W1 - Solving the Social Choice Problem & Efficiency, Markets and Market Failure

Question 1

Define exchange/allocative and production efficiency

Answer 1

1) Goods/services are distributed to the people that value them the most - divides the existing pie in the best way or two individuals have the same MRS

2) Producing the most output possible with resources/tech available - making the pie as big as possible or on PPF curve

Question 2

Define Pareto efficiency

Answer 2

Impossible to make someone better off without making at least one person worse off

Must be both exchange and production efficient

Question 3

Define the first and second welfare theorems

Answer 3

1) Market equilibrium is Pareto efficient when competitive
2) If a specific Pareto optimum wants to be achieved (maybe as its equitable for society), distribute endowments appropriately, then let competitive market operate

Question 4

Use an Edgeworth box to explain how free exchange leads to a Pareto efficient distribution of goods (exchange/allocative efficiency)

Answer 4

okay

Question 5

Use a PPF curve to show where profits are maximised, explain what the gradient of the PPF means. What are the 3 requirements of production efficiency?

Answer 5

1) On the PPF
2) Firms must be profit maximisers (Where MRT = negative price ratio)
3) All firms MRT’s must be equal i.e.. competitive market

Question 6

For a price mechanism to efficiently direct the allocation of resources between competing uses and users, what 2 characteristics must resources have?

Answer 6

1) Excludable - can preclude someone else from using it
2) Rival - your consumption of a good reduces the amount available left for others to use

Question 7

Draw the graph of the optimal provision of public goods and compare it to how it normal (rival) goods are produced

Answer 7

Public - vertical summation of demand curves
Rival - horizontal summation
Vertical gives a higher level of output

Question 8

What implications does the characteristics of public good imply for its provision? What is a possible solution to the issue?

Answer 8

Non excludability - free riding behaviour so infeasible to charge people for the good
Non rival - MC of public good is 0, so optimal price is 0
These imply private market has no price incentive to provide the optimal level of public goods (Pareto efficient). I.e.. lack of appropriate price signals, so under provision of public goods.

Role of government - intervene so optimal level of goods/bads provided. How much should we tax each person to provide optimal amount?

Lindahl pricing, charge each person their MWTP for the level of Q*, however demand revelation (incentive to hide true MWTP) prohibits this. So average WTP not marginal is used.

Question 9

Define externality, is the concept useful?

Answer 9

Cost or benefit imposed on a 3rd party.

Concept can be redundant as you can frame externality as a public good/bad which highlights the market failures.

Question 10

Draw the graph of a modest and severe externalities effect on the PPF

Answer 10

Okay

Question 11

What are the 4 mechanisms of social choice to choose between different allocations two goods?

Answer 11

1) Voting
2) Pareto Criterion
3) 2) + compensation
4) Social Welfare Functions

Question 12

Explain voting and its limitations

Answer 12

Used for binary choices. Usually >50% needed, but higher threshold for important thing like free speech

Limitations:
- Tyranny of the majority
- Hard to express intensity of preference. eg majority say A is okay but minority HATE B
- When choice is not binary, multiple single step ways of choosing which can lead to Condorcet paradox ( A > B, B > C but C > A) meaning no single option is preferred.

Question 13

Explain Social Welfare Function and its limitations

Answer 13

Provides a society indifference curve by aggregating individual preferences. Allows allocation decisions to be made by society as if it was just one person and can execute optimal social choice.

Limitations:
3 types of SWF’s
1) Utilitarian (Benthamite) - aggregates individual utilities
2) Egalitarian - focuses on reducing inequalities
3) Rawlsian - society is only as well off as its least fortunate member

Which one to use? They all lead to different policy prescriptions

Question 14

Explain Pareto Criterion and its limitations

Answer 14

Choose bundle that makes at least one person better off and no one worse off. This is unanimous voting.

Individualistic as focuses on individuals welfare and their own assessment of their welfare.

Limitations:
Cannot rank or compare allocations
Latent value judgement that status quo is better as decisions must be unanimous.
Overall, criterion is too strict

Question 15

Explain Pareto Criterion with compensation and its limitations

Answer 15

The inability to rank all bundles is unsatisfactory so can either

1) Provide direct 1-1 compensation for loss
2) Kaldor-Hicks (potential compensation) - If movement means social benefits > social costs do it, benefits could be redistributed to loser.

Limitations
of 1) - Infeasible and equity not considered, what if someone has unlimited WTA so would not accept any money even infinite

2) Net benefits unevenly redistributed
Assumes everyone values an extra £ equally - MU £ not equal

Question 16

What is Arrow’s Impossibility Theorem?

Answer 16

Arrow gave 6 criteria that a social choice mechanism should have. Showed there is no mechanism that satisfies all conditions, so there is no perfect mechanism for making social decisions.