Welfare economics

Question 1

What is the Pareto criterion?

Answer 1

Outcome A is Pareto superior to outcome B if no one finds A worse than B and at least one person finds A strictly better than B. An outcome is Pareto efficient if no other outcome is Pareto superior.

Question 2

What are arguments for and against the Pareto principle? [3+3]

Answer 2

​​+ Everyone is always weakly better off
+ Don’t need cardinality
+ Avoids ‘strength of preference’ problems

• Nothing about equality
• Doesn’t cover all choices
• Very few actions harm no-one, so it favours the status quo

Question 3

What is a social welfare function?

Answer 3

The aggregate of individual orderings into a social ordering. It must be:

1. Complete, transitive and continuous
2. Individualistic - uses welfare measures of individuals as inputs
3. Non-paternalistic - reflects only the citizen’s own evaluation of their well-being
4. Benevolent - no other objective than social welfare maximization

Question 4

List different means of aggregating individual preferences [4]

Answer 4

1. Majority rule - society prefers A to B
2. Dictatorship
3. Maximin (Rawlsian) - society prefers A to B if the worst-off in A are better off than the worst-off in B
4. Utilitarian - society prefers A to B if the sum of utilities in A is higher than in B (needs cardinality)

Question 5

Is majority voting effective?

Answer 5

1. What if there’s a tie?
2. How do you define ‘majority’?
3. There may not be an option most-liked by a majority
4. What about minority rights?
5. What about intensity of preference?

Question 6

What is Arrow’s impossibility theorem? [4]

Answer 6

Criteria for aggregation:

1. Universal domain - works for all individual preferences
2. Pareto efficient
3. Independence of irrelevant alternatives - in a choice between A and B, preferences of C are irrelevant
4. Non-dictatorship

Theorem: no such ordering is possible

Question 7

What do we mean by single peaked preferences?

Question 8

What is the 1st theorem of welfare economics?

Answer 8

A general competitive equilibrium leads to a Pareto efficient allocation of resources.

The price system from a perfectly competitive economy induces selfish individuals, independently maximising their private wellbeing, to bring the economy to a socially optimal state. Consumer sets MRS=price ratio; firm sets MRT=price ratio; equilibrium is efficient.

Suggests that markets do (weakly) better than a social planner.

Question 9

When would general equilibrium not be efficient?

Answer 9

If different agents face different prices:

• Taxation - wedge between the prices that buyers and sellers pay and receive
• Monopoly power - monopolist optimisation based on marginal revenue, not price

Question 10

What are the assumptions of the 1st welfare theorem? [5]

Answer 10

1. Local non-satiation of preferences
2. No externalities - one person’s preferences don’t affect another’s
3. Everyone is optimising
4. No one is cheating - e.g. stealing
5. Perfect competition - no monopolies / distortionary taxation

Question 11

What are the problems with the 1st welfare theorem? [6]

Answer 11

1. Preferences are not always well-behaved
2. Imperfect information leads to wrong choices
3. Irrationality - purchasing ‘on a whim’
4. Don’t always optimise - altruism, charity, pollution
5. Gifts are an example of cheating
6. No consideration of equity in resource distribution

Question 12

What is the 2nd theorem of welfare economics?

Answer 12

Any Pareto efficient allocation can be achieved through a compeittive equilibrium, given the appropriate initial allocation of endowments.

A specific efficient outcome (point on the contract curve) can be chosen and attained by picking the initial endowments (to get the right budget constraint) and then allowing trade.

Implies that you can separate efficiency and equity (through lump-sum distributions of wealth).

Question 13

What are the assumptions of the 2nd welfare theorem? [2]

Answer 13

1. It is possible to redistribute endowments
2. Preferences and production sets are convex (remember diagrams)

Question 14

What are the problems with the 2nd welfare theorem? [4]

Answer 14

1. Only lump-sum redistribution is allowed
2. Political problems with taxation, benefits, etc.
3. How do you decide what final outcome you want?
4. If transfers are available, why not just move straight to the final outcome?

Question 15

What are the main causes of market failure? [3]

Answer 15

1. Monopoly power - prices aren’t set at marginal cost
2. Externalities / public goods - problems of underprovision and free riding
3. Information asymmetries - e.g. moral hazards in the insurance market

The existence of market failure is necessary but not sufficient for intervention - will the planner do better than the market?

