WEEK 7 - General Equilibrium and Welfare (Including Welfare Analysis of Large projects)

Question 1

In this exchange economy established for an edgeworth box how do we derive price?

Answer 1

Implement a Walrasian Auctioneer

Question 2

What is a Walrasian Auctioneer?

Answer 2

Someone employed to set the price for good 2 in terms of good 1

Question 3

How does a Walrasian Auctioneer do their job?

Answer 3

Individuals A&B are price takers and don’t question the judgement

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Question 4

When can trading proceed?

Answer 4

When the market has cleared, only then can trading proceed (called Tatonement)

Question 5

What happens if substitution effect outweigh income effects?

Answer 5

If sub effect outweighs income effect
- Lower price for Good 1 implies both parties want more of Good 1 and less of good 2, than in equilibrium at D (see a Edgeworth box for this). Market don’t clear

Question 6

What happens if Income Effect outweigh Sub Effect?

Answer 6

If income effect outweighs Sub Effect
- Lower price in good 1, may cause one consumer to demand more of it, and others to demand less

• So multiple equilibria possible even with single endowment points

Question 7

What do we assume to be the case in regards to differing effects?

Answer 7

Overall assume sub effects outweigh income effects

Question 8

What can happen under differing initial endowment points?

Answer 8

Dif endowment points lead to dif market equilbria
- Price may or may not change

Welfare:
- At D’ consumer A better off, but Consumer B worse off

SEE GRAPH IN NOTES

Question 9

Why is every point on the contract curve/ edgeworth (point D) pareto optimal?

Answer 9

Intersection of 2 dif indiv curve (Consumer A & B)

- Any further, one party is made worse off where other is made better off

Question 10

What are some important points regarding the Contract Curve?

Answer 10

• Every point on contract curve represent possible competitive outcome, where A’s indif curve and B’s indif curve are tangent
• Where the comp outcome actually takes place depends on initial endowments
• But, every point on CC is pareto efficient

Question 11

How could the price determining mechanism (Walrasian Auctioneer) alter based on A and B?

Answer 11

If A or B had monopoly power, may be able to influence auctioneer’s price by altering their bids but outcome not Pareto Efficient

Question 12

What is the first fundamental theorem of welfare economics?

Answer 12

As long as producers and consumers act as price takers and there’s a market for every commodity, the equilibrium allocation of resources is pareto efficient

(Economy operates at some point on utility possibilities frontier

Question 13

What is the second fundamental theorem of Welfare Economics?

Answer 13

• Provided all indif curves and isoquants convex to the origin, for each pareto efficient allocation of resources, there’s a set of prices that can attain that allocation as a general competitive equilibrium

Question 14

How do you maximise social welfare?

Answer 14

Diminishing Marginal Returns to Substitution + Correct Initial Distribution

Question 15

What is the graph to display Investment projects (DCF)?

Answer 15

SEE GRAPH IN NOTES

Question 16

Why do we discount in DCF analysis?

Answer 16

Use discounting to see what small/ big returns look like

i.e sums of cash

Question 17

What are some other aspects of DCF analysis?

Answer 17

1. If private firms, revenues should be net of taxes
2. Interest cost on loans
   - May appear in P/L statements
   - Not usually included in DCF analysis
   - > Already discounting future profits and charging interests as extra expense would be double counting
3. Capital may need annual maintenance
   • > Is cash flow and should be included in DCF analysis
   • > Capital may need replacing/upgrading every few years - These costs should also be included

Question 18

What are the uncertainties that are considered when appraising projects?

Answer 18

• Econ growth
• Key prices
• Tech
• Exchange Rates

Question 19

How do appraisers account for these uncertainities?

Answer 19

Cover via DCF analysis and NPV for each scenario

• For each scenario apply probability (Ps) to give probability weight NPV
• Across all scenarios prob sum to 1 -> Not accounting for unseen things

Question 20

What is the expected NPV of Project?

Answer 20

NPV e = (NPV1 x Prob 1) + (NPV2 x Prob 2) etc.

Question 21

How do you appraise Public Sector Projects?

Answer 21

• Similar methodology to DCF
• Returns on public sector investments/ subsidies
• Appraisals modified to account for social factors

Question 22

What are the social factors that must be considered in Public Sector appraisals?

Answer 22

• Tax : If profitable yields tax revenue, Public Benefit
• External Benefits:
  
  • > Regional Gains like jobs increase
  • > Spillover to other firms
  • > Environmental Benefits

Social Costs:
- Externalities
(which may be decreased via pollution tax etc.)