Lecture 7: Conceptual Foundations of Economic Analysis for Policy Flashcards
(29 cards)
Forces of Allocation driving the flow of money
- Markets: Require defined property rights and enforceable contracts
- States: Have power to define citizenship, markets, taxes,etc.
- Reciprocity: Non-monetary allocation b/w individuals (e.g. housework)
Assumption of Markets and Individuals/Households
- Individuals get utility from diff sources (U=f(u, u1, u2…, un)
- in econ, u1, u2, etc. are usually characterised as goods/services in exchangable markets.
- Assumption = individuals are utility maximisers and marginal utility decreases as quantity increaes
Individual Preferences on Indifference Curves
- Shape reflects diminshing marginal utility of consumption for each good;
- Slope is (changing) marginal rate of substitution (MRS) between goods
Indifferent Curves Combined = Edgeworth Box
Two indifference curves for different individuals.
- Contract curve = same slope at all points and Pareto optimal /efficient
- Both individuals will trade until they reach some point between the Edgeworth Box that’s on the Contract curve (though where they end up on the curve depends on bargainning power)
Exchange (Edgeworth Box) with Market Prices
- If prices introduced for both products (pCheese and pWine) then now a budget line is introduced for how much value of goods can be before and after trade. This breaks through the middle of the Edgeworth box.
- Thus they will negotiate until they get to the point on the Budget Line that meets the Contract Curve because then no one can be better off.
Budget Line in Edgeworth Box
- Straight line through the endowment point
- Slope = -P1/P2 (ratio of prices)
- Where the budget line touches the contract curve = competitive equilibrium (MRSa = MRSb = Price Ratio)
Goods & Bads Edgeworth Box
- With a bad introduced where you have to accept a bad as you accept the good, the curve of the indifference curve is positive and slanted to the right as it grows.
- Still with Edgeworth, the efficient condition is when the MRS is equal between traders and equal to slope of budget line (which is now positive instead of negative becaues garbage has negative price)
Key Efficiency Condition in Consumption (Edgeworth Box)
The Marginal Rate of Substitution (MRS) between all trades in the economy is the same for the traders and is equal to the slope of the budget line which is set by relative prices of two goods.
Production Possibilities Frontier
Defines how much of each good can be produced with given input L.
- Concave shape assumes that the most efficient inputs for each good get used first.
- Slope at any point of PPF = MRT (Marginal Rate of Transformation)
Marginal Rate of Transformation (MRT)
The slope at any point of the PPF curve
Placing the Contract Curve within the PPF
Different points on the Contract curve = Utility Possibility Curve (UPC)
Competitive Economy what is equilibrium b/w MRS and MRT
MRS = MRT = Price Ratio of 2 Goods
Conditions for a Competitive Economy
- Complete Property Rights
- Complete Information
- Atmospheric Participants (no market power by actors)
- No transaction costs
Market Failures due to the structure of the market
Increasing returns to scale
- Leads to natural monopolies
Barriers to entry
- Any obstacls hindering the entry of a firm even though it’s socially beneficial to enter
Network externalities (effect)
Mainly related to market regulation e.g. competition & markets authority
Market Failures due to Nature of Goods & Services
- Public goods
- Externalities
- Information failures including asymmetric information
When Markets Fail
- Property rights: externalities, public goods
- Market power: monopoly, oligopoly, anti-trust, regulation
- Innovation: e.g. of positive externality
- Infrastructure
- Information failure
- Long/term generational issues
Consumer Surplus
The extent to which WTP exceeds the market price –> area between price and demand curve
Producer Surplus
Extent to which market price exceeds supply costs –> area between price and supply curves
What happens to CS or PS in a departure from equilibrium
Becomes deadweight loss
- The magnitude of loss is influenced by the slope of the curve – related elasticity
Cost-Benefit Analysis
- A competitive market will maximise total benefit but could be sociall beneficial for the gov’t to intervene with policy; just need to make the benefit > loss of policy
- Could be through regulation of quantity or a tax to reduce quantity to set level, but government doesn’t usually know supply/demand curves to set it.
- So to do a CBA with benefit > loss of policy, need to start w a discount rate
Discount Rates
- Normally positive because we value oney more today than in the future because (1) people will be richer in the future (2) interest rate (3) impatience
- Represented by ‘r’
- Really influences CBA (Treasury Green says 3% while Stern Review argued that discount rate should be closer to 1%).
Discount factor formula
Bt = 1 / (1+r)^t
Where Bt = discunt factor; r = discount rate
Elasticity
The proportionate change in one variable given a proportionate change in another (n)
- How much does demand grow as price drops for example. Water and electricty are less elastic while luxury goods are highly.
Elasticity Meanings if =1, >1, <1
= 1: if price increases 20% then demand decreases by 20%
> 1: Elastic
<1: Inelastic
