Equity efficiency tradeoff
By making things more equitable, you’ll make them less efficient
What’s lost as we transfer wealth/resources to be more equitable
Perfect competition is ______ efficient compared to a perfectly price-discriminating monopolist.
Perfect competition and a perfectly price-discriminating monopolist are equally efficient. Under both regimes, all beneficial trades occur and total surplus is maximized. With perfect competition, the gains are split between consumers and producers. With a perfectly price-discriminating monopolist, the monopolist reaps all the gains, so the equity effects of the two regimes are quite different.
In Arthur Okun’s leaky bucket, leakages are…
In Okun’s leaky bucket, the rich put money in a bucket to give to the poor, but there are leakages along the way. These leakages mean that the poor receive less than the rich put in. The amount less that the poor receive will be lost to the economy, so these leakages result in efficiency losses for the economy.
Social welfare functions
Some function that takes everyone’s utility and aggregates it into a number
Combination of resource allocations that leave society indifferent
Maximization of social welfare function
Everyone is weighted the same in the social welfare function; simply add up everyone’s utility
Indifferent to everyone; theoretically would want massive income redistribution, taking $1 from rich person would dramatically improve poor person’s utility (vs. loss in rich person’s utility)
Not relating to wealth - because diminishing marginal utility concept; we don’t want everyone’s wealth to be the same necessarily - just their utility
The utilitarian social welfare function is the sum of all individual utilities by definition. In this equation, every person is given equal weight. This does not mean that utilitarians are indifferent about who holds the money, because the diminishing marginal utility of money means that money will increase poor persons’ utility more than rich persons’. Additionally, utilitarians would not necessarily seek to maximize the size of the economy if redistributing to poor people caused the economy to shrink but overall utility to grow.
Rawlsian social welfare function
= min (u1, u2, ….)
Making sure the worst off person has the highest utility possible
Rawls believed that society should maximize the utility of the worst off person. He used the veil of ignorance to argue that if we did not know where we would end up in society, then we would agree that maximizing the utility for the worst off person would be the best course of action. (This is a simplification of Rawls’s views).
Equality of opportunity
Make sure everybody starts equally and then let the market go
Weakness - we are not born equally; people end up richer more due to luck vs. skill
Nozick says that a society only needs to ensure equality of opportunity and then, people should be allowed to become rich or poor based off their skills and choices. One weakness of this approach is that people can suffer from bad luck even if they have equality of opportunity. Another weakness is that it is nearly impossible to create true equality of opportunity.
Commodity egalitarianism states that society should ensure that everyone attains some minimum standard of living. This usually means that society ensures the basic necessities for the poor, but does not care if there is a huge gap between the standard of living of the rich and the standard of living of the poor. Commodity egalitarianism does not address the relative weighting of Americans and foreigners.
From 1967 to 2013, the distribution of income in the United States seems to have ______.
In 1967, the bottom quintile controlled 4% of resources while the top quintile controlled 43.8% of resources. In 2013, the bottom quintile controlled 3% of resources and the top quintile controlled 51% of resources. This suggests that inequality increased over this time period.
Compared to other countries in the OECD (Organization for Economic Co-operation and Development), the United States has ______.
The United States is more unequal than every OECD countries besides Mexico. The share going to the bottom 10% in the United States is about half of the average across OECD countries and the share going to the top 10% is about 20-25% higher in the United States than in other OECD countries.
The poverty line is a measure of…
The poverty line is a measure of the minimum resources needed to live in America (or any other given context). The poverty line does not compare the wealth of the poor to others, so it is a measure of absolute deprivation rather than a measure of relative deprivation or inequality. It does not measure overall wealth of a country.
How have poverty rates in the United States changed since 1970?
As shown in Figure 22-7, the poverty rates have stayed fairly constant since 1970 (perhaps with a slight rise). On the other hand, inequality in the United States has increased significantly.
What are sources of leakages when redistributing?
