Midterm Study Guide: The Economic Analysis of Public Policy (Chapters 1–7)

Comprehensive vocabulary flashcards covering the economic and ethical principles of public policy analysis, market efficiency, market failures, government interventions, and benefit-cost analysis from Chapters 1 through 7.

Allocative Efficiency

Achieving the greatest well-being for society given limited resources; for a single policy, it means maximizing total benefits minus total costs, including non-monetary and indirect effects.

Progressive Neutral Expert

A policy analyst role based on the view that government should be above corrupting interests and run on sound management, with rational analysis driving policy.

Entrepreneur for Efficiency

A policy analyst role rooted in 1950s interest-group theory, viewing government as a struggle among self-interested groups, where the analyst actively promotes and analyzes efficiency-based designs.

Ideological Combatant

A policy analyst role based on the view that ideas and ideology matter as much as interests (for example, debates between economists and environmental activists over pollution cleanup methods).

Bureau of Labor Statistics (BLS)

The federal agency that calculates the unemployment rate and tracks discouraged and marginally attached workers, as well as the Consumer Price Index ($\text{CPI}$).

Bureau of Economic Analysis (BEA)

The federal agency responsible for measuring Gross Domestic Product ($\text{GDP}$) and output by type of product.

Unemployment Rate

The percentage of the labor force calculated as $(\text{unemployed} \times 100) \times \frac{1}{\text{labor force}}$, where unemployed individuals are defined as those not working for pay but actively seeking work.

Price Elasticity of Demand (Midpoint Formula)

A measure of responsiveness calculated as $\frac{\Delta Q / \text{average } Q}{\Delta P / \text{average } P}$. Demand is elastic if $|e| > 1$, inelastic if $|e| < 1$, and unit elastic if $|e| = 1$.

Consumer Surplus (CS)

The difference between total willingness to pay (total value) and total spending ($P \times Q$), represented graphically as the area below the demand curve and above the market price.

Producer Surplus (PS)

Total revenue ($P \times Q$) minus opportunity cost (total variable cost), represented graphically as the area above the supply curve and below the market price.

Economic Profit

Total revenue minus explicit input spending and implicit costs (such as forgone wages and forgone investment return). In long-run competitive equilibrium, it equals zero.

Economic Rent

Revenue minus opportunity cost received by owners of resources that are more productive, cheaper to extract, or better located than the marginal resource.

Marginal Rate of Substitution (MRS)

The rate at which a consumer is willing to give up good $Y$ for one more unit of good $X$ holding utility constant, equal to $\frac{\text{MU}_X}{\text{MU}_Y}$.

Equal Marginal Principle

The utility-maximization condition where the budget line is tangent to an indifference curve, expressed as $\frac{\text{MU}_X}{P_X} = \frac{\text{MU}_Y}{P_Y}$.

Substitution Effect

The change in consumption along the original indifference curve resulting solely from a change in relative prices while holding utility constant.

Income Effect

The change in consumption resulting from a parallel shift to a new budget line and tangency, reflecting the change in purchasing power and real utility.

Compensating Variation (CV)

The maximum amount a person would pay for a good or benefit, measured as the income change that restores the individual to their original utility following a price decrease.

Equivalent Variation (EV)

The minimum dollar compensation a person would accept to tolerate a cost, price increase, or risk, returning them to their initial utility level.

Hicks Demand Curve

An income-compensated demand curve that reflects only the substitution effect by continuously adjusting income to hold utility constant.

Welfarism

The ethical principle that the value of an action depends solely on the utility (welfare) it generates for affected individuals, rather than on adherence to overarching moral duties.

Rank-Sum Rule

The utilitarian principle stating that society's total welfare is the equal-weighted sum of all individual utilities ($\text{SWF} = U_R + U_P$).

Consequentialism

An ethical approach that evaluates policies entirely based on their outcomes or ends, rather than the intrinsic nature of the means used to achieve them.

Veil of Ignorance

Rawls's hypothetical original position in which decision-makers do not know their personal social status, income, abilities, or demographic group, preventing bargaining for individual advantage.

