Week 2 - Consumer & producer theory, welfare

Question 1

How do we know whether a person is better or worse off after price changes?

Answer 1

1. If can still afford previous bundle of consumption, cannot be worse off but might be better off
2. If cannot afford previous bundle of consumption, we can’t say much

Question 2

CPI, Consumer price index

Answer 2

1. A base-weighted price index
2. Used as a measure of inflation
3. Represents the average increase in the price of goods as measured by a fixed, representative basket of goods
4. Computed by the ratio of the amount of $$ it takes today to buy the REPRESENTATIVE BASKET over the amount of $$ it took last year to buy the same basket

Question 3

2 issues with CPI & what is the better alternative?

Answer 3

1. CPI is an average of ppl’s consumption costs, so not specific to a person & not good estimate of individual inflation
   - may OVER-/UNDER-COMPENSATE ppl when price change
2. Ppl react to price changes. CPI doesn’t account for SUBSTITUTION BIAS

EXPENDITURE-BASED price index would be better as it takes into account how consumers will substitute towards relatively cheaper goods → NO substitution bias
- calculate how much it costs today to buy a new bundle of new G&S to get to same level of utility as yesterday

Question 4

Producer theory

Answer 4

1. Assume firms use inputs (labour, capital) to produce outputs (goods, services)
2. Assume firms will maximise their profits

Profit = Revenue - costs
How to maximise revenues? Depends on quantity/price.
How to minimise costs? Depends on capital/labour to employ.

Question 5

4 Social welfare functions

Answer 5

1. Pareto principle
   - If a policy is a Pareto improvement, ie. benefits at least 1 person in society better off and does not make anyone worse off → go ahead w/ policy
2. Utilitarian SWF
   - if sums of utilities of everyone in society increases → go ahead
   - utilitarian criterion maximises the sum of utilities (utilitarian optimum)
3. Rawlsian/maximin SWF
   - if policy benefits everyone except the worst off ppl in society (w/ least utility), don’t do it. Only go ahead if it improves those worst off in society.
4. Inequality-averse SWF
   - if policy reduces inequality → go ahead. Don’t if it promotes inequality.