With this summary for the IBEB course Economics of the Welfare State, you have everything you need to succeed! It includes both content from the book, as well as from lecture slides. (FEB12017X / FEB12017)
Chapter 1: Why study public finance?
public finance: study of the role of the government in the economy.
- When/how/what/why should the government intervene in the economy?
- When?:
- Market Failures: market economy does not always maximize efficiency. Negative
externalities (in health insurance): impose costs on others that you do not bear
yourself. → government can increase efficiency by intervening.
- Redistribution: shifting resources from some groups in society to others. Society
may decide that the distribution by the market is unfair.
- efficiency losses: less efficiency due to redistribution because people shit
their behavior away from the maximum efficiency point.
- equity-efficiency tradeoff: trade-off between efficiency and ‘fair’
distribution.
- How?
- Tax/Subsidize Private Sale or Purchase: change the price by increasing/decreasing it
with taxes/subsidies. Helps address failures in the market.
- Restrict/Mandate Private Sale/Purchase: force people to buy health insurance for
example.
- Public Provision: government provides the good directly (public healthcare)
- Public Financing of Private Provision: government reimburses private entities for
certain goods they buy themselves.
- What are the effects?
- Direct effects: the effects predicted if people did not change their behavior in
response to the policy.
- Indirect effects: effects only due to individuals changing behavior in response to the
interventions. Example: if you introduce public free healthcare, how many people
will give up their private healthcare for the public one?
- Why?
- To satisfy to the political pressure the government faces. To find the right
compromise between efficiency and social preference.
Gini-index: A / A+B under Lorenz / 2* A
- 0 = absolute equality, 1 = absolute inequality
- Cannot say anything about Lorenz if they cross
Income inequality has been rising over the last decades
,deficit: shortfall of revenues relative to spending. Government has to borrow money.
debt: accumulation of past deficits over time.
public good: goods for which the investment of any one individual benefits everyone in a larger
group.
social insurance programs: government provision of insurance against adverse events to address
failures in the private insurance market.
Chapter 2: Theoretical tools of PFD
Theoretical tools: tools designed to understand the mechanics behind economic decisions
Empirical tools: tools designed to analyze data and answer questions raised by theoretical analysis.
Utility functions: function representing an individuals preferences.
- People maximize this constrained to their resources
- Assumptions:
- More is better
- Create Indifference Curves: downward sloping.
Marginal utility: additional utility from consuming one more unit of a good.
- Diminishing marginal utility
Marginal rate of substitution: the rate at which a consumer is willing to trade one good for another.
- Slope of indifference curve.
- Diminishes
- MRS = - MUX / MUY
Budget constraint: all combinations of goods an individual can afford.
- Y = PXQX + PMQM
- Slope: PX / PY
- Optimal choice: where highest IC is tangent to the budget constraint
- MRS = - PX / PY = - MUX / MUY
Substitution effect: holding utility constant, a relative rise in the price of a good will always cause an
individual to choose less of that good.
- as price rises, close substitutes will become more attractive than before and people will buy
those instead of the original product
Income effect: a rise in price will typically cause an individual to choose less of all goods because her
income can purchase less than before.
- In real terms, you can buy less because of the increase in price
When the relative price of a good changes, you buy less of that good because:
- Income effect
- Substitution effect.
, Work-leisure tradeoff:
- “Cost” of one hour of leisure is your hourly wage
- Can make into budget constraint: consumption on y axis, leisure on x. Slope = -w.
welfare economics: the study of the determinants of wellbeing, or welfare, in society.
- TANF: cash payments (to avoid confusion with the word ‘welfare’)
demand curve: relationship between price and quantity demanded.
- Derived by: using a budget constraint, varying the prices in that budget constraint and taking
note how the optimal quantity (tangent BC and Indifference Curve) changes. Doing this for
many different prices, you can trace a demand curve.
ΔQx/Qx
elasticity of demand = % change in quantity demanded / % change in price = ΔP x/P x
- Typically negative: if price up, then demand down.
- Typically not constant along demand curve.
- perfectly inelastic (0): vertical demand curve, demand does not change with higher price.
- perfectly elastic (-∞): horizontal demand curve, demand drops to zero if price changes.
ΔQx/Qx
- cross-price elasticity: ΔP z/P z
- positive → x and z are substitutes
- negative → x and z are complements
supply curve: curve showing the quantity supplied at each price
- Based on production function ( √K * L (Capital and Labor)
- The marginal cost curve is the supply curve.
marginal productivity: impact of a one-unit change in any input, holding other inputs constant, on
output.
- Diminishing marginal productivity: each extra input raises the output by less and less.
marginal cost: the cost to a firm of producing one more unit of a good
- Derivative of total cost function
- Diminishing marginal productivity → rising marginal costs.
- Profit maximized when Marginal Costs = Marginal Revenue = Price \
- Marginal cost curve is the supply curve
Equilibrium: the price at which demand and supply are equal.
Social efficiency: the net benefits consumers and producers receive as a result of their trades.
Demand/supply curves are used to measure this.
- Consumer surplus: the willingness to pay minus the price. Area below the demand curve and
above equilibrium market price. Determined by the price and the elasticity of demand.
- Low elasticity of demand: large surplus due to lack of good substitutes
- High elasticity: low surplus due to availability of good substitutes.
- Producer surplus: benefit of producing a good. Area above the supply curve, under
equilibrium price. Depends on price and price elasticity of supply.
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