxes is the sum of the population growth 'n' and real wage growth (per worker) 'g'
Benefits = tax paid*(1+n)(1+g)
which is approximately tax paid*(1+n+g)
Funded: Workers contributions are invested in financial assets and will pay for benefits when they retire (no generational link), returning Tax payment * (1+r)
Current benefits = past contributions + market returns on past contributions
Most private pension plans are funded, whilst social security is unfunded.
195
Week 4 Social Security and Retirement - When is an unfunded or funded pension system desirable?
Unfunded when n+g>r
When this is the case, the economy is call dynamically inefficient.
In general though, N+G>r.
r is more risky. The risk adjusted market rate of return should be lower than average market rate r but higher than n+g.
Funded systems deliver higher returns as they do not deliver a free lunch to the first generation.
The choice between the two systems is an intergenerational redistribution tradeoff.
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Week 4 Social Security and Retirement - What is Social Security Wealth?
How is it calculated?
SSW is the expected present discounted value of a person\s future Social Security payments minus the expected present discounted value of a person's payroll tax payments.
Calculated:
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Week 4 Social Security and Retirement -
-Calculate the entire future stream of benefits that a person expects to receive before he or she dies.
-Use a discount rate to calculate the present discounted value
(PDV) of that stream of benefits.
-Calculate the entire future stream of social security taxes that
a person expects to pay before he or she dies.
- Compute the PDV of that stream of taxes.
- Take the difference between these two to get the SSW.
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Week 4 Social Security and Retirement - How does SSW vary within groups?
Females have higher SSW as they live longer.
Married couples have more SSW than single people.
Single earner couples earn more SSW than two earner couples
The gains to the poor relative to the rich from SS are overstated as length of life rises with income
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Week 4 Social Security and Retirement - What are the two rationals for social security?
1. Individual Failure: Not saving enough due to myopia, self control problems and lack of information
2. The longer a person lives, the less money the insurer makes from an annuity contract (Moral Hazard Problem with adverse selection - people who expect to live longer will take an annuity)
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Week 4 Social Security and Retirement - Rational vs myopic savers model?
BA 15.
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Week 4 Social Security and Retirement - How would government intervention effect myopic vs rational individuals in Social Welfare?
Rational individuals would be unaffected as long as the savings rate in tax is less than nor equal to their savings rate, it simply crowds out their private savings.
The Myopic individual will have their welfare maximised as they will have savings.
See BA 16.d
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Week 4 Social Security and Retirement - Comments on the Forced Savings Model for Social Security?
1) Universal vs. Means-Tested Programme: Universal forced savings is better than means-tested programme financed
by tax on everybody [Samaritan's dilemma]. With means-test
programme, two drawbacks:
a) Responsible individuals subsidize myopic individuals
b) Incentives to under-save to get means-tested pension
2) Heterogeneity in w: Forced saving should be proportional to w (as long as govt does not care about redistribution)
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Week 4 Social Security and Retirement - Does social security smooth consumption?
If individuals are rational, SS may be simply crowding out the savings that individuals would other wise set aside for retirement, instead relying on the government. The larger the crowd out, the less consumption smoothing.
In Italy, studies estimate that 30-40% of the reduction in SSW was offset by higher private savings.
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Week 4 Social Security and Retirement - Does evidence of Myopia exist?
Old are poverty has fallen as social security has expanded. This is not the case with poverty in other areas.
Fall in consumption in retirement. Hamermesh shows that consumption falls by 5% per year for the elderly
Fall in consumption at retirement for all groups except the wealthiest.
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Week 4 Social Security and Retirement - Consumption drop at retirement empirical evidence?
1) Confirm that expenditure on food falls by 17% at retirement, but
2) time spent on home production rises by 60%
3) all measures of caloric intake, vitamin intake, meat quality,
etc. do not drop at retirement (nd that caloric intake falls
when getting unemployed, hard to believe but suggestive)
26
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Week 4 Social Security and Retirement - What three key elements of a social security system affect retirement behaviour?
1. Availability of benefits at Early Retirement Age (EEA) - 62 in the US, UK: state pension age required to be reached. - Rational people not effected as they will have enough savings to reach retirement age.
2. non-actuarily fair adjustments of benefits for this retiring after EEA will have huge implicit tax on work.
3. Social norm created by retirement benefits. Govt calling some age the "Normal Retirement Age" can affect decision in spite of no underlying economic incentives.
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Week 4 Social Security and Retirement - Retirement Hazard Rate?
The percentage of workers retiring at certain ages.
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Week 4 Social Security and Retirement - Focal Point and Social Norms of the retirement age.
NRA are not always associated with economic incentives.
US SS is actuarially fair so NRA should be irrelevant)
Siebold '17 shows that in Germany, 30% of workers retire at statutory retirement ages even with no specific underlying economic incentives and this not being option by default
Siebold '17 shows that statutory age bunching much larger than bunching around kinks of lifetime budget constraints created by retirement system:
- Cannot be explained within standard model.
- NRA perceived as a social injunction obeyed by workers
- Nominal NRAs can potentially be a powerful govt tool to
change the retirement age
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Week 4 Social Security and Retirement - What problems exist in the current state pension system ? (3)
n+g has declined from over 3% to 2% due to:
1) n: Retirement of baby boom large cohorts born 1945-1965:
2) Increase in life expectancy at retirement age
Note: top half of individuals (in terms of lifetime earnings) has seen large
life expectancy gains while bottom half life expectancy has stagnated in
recent decades
1)+2) imply number of elderly per working age person in-
creases from .15 in 1960 to .35 in 2030
3) g: Slower productivity growth since 1975 (from 2% to 1%)
System requires adjusting taxes or benefits to remain in balance
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Week 4 Social Security and Retirement - What options exist for social reform of the Pension system?
Increase contribution.
Reduce Benefits (not politically feasible) through Indexing retirement age to life expectancy or removing the triple lock of pensions.
Means-tested benefits: bad for savings incentives and could make the programme plicately unstable.
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Week 4 Social Security and Retirement - Pension Privatisation Issues?
(5)
A number of transitional generations will have to pay for themselves and the currently retired.
Risk: stock market fluctuates a lot and privatisation should therefore need to include a minimum pension provision.
Annuitization: Hard to impose on a privatised system because of political constraints, meaning some people would exhaust benefits before death.
Lack of financial literacy: Govt may be able to do this more efficiently for people.
Admin Costs: In Chile, the admin costs are 1% of assets, 10x higher than SS. This is due to wasteful advertisement by mutual funds due to lack of financial literacy.
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Week 4 Social Security and Retirement - Conclusion of SS?
State Pension accounts for £94 Billion in government expenditure in the UK and is the single largest SS expenditure.
Individual failure key - individuals inability to save adequately.
Long run problem in which taxes must be increased or benefits cut.
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