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Samenvatting Topics in Public Economics
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SAMENVATTING TOPICS IN PUBLIC ECONOMICSTOPIC 1: INTRODUCTION & EQUILIBRIUM AND EFFICIENC Y
Chapter 1 and 2
CLASS 1
PUBLIC ECONOMICS
= Public Economics is the study of the public economy, i.e., of economic questions which are not
purely market, intra-household or intra-firm, with emphasis on logic-intensive (scientific) analysis
and on ethical–normative questions”
- Intersection between public and private incentives
Scope: Economic phenomena which are not purely market, intra-household, or intra-firm
Method: scientific inquiry and combining positive (“what is”) and normative (“what ought to be”)
analysis
- Ex: what is inequality and what how should we solve this and what parameters say that it is
solved?
ECONOMIC MODELS
Why models?
Economists use models to understand reality
- Difficult to conduct large scale experiments
o Economy is too complex to analyse in its entirety
o Simplifications to (hopefully) capture the essential aspects
- Formal modelling ensures that arguments are logically consistent with all the underlying
assumptions exposed
Typical structure
- Inputs: exogenous variables
o autonome wijziging van een variabele die niet wordt beïnvloed door de werking van
het economische model.
- Modelling: optimization under constraints (e.g., utility or profit maximization)
- Outputs: endogenous variables
o een variabele die afhankelijk is van andere variabelen in een statistisch en/of
economisch model
Modelling focus
- partial equilibrium: only a single market is studied
- general equilibrium: many markets are studied simultaneously
EQUILIBRIUM A ND EFFICIENC Y
INTRODUCTION
Competition and efficiency
- Adam Smith (1776) was the first to describe the link between competition and efficiency
o Competition « many consumers and firms make independent decisions
o Efficiency « "good use" of scarce resources
- This was formalized in the 20th century (by, e.g., Arrow, Debreu, McKenzie)
1
, o An equilibrium is obtained by prices adjusting to equate demand and supply
o This equilibrium is shown to be Pareto efficient (see appendix).
Optimality is when you can’t influence others negatively by choosing for
example another bundle (opzoeken)
o This is remarkable: consumers and firms pursue their independent objectives and
yet the resulting equilibrium has some desirable properties
Dit is opmerkelijk: consumenten en bedrijven streven hun onafhankelijke
doelen na en toch heeft het resulterende evenwicht enkele wenselijke
eigenschappen. (zie volgende titel)
ECONOMIC MODELS
COMPETITIVE ECONOMIES
Feature 1: agents are - Agents’ actions do not influence prices. This is justifiable when
price-takers agents are negligible in size relative to the overall economy
- Prices are signals that guide the decisions of agents. The price
signal contains sufficient information such that an efficient
outcome can be obtained through the decisions of independent
economic agents
Feature 2: agents have - No agent has an informational advantage
access to the same
information
THE EXCHANGE ECONOMY
Building blocks: endowments (= initial stock of goods) and preferences
- No production sector, only exchanges or trade
- Consumers have endowments, i.e., an initial stock of goods
o Since there is no production, total endowments remain constant within the economy
- Consumers have preferences over these goods
o By trading, consumers can achieve consumption plans that are preferred to their
initial endowment
o The rate at which goods can be traded is given by market prices
o Consumers believe that their behavior cannot affect market prices
The two consumer, two-good exchange economy
- Endowments
o The endowments of consumer h is denoted by
o At prices p1 and P2, a consumption plan is affordable if it satisfies
the budget constraint
o A consumption plan is feasible when
- Preferences
o The preferences of consumer h are represented by the utility function
which assumed to be well-behaved (see appendix)
2
,This economy can be visualized in the Edgeworth box
- In this box you can find normal indifferences curves and the budgetconstraint
- You turn one graph on the other
o Je draait dus de ene grafiek naar boven
o What consumer 1 wins, loses consumer 2
- The budget constraint must go through the endowments w. it is common to both consumers
and has slope -p1/p2
o The slope is also the trading cost
o There is an optimal p
- For a fixed budget constraint, the utility-maximizing choices are determined by the
standard tangency condition between the highest attainable indifference curve and the
budget line
- The figure below shows an example of a "no equilibrium" situation, as supply does not equal
demand
3
, o Demand for good 1 is too high for the supply their is and for good 2 too low
o Both utility functions (IC) should fall on the
same spot
o Blue line is the same good but different
consumer
- The equilibrium can be achieved via the
adjustment of prices. At equilibrium prices, demand is equal to supple
- Since the demand for good 1 is too high (and the demand for good 2 is too low), its relative
price needs to increase
- In equilibrium, the indifference curve of both consumers have a point of common tangency
on the budget line
- On the right side you can see that this a better option because both utility functions fall
together on the budget line
Excess demand
- Whenever there is an excess of demand for one good, these is a corresponding deficit of
demand for the other
o The level of excess demand for good i:
o Some algebra (using the budget constraints) shows that the value of excess demand
is . This is called Walras’ law. Intuition: since all
consumers are equating their expenditure to their income, so must the economy as
a whole.
That is if demand is equal to supply for good 1, then demand must also
equal supply for good 2.
4
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