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EC325 MT Notes
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Michaelmas Term: In-depth lecture notes, case studies, and summary of key points and concepts. Author achieved a 1st Class in the subject.
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CONTENTSM1: INDIVIDUAL WELFARE AND REVEALED PREFERENCE ................................................................................................. 5
M1.1 Constrained Utility Maximisation .................................................................................................................. 5
M1.1.1 Utility Functions ......................................................................................................................................... 5
M1.1.2 Budget Constraints ..................................................................................................................................... 5
M1.1.3 Constrained Choice .................................................................................................................................... 6
M1.1.4 Policies That Affect People’s Budget Constraints: Income and Substitution Effects.................................. 6
M1.1.5 Demand and Demand Elasticities .............................................................................................................. 7
M1.2 Money Metric Individual Welfare .................................................................................................................. 7
M1.3 Defining Revealed Preference........................................................................................................................ 8
M1.3.1 Samuelson’s Weak Axiom of Revealed Preference (“WARP”) ................................................................... 8
M1.3.2 Arguments For RP ...................................................................................................................................... 8
M1.3.3 Arguments Against RP ................................................................................................................................ 8
M1.3.4 Rationality .................................................................................................................................................. 9
M1.3.5 Revealed Preference and Welfare Metrics ................................................................................................ 9
M1.4 Social Welfare Function ................................................................................................................................. 9
M2: WELFARE IN MARKETS ..............................................................................................................................................10
M2.1 A Model of an Exchange Economy and Its Assumptions .............................................................................10
M2.1.1 Supply Curves ...........................................................................................................................................10
M2.1.2 Equilibrium and Distribution ....................................................................................................................10
M2.2 Economic Incidence .....................................................................................................................................11
M2.2.1 House Price Capitalisation: Economic Incidence and Revealed Preference ............................................11
M2.3 Pareto Efficiency...........................................................................................................................................11
M2.3.1 First Fundamental Theorem of Welfare Economics (“FFWTE”) ...............................................................11
M2.4 Equity vs Efficiency .......................................................................................................................................12
M2.4.1 Second Fundamental Theorem of Welfare Economics (“SFWTE”) ..........................................................12
M2.4.2 Social Welfare Function ...........................................................................................................................13
M3: EXTERNALITIES ..........................................................................................................................................................14
M3.1 Externality Theory ........................................................................................................................................14
M3.1.1 When Are Externalities Present? .............................................................................................................14
M3.1.2 Simple Model of Externalities ..................................................................................................................14
M3.1.3 Market Equilibrium Is Not First-Best / Social Equilibrium ........................................................................14
M3.2 Private Solution to Externalities...................................................................................................................15
M3.2.1 Private Solution: Coasian Bargaining .......................................................................................................15
M3.3 Public Reduction of Externalities .................................................................................................................15
M3.3.1 Market for Pollution Reduction ...............................................................................................................15
M3.3.2 Public Price Instrument: Pigouvian Corrective Taxation ..........................................................................15
M3.3.3 Public Quantity Instrument: Regulation ..................................................................................................16
M3.3.4 Public Quantity Instrument: Permits / Cap-and-Trade ............................................................................16
, M3.4 Externalities Empirics ...................................................................................................................................16
M3.4.1 Contingent Valuation ...............................................................................................................................16
M3.4.2 Capitalisation ...........................................................................................................................................17
M3.5 Weizmann (1974): Pigouvian Tax vs Cap-And-Trade....................................................................................18
M4: PUBLIC GOODS .........................................................................................................................................................19
M4.1 What Is a Public Good? ................................................................................................................................19
M4.2 First-Best Allocations: Public Good vs Private Good ....................................................................................19
M4.2.1 Efficiency If 𝑮 Is a Private Good: Pareto Efficiency ..................................................................................19
M4.2.2 Efficiency If 𝑮 Is a Public Good: The Samuelson Rule (1954)...................................................................20
M4.2.3 Samuelson Rule and Private Provision .....................................................................................................20
M4.3 Free Riding ...................................................................................................................................................20
M4.3.1 Limitations of the Samuelson Rule ..........................................................................................................20
M4.4 Optimal Public Good Provision Policy: Lindahl Pricing ................................................................................21
M4.4.1 Lindahl Pricing Satisfies Samuelson’s Rule ...............................................................................................21
M4.4.2 Lindahl Pricing Constraints.......................................................................................................................21
M4.5 Public Provision with Endogenous Private Provision of a Public Good .......................................................21
M4.6 Prosocial Behaviour and Intrinsic Motivation ..............................................................................................22
M5: POLITICAL ECONOMY AND SCOPE OF THE ECONOMY .............................................................................................23
M5.1 Intricacies of Social Choice: What is Political Economy? .............................................................................23
M5.1.1 Motivation: Social Choice ........................................................................................................................23
M5.2 Democracy in an Economic Model ..............................................................................................................24
M5.2.1 Condorcet Paradox ...................................................................................................................................24
M5.2.2 Arrow’s Impossibility Theorem (Arrow, 1951) .........................................................................................24
