394 Midterm Review

Class one – Key Economic Concept

Vocabulary to Memorize:
 Rationality – Selfishly maximizing my own anticipated utility
 Surplus – The difference between the utility of having the good and the utility of the transaction
price
 (Social) Welfare – The sum of everyone’s utility
 Free Market – Transactions are voluntary
 Pareto-efficiency – no one can be better off without making other worse off
o Pareto-efficiency won’t occur when there are the followings:
 Imperfect competition
 Information problems
 Externality
 Public good
o It doesn’t happen in reality, it happens under perfect competition
 Incentives – lining an agent’s utility to some action or outcome
 Opportunity cost – the utility an agent gets by doing (the best) something else with their
time/effort
o The opportunity cost of X is the amount of Y give up to get X, where Y is the best
alternative of X
o Exclude sunk costs
o Include costs for which there is no observed outlay
 Willingness-to-pay – the total utility an agent gets from a good, expressed in dollars
 Transfer seeking – any activity that tries to increase one’s share of wealth without creating new
wealth
 Marginalism – The marginal effect of any activity is the effect of doing the activity just a little bit
more
o The amount spent on the policy should be such that the benefit from the last dollar
spent should be equal to the cost of raising that dollar spent should be equal to the cost
of raising that dollar
o Resources should be divided so marginal benefits are equal
 Paradox of Value
o Water is vital necessity of life. Diamonds are luxuries that no one really “needs”
o Hence we can agree that water is more valuable (important) than diamonds
o Prices are determined on the margin (according to how much marginal
utility they provide)
 Unintended consequences
o The Peltzman effect arises when people adjust their behavior based on the regulation in
a way that counteract the intended effect of the regulation
o Ex. Cobra (snake), Parents late to pick kids up
Class two – Efficiency
 Perfect competition
o prices are set by the market (no one has the power to “set price”)
o entry of new firms drive profit to zero
o buyers and sellers have all relevant information
 Efficiency – 2 kinds
o The general meaning of efficiency is “getting the most out of what you put in”
o Allocation = pareto efficiency (most common and have more emphasis)
 The appropriate amount of each good being produced
o Market = Management efficiency or production efficiency
 A given level of output being produced at lowest input usage (therefore lowest
cost)
 Less emphasis due to the assumption of market competition would be enough
to ensure：
 Company will minimize cost
 The ones that don’t manage efficiently go out of business
 However, management inefficiency does occur, referred as X-inefficiency
 X-inefficiency
o Leibenstein – a Harvard economist
o Reasons that might create x-inefficiency
 Lack of competition
 Subsidy
 Pareto (Allocational) Efficiency
o When it is impossible to make someone better off without making someone else worse
off
o Textbook definition: it is impossible to re-allocate resources among a group of people in
such a way as to make at least one person better off without making anybody worse off
o Pareto efficient situation = no DWL
o Pareto improvement: at least one person is better off, and no one is worse off
o Potential Pareto-improvement: a re-allocation of resources allows those individuals who
are net gainers to fully compensate for the net losers, and still be better off
 Second welfare theorem
o Social welfare can be maximized through redistribution of endowments
 Game Theory
o Game: consists of players
o Strategy: A complete contingent plan
o Outcome
o Nash equilibrium: Each player chooses the action that maximizes his utility, taking the
other players action as given, strategies are in equilibrium when every strategy is a best
response to every other strategy
 Prisoner’s Dilemma
 o The welfare maximizing solution can’t be reach due to participants (selfish) incentives
o Examples:
 Prisoners confess and cooperate
 Competition companies – such as Pepsi and coco-cola (better off if they
cooperate)
o Solutions:
 Implement punishment
 Enforce rules
 Signaling
 Market Failure
o 4 Reasons that cause market to fail to achieve Pareto Efficiency (Brander):
1. Imperfect competition
 When sellers and/or buyers exert some control over prices
 Entry and/or exit is blocked
 Have some market power
 Types of imperfect competition
o Monopoly – markets with a single seller
o Cartels – a type of oligopoly but they cooperate to gain greater
profit by collude on price
o Oligopoly – a small number of sellers compete, recognizing they
are large enough to affect the price
o Monopolistic competition – a large number of sellers of
differentiated varieties of the same product. Entry/exit costs are
low. Each firm has a mini-monopoly on its style, flavor or brand.
