Utility Maximisation (easy) Flashcards
Marginal rate of substitution
Formula
What is it
-MU₁/MU₂
The rate at which the individual will trade good Y for good X
Slope of indifference curve
Budget constraint
Assume they spend all income
B)
How can we make this useful in diagrammatic form
P₁X₁ + P₂X₂ = Y
B) Rearrange to make X₂ subject where we find slope -p1/p2
The rate at which they can exchange these goods
Where do they max utility
Where IC tangent to BC i.e -MU1/MU2 = -P1/P2
Price effect is broken into 2 effects
Consider an increase in price. What are the 2 effects
Substitution effect - substitute good that increased in price for the cheaper good.
Income effect - consume less overall as relative income fallen
Price effect diagram: increase in price of movies to show 2 effects
Original point A: increase in Pm means budget constraint falls (green BCg)
Substitution effect A>B: still on original IC, now just substituted movies for more cakes
Income effect: to represent fall in relative purchasing power, draw parallel BCg (BC2) lower to overall less consumption
1st welfare theorem
If perfect comp and info, no externalities and rational agents, private market equilibrium is Pareto efficient (impossible to increase everybodys welfare together)
2nd welfare theorem
Pareto efficiency can be reached given appropriate redistribtuion of initial endowments
So 1st theorem says competitive markets are pareto efficient, no intervention req. 2nd said intervention required (redistribution)
According to 2nd theorem: How to reach pareto efficient allocation
B) why is this good
Redistribute initial endowments (lump-sum taxes based on individual characteristic)
then after let markets work freely
B) no efficiency and equity trade-off since done before, then let market operate free
Why does 2nd theorem not work in reality
B) So what should they use instead
Since initial endowments/characteristics cannot be observed by gov
B) discretionary taxes and transfers based on economic outcomes e.g income
So can’t do 2nd theorem. Instead, solve by distortionary taxes, but what does this create?
Equity-efficiency trade-off
More equity, balance but efficiency loss since less incentive to get rich as taxed away!
Good example of 2nd welfare theorem (government being unable to observe initial endowments/characteristics) pg41
Basically gov can’t tell apart disabled from just non-working able people,
so they may unintentionally give to non-working but able. If so, destroys incentive to work again!
If MU of money falls with income, what is good policy?
B) what is this an example of
Redistribution from rich to poor
Since taking £1 from rich will not reduce their utility a lot, but £1 to poor will increase their utility by a larger amount
B) Utilitarian SWF - aim to maximise individuals utility, who are weighted equally
Rawlsian social welfare function
B) expression
Maximise wellbeing of the worst-off member (more redistributive than utilitarian since want to make transfers to poor as big as possible)
B) SWF = min (u₁,u₂,u₃…)
Other social justice principles (3)
Just deserts - compensation based on contributions
Commodity egalitarianism - society ensure basic needs met, but beyond that distribution is irrelevant
Equality of opportunity - equal opps for success
Key findings of testing social preferences (3)
A) do we have utilitarian preferences IRL
B) Do people care whether income has been earnt through work vs not
C) Do people care what people do if no gov intervention?
No; we do not weight individuals equally - consumption lover seen as less deserving than frugal person
B) Yes: People see workers as more deserving of tax-break
C) yes: people see lazy ppl choosing to not work less deserving than those with inability that cannot work
General conclusion of findings: when do people favour redistribution
People favour redistribution if inequalities are unfair (e.g will accept being taxed if goes to disabled rather than lazy) , however unfair means different to other people
