Welfare economics Flashcards
What is the Pareto criterion?
Outcome A is Pareto superior to outcome B if no one finds A worse than B and at least one person finds A strictly better than B. An outcome is Pareto efficient if no other outcome is Pareto superior.
What are arguments for and against the Pareto principle? [3+3]
+ Everyone is always weakly better off
+ Don’t need cardinality
+ Avoids ‘strength of preference’ problems
- Nothing about equality
- Doesn’t cover all choices
- Very few actions harm no-one, so it favours the status quo
What is a social welfare function?
The aggregate of individual orderings into a social ordering. It must be:
- Complete, transitive and continuous
- Individualistic - uses welfare measures of individuals as inputs
- Non-paternalistic - reflects only the citizen’s own evaluation of their well-being
- Benevolent - no other objective than social welfare maximization
List different means of aggregating individual preferences [4]
- Majority rule - society prefers A to B
- Dictatorship
- Maximin (Rawlsian) - society prefers A to B if the worst-off in A are better off than the worst-off in B
- Utilitarian - society prefers A to B if the sum of utilities in A is higher than in B (needs cardinality)
Is majority voting effective?
- What if there’s a tie?
- How do you define ‘majority’?
- There may not be an option most-liked by a majority
- What about minority rights?
- What about intensity of preference?
What is Arrow’s impossibility theorem? [4]
Criteria for aggregation:
- Universal domain - works for all individual preferences
- Pareto efficient
- Independence of irrelevant alternatives - in a choice between A and B, preferences of C are irrelevant
- Non-dictatorship
Theorem: no such ordering is possible
What do we mean by single peaked preferences?
What is the 1st theorem of welfare economics?
A general competitive equilibrium leads to a Pareto efficient allocation of resources.
The price system from a perfectly competitive economy induces selfish individuals, independently maximising their private wellbeing, to bring the economy to a socially optimal state. Consumer sets MRS=price ratio; firm sets MRT=price ratio; equilibrium is efficient.
Suggests that markets do (weakly) better than a social planner.
When would general equilibrium not be efficient?
If different agents face different prices:
- Taxation - wedge between the prices that buyers and sellers pay and receive
- Monopoly power - monopolist optimisation based on marginal revenue, not price
What are the assumptions of the 1st welfare theorem? [5]
- Local non-satiation of preferences
- No externalities - one person’s preferences don’t affect another’s
- Everyone is optimising
- No one is cheating - e.g. stealing
- Perfect competition - no monopolies / distortionary taxation
What are the problems with the 1st welfare theorem? [6]
- Preferences are not always well-behaved
- Imperfect information leads to wrong choices
- Irrationality - purchasing ‘on a whim’
- Don’t always optimise - altruism, charity, pollution
- Gifts are an example of cheating
- No consideration of equity in resource distribution
What is the 2nd theorem of welfare economics?
Any Pareto efficient allocation can be achieved through a compeittive equilibrium, given the appropriate initial allocation of endowments.
A specific efficient outcome (point on the contract curve) can be chosen and attained by picking the initial endowments (to get the right budget constraint) and then allowing trade.
Implies that you can separate efficiency and equity (through lump-sum distributions of wealth).
What are the assumptions of the 2nd welfare theorem? [2]
- It is possible to redistribute endowments
- Preferences and production sets are convex (remember diagrams)
What are the problems with the 2nd welfare theorem? [4]
- Only lump-sum redistribution is allowed
- Political problems with taxation, benefits, etc.
- How do you decide what final outcome you want?
- If transfers are available, why not just move straight to the final outcome?
What are the main causes of market failure? [3]
- Monopoly power - prices aren’t set at marginal cost
- Externalities / public goods - problems of underprovision and free riding
- Information asymmetries - e.g. moral hazards in the insurance market
The existence of market failure is necessary but not sufficient for intervention - will the planner do better than the market?
Give examples for each taxonomy (classification) of goods.
Rival & excludable - market goods
Rival & non-excludable - fish
Non-rival & excludable - museums
Non-rival & non-excludable - national defence
What is Coase’s theorem?
Bargaining will lead to an efficient outcome, regardless of the initial allocation of property
Initial utility < utility with bribe
φ(h*) < φ(h) +/- B
What can prevent Coasian bargaining? [3]
- If trade in the externality is not possible
- High transaction costs
- Poorly defined property rights
What is a Pigouvian tax?
A tax applied to a market activity that is generating negative externalities. It is intended to correct the inefficient market outcome, and does so by being set equal to the size of the externality.
Optimal tax per unit, t = MSC
Total tax revenue, T = t * h (where ‘h’ is level of pollution / number of units)
What are the advantages of Pigouvian taxation?
- It raises the price, lowering quantity demanded (of fossil fuels)
- Price mechanism internalises external cost
- Firms switch to renewable alternatives, better production processes - can be subsidised
- Government can use tax revenue to repair damage
What are the problems with Pigouvian taxation? [6]
- Only controls individual firms, not total pollution level
- Demand for fossil fuels is price inelastic
- Calculating the correct tax - hard to determine social cost
- Administration costs
- Deciding who gets the revenue from the tax
- Discrepancies between countries; tax havens
What is the optimal level to set a quota?
Where MSB = MSC
(Often where benefit to firms = cost to consumers)
How does the ‘Cap and Trade’ system work? [4]
- Total emission level agreed
- Permits are allocated either for free based on previous emissions…
- …or by auction, giving to person who values highest (VCG)
- Firms can then trade
What are the advantages of tradeable permits? [6]
- Total supply is fixed
- Those who can reduce emissions cheaply gain
- Incentive to develop low-emission technology
- Number of permits can be reduced each year
- Mor responsive to changes in inflation
- Avoids government failure - don’t need individual production functions
What are the problems with tradeable permits? [4]
Is there a hybrid system between taxes and quotas that could work for externalities?
- Permits, with emissions tax beyond
- Places ceiling on emissions permits, government commits to sell permits at ceiling price
- Also creates price floor - commitment to buy at floor price
- In between, permits are traded
Better because it gives more certainty in total level and price of emissions, and the price price doesn’t fluctuate too far
What is the Lindahl Equilibrium?
Individuals pay for the provision of a public good according to their marginal benefits, in order to determine the efficient level of provision for public goods.
In the equilibrium state, all individuals consume the same quantity of public goods but may face different prices because some people may value a particular good more than others.
Why is the Lindahl mechanism inefficient?
We do not know how much each person values a certain good, and individuals have an incentive to underreport
How does the Vickrey-Clarke-Groves (VCG) preference revelation mechanism work?
- Voters state preference value (sealed bid)
- State values are added, and the policy option that has the highest aggregate value is chosen
- If a voter’s vote was decisive, charge him a tax equal to the net gain to other voters in the absence of this vote
- If the voter’s vote was not decisive, charge no tax
What are the consequences of the CGV mechanism? [3]
- Socially optimal assigning: each individual is charged the harm they cause to other bidders
- The optimal strategy for each bidder is to bid their true valuation
- Tax paid never exceeds benefits recieved
What are three broad aims of government policy?
- Correct market failure - regulate monopoly, correcy externalities, provide public goods
- Override ‘inappropriate’ choices of the individual - e.g. education, heroin
- Achieve a desirable distribution of income
What is the theory of second best?
When the market isn’t perfect and an optimality condition cannot be satisfied (e.g. imperfect information), perhaps the next-best solution involves changing other variables away from their optimal values.
