EC270 Final Exam

First Fundamental Theorem of Welfare Economics (FFTWE)

private market outcomes are pareto-efficient under a broad set of conditions

• rational agents

• no externalities

• complete mkts

• symmetric info

• perfect comp.

pareto efficiency

no one can be made better off w/out making someone else worse off

Second Fundamental Theorem of Welfare Economics (SFTWE)

any pareto-efficient allocation can be achieved through a decentralized equilibrium after redistribution, under a broad set of conditions

why gov intervention?

create a framework of law, mkt failures, paternalistic concerns (when indiv. act against their own self interest), redistr.

how do mkts get secure property rights?

police/justice system to ensure that private contracts are enforceable

source of mkt failure

lim rationality, externalities + public goods, asymmetrical info, imperfect info

paternalism critique

positive benefits from gov intervention create lim rationality (ex: social security, mandatory seat belts)

equity-efficiency trade-off

redistr. distorts incentives (ex: to work); lump-sum redistr. not feasible in real world

how does the gov intervene?

through maximizing an objective

how does the gov set a social objective?

organic holistic view: obj. can be defined ex abstracto at the social level

individualist/democratic view (modern pub econ view): attempt to deal with and/or aggregate indiv. preferences.

fundamental conflict btwn social + indiv. choice

aggregation of indiv. preferences may be the best of a set of unsatisfactory alternatives

effects of gov intervention

direct (mechanical) effects: tax raises revenue for gov

indirect (behavioral) effects: with tax, ppl reduce consumption → tax collections fall → DWL

why are optimal policies not always implementable

may lack majority support, first-best policies are not always credible + are costly or difficult to implement because of information, administrative things, ect;

gov failures

policy makers have own objectives that differ from social welfare

marg. utility

incremental utility gained by an additional unit of consumption

marg. rate of substitution (MRS)

rate at which consumers are willing to trade one good for another

• describes slope of IC

IC

a curve containing the set of consumption bundles from which the consumer obtains the same level of utility

BC

mathematical representation of all affordable combination of goods; quantity demanded changes as income changes:

• normal goods: quantity and income move in the same direction

• inferior goods: opposite direction

income effect

tax makes consumers poorer, leading them to reduce consumption of normal goods

substitution effect

tax increases the relative price of good A leading consumers to substitute away from it and towards good B

normal goods

income and substitution effects reinforce each other

inferior goods

income effect moves in the opposite director that substitution effect does but the latter prevails.

giffen good

inferior good for which the income effect prevails

demand curve

describes the quantity of a good consumed at each price

compensating variation (CV)

what change in income would restore the consumer’s well-being to what it was before the price change

equivalent variation (EV)

what change in the consumer’s income would have an equal effect on the consumer’s well-being as the price changes

CV vs EV vs change in CS

no income effect: CV = EV = change in CS

both normal goods: CV > change in CS > EV

one inferior good: CV < change in CS < EV

supply curve

traces quantity of a good that firms are willing to supply at each price

perf. comp

homogeneous goods, full info, small econ of scale (rapid increase in avg costs if firms increase output), no entry or exit barriers

mkt power

the ability of a firm to profitably raise price above MCs

DWL

cost to society due to an ineffic. allocation of resources caused by mkt power

• if DWL exists, CS + PS is negative

mkt equil.

S=D; mkt clearing condition

CS

benefit to consumers beyond the equil. price they pay in the mkt

PS

aka profit; benefit to producers beyond the cost of producing

effic. equil.

equil. that max. welfare (min effic. criterion = pareto effic.)

condition for effic. production

MB=MC

utility possibility curve (UPC)

captures trade-off inherent in diff. utility outcomes (similar to BC or PPC)

• represents all pareto-effic possibilities → negative slope

Kaldor-Hicks improvement

if winners can compensate the losers

• sum cv greater than or equal to 0

• after compensation there is a pareto improvement

• K-H effic = max W_utilitarian

• justifies use of econ growth for welfare

revealed preference

principle that choices are informative about utility

PPC

max amount of s possible for a given level of production I, holding technology and total amount of inputs constant

treatment effect

avg casual effect of a binary (0-1) variable on an outcome of interest; the diff in two potential outcomes

evaluation problem (while finding the casual effect of a policy)

• indiv. can only be in one state at the same time

• counterfactual outcome is missing

identifying assumptions that remove selection bias

• randomized experiments (makes assignment independent of potential outcomes

• natural experiment / DiD

• IV methods

• discontinuity design methods

common trend assumptions

key assumption for any DiD strategy is that the outcome in T and C groups would follow the same time trend in the absence of the treatment.

problems with DiD + natural experiments

composition of T and C groups evolve over time, substitution bias, externalities + general equil. effects

coase theorem

if transaction costs low + sources of damage can be identified, once property rights are completely defined, private bargaining will restore efficiency irrespective of initial assignment of property rights.

