Theory Flashcards
Pareto efficiency
no one can be made better off without
making at least one person worse off
Productive efficiency
: no additional output without
increasing inputs
Consider 2 people A and B. There is $100 to share between
the two. What is Pareto efficient?
(50, 50) and (99,1), and (1,99) are all Pareto efficient
You have $100 to distibute between A and B (70 - 25) Efficient?
Utility function:
A mathematical function representing
an individual’s set of preferences, which translates her
well-being (=utility) from different consumption
bundles (=set of goods & services they consume) into
units that can be compared in order to determine
choice
First fundamental Welfare Theorem
A market delivers Pareto efficient outcomes if:
* Perfect information of market participants
* Perfect competition: no monopolies, or price fixing of any
kind, easy entry and exit from market
* Complete markets with no transaction costs: the complete
set of possible bets on future states of the world can be
constructed with existing assets without friction (e.g.
insurance)
* Implications: “invisible hand”, perfect markets deliver Pareto
efficient outcomes without government intervention.
Market failure:
Market failure: A problem that causes the market economy to deliver an outcome that does not maximize efficiency
When Should the Government Intervene in the Economy?
redistribution, efficinecy
Equity-efficiency tradeoff
Re-cutting the pie (redistribution) may reduce the size of the pie (efficiency loss).
price mechanism
price mechanism, changing the price of a good to encourage or discourage use.
Ways to discourage consumption vs encourage
taxes v quota and public financing
Direct effects:
The effects of government interventions that would arise if individuals did not change their behavior in response to the interventions.
Indirect effects:
The effects of government interventions that arise only because individuals change their behavior in response to the interventions
payroll v income tax
Payroll taxes: The taxes on worker earnings that typically fund social insurance programs.
Individual income tax: A tax levied on the income of U.S. residents.
Example of public provision v public financing
provision: public education
finances: medicare
what are three ways the government intervenes
price mechanisms (taxes/subsidies)
regulations/mandates
public provision
What are rationales for gover
When should public provision be used?
Fully funds and provides service
Should be used for goods that have positive externalities or public goods
what are public goods
non-rival and non-excludable
example of govt intervention in regulation/mandate
Clean Air Act
Affordable Care Act
Constrained utility maximization
he process of
maximizing the well-being (utility) of an individual,
subject to her resources (budget constraint)
payroll v income taxes
income taxes are progressive, payroll are automatically deducted
What is the equity-efficiency trade-off?
What is the leaky bucket?
There can be a loss of efficiency when redistributing
What is economic efficiency and what are the two types?
when goods distributed
Pareto
productive: producing goods at lowest possible costs
What are the four questions of public finance?
When the govt intervene? Why? How? What are the effects?
How has US funding - sources and payment changed?
What is the first welfare theorem?
The competitive equilibrium, where supply equals demand, maximizes social efficiency.
what are the effects of govt intervention
indirect - happens when behavior change once intervention is in place (people leaving private market because of govt insurance)
direct - effects without behavior change
total social surplus
also known as social efficiency
represents the net gains to society from all trades that are made in a market, and it consists of the sum of two components: consumer and producer surplus
what is the indifference curve? What are two key properties?
graph of all goods bundles that make someone equally well-off
Because these bundles
have equal utility, an individual is indifferent as to
which bundle they consume
consumers prefer higher indifference curves: more
is better, downward sloping
producer surplus
profit; The benefit that producers derive from selling a good, above and beyond the cost of producing that good.
consumer surplus
The benefit that consumers derive from consuming a good, above and beyond the price they paid for the good.
market equilibrium
consumer and producer surplus are both maximixed
income effect
spend less money on goods overall because feel poorer
substitution effect
when price of one good increases we are more likely to choose another
when does
when marginal rate
what is a budget constraint
mathematical representation of all the combinations of goods an individual can afford to buy if she spends her entire income.
slope = relative price to trade goods for each other, trade-off rate = -Pgood1/Pgood2
How does TANF impact labor supply?
Assume that, without TANF, the labor market is in competitive equilibrium.
When TANF is introduced, labor supply falls, which creates a deadweight loss in the labor market, i.e. some people who would have worked without TANF no longer work so these jobs (trades) are lost.
When TANF benefits are reduced, labor supply increases and social efficiency in the labor market rises, i.e. number of jobs increases closer to competitive equilibrium (but single mothers are worse off due to income effect).
marginal utility
additional increment to utility by consuming additional unit
diminishing marginal utility
consumption of additional unit gives the individual less utility than the previous
marginal rate of substitution
rate at which consumer is willing to trade one good for another
= slope of indifference curve
MRS = -MUgood1 / MUgood2 = Pgood1/Pgood2
price trade of = utility trade off
Opportunity cost:
The cost of any purchase is the next best alternative use of that money, or the forgone opportunity.
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 (substitute away from more expensive goods).
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 (poor consume less overall).
Market equilibrium
The combination of price and quantity that satisfies both demand and supply, determined by the interaction of the supply and demand curves.
deadweight loss
The reduction in social efficiency from preventing trades for which benefits exceed costs.
Reduction of social efficiency can be justified by some social welfare functions: e.g. Rawlsian, which gives priority to the worst off.
Price ceiling (e.g. rent control) decreases social surplus by creating deadweight loss DE. Some producers no longer sell (E) and some consumers can no longer buy (D).
A market delivers Pareto efficient outcomes if:
Perfect information of market participants
Perfect competition: no monopolies, or price fixing of any kind, easy entry and exit from market
Complete markets with no transaction costs: the complete set of possible bets on future states of the world can be constructed with existing assets without friction (e.g. insurance)