Difference Principle

Rawls's maxi-min rule stating that social primary goods must be distributed equally unless an unequal distribution works to the advantage of the least well-off members of society.

Moral Side Constraints

Nozick's concept of relatively absolute boundaries that prohibit violating individual basic rights in pursuit of social goals.

Leaky Bucket Analogy

Okun's metaphor demonstrating that redistributive transfer programs take more wealth from the rich than the poor actually receive due to administrative expenses, tax disincentives, and socio-economic leakages.

Pareto Optimal

An economic state in which it is impossible to make any single individual better off without making at least one other individual worse off.

Pareto Improvement

A reallocation that makes at least one person better off while making no one worse off, requiring total benefits to exceed total costs and full compensation for all losers.

Contract Curve

The set of all Pareto optimal points inside an Edgeworth box, formed by connecting the tangency points of two individuals' indifference curves where their marginal rates of substitution are equal.

Kaldor-Hicks Principle

A decision rule stating a policy should be adopted if the beneficiaries could, in principle, compensate the losers, requiring net positive social benefits ($\text{Total Benefits} > \text{Total Costs}$) without requiring actual compensation.

First Welfare Theorem

The proposition that a competitive market equilibrium with fully defined property rights is Pareto optimal, maximizing the sum of consumer and producer surplus.

Second Welfare Theorem

The proposition that any desired Pareto optimal allocation can be achieved through competitive market mechanisms following an initial lump-sum redistribution of endowments.

Marginal Social Cost (MSC)

The sum of marginal private cost ($\text{MPC}$) and marginal external cost ($\text{MEC}$); when negative production externalities exist, $\text{MSC}$ lies above $\text{MPC}$.

Public Good

A good characterized by non-rivalry in consumption and non-excludability, which creates a free-rider problem that leads private competitive markets to under-provide it.

Pigovian Tax

A corrective tax set exactly equal to the gap between marginal social cost and marginal private cost ($\text{MSC} - \text{MPC}$) at the socially optimal output level to internalize an externality.

Natural Monopoly

An industry where economies of scale are so substantial that average total cost continuously declines over the relevant output range, allowing one firm to serve the entire market at lower cost than multiple firms.

Arrow's Impossibility Theorem

The mathematical finding that no collective voting system can simultaneously satisfy unrestricted domain, complete ranking, Pareto consistency, transitivity, independence of irrelevant alternatives, and non-dictatorship.

Median Voter Model

A public choice model showing that in majority-rule elections, candidates and policy platforms tend to converge on the position favored by the median voter.

Rent-Seeking

The expenditure of resources (such as lobbying or campaign donations) by interest groups to secure unearned transfers or favorable regulations from government.

Regulatory Capture

Stigler's theory that regulatory agencies eventually become dominated and manipulated by the very industries they are charged with regulating.

Benefit-Cost Ratio (BCR)

A project evaluation metric calculated as $\frac{\text{Total Benefits}}{\text{Total Costs}}$; a project is acceptable if $\text{BCR} > 1$, though rankings can differ from net benefits based on cost classification.

Cost-Effectiveness Ratio

A decision metric calculated as $\frac{\text{Total Cost}}{\text{Total Non-Monetary Effect}}$, used to select the lowest cost per unit of output when outcomes cannot easily be expressed in dollars.

Feldstein Weight

A distributional equity weighting formula defined as $\left(\frac{Y_{\text{median}}}{Y_i}\right)^\alpha$, where $\alpha$ represents the marginal social utility of income.

Present Value (PV)

The current value of a future sum of money, calculated using the formula $\text{PV} = \frac{\text{FV}}{(1 + r)^t}$, where $r$ is the discount rate and $t$ is time in years.

Internal Rate of Return (IRR)

The discount rate that sets the net present value ($\text{NPV}$) of an investment project's future net benefits stream exactly equal to zero.

Equivalent Annuity Value (EAV)

A method used to compare repeatable projects of unequal durations, calculated by dividing a project's $\text{NPV}$ by the present value annuity factor of 1\,\ per year over its life.