• cost of bargaining → need lots of agents to bargain → reduce transaction costs through gov

• cost of enforcement → high cost of monitoring (econ. of scale), hard to identify exact source of damage (marg. damage unclear)

public solution to externalities

• pigouvian correction taxation

• regulation

• permits (cap + trade)

regulation

ex: reduce pollution to set level or face legal sanctions; same outcome as pigouvian tax if we know effic. quantity

• advantages → ease of enforcement, salience/political expedience

• disadvantages → dynamics: no incentive to innovate, allocative ineffic. w/ heterogeneity in pollution reduction cost

need to know each firm’s cost + demand function for effic. regulation (not effic. otherwise)

model w heterogeneous costs

optimum outcome is to have the low cost firm do more pollution reduction than the high cost firm

taxes vs regulation solution

uniform quantity regulation not effic. because diff MC of polluting costs per firm

permits/cap + trade

hybrid of regulation + coasian solution because firms w highest MC buy permits, firms that can easily reduce pollution will sell permits

if tot # of permits set to achieve the social optimum → allocative + productive effic. achieved + maintains dynamic incentives to innovate

taxes fixes price vs cap + trade fixes quantity

taxes fixes price vs cap → quantity of pollution adjusts

trade fixes quantity → price of permits adjusts

when accounting for externalities need to know:

• costs of damages associated w various levels of the externality-producing activity

• cost of reducing the externality-producing activity

• the certainty w which we have estimated these costs

general issues w survey data

framing, anchoring, strategic responses

house price capitalization

the net present value of a house is the sum of the discounted flow of future benefits associated w owning it.

public good

non-rival in consumpt. + non-excludable

non-rival in consumpt

one indiv. consumption of a good does not affect another’s opportunity to consume the good

non-excludable

indiv. can’t deny each other the opportunity to consume a good

free rider problem

ineffic. private provision; FFWTE breaks down

• when investment has a personal cost but common benefits, individuals will under invest. → bc of free riding, mkt under prov. of pub goods compared to samuelson formula.

why is priv. provision suboptimal?

bc the sum of MRS is H times 1 → greater than MRT

• indiv. will invest too little in G → pareto improv. if each indiv. invested more $ in G so MRS = 1/H

samuelson rule: limitations

• free riding legitimizes public intervention to reach samuelson rule, but difficult to implement

• gov needs to know preferences/reveal them

• issue of how to finance the public good if only distortionary taxes availanle

• sam. analysis is a first-best benchmark

• avaiable policy tools to implement optimal level of public good

public provision w endogeneous private provision of PG

in some cases the priv. sector may provide a pub. good, albeit less than the optimal amount

• ex: sanitization + additional security of Times Square by a group of businesses

• when this exists it may cause a public provision “crowd out” of private provision based on FR argument

preference revelation

1st fundamental issue is to make sure we can elicit truthful revelation of preferences

how: price mechanism in competitive mkts, but unfeasible for public goods bc FR problem

Clarke-Groves mechanisms

help elicit preferences by setting up side by side payments equivalent to net increase in the surpluses of others in the mkt

• but doesn’t guarr. balanced budget (Groves 1977)

• relies critically on availability of lump-sum transfers

2nd fundamental issue of aggregating preferences

needs to fulfill 3 conditions:

• dominance: if one choice is preferred by all voters, aggregation must be such that this choice is made by society

• transitivity: if A is preferred to B, and B pref to C, the aggre. must be such that A is pref to C

• independence of irrelevant alternatives: if A is pref to B, then intro of C in the choice set should not change the fact that A is pref to B

condorcet paradox

maj. voting does not lead to stable outcome

mediian voter theorem

w single-peaked preferences, maj. voting produces equilibrium

• in general, not pareto-effic.