Behavioral responses are a source of leakages, because taxes on the rich may discourage the rich from working and giving benefits to people for looking poor may discourage people from working. Both of these mechanisms shrink the size of the economy. Administrative costs are the costs of paying people to institute the redistribution program. For example, paying tax collectors to get taxes from the rich and paying welfare workers to give benefits to the poor.
When the government offers cash transfers to individuals below a certain income, how do the substation and income effect change how hard someone works?
The income effect encourages them to work less, because they are richer and need the money less. The substitution effect also encourages them to work less, because working will lower the amount of cash transfers they receive. This implicit taxation of labor makes leisure less costly, so individuals will take more leisure.
In the lecture example, how does the redistribution program affect the labor market?
The redistribution discourages people from working, because it taxes people for having high incomes and gives benefits to people for having low incomes. This will reduce the number of hours of labor supplied, which shifts the labor supply curve inward and creates deadweight loss.
What does it mean for an income tax to be progressive?
A progressive income tax charges people with more income a higher tax rate. A tax system where everyone pays the same tax rate would result in the rich paying more in total, but this would not be a progressive tax system.
What type of tax is the United States’ payroll tax?
The payroll tax is a flat tax on one’s labor income. A flat tax means that everyone pays the same tax rate. In a progressive tax, the rich pay a higher rate. In a regressive tax, the poor pay a higher rate. A steep tax is not an economics term.
What is an excise tax?
An excise tax is a consumption tax on a specific good (for example, a tax on cigarettes). A tax on income is an income tax, a tax on general consumption is a consumption tax or a VAT (value-added tax) and a tax on wealth is a wealth tax.
According to economists, what is a benefit of taxing consumption instead of income?
With their income, individuals have to choose between saving it and consuming it. Taxing consumption only increases the implicit price of consumption, which will encourage more savings if the substitution effect dominates (which economists usually assume it does). Economists see promoting savings as a benefit, because promoting savings lowers the interest rate, increases investment and thus, increases economic growth.
According to economists, what is a drawback of taxing consumption instead of income?
Since the rich save more as proportion of their income than the poor, a consumption tax will likely be regressive (the poor will be taxed at a higher rate relative to their income). Therefore, moving from an income to a consumption tax could make a society more inequitable, which many people view as undesirable.
A negative externality exists when…
A negative externality is when the marginal social cost exceeds the marginal private cost. Intuitively, this means that your consumption of a good imposes costs on other people. Professor Gruber gives the examples of cigarettes causing fires, gasoline causing global warming and fatty and sugary foods causing higher public medical costs.
The presence of negative externalities may lead to…
With a negative externality, the consumers will consume until marginal private cost equals marginal benefit. Since marginal private cost is lower than the marginal social cost, consumers will consume beyond the point where the marginal benefit equals the marginal social cost. From society’s perspective, consumption beyond where marginal benefit equals marginal social cost is overconsumption that shrinks the economic pie and thus, creates deadweight loss.
What is corrective taxation?
Corrective taxations is meant to align private costs with social costs. Essentially, corrective taxation forces the individual consumer to account for negative externalities by imposing a tax equal to the negative externality created by consuming the good. Taxing the rich at higher rates is progressive taxation. Taxing the poor at higher rates is regressive taxation. C. is incorrect, because corrective taxation is based on increasing efficiency rather than punishing people.
Why might it make sense to ban a drug?
If consumers make systematic mistakes in their consumption decisions, it might make sense to ban a drug to protect consumers from making these decisions. Professor Gruber gives the example of high school kids who start smoking without realizing how hard it will be to stop. Large externalities do not justify a ban, because we could just tax the drug up to their externality. Crime and lower productivity are just examples of possible externalities from drugs.
What does the peak of the Laffer Curve represent?
The Laffer Curve has the tax rate on the x-axis and the tax revenue on the y-axis. Therefore, the highest point will be the highest value on the y-axis, which will be the point at which the government raises the most revenue.
The [categorical] characteristic used to target a categorical transfer should be ______ if you are concerned about efficiency and equity.
