Chapter 3
Welfare economics: the branch of economics that evaluates the social desirability of alternative
economic states.
Edgeworth Box: a device used to depict the distribution of goods in a two good-two person world
Indifference curves with greater numbers represent higher levels of happiness
Pareto efficient: an allocation of resources such that no person can be made better off without
making another person worse off.
Pareto improvement: a reallocation of resources that makes at least one person better off without
making anyone else worse off
Contract curve: the locus of all Pareto efficient points
Marginal rate of substitution (MRS): the rate at which an individual is willing to trade one good for
another; it is the absolute value of the slope of an indifference curve
Pareto efficiency requires:
MRSadam = MRSeve
Production possibilities curve: a graph that shows the maximum quantity of one output that can be
produced, given the amount of the other output
,Marginal rate of transformation (MRT): the rate at which the economy can transform one good into
another good; it is the absolute value of the slope of the production possibilities frontiers
Marginal cost: the increment cost of producing one more unit of output
MRTaf = MCa/MCf
MCa = w-y
MCf = z-x
Condition for Pareto efficiency:
MRTaf = MRSadam = MRSeve
➔ MCa/MCf = MRSadam = MRSeve
Only when the slopes of the curves for each are equal it is impossible to make a Pareto improvement,
Hence; MRT = MRS is a necessary condition for Pareto efficiency.
To maximize utility:
MRS = Pa/Pf
THE FIRST FUNDAMENTAL THEOREM OF WELFARE ECONOMICS.
A profit-maximizing competitive firm produces output up to the point at which marginal cost an
dprice are equal:
MCa/MCf = Pa/Pf
Utility possibilities curve: a graph showing the maximum amount of one person’s utility given each
level of utility attained by the other person
Social welfare function: a function reflecting society’s views on how the utilities of its members
affect the well-being of society as a whole
Social welfare = W
W = F(Uadam, Ueve)
We conclude that, even if the economy generates a Pareto efficient allocation of resources,
government intervention may be necessary to achieve a “fair” distribution.
,Second fundamental theorem of welfare economics: society can attain any Pareto efficient
allocation of resources by making a suitable assignment of initial endowments and then letting
people freely trade with each other
Monopoly: a market with only one seller of a good (then the First welfare theorem doesn’t hold)
Asymmetric information: a situation in which one party engaged in an economic transaction has
better information about the good or service traded than the other party
Externality: a situation that occurs when the activity of one entity directly affects the welfare of
another in a way that is outside the market mechanism (then the First welfare theorem doesn’t hold)
Public good: a good that is nonrival and nonexcludable in consumption
Merit good: a commodity that ought to be provided even if people do not demand it
Chapter 4
Nonrival: once it is provided, the additional resource cost of another person consuming the good is
zero
Nonexcludable: to prevent anyone from consuming the good it is either very expensive or impossible
Pure public good: a commodity that is nonrival and nonexcludable in consumption
Private good: a commodity that is rival and excludable in consumption
- Even though everyone consumes the same quantity of the good, it need not be valued
equally by all
- Classification as a public good is not an absolute; it depends on market conditions and the
state of technology (impure public good)
- A commodity can satisfy one part of the definition of a public good and not the other
- Some thing that are not conventionally thought of as commodities have public good
characteristics (honesty)
- Private goods are not necessarily provided exclusively by the private sector
(housing/medicine)
- Government provision of a good does not necessarily mean that it also must be produced by
the government
Horizontal summation: the process of creating a market demand curve by summing the quantities
demanded by each individual at every price (only with private goods)
At equilibrium:
MRSadam = MRSeve = MRSfa
Efficiency requires that provision of a public good be expanded until the point at which the sum of
each person’s marginal benefit for the last unit just equals to marginal cost
Vertical summation: the process of creating an aggregate demand curve for a public good by adding
the prices each individual is willing to pay for a given quantity of the good (public goods)
With a private good: (decide how much to buy for a given price)
- Everyone has the same MRS, but people can consume different quantities
With a public good: (decide how much to pay, for a given quantity)
- Everyone consumes the same quantity, but people have different MRSs.
, The equilibrium:
MRSadam + MRSeve = MRT
Free rider: the incentive to let other people pay for a public good while you enjoy the benefits
Perfect price discrimination: when a producer charges each person the maximum he or she is willing
to pay for a good
Privatization: the process of turning services that are supplies by the government over to the private
sector for provision and/or production
What criteria should be used to select the amount of input of private or public provided goods:
- Relative wage and material costs
- Administrative costs
- Diversity of tastes
- Distributional issues
Commodity egalitarianism: the idea that some commodities ought to be made available to
everybody
The real benefit of privatization is to perpetuate the gains (according to Dewenter and Malatesta)
Chapter 5
Externality: a cost or benefit that occurs when the activity of one entity directly affects the welfare of
another in a way that is outside the market mechanism
- Externalities can be produced by consumers as well as firms
- Externalities are reciprocal in nature
- Externalities can be positive public goods can be viewed as a special kind of externality
Welfare economics: the branch of economics that evaluates the social desirability of alternative
economic states.
Edgeworth Box: a device used to depict the distribution of goods in a two good-two person world
Indifference curves with greater numbers represent higher levels of happiness
Pareto efficient: an allocation of resources such that no person can be made better off without
making another person worse off.
Pareto improvement: a reallocation of resources that makes at least one person better off without
making anyone else worse off
Contract curve: the locus of all Pareto efficient points
Marginal rate of substitution (MRS): the rate at which an individual is willing to trade one good for
another; it is the absolute value of the slope of an indifference curve
Pareto efficiency requires:
MRSadam = MRSeve
Production possibilities curve: a graph that shows the maximum quantity of one output that can be
produced, given the amount of the other output
,Marginal rate of transformation (MRT): the rate at which the economy can transform one good into
another good; it is the absolute value of the slope of the production possibilities frontiers
Marginal cost: the increment cost of producing one more unit of output
MRTaf = MCa/MCf
MCa = w-y
MCf = z-x
Condition for Pareto efficiency:
MRTaf = MRSadam = MRSeve
➔ MCa/MCf = MRSadam = MRSeve
Only when the slopes of the curves for each are equal it is impossible to make a Pareto improvement,
Hence; MRT = MRS is a necessary condition for Pareto efficiency.
To maximize utility:
MRS = Pa/Pf
THE FIRST FUNDAMENTAL THEOREM OF WELFARE ECONOMICS.
A profit-maximizing competitive firm produces output up to the point at which marginal cost an
dprice are equal:
MCa/MCf = Pa/Pf
Utility possibilities curve: a graph showing the maximum amount of one person’s utility given each
level of utility attained by the other person
Social welfare function: a function reflecting society’s views on how the utilities of its members
affect the well-being of society as a whole
Social welfare = W
W = F(Uadam, Ueve)
We conclude that, even if the economy generates a Pareto efficient allocation of resources,
government intervention may be necessary to achieve a “fair” distribution.
,Second fundamental theorem of welfare economics: society can attain any Pareto efficient
allocation of resources by making a suitable assignment of initial endowments and then letting
people freely trade with each other
Monopoly: a market with only one seller of a good (then the First welfare theorem doesn’t hold)
Asymmetric information: a situation in which one party engaged in an economic transaction has
better information about the good or service traded than the other party
Externality: a situation that occurs when the activity of one entity directly affects the welfare of
another in a way that is outside the market mechanism (then the First welfare theorem doesn’t hold)
Public good: a good that is nonrival and nonexcludable in consumption
Merit good: a commodity that ought to be provided even if people do not demand it
Chapter 4
Nonrival: once it is provided, the additional resource cost of another person consuming the good is
zero
Nonexcludable: to prevent anyone from consuming the good it is either very expensive or impossible
Pure public good: a commodity that is nonrival and nonexcludable in consumption
Private good: a commodity that is rival and excludable in consumption
- Even though everyone consumes the same quantity of the good, it need not be valued
equally by all
- Classification as a public good is not an absolute; it depends on market conditions and the
state of technology (impure public good)
- A commodity can satisfy one part of the definition of a public good and not the other
- Some thing that are not conventionally thought of as commodities have public good
characteristics (honesty)
- Private goods are not necessarily provided exclusively by the private sector
(housing/medicine)
- Government provision of a good does not necessarily mean that it also must be produced by
the government
Horizontal summation: the process of creating a market demand curve by summing the quantities
demanded by each individual at every price (only with private goods)
At equilibrium:
MRSadam = MRSeve = MRSfa
Efficiency requires that provision of a public good be expanded until the point at which the sum of
each person’s marginal benefit for the last unit just equals to marginal cost
Vertical summation: the process of creating an aggregate demand curve for a public good by adding
the prices each individual is willing to pay for a given quantity of the good (public goods)
With a private good: (decide how much to buy for a given price)
- Everyone has the same MRS, but people can consume different quantities
With a public good: (decide how much to pay, for a given quantity)
- Everyone consumes the same quantity, but people have different MRSs.
, The equilibrium:
MRSadam + MRSeve = MRT
Free rider: the incentive to let other people pay for a public good while you enjoy the benefits
Perfect price discrimination: when a producer charges each person the maximum he or she is willing
to pay for a good
Privatization: the process of turning services that are supplies by the government over to the private
sector for provision and/or production
What criteria should be used to select the amount of input of private or public provided goods:
- Relative wage and material costs
- Administrative costs
- Diversity of tastes
- Distributional issues
Commodity egalitarianism: the idea that some commodities ought to be made available to
everybody
The real benefit of privatization is to perpetuate the gains (according to Dewenter and Malatesta)
Chapter 5
Externality: a cost or benefit that occurs when the activity of one entity directly affects the welfare of
another in a way that is outside the market mechanism
- Externalities can be produced by consumers as well as firms
- Externalities are reciprocal in nature
- Externalities can be positive public goods can be viewed as a special kind of externality