• equil. outcome = the median indiv. pref. on spending for G

• diff btwn median and mean of MRS determines the degree of ineffic.

corruption as agency problem

lots of asymm. info + agency issues in poltic. process → moral hazard + corrupt

ownership

def. by residual right of control: who gains the benefit/bears the cost of actions taken outside scope of a contract

privatization vs state provision

priv. when quality can be contractually ensured, innovation + competition matter + gov is ineffic

pub: when quality is hard to monitor; competition is weak (ex: policing, health care)

mkts w asymm info

agents in mkt have private info regarding their own characteristics (adverse selection/hidden info: willingness to pay, cost, quality of product) and behavioral (moral hazards/hidden actions: secret price cut, effort)

info. rents

possessors of priv info can exploit this

Akerlof’s lemon model

always effic. to trade both types of goods, many buyers + sellers, the true quality known to sellers, not buyers

adverse selection

a mkt situtation where worse goods, products, or services get selected over superior ones due to asym. priv. info that prevents the mkt from distnguishign themselves

• ex: houses (buyer’s remorse), hiring (job condition known to employer, ability known to the employee)

moral hazard

a mkt situation where an agent chooses inefficient actions bc the mkt can’t observe the agent’s actions and reward the effic. choice (or punish ineffic)

• ex: reckless behav. ensured by emploers, risky invest by fund agents, embezzlement

• when consumers can’t observe quality, firms have no incentive to provide it and choose the cheape,r lower quality opt → ineffic, unless quality can be credibly signaled

risk adversion + insurance

insurance is valuable because of risk adversion from dimin. marg. util.

consumption smoothing

indiv. desire consumption smoothing → maintaining a stable level of consumpt. over time, even when their inc. fluctuates

single crossing condit.

low risk type’s IC is always steeper

separating equilibrium

two insurance contracts offered

pooling equilibrium

only one insurance contract is offered

social insurance (SI)

gov intervention to provide insurance against adverse events; citizens “buy” through taxes or mandatory contributions (typically not M-T); can compel indiv. to participate → ensures insurance for everybody at the actuarially fair rate for the whole pop.

• main types: unemploy. insurance, disability insurance, health insurance, SS

• manditory SI @ one price can create a pareto improvement

Probs. w SI

1) crowding out: a) may crowd out existing forms of private insurance b) the availability of priv insurance determines the extend of crowd out and hence the value of SI

2) moral hazard: a) another asymm. info prob b) adverse (and unobservable) actions taken by indiv. in resp. to insurance

3) classification errors type 1 (a truly eligible indiv. applies for benefits but is rejected) and type 2 (ineligible; accepted)

types of moral hazard

1) reduced precaution against entering the adverse state

2) increased propensity of claiming the adverse state

3) increased expenditures when in adverse state

4) supplier responses to insurance against adverse state

cost of moral hazard

creates adverse responses to SI → two kinds of externalities

• 1) insurance program becomes more expensive → higher premium/taxes for all insured indiv.

• 2) often an insurance claim (e.g. in UI and DI) is associated with lower labor supply → reduces tax rev. for other productive uses

^^ both create effic. cost

unemploy. insurance (UI)

provide cash benefits to workers suffering involuntary job losses. benefits are a functoon of pre-unemploy. earnings

moral hazard in UI

i) an effect on the incidence of unemploy

ii) an effect on the duration of unempoy.

*hard to estimate effect of UI since they are national so hard to define T or C groups

SS

smooths consumpt. + provides insurance against lost of earnings at older age (or disability)

• in many countries: large SI program, fast growing major fiscal imbalance

indiv. failures

indiv. may not save adequately for retirement on their own (info + self-control problems)

indiv failures: paternalism

gov imposes its preferences against indiv. → indiv. should oppose gov program

indiv failures: behavorial

indiv. understand that they have probs. + welcome gov intervention

redistr within generations

retirement programs can redistr. based on life-time earnings (instead of annual)

redistr across generations

retirement programs can redistr. across cohorts (so does gov. debt)

pub. pensions

indiv. pay SS contributions (payroll taxes) while working and receive retirement benefits when thhey stop workign till the end of their life (annuity)

fully funded pension

savings used to pay future benefits, contributions are invested in assets, returns are credited to the scheme’s fund

PAYG pension

contributions from today’s workers pay benefits for today’s retirees, contractian in nature, run by the state, allows for redistr. + insurance across generations, legacy debt

• rate of growth > interest rate: every generation could receive more than it contributes (Samuelson 1958)

legacy debt

first generation receives benefits without contributing

defined contribution scheme

accumulate contribu. + returns in account used to finance/calcuate pension depends on:

• how much you and your employer pay in

• investment performance

*retirees bear risk: real rates of return to assets, future earnings trajectories, future pricing of annuities

defined benefit schemes

pays a guaranteed income in retirement usually based on 1) final or avg salary 2) # of years worked

• wage hist. + length of service are used to calc. pension

• sponsor (= tax payers) bear risk of adverse outcomes

SS + labor

insurance may reduce labor supply (moral hazard)

imperfect info + healthcare

adverse selection: only sick ppl buy insurance

• heterogeneous + unobservable health risks

• fixed price of insurance; ppl w higher risk buy insurance

• prices must be high to cover insurer’s costs

• mkt offer less than full insurance