Economics 4th lecture

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Pareto improvement example

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1

Pareto improvement example

A restaurant owner hires additional staff to reduce wait times for customers, which also allows the employees to work more efficiently and lead to higher profits.

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 Pareto efficient

improve welfare of sb without making sb worse of, through changing allocation of resources

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Utility Possibility Curve

  • All points on the Utility Possibility Curve assume that you make the best possible use of all resources and technology available to you.

  • The utility possibility curve shows the maximum utility of a person, given the utility of all other  people in a society,  when you make the best possible use of all resources and technology available to you. 

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What are the two main things about utility possibility curve?

  1. it Shows the maximum utility of a person, given the utility of all other persons in a society

  2. when you make the best possible use of all resources and technology available to you.

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What does not pareto efficiency tell about?

interpersonal distribution

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Which point on the following graph, showing a Utility Possibility Curve, is Pareto efficient for a society with a given set of resources and technology?

B

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What type of society is ilustrated here?

utilitarian social indifference curve

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8

What does the second welfare theorem imply regarding the justification for state intervention?

It justifies the ex-ante redistribution of initial resources; to achieve a more equitable outcome governments should aim for interventions that do not shape the choices that people make in markets (to avoid a reduction in efficiency). 

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market failure

Decline in tourism because the coastline is too polluted by the harbour and farming sector.

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Government failures

  • when governments distort incentives in a way that creates inefficiencies and decline in welfare)

  • ex: Tax evasion by companies that shift their profits to foreign subsidiaries in other countries.

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One policy option to reduce energy consumption is to set up calculators that allow households to find out how much they can save by changing their behavior. Which market failure does this policy aim to address?

Imperfect information.

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12

Which of the following market failures describes the following situation: “Ben goes shopping for new shoes; but overwhelmed with the abundance of choices, he goes home without making a purchase”. 

Bounded rationality.

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13

Consider the following excerpt of a newspaper article “Ban on takeaways near schools and playgrounds to battle obesity”New rules could mean that fast-food restaurants will be banned from building in certain exclusion zones around schools and playgrounds in a bid to battle the country’s obesity problem.Which market failure does the policy proposal in the following example aim to address?

Bounded willpower

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Pareto criterium

social improvements are possible as long as the welfare of at least one individual can increase, without decreasing the welfare of another

  • Pareto Optimal does not mean a Social Optimum!

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Pareto efficiency outcome

the outcome when no further Pareto improvements are possible, action that harms no one and helps at least one

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Social improvement ( example)

By hiring additional staff, everybody benefits. Customers have shorter waiting times, waiters less pressure and the owner higher profits

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First Welfare Theorem

  • As long as some conditions are fulfilled competitive markets will lead you to Pareto efficient outcome ( markets play a crucial role ) 

  • If certain conditions are fulfilled (i.e. in a first-best world)...

  • Everyone is a rational actor with perfect information, everyone is a price-taker, and there are no externalities or barriers to entering or leaving the market ( perfect economy ) 


the operation of perfect competition will lead to ->  So uninterrupted markets

a Pareto Efficient allocation of resources -> So on the Utility Possibility Curve

governments only take part when the market fail - government defensive


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First Welfare Theorem: Implications

  1. Market mechanisms play a key role in creating welfare!

  2. Government intervention is put in the backseat: only allowed when markets fail

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A Social Indifference Curve shows

  • All possible combinations of individual welfare for which total societal welfare remains the same.

  • So presents trade-offs between individual welfare which do not result in a reduction of overall societal welfare

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Utilitarian approach

  • This society is indifferent as to who gains an additional unit of utility.

  • Social welfare equals the sum of each persons’ individual welfare

  • Bentham 

  • indifferent to inequality

<ul><li><p>This society is indifferent as to who gains an additional unit of utility.</p></li><li><p>Social welfare equals the sum of each persons’ individual welfare</p></li><li><p><strong>Bentham&nbsp;</strong></p></li><li><p><strong>indifferent to inequality </strong></p></li></ul>
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Ravlisian approach

Total welfare cannot be improved without first improving the welfare of the person who’s worst off (so extreme aversion to inequality)

<p>Total welfare cannot be improved without first improving the welfare of the person who’s worst off (so extreme aversion to inequality)</p>
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Second Welfare Theorem

  • You can achieve any Pareto Optimal outcome So any desired point on the UPC by changing the initial endowments only 

  • This is all the wealth or resources people have before they engage in market transactions and then allow perfect competition to do its magic.

