Week 1: Markets and Efficiency Readings

Question 1

Views held before Smith regarding the role of government

Answer 1

1. Achieving the best interests of the public requires an active government.
2. But - some countries with more passive govs prospered
3. Some countries with an active government did not prosper as their resources were wasted on wars and unsuccessful public ventures.

Question 2

Explain Adam Smith’s ‘Invisible Hand’ theory

Answer 2

Competition would lead the individual in the pursuit of his/her private interests (profits) to pursue the public interest - as if by an invisible hand

Question 3

Amongst the contradiction between whether a country is more prosperous with an active or passive gov, what did Smith do?

Answer 3

He asked the question: Can society ensure that those entrusted with governing actually pursue the public interest?

Question 4

Can society ensure that those entrusted with governing actually pursue the public interest? - Answer according to Smith’s perspective.

Answer 4

1. Experience showed - although at times the policies governments pursued seemed consistent with the public good, other times, they weren’t.
2. Rather, those in the position of governing sometimes seemed to pursue their private interests at the expense of the public interest.
3. Even well-intentioned leaders led their countries astray.

Question 5

Can society ensure that those entrusted with governing actually pursue the public interest? - Answer according to Smith’s perspective. (Continued)

Answer 5

Smith argued - not necessary to rely on the government or any moral sentiments to do good.

The public interest is served when each individual simply does what is in his/her self-interest.

Question 6

What does Smith say about ‘Self-Interest’?

Answer 6

A more persistent characteristic of human nature than a concern to do good - provides a more reliable basis for the organization of society

People are more certain about their own self-interest than determining what is the public interest.

Question 7

What is the sentiment behind Smith’s Invisible Hand Theory?

Answer 7

If there is some commodity or service that individuals value but that is not currently being produced, then they will be willing to pay something for it > entrepreneurs in search of profits are always looking for this opportunity.

Question 8

When does an entrepreneur choose to produce a commodity?

Answer 8

1. If the value of a certain commodity to a consumer > costs of production, there is potential for profit
2. There is a cheaper way of producing a commodity that is discovered, an entrepreneur who discovers this cheaper method will be able to undercut competing firms + make a profit

Question 9

According to Smith, do governments need to decide whether a commodity should or should not be produced?

Answer 9

No. It will be produced if it meets the market test - if what individuals are willing to pay exceeds the costs of production

Question 10

According to Smith, does a gov committee need to oversee if a firm is producing efficiently?

Answer 10

The competition will drive out inefficient producers

Question 11

Define Pareto efficient or Pareto optimal (efficiency)

Answer 11

Resources allocations that have property that no one can be made better off without someone being made worse off

Question 12

Define Pareto improvement

Answer 12

A change that makes some individuals better off without making anyone worse off.

Question 13

Give an example of pareto improvement

Answer 13

A gov is thinking about building a bridge. Those who wish to use the bridge are willing to pay more than enough in tolls to cover the costs of construction and maintenance. Construction of the bridge - likely Pareto improvement

Question 14

Why is the word ‘likely’ used to describe the construction of the bridge as Pareto improvement?

Answer 14

Likely is used because there are always others who might be adversely affected by the noise of bridge traffic and the shadows cast by the bridge superstructure)

Question 15

What are the two criteria of Pareto efficiency?

Answer 15

1. Individualistic in two ways:

a) Concerned only with each individual’s welfare, not with the relative well-being of different individuals

> Not concerned explicitly with inequality - thus, a change that made the rich much better off but left the poor unaffected would still be a Pareto improvement.

b) It is each individual’s perception of his or her own welfare that counts

> Consistent with the general principle of consumer sovereignty - individuals are the best judges of their own needs and wants

Question 16

What are the 2 fundamental theorems of welfare economics?

Answer 16

1. If the economy is competitive (and satisfies certain other conditions), it is Pareto efficient.
2. Social welfare can be maximised at an equilibrium with a suitable level of redistribution.

Question 17

Explain the second theorem.

Answer 17

1. By transferring wealth from one individual to another, we make the second individual better off and the first worse off.
2. After we make the redistribution of wealth, if we let the forces of competition free play themselves out, we will obtain a Pareto efficient allocation of resources
3. E.g. if we take wealth away from those who like chocolate ice cream and give it to those who like vanilla, more vanilla ice cream will be produced and less chocolate.

> Therefore, no one can be made better off in the new equilibrium without making someone else worse off.

Question 18

Explain the second theorem (continued)

Answer 18

• The only thing the government needs to do is redistribute initial wealth
• Every Pareto efficient resource allocation can be obtained through a competitive market process with an initial redistribution of wealth.

Question 19

According to the second fundamental theorem, every Pareto efficient allocation can be attained using…

Answer 19

A decentralised market mechanism

Question 20

What happens in a decentralised system?

Answer 20

Decisions about production and consumption (what goods get produced, how they get produced and who gets what goods) - carried out by firms and individuals in the economy

Question 21

What is a centralised allocation mechanism?

Answer 21

• All decisions are made by a single agency
• The central agency/ single individual is referred to as the central planner

Question 22

Has any economy been fully centralized?

Answer 22

• No economy has even come close
• Under communism in the former SU and some other Eastern bloc countries, economic decision making was much concentrated than in the US + other Western economies

Question 23

To attain an efficient allocation of resources, is it necessary to have a central planner?

Answer 23

No, competitive enterprises, attempting to maximise their profits can do as well as central planners

Question 24

Define the demand curve of an individual

Answer 24

An individual gives the amount of the good the individual is willing to demand at each price

Question 25

The market demand curve

Answer 25

Adds up the demand curves of all individuals - gives the total quantity of the good that individuals in the economy are willing to purchase

Question 26

What is the direction of a demand curve?

Answer 26

Downward sloping

Question 27

Principle of demand

Answer 27

As prices increase, individuals demand less of the good

Question 28

Individuals equate the marginal (add