Welfare Economics

Question 1

Explain the 2 types of equity?

Answer 1

Horizontal - identical treatment of identical people
Vertical - different treatment of different people to reduce consequences of their differences

Question 2

What are 3 ways that perfectly competitive markets are efficient?

Answer 2

Production efficiency - firms choose least cost inputs, and allocation of output between firms in the same industry minimizes costs
Consumption efficiency - the allocation of goods between consumers is efficient
Top-level efficiency - the allocation of output across industries maximizes consumer utility

Question 3

What is pareto efficiency?

Answer 3

An allocation is pareto-efficient if for a given set of consumer tastes, resources and technology if is impossible to move to another allocation which would make some people better off without making anyone else worse off

Question 4

Name 5 market failures?

Answer 4

1. Under provision of public goods
2. Externalities
3. Imperfect competition
4. Missing markets
5. Imperfect information

Question 5

What is a public good?

Answer 5

Non-rivalary = when the good is consumed it doesn’t reduce the amount availible for other
Non - excludability = cannot provide the good without making it availible for everyone

e.g. street lighting, flood defence

Question 6

Why are public goods under provided by the market? What is the solution?

Answer 6

If producer cannot exclude people, they cannot charge for it. If consumption by one person doesn’t affect anothers consumption then it is inefficient to charge for it. This means there sin;t an incentive to produce the efficient level of public goods.

Solution = government provision

Question 7

What are externalities?

Answer 7

Occur when producing/consuming a good which causes an impact on a 3rd party not directly related to the transaction

Question 8

On a diagram, what represents the marginal social benefit?

Answer 8

The demand curve

Question 9

Where is the socially optimal point on a diagram with marginal social costs/benefits?

Answer 9

Where marginal social cost = marginal social benefit

Question 10

When there is a negative externality what happens to social costs/benefits?

Answer 10

Marginal social cost is above marginal social benefit, the area between them gives the overall welfare loss

Question 11

What is the problem of imperfect competition?

Answer 11

Consumers pay prices that are above the marginal cost, which reduces efficiency (as allocation of output and consumption has been distorted)

Question 12

What is the problem of imperfect information?

Answer 12

Consumers don’t know the qualities of the products that they buy and firms don’t know available technologies, can result in pareto-inefficiency.

Question 13

What is the problem with redistribution taxes?

Answer 13

Taxes have a distortionary cost, which can result in a welfare loss.

Question 14

What is the distortionary effect of a tax on wages?

Answer 14

A tax on wages (W) shifts the supply curve to the left, workers receive a lower wage (w1) but firms also pay a higher wage (w2), so there is a difference between w1 and w2 (with orig wage w in the middle) so there is a welfare loss to society

Question 15

What is the trade-off between equity and efficiency in regards to tax on wages?

Answer 15

Higher tax can reduce inequality but they often reduce incentives to work (and businesses to invest)

Question 16

How do governments decide how much of a public good should be provided?

Answer 16

Quantity should be where marginal social benefit = marginal cost

Question 17

What is the value of marginal social benefit for a pure public good?

Answer 17

Sum of all marginal values each person puts on the public good

Question 18

How are marginal values measured?

Answer 18

1. asking people (but over-state when don’t have to pay, and understate when do)
2. measuring value indirectly e.g. through value placed on parks by looking at house prices

Question 19

What are the 3 main government interventions to correct externalities?

Answer 19

1. Regulation
2. Tax
3. Tradeable permits

Question 20

Explain the regulation approach to externalities? (use environment as an example)

Answer 20

Implementing regulation e.g. banning chloroflurocarbons that destroy ozone layer to try and reduce negative externalities

Question 21

What is the problem with regulation approach? What is the benefit?

Answer 21

Con - Seen as inefficient as can result in different costs per unit of improvement across firms

Pro - approach has known effect and policy makers like it

Question 22

Explain the tax approach to externalities?

Answer 22

Impose a ‘Pigovian’ tax that reflects the marginal value of the externality, it is referred to as internalising an externality as the individual causing the externality is now bearing the cost for it

Question 23

What is moral hazard?

Answer 23

Individuals have incentives to alter their behaviour when their risk or bad-decision making is borne by others.

Question 24

What is adverse selection?

Answer 24

Occurs when there is asymmetric (unequal) information between buyers and sellers. This unequal information distorts the market and leads to market failure.

Question 25

What is the Coase Theorem?

Answer 25

Under ideal economic conditions, where there are conflicts relating to externalities, the agents involved can bargain/negotiate terms that will accurately reflect the full costs and underlying value of the property rights, resulting in the most efficient outcome. For this to work, there must be complete perfectly competitive markets, with no transaction costs and perfect information.

Question 26

What is the first Fundamental Theorem of Welfare Economics?

Answer 26

Any competitive equilibrium leads to a pareto efficient allocation of resources

Question 27

What is the second Fundamental Theorem of Welfare Economics?

Answer 27

Social welfare can be maximized at an equilibrium with a suitable level of redistribution

Question 28

What are the problems with the Coase Theorem?

Answer 28

1. Costs of bargaining
2. Difficulties assigning property rights
3. The holdout problem
4. Difficult to identify source of damage
5. Asymmetric information