Ex. restaurant
o Monopsony – markets where there is a single buyer, exist when
the company is large enough to affect the entire market thus,
controlling the supplier as well. Ex. Walmart
2. Public goods
 2 characteristics:
o Non-rival (everyone can benefits from it) – the benefits
obtained by one “consumer” are not subtracted from benefits
available to others
o Non-excludable (accessible to everyone) – it is prohibitively
costly to selectively prevent people from using it
3. Externalities
 Activity by-products that generate “non-priced” costs or benefits
affecting 3rd parties
o 3rd parties = anyone that’s not buyers or sellers
 Pecuniary externalities (included in price) are those where the
externality is incorporated into the price
  Positive externalities:
o Education
o Insurance
o Vaccine
 Negative externalities:
o Pollution cigarettes/smoking
o Construction
o Traffic
4. Informational market failure = imperfect Information
 One side of the transaction has more info than the other
 Exchange is guaranteed to be mutually beneficial only if both parties are
rational and well-informed
o Adverse Selection
 Occurs when the seller doesn’t know the buyer’s type, and is unable to correctly
screen the types so that it is much more likely to select the bad types:
 Arises from asymmetric information
 Take place before a ‘contract’ has been made
 Moral hazard
o Occurs when an agent’s behavior changes because they don’t bear all the costs of their
actions. In many cases agents take more risk than they would do otherwise
 Drivers taking less care when driving cause increased safety of motor vehicles
 People taking more risks when they are insured
o Adverse selection is a type of moral hazard
Class three – Fairness (2 types)
 Distributive fairness:
o the final allocation of benefits (or goods) across individuals (or groups) is just (or morally
acceptable)  in general is more resources are distributed fairly
 complete ‘equality of outcomes’ (equal shares) not desired
 incentive costs
 Procedural fairness:
o The “rules of the game” are just (morally defensible) – regardless of the final allocation
that results  in general fairness in opportunity and taking action, so no one is forced
 Non-coercion: no individual forced to take an action he or she does not want to
take
 ‘Equality of opportunity’ required
 Fairness vs. efficiency trade-offs
o Policies that promote distributional fairness generally come at a cost of reduced
efficiency (DWL)
 People who make different level of effort still get same payoffs, so less reason to
exert effort and or to do less desirable activities
 If prices moved away from competitive equilibrium to benefit buyers (price
ceilings, such as rent control) or sellers (price floors, e.g. farmers) there will be
DWL
 Joseph Stiglitz – The price inequality
o Significant cause of inequality is through “rent seeking” by the wealthy
o It’s unfair but also hurts productivity by suppressing aggregate demand
 Thomas Piketty – Capital in the 21st century
o Clear evidence of high levels of inequality
o Two policies:
 Direct redistribution (increasing wages)
 Fiscal redistribution (tax on capital) – more prefer cause increase in wage means
increase in cost of labor thus increase unemployment
o Different initial allocations of capital are unfair, however taxing capital has problems:
 Capital is internationally mobile and tax competition makes capital highly elastic
 Solution – progressive global tax on wealth
o Summary: fiscal (tax on capital -> preferred) & direct (increase wages) distribution,
however it has problem is tax on capital, as capital is internationally mobile and tax
competition makes capital highly elastic, the solution would be progressive global tax on
wealth
 John Rawls - “veil of ignorance”
o To decide on what is fair you must put yourself int the “original position” behind a “veil
of ignorance”
 Which is forgot all common factors
o Maximin principle – preference for the welfare of the least advantaged
 Individual Sovereignty
o A philosophical construct that is widely embraced in the Western world. It is key to the
notion of private enterprise
o Includes:
 Economic freedom – the freedom to enter into voluntary economic agreements
 Consumer sovereignty (authority) – the right to one’s own tastes and
preferences  implies the ultimate determiner of what will be made and sold
and consumed is the consumer
 Paternalism
o Placing limits on a person’s liberty or autonomy for their own good
o May placed against person’s will
o Examples:
 Restrictions on narcotics (drugs)
 Safety requirement – seat belt etc.
 Restrictions on the activity of minors
Class four – Moral Philosophy
 The Four “isms”:
o Relativism – There is no absolute right or wrong but we can say acts are morally
acceptable as long as they conform
 Moral standards differ across cultures
 Leads to conventionalism (it is right to do whatever immediate social
environment dictates)
o Consequentialism – Acts are good if they have a good consequence
 Problems to consider – surgery example, kill someone to save another person
o Egoism – Acts are good if they benefit me
 Ethical egoism: moral agents should do what is in their self-interest
 Smith – When we each pursue our own self-interest, we are collectively
better off. When we try to help others it is unsatisfactory because we
invasively impose our own preferences, charity is degrading and
debilitating
 Rand – Egoism recognizes the supreme value of each individual life.
 Psychological egoism: self-interest is what motivates people in fact
 In prisoner’s dilemma situations, egoism makes both parties worse off than they
might be under cooperation
o Utilitarianism – Acts are good if they can be expected to raise the sum of all human
welfare  generally speaking the acts with the greatest impact
 Founder – Jeremy Benthem
 Act utilitarianism – an action is good if it expected to raise the sum of all human
happiness
 Rule utilitarianism – the moral correctness of an action depends on the
correctness of the rules that allows it to achieve the greatest good  generally
speaking, obey rules, that if followed by others, would maximize human
happiness
 Examples – why the doctor shouldn’t slice up the traveller  lower
social welfare
 The Three Rules:
o Golden Rule – Do unto others as you would have other do unto you (the others would
like to be treated the way you would like to be treated)
o Kant’s 1st Rule – Act according to principles that are universalizable
o Kant’s 2nd Rule – Do not treat people purely as a means
 Moral Rules (2 concepts) – to established a rule must satisfy the following two
o Universality – I want everyone to follow that rule
o Reversibility – The rule should apply to me