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Second Welfare Theorem implications

If the conditions are right, we can separate between two problems:

  • CREATING welfare role of the markets

  • REDISTRIBUTING welfare role of the state

You can achieve any Pareto Optimal outcome by changing the initial endowments only and then allowing for perfect competition.

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Leaky bucket metaphor

- Redistributing money between people is like carrying water with a bucket that leaks

  1. Taxes distort incentives (zachety) - im wiecej mamy kasy tym jak jestesmy biedni, latwie je wydajemy

  2. Administering taxes and transfers is costly

  3. Complying with tax law etc. is costly and not productive

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equity

left-winged welfare state

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efficiency

right-winged, economy 

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Efficient allocation of resources

Everyone is a rational actor - no externalities and market power, everyone can exit and leave Market 

• Everyone has perfect information

• There are no externalities

• Everyone is a price-taker

• Everyone can freely access and exit markets

Akerlof, Spence and Stiglitz (2001)

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Contract Theory

Bengt Holmström and Oliver Hart (2016)

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Behavioural economics people as not rational actors

Richard H. Thaler (2017) and Daniel Kahneman (2002)

  1. imperfect information - how much money you save, quality of new phones, very little information abt important things; state intervations : labelling  

  2. behavioral deviations : it is difficult to make a savings plan 

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Implications of market failures for policymakers?

  • Potential justification for government intervention (Ex: using taxes to pay for retirement) government intervention corrects 

  • Possible to improve both equity and efficiency (if interventions also address market failures) 

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Imperfect information

Constant market failure

ex: asymmetric information or behavioral issues

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What can be the possible optimal outcome in casse of market failures

  • regulation - nutri score abc( if something is healthy, it is visible )

  • public finance ( taxes on cigarettes) 

  • public provision - public hospitals etc

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what are the two different mechanisms of alocating scare resources in our society?

  1. markets

  2. states

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How can we recognize the optimal allocation of resources?

  1. Pareto optimal

  2. Pareto efficiency

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What are the key characteristics of a social optimum?

  1. Utility possibility curce

  2. Social indifference curve

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How do we get at the social optimum?

1st and 2nd Welfare Thoremes

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What if we do not live in a world where the

first-best world assumption apply? (Intervention without distortion?What if markets fail?)

  • Incentive distortion & Efficiency-Equity,Trade-off

  • Market failures & behavioral deviations from the first best-world

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Welfare economics

analytical framework to evaluate how we should allocate goods and resources to improve social welfare in a society

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When Should Governments Intervene in Markets?

  1. correcting mistakes ( market failures, externalities by putting regulations 0

  2. To balance economy

  3. To promote equity

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Market mechanisms

  1. price market

  2. stock market

  3. exchange market

they aggregate information based on technological advancement,

they allocate resources

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Markets

  • Voluntary exchange

  • Decisions by individual actors

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State

  • Use power to enforce or shape decisions

  • Decisions through collective processes

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Social Indifference Curve

  • shows all possible combinations of individual welfare for which total societal welfare remains the same

  • presents trade offs between between individual welfare which do not result in reduction of overall societal welfare

  • increases welfare for some and for some recuces

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Why does Okun – using the metaphor of a leaky bucket – argue that pursuing equity goals comes at the cost of reducing efficiency?

Because people who have to contribute more to social insurance will be inclined to work less, resulting in a smaller pie to share.Because people who have to contribute more to social insurance will be inclined to work less, resulting in a smaller pie to share.

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Centre left political parties on taxes

Equity - welfare state

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Centre right political parties on taxes

Efficiency - economy

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the first best world conditions

  1. everyone is a rational actor

  2. everyone has a perfect information

  3. there are no extarnalities

  4. everyone is a price taker

  5. everyone has free market exit and access

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Imperfect imformation - how does state intervene?

labelling, safety standards, regulations

<p>labelling, safety standards, regulations </p>
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contract

insurance

market solutions to deal with imperfect information

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In case of market failure, can the government steer us towards a more optimal outcome?

  1. regulation (a,b,c,d labels on food)

  2. public finance ( taxes or subsides to shape decisions)

  3. public provision ( using public resources to provide services or goods)

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