The characteristic should be correlated with need, so that the transfer helps make the society more equitable. The characteristic should be costly to change, because then less needy individuals will not try to fake the characteristic and the policy will not induce unintended behavioral changes. A categorical transfer is based on characteristics other than income by definition.
Which of the following might be effective characteristics to target with a categorical transfer?
In lecture, Professor Gruber discussed the evidence that single motherhood is correlated with poverty and unlikely to be faked. Being born with a disability would also reduce one’s earning potential (correlated with poverty) and cannot be changed. Blue eyes is costly to fake, but also not likely to be correlated with poverty. Wearing a torn t-shirt is likely to be slightly correlated with poverty (richer people might wear newer button-down shirts), but it is not costly to change.
Examples of in-kind benefits
In-kind benefits are welfare benefits given in goods rather than cash. Food stamps gives food, Medicaid gives health insurance and public housing gives housing. These are all goods. On the other hand, TANF simply transfers cash, so it is not an in-kind benefit.
Which of the following is true about an in-kind benefit relative to a cash transfer of an equivalent market value?
Recipients generally value in-kind benefits less. An equivalent cash transfer can be used on anything while the in-kind benefit can only be used for the specified good, so the cash transfer will be more valuable. However, making in-kind benefits less valuable creates less behavioral distortions. It lessens the incentive for individuals who can work to stop working in order to get the benefit, because now the benefit is far less attractive. This means that there will be less people who decrease their hours of labor.
What is the EITC (Earned Income Tax Credit)?
The EITC is a conditional wage subsidy. The EITC only goes to those earning a wage. For low-wage earners, the EITC increases as one earns more money before being phased out. This structure is meant to encourage people to enter the labor force.
What were the effects of the EITC?
Empirically, the EITC appears to have increased the labor supply from single mothers by around 20%. The EITC also decreases inequality by transferring money from the relatively rich (those who pay the majority of taxes) to the relatively poor (low-wage earners).
Behavioral economics incorporates insights from psychology into economic models. As Professor Gruber notes, incorporating psychology recognizes the limits of purely economic models, but does not mean that traditional economic models or concepts (like diminishing marginal utility or budget constraints) are wrong or useless.
Which of the following are true about self-control problems?
Self-control problems arise when there are short-term costs and long-term benefits, because people will want to reap the long-term benefits, but will not have the self-control in the moment to withstand the short-term costs.
In the snack experiment, what happened when participants were allowed to change their choice right before they received the snack?
As Professor Gruber said in lecture, more than half of those who chose the healthy snack switched to the unhealthy snack. Once the individuals had to face the short-term cost of eating healthily, they could not control themselves and switched to the unhealthy snack even though they knew it was worse for them in the long-run.
activities where might one face a self-control problem?
Dieting means taking the short-term costs of eating less tasty food in order to be healthy in the long-run. Exercising means taking the short-term costs of a strenuous activity and not doing more fun activities in order to be healthy in the long-run. Stopping smoking means taking the short-run cost of withdrawal symptoms in order to be healthier in the long-run. Saving money means taking the short-term cost of less consumption in order to be able to spend more in the long-run.
Time consistent and time inconsistent equations
U=∑Ti=tδiCi (“exponential discounting”) is a time consistent model, because every additional year is discounted exponentially at the same rate δ .
U=Ct+β∑Ti=t+1δiCi (“quasi-hyperbolic discounting”) is a time-inconsistent model because moving from the present to the future causes consumption to be discounted by an additional β , but moving from one year in the future to two years in the future will not be discounted by this β
Naturally impatient; would rather have something today vs. tomorrow
The government should set the income tax rate, τ …
The revenue maximizing tax rate ( τ∗ ) is not necessarily the optimal tax rate from the perspective of maximizing social welfare. The government certainly should not set τ on the “wrong side” of the peak of the Laffer curve, because it is self-defeating: it causes additional deadweight loss relative to the peak of the Laffer curve, but yields less tax revenue. The optimal tax rate is somewhere between 0 and τ∗ , and the government should trade off between the deadweight loss from taxation and the equity benefits of redistribution, according to the social welfare function it is using.