Econ 435 - Exam 1
A distribution of income point B is said to be Pareto Superior to point alpha if:
1. No person is worse off at B than at 2. At least one person is better off at B than at alpha
RQ 1 #9: What does it mean for production to be Pareto Optimal (efficient).
A distribution of income is said to be Pareto Optimal if it is impossible to make one person better off without making another person worse off Requires: (-) slope UI = (-) slope UII à MRSI = MRSII Production is said to be Pareto Optimal if an increase in the production of one good requires a decrease in the production of another good i.e. impossible to produce more of one good without producing less of another
1. Public Good
A good that is both non-rival and non-exclusive in consumption.
Maybe RQ 1 #4:
An edgeworth box is a diagram of the endowment constraints in the given market and any point in the box is an example of a combination of a possible allocation of goods in that market.
RQ 1 #17: What is market failure? What are some potential causes of such a failure?
Any situation in which a market equilibrium does not produce PO production and distribution that cannot be dominated. (unless all is perfect, it's a failure) Causes: 1) Public Goods 2) Externalities 3)Taxes/Subsidies/Regulations 4) Price Discrimination 5) Imperfect Competition
5. What is the free rider problem?
Avoiding making voluntary contributions towards the provision of a public good.
Marginal Rate of Substitution (MRS) *
Change in consumption of one good per change in consumption of another good that will make a given individual indifferent. MRS = ∆X / ∆Y -> Utility held constant MRS = (-) slope of the IC "Diminishing MRS" implies that goods are more highly valued when they are scarce
9. Coase Theorem
Coase Theorem = If sources of externalities are identified, if property rights are assigned, and if transaction costs are low, then, private bargaining can lead to the social optimum independent of the assignment of property rights. Assumptions: 1) polluters are known/identified 2) environmental rights are established 3) easy to get together to negotiate
RQ 1 #9: What is contract curve? Show and explain how such a curve can be derived. What condition holds along such a contract curve?
Contract Curve = locus of all Pareto Optimal distribution points Along this contract curve, both parties are at least as well off as under their endowment.
RQ 1 #20: What is credible preference misrepresentation? What is demand revelation?
Credible Preference Misrepresentation = Acting as if your true preferences are something other than what they really are. Demand Revelation = Acting in accord with one's true preferences.
1. What is externality?
Externality - A situation in which the behavior of certain economic agents affects other individuals who are not a part of the transaction in a manner that is not captured by the market process. Externalities can be positive and negative. Also, they may be due to consumption and/or production. Negative Externalities: Pollution: air, water, ground, sound.
6. Explain the difference in the distributional effects of #5 .a and #5 .b above
For taxation, a Marginal Tax Rule T could be implemented. Setting T = MEDx would give (MPCx + T) MSCx - MBx à Xs
RQ 1 #22: Show and explain how and why an individual whose behavior can affect market prices can gain by appropriately misrepresenting their preferences. What can happen to Pareto efficiency in such a case? How so?
If a person can affect market prices, they might pretend that the object is not as important to them as it truly might be to get the seller to lower their price. By lowering their price, this will cause the person's budget line to expand and create a new optimum on this falsely generated BL and thus creating a new false optimum which will put them on a false IC which creates a higher utility than they had before. Efficiency Problems: If person 1 acts truthfully but person 2 acts falsely and both get the same deal then: MRS1 = Px/Py, but MRS2 does not equal the false MRS2, so > MRS1 does not equal MRS2 > distribution is not PO > MARKET FAILURE
6. Explain free ridding may prevent the voluntary provision of a public good in spite of the fact that such a provision could benefit all individuals
If building a dam in community of 100 households costs $60,000 or $600/household and provides $1000 benefits/household, then if each household helps pay, everyone will be better off. If a few free ride, then others will have to carry their burden but the dam could still be built, but if a large number of people chose to free ride, the dam wouldn't be built.
7. In the voluntary provision of a public good, how can the size of the group affect the severity of free riding behavior? Explain.
In general, the possibility of free riding tends to increase as the number of participants increase. If only two people involved, they might not want to free ride in order not to look bad since everyone will know who didn't help. In large groups, it is sometimes harder to tell who is free riding and who isn't which increases the incentive to free ride.
2. Show and explain fully how and why private actions in the presence of a negative externality tend to result in the overproduction of the good causing the externality. Explain the economic "intuition" for this result.
In the presence of a negative externality, Marginal Social Costs (MSC) are different than Marginal Private Costs (MPC) by the amount of the Marginal External Damages (MED) caused by producing the good. > MPC = MB = Xp = private optimum > MSC = MB = Xs = social optimum > since Xp does not equal Xs (Xp>Xs), there is a market failure Xp > Xs which causes firms to overproduce. Intuition: Private firms only take their private costs and benefits into account when making decisions. Since the private costs are lower than the social costs, they find it profitable to produce more than what is socially acceptable.
15. Show and explain fully how and why private actions in the presence of a positive externality trend to result in the underproduction of the good causing the externality. Explain the economic "intuition" for this result.
In the presence of a positive externality, MPCx = MSCx = MCx. Here we have a private optimum at Marginal Private Benefits (MPBx) = MCx -> Xp. But with positive externalities come Marginal External Benefits (MEBx). MPBx + MEBx = Marginal Social Benefits (MSBx). The social optimum exists when MSBx = MCx -> Xs -> Xp < Xs so firms under produce Intuition: Private parties only take into account their own private benefits and are only concerned with their own self-interests. Here, private costs are less than social costs so they under produce, even if it is socially acceptable to produce more.
Inferior Goods
Increases in income causes decreases in the quantity demanded. All goods cannot be inferior, but at least one good must be normal.
Normal Goods
Increases in income causes increase in the quantity demanded.
Rational Choice Hypothesis
Individuals behave as if they maximize their utility subject to relative constraints. Climb onto highest possible indifference curve while on the BL. At consumer's optimum: (-) slope of IC = (-) slope of BL à MRS = Px/Py Intuition: If the amount of good y that the consumer is "willing" to give up to attain one more unit of x so as to remain equally happy, is greater than the amount of y that the consumer "must" give up to obtain one extra unit of x, then the consumer can move up to a new utility curve until the slope of the BL is equal to the slope of the indifference curve
Budget Line
Locus of (x,y) combinations that satisfy Px * X + Py * Y = M (income) Slope of the budget line is determined by the Price of X (Px) over the Price of Y (Py) --> Px/Py Factors causing the B.L. to shift 1) ∆M - More income will increase amount consumer is able to spend on goods 2) ∆Px - Increase will cause BL to shrink while decrease will cause BL to grow 3) ∆Py - See #2
Indifference Curve (IC)
Locus of various commodity bundles that yield to a given individual a fixed level of satisfaction (or utility) IC's requires the person's tastes, preferences, likes and dislikes for the items in the commodity bundle to figure out the slope of their indifference curves. IC curves cannot intersect because this would imply that a single combination of two goods would render two different levels of satisfaction, which is impossible
RQ 1 #18: Show and explain fully how and why monopoly can lead to market failure.
Monopolies (firm x) max profit when marginal revenue MRx = MCx marginal cost. > Px > MRx > Px > MCx Perfectly competitive firms (firm y) max profit when Py = MCy >So Px>MCx and Py=MCy > Px/Py > MCx/MCy = MRT Consumers max U when MRS1 = MRS2 = Px/Py > MRS1 = MRS2 = Px/Py > MRT This causes a MARKET FAILURE
4. "It is beyond all understanding how in a competitive market economy there can be any possible conflict between desirable private versus desirable social outcomes"
Not all private firms are concerned with pollution. For almost all, if not all firms, it is in their best interest to watch the bottom line...PROFIT. If it is in their better interest to ignore the negative effects of their decisions in order to provide the best possible private outcome, they will tend to do so.
Public Finance / Public Sector Economics
Study of how government expenditures, taxation, and regulation affects an economy's allocation of resources and distribution of income.