Question 16

Give examples for each taxonomy (classification) of goods.

Answer 16

Rival & excludable - market goods

Rival & non-excludable - fish

Non-rival & excludable - museums

Non-rival & non-excludable - national defence

Question 17

What is Coase’s theorem?

Answer 17

Bargaining will lead to an efficient outcome, regardless of the initial allocation of property

Initial utility < utility with bribe

φ(h*) < φ(h) +/- B

Question 18

What can prevent Coasian bargaining? [3]

Answer 18

1. If trade in the externality is not possible
2. High transaction costs
3. Poorly defined property rights

Question 19

What is a Pigouvian tax?

Answer 19

A tax applied to a market activity that is generating negative externalities. It is intended to correct the inefficient market outcome, and does so by being set equal to the size of the externality.

Optimal tax per unit, t = MSC

Total tax revenue, T = t * h (where ‘h’ is level of pollution / number of units)

Question 20

What are the advantages of Pigouvian taxation?

Answer 20

1. It raises the price, lowering quantity demanded (of fossil fuels)
2. Price mechanism internalises external cost
3. Firms switch to renewable alternatives, better production processes - can be subsidised
4. Government can use tax revenue to repair damage

Question 21

What are the problems with Pigouvian taxation? [6]

Answer 21

1. Only controls individual firms, not total pollution level
2. Demand for fossil fuels is price inelastic
3. Calculating the correct tax - hard to determine social cost
4. Administration costs
5. Deciding who gets the revenue from the tax
6. Discrepancies between countries; tax havens

Question 22

What is the optimal level to set a quota?

Answer 22

Where MSB = MSC

(Often where benefit to firms = cost to consumers)

Question 23

How does the ‘Cap and Trade’ system work? [4]

Answer 23

1. Total emission level agreed
2. Permits are allocated either for free based on previous emissions…
3. …or by auction, giving to person who values highest (VCG)
4. Firms can then trade

Question 24

What are the advantages of tradeable permits? [6]

Answer 24

1. Total supply is fixed
2. Those who can reduce emissions cheaply gain
3. Incentive to develop low-emission technology
4. Number of permits can be reduced each year
5. Mor responsive to changes in inflation
6. Avoids government failure - don’t need individual production functions

Question 25

What are the problems with tradeable permits? [4]

Question 26

Is there a hybrid system between taxes and quotas that could work for externalities?

Answer 26

1. Permits, with emissions tax beyond 2. Places ceiling on emissions permits, government commits to sell permits at ceiling price 3. Also creates price floor - commitment to buy at floor price 4. In between, permits are traded ## Footnote *Better because it gives more certainty in total level and price of emissions, and the price price doesn't fluctuate too far*

Question 27

What is the Lindahl Equilibrium?

Answer 27

Individuals pay for the provision of a public good according to their marginal benefits, in order to determine the efficient level of provision for public goods. In the equilibrium state, all individuals consume the same quantity of public goods but may face different prices because some people may value a particular good more than others.

Question 28

Why is the Lindahl mechanism inefficient?

Answer 28

We do not know how much each person values a certain good, and individuals have an incentive to underreport

Question 29

How does the Vickrey-Clarke-Groves (VCG) preference revelation mechanism work?

Answer 29

1. Voters state preference value (sealed bid) 2. State values are added, and the policy option that has the highest aggregate value is chosen 3. If a voter's vote was decisive, charge him a tax equal to the net gain to other voters in the absence of this vote 4. If the voter's vote was not decisive, charge no tax

Question 30

What are the consequences of the CGV mechanism? [3]

Answer 30

1. Socially optimal assigning: each individual is charged the harm they cause to other bidders 2. The optimal strategy for each bidder is to bid their true valuation 3. Tax paid never exceeds benefits recieved

Question 31

What are three broad aims of government policy?

Answer 31

1. Correct market failure - regulate monopoly, correcy externalities, provide public goods 2. Override 'inappropriate' choices of the individual - e.g. education, heroin 3. Achieve a desirable distribution of income

Question 32

What is the theory of second best?

Answer 32

When the market isn't perfect and an optimality condition cannot be satisfied (e.g. imperfect information), perhaps the next-best solution involves changing other variables away from their optimal values.