Economics of Public Policy - Week 1

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(Q_c-Q_m)(P_m-P_c)

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)

1. The profit maximization outcome coincides with the utility maximization outcome (S = D)

2. MB = MC

What is the formula for allocative efficiency?

MRS¹_A,B=p₁/p₂=MRS²_A,B

What is the formula for productive efficiency?

MRT¹_A,B=p₁/p₂=MRT²_A,B

What is the formula for equilibrium?

MRS_1,2=p₁/p₂=MRT_1,2

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?

1. Perfect competition doesn’t really exist

2. 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)

1. dynamic efficiency is not well captured. all companies have varying levels of technology because they’re all striving for efficiency improvement

2. 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)

1. Behavioral biases

2. Information asymmetry

3. Externalities

4. Natural monopoly

5. 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?

1. second hand car market - buyer doesn’t know car quality but seller does

2. 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?

1. Government ownership

2. Subsidize

3. 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?

1. Information asymmetry

2. Different objectives in government (i.e. re-election vs environmental protection)

3. 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