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What do economists assume the goal of the government is?
Maximize economic welfare
What is the allocation where all consumers and firms doing what is optimal for them called?
Pareto Efficiency
What is the deadweight loss formula (assuming MC is constant)?
0.5(Qc-Qm)(Pm-Pc)
What condition needs to be met for pareto efficiency in an exchange economy with two consumers who have fixed endowments of a good?
The marginal rate of substitution of consumers are equal and are both tangent to the relative price line (feasible frontier)
What is another word for Pareto Efficiency?
Allocative efficiency
What condition needs to be met for productive efficiency?
The marginal rate of transformation, from the production function, is equal to relative prices
What does productive efficiency look like on a graph?
Producing on the boundary of the production possibilities frontier
What does the highest level of profit possible look like on a graph?
tangent to the production possibilities curve
What conditions need to be met for efficient equilibrium? (2)
The profit maximization outcome coincides with the utility maximization outcome (S = D)
MB = MC
What is the formula for allocative efficiency?
MRS1A,B=p1/p2=MRS2A,B
What is the formula for productive efficiency?
MRT1A,B=p1/p2=MRT2A,B
What is the formula for equilibrium?
MRS1,2=p1/p2=MRT1,2
What tells us we can get to Pareto efficiency if we have perfect competition?
The fundamental welfare theorems
What is the 1st welfare theorem?
A competitive equilibrium (if it exists) is Pareto efficient
What is the 2nd welfare theorem?
Given an initial allocation of resources, a Pareto efficient outcome can be reached by trade
What are the two problems with the welfare theorems and the government leaving the market to maximize economic welfare?
Perfect competition doesn’t really exist
Even if we did have perfect competition, it doesn’t cover everything we care about, including economic welfare
Why is perfect competition limiting over time if we want innovation and dynamic efficiency? (2)
dynamic efficiency is not well captured. all companies have varying levels of technology because they’re all striving for efficiency improvement
Monopolies also don’t have incentive to innovate
How does the government persuade firms and consumers to make different choices?
carrot and stick - subsidy and regulations
What is the reason the government has to implement rules and regulations into the market?
Principal-agent problem
What prevents the government from knowing how to tell the producer/consumer what to do?
Asymmetric information
What does the government seek to alter when incentivizing firms and consumers to make decisions aligned with social welfare maximization?
their objective function (profit/utility) and/or constraints
What is the basis of the mechanism theory?
There needs to be a common understanding of what the mechanism is, how it works, and belief that the mechanism will be used and remain in place
What do those being incentivized need to understand?
What the incentive is, what they are expected to do, what the reward is, what the penalty is, and that the incentive will be adhered to
When do governments intervene?
When private firms and private buyers cannot deliver the outcome that maximizes social welfare
What is the instance in which market competition is potentially the solution, but needs government intervention to work effectively
imperfect competition or market power
What factors cause market systems to not result in socially optimal outcomes and competition is not the answer? (5)
Behavioral biases
Information asymmetry
Externalities
Natural monopoly
Public good
What can behavioral biases do?
cause consumers to consume too much or little relative to what is optimal
What is it called when parties in a transaction do not always have the same information about the cost and value of a product?
information asymmetry
What are two examples of asymmetric information - adverse selection?
second hand car market - buyer doesn’t know car quality but seller does
experience products - buyer doesn’t know their preference for something they have no experience of
What happens when rational consumers are willing to pay an expected value that is below the price a firm is willing to sell high quality for?
Missing markets because there is no trade in high quality
What are the two types of market failures?
Adverse selection and moral hazard
What happens when there is an externality cost?
Too much is produced and pricing is too low
What happens when there is an externality benefit?
Too little is produced and pricing is too low
What can the government do if private negotiations do not work?
Pigouvian tax/subsidy
What is the tax value determined by?
The marginal external cost at the quantity produced
Why is it difficult to implement a pigouvian tax/subsidy?
The government does not know the marginal external cost or how to measure social burden, nor does it know supply and demand elasticity
What can the government do besides implement a tax to address externalities?
Issue permits that are tradable
What types of interventions are needed when we have a positive externality?
subsidies and nudges
What are the features of a natural monopoly?
High fixed costs, low marginal costs, declining ATC always greater than MC
While it is cost efficient to have a natural monopoly, what is the downside?
It will not maximize economic or social welfare
Why do private competitive markets not produce public goods?
They cannot earn revenue from customers because consumers will free ride
What is a consequence of private firms not producing public goods?
Missing markets
What will ensure that the government will produce a public good?
If the social benefit outweighs the social cost
What are the 3 options for a government to get involved in the realm of public goods?
Government ownership
Subsidize
Make excludable
While excludability can help, why is it not always feasible/pursued by the government?
Increase in excludability usually means a decrease in social welfare
Why does the market usually know better than the government?
Information asymmetry
Different objectives in government (i.e. re-election vs environmental protection)
Capture and lobbying
What is the profit function?
P(Q)Q - c(Q)Q - F
What needs to be established for private bargaining?
property rights
What is the minimum acceptable offer?
The area below the price line, above the MPC - the lost profit
What is the maximum offer that someone will make?
The total gains, which is the area between MPC and MSC between the two quantities
What can the government enforce to reduce output to reduce social costs?
subsidize (compensate), regulate, tax
What area represents compensation on the graph?
the area between MPC and MSC which shifts the practical cost curve up and causes them to produce the optimal amount
For a Pareto efficient allocation of resources, what must be true?
MSC = MSB
Why are public goods a special case of external benefits?
They are non-rival: the marginal cost of supplying an additional user is zero
Know the difference between MSC and MEC
MSC = MPC + MEC
In coasean bargaining, will the final outcome be pareto efficient regardless of property rights?
Yes
What determines the distribution of net social gain?
Bargaining power
How do property rights make someone impacted by social cost better off?
Rather than paying to achieve the social cost, they would be compensated or not have the social cost
Can public goods be excludable?
Yes
What can hidden action result in?
Missing markets. There are some risks, such as unemployment, where private markets for insurance do not exist.
How can you reduce the moral hazard problem?
requiring equity or collateral
What is the formulaic reasoning behind the slope of an indifference curve? (MRS)
MRS= dy/dx = - (du/dx) / (du/dy) = Marginal Utility of x / Marginal Utility of y
What are the characteristics of natural monopoly technology? (2)
average total cost is declining over the relevant demand area and marginal cost is always below average cost
How do you find ATC from TC?
Divide it by Q
How do you know if ATC is declining or increasing?
The change in ATC (derivative) is negative or positive respectively
What is the formula for deriving wrt x when 1/x?
-1/x2 which is also -x-2
What determines whether lemons and peaches will be sold (both or one)?
sellers will only sell a peach if the buyer’s expected value/willingness to pay is high enough to cover their willingness to sell