M5.2.3 Median Voter Theorem ............................................................................................................................24
M5.3 Positive Analysis of Government Policies ....................................................................................................25
M5.3.1 Taxation and transfer ...............................................................................................................................25
M5.4 The Policial Coase Theorem (Acemoglu 2003) ............................................................................................26
M5.5 The Scope of Government ...........................................................................................................................26
M5.5.1 New Contract Theory ...............................................................................................................................26
M5.5.2 Privatisation vs State Provision ................................................................................................................26
M7: SOCIAL INSURANCE ..................................................................................................................................................27
M7.1 What Is Social Insurance (“SI”)? ...................................................................................................................27
M7.2 Why Do People Value and Invest in Insurance? ...........................................................................................27
M7.2.1 Optimal Insurance ....................................................................................................................................27
M7.3 Asymmetric Information: Adverse Selection ...............................................................................................28
M7.3.1 Market for Lemons: A Case of Market Breakdown .................................................................................28
M7.3.2 Partial Insurance and Screening ...............................................................................................................28
M7.4 The Scope for Social Insurance ....................................................................................................................28
M7.5 Problems with Social Insurance ...................................................................................................................28
, M7.5.1 The Moral Hazard Effect of Insurance ......................................................................................................28
M7.5.2 Two Types of Classification Error .............................................................................................................29
M7.6 Case Study: Unemployment Insurance (“UI”) .............................................................................................29
M7.6.1 Evidence of Moral Hazard in UI ................................................................................................................29
M7.6.2 How Can We Estimate the Effects of UI? .................................................................................................30
M8: RETIREMENT PENSIONS............................................................................................................................................31
M8.1 Why Should Government Intervene? ..........................................................................................................31
M8.2 Government Intervention in Retirement Policy...........................................................................................31
M8.3 Fully Funded vs PAYG Schemes ....................................................................................................................31
M8.3.1 PAYG Schemes and Population Aging.......................................................................................................31
M8.4 Retirement and Savings ...............................................................................................................................32
M8.4.1 Consumption Drop Upon Retirement ......................................................................................................32
M8.4.2 Crowding-Out: Quasi-Experimental Evidence..........................................................................................32
M8.4.3 Default Options and Savings ....................................................................................................................33
M8.4.4 Financial Education and Savings ..............................................................................................................33
M8.5 Social Security and Labour Supply ...............................................................................................................33
8.6 Evaluating Welfare Effects of Pension Reforms ...............................................................................................34
M9: HEALTH POLICY .........................................................................................................................................................35
M9.1 Scope for Government Intervention ............................................................................................................35
M9.1.1 Imperfect Information .............................................................................................................................35
M9.1.2 Redistributive Arguments ........................................................................................................................35
M9.2 The Choice of Instruments in Health Care ...................................................................................................35
M9.3 The Generosity of Optimal Health Insurance ..............................................................................................36
M9.3.1 Moral Hazard Cost of Subsidised Health Insurance .................................................................................36
M9.3.2 The Price Elasticity of Health Care Demand ............................................................................................36
M9.3.3 Optimal Health Insurance Provision: RAND Health Insurance Experiment (“HIE”) .................................36
M9.4 Public Health Care in the US ........................................................................................................................38
M9.4.1 How Does Medicaid Affect Health? .........................................................................................................38
M9.4.2 Case Study: The Oregon Health Insurance Experiment ...........................................................................38
M9.3 The Rise in Health Care Spending ................................................................................................................38
M9.3.1 Why Is Health Care Spending Rising? ......................................................................................................38
M10: BEHAVIOURAL PUBLIC ECONOMICS ................................................................................................................39
M10.1 Very Simple Theory ......................................................................................................................................39
M10.2 Empirical Evidence of Mistakes ....................................................................................................................39
10.2.1 Framing: Asian Disease Experiment (Kahneman and Tverskey, 1981) ....................................................39
10.2.2 Observational Evidence: Default and Effects ...........................................................................................40
M10.3 Policy Implications .......................................................................................................................................40
10.3.1 Savings and Pensions ...............................................................................................................................40
10.3.2 Correcting Externalities ............................................................................................................................41
, 10.3.3 Social Insurance (Spinnewijn, 2014) ........................................................................................................41
10.3.4 Health Insurance ......................................................................................................................................41
M10.4 Regulation and Consumer Protection ..........................................................................................................41
10.4.1 How Much Regulation Is Too Much? .......................................................................................................42
10.4.2 Optimal Policy in a Behavioral World.......................................................................................................42
M10.5 Positive and Normative Rationality..............................................................................................................42
M10.6 Biases vs Strange Preferences ......................................................................................................................43
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