16. In the presence of a positive externality show and explain how a subsidy could be used to achieve the socially efficient output level.
Subsidies: Government could pay a per unit subsidy of side S for each unit increase of X starting at Xp. At X*, firms operating profit falls by Q and subsidy received increases by S. Eventually MPBx = MSBx = MCx and the social optimum Xs will be reached. Firms will gain by increasing output until X = Xs.
4. Provide an example of how an appropriate technological innovation can transform a certain non-excludable good into an excludable good.
Technology can turn some non-exclusive goods, into exclusive goods. Examples: Cable Television and Toll Booths on Bridges and Highways
3. "No positive level of pollution is ever socially acceptable."
The fact is that pollution exists everywhere. Mother Earth produces more pollution than any business ever will. Pollution is something that will exist and whether people like it or not, there is nothing that can be done to completely get rid of it. All that can be done is to monitor and control firms to take into account the effects of pollution when making their decisions.
2. Show and explain how two individuals who both value ("like") parks and libraries can disagree on the combination of parks and libraries that should be built. *
They can both "like" parks and libraries, but one can like them more than the other which would make them want different combinations of the two.
RQ 1 #16: What is the Fundamental Theorem of Welfare? Prove this theorem. What is the economic "intuition" for such a result?
Under the 'usual assumptions', a perfectly competitive equilibrium will produce Pareto Optimal production and distribution which cannot be dominated.
10. What argument is often used to try to justify government involvement in the provision of public goods? Why might it be difficult for the government to determine the actual socially optimal output level and pricing of the public good?
When free riding leads to a market failure, some individuals argue that this creates a role for the governments.
3. Non-Excludable Good
a good is non-excludable if it is impossible (or prohibitively costly) to define the benefits of the good once it is provided to selected individuals. Examples: Many goods that are non-rival are also non-exclusive
2. Non-Rival Good
a good is non-rival if the consumption of that good by one person, does not diminish the ability of others to consume that very same good. Examples: 1. Light House 2. National Defense 3. Broadcast Signals 4. Internet 5. Highways 6.Performances/Lectures Rival = Opposite of non-rival good (examples: clothes, food, electronics, etc.)
5. In the presence of a negative externality show and explain how each of the following alternative actions can, if the government has all the required information, lead to the production of the socially efficient output : a. Taxation b. Subsidies (to reduce production/ pollution) c. Regulation (pollution standards / limits)
a. Taxation: If firms are taxed, this tax is added to their MPC until the MPC is shifted to the left enough to equal the point at which MSC = MB so as to reach a socially optimal outcome. b. Subsidies: Government could pay a per unit subsidy of side S for each unit reduction of X starting at Xp. At X*, firms operating profit falls by Q and subsidy received increases by S. Eventually MPC = MSC = MB and the social optimum Xs will be reached. Firms will gain by reducing output until X = Xs. c. Regulation: If the government sets up a maximum allowable pollution amount, then a social optimum could be reached. By limiting pollution, the government can limit the amount of output a firm can produce.
Production Possibilities Curve
locus of all Pareto Optimal production points. Changes in the Endowments of Capital and/or Labor would cause shifts in the PPC
RQ 1 #10: What is a production contract curve? Show and explain how to derive such a curve. What conditions holds along such a curve?
locus of all Pareto Optimal resource allocations. In an Edgeworth Box, you connect all of the PO points on a line from origin one to origin two. Along the curve: MRTSI = MRTSII
Isoquant
locus of various input combinations that will produce the same level of output, given the state of technology.
RQ 1 #21: Show and explain how and why an individual who cannot affect market prices should always behave "truthfully"
"An individual who cannot affect market prices should always behave 'truthfully'." This is true, because if a person cannot affect the price, they should act at their true optimum on the true indifference curve. My misrepresenting their preferences they can only move along the budget line which will put them lower than their true indifference curve and their utility will decrease.
Marginal Rate of Technical Substitution (MRTS)
(-) change in the use of one input per change in the use of another that will maintain a fixed level of output à MRTS = (-) slope of Isoquant