Economic Applications - Freedom to trade and some basic of Welfare Economics

What is initial endowment?
Click the card to flip 👆
1 / 29
Terms in this set (29)
What is initial endowment?
The allocation that people start off with.
What is an Edgeworth box?
This is a rectangle where each side represents the consumption of one good by one person. (kind of like two indifference maps puzzled together).
How would you draw an Edgeworth box when person A, Kat, is initially endowed with 30 of good 2 and 20 of good 1. And person B, Bill, is initially endowed with 20 of good 2 and 20 of good A.
Image: How would you draw an Edgeworth box when person A, Kat, is initially endowed with 30 of good 2 and 20 of good 1. And person B, Bill, is initially endowed with 20 of good 2 and 20 of good A.
What are the two things Bill and Kat can do?
They can consume their initial endowment and they can trade.
Trade is voluntary so it will only be done if both parties find it beneficial, how would this be?
Whether one of both of them want to move away from their initial endowment.
What would indifference curves on an Edgeworth box look like and where is there initial endowment in relation to this?
Where the straight lines cross, there will be a crossing of both indifference curves as well, this is the initial endowment point. (can draw more below and above).
Image: What would indifference curves on an Edgeworth box look like and where is there initial endowment in relation to this?
Where will trade be beneficial for Bill and Kat separately and the same time?
All points on a higher indifference curve, so more south west for Bill and north east for Kat. The points where it will be better for both is more towards the centre where the curves cross now, then they will both be on higher indifference curves. Here trade is beneficial and they both want to engage in it. Trade will continue until both curves are tangential.
What does it mean when both indifference curves for each person are tangential?
Here the indifference curves have a gap between them but they move in opposite directions until both minimums equal each other and they look like an 𝒳. Where they are tangential is where no party can improve without putting the other into a worse position.
What is the allocation point called?
The Pareto-optimal, this is where the indifference curves are tangential. Anywhere past the Pareto optimal is called Pareto-improvements, where at least one person was better off while the other person was at least not worse off.
There are many Pareto-optimal allocations, what two things depend where they will end up?
The initial endowment and the partners relative bargaining strength.
If we start with point Z what are the allocations possible between?Allocations between C and D are possible.What is the contract curve?This connects all allocations where Bill and Kats IC are tangential. Each of these allocations is Pareto-optimal. As long as they are allowed to trade they will always end up on this curve, if they move off they will be worse off. So allocations on the contract curve are always better off than allocations not on it.What happens when a government can take away goods from one person and give them to another?They can use allocation of goods by swapping resources i.e making the initial endowment more equal and fair. Both allocations will be Pareto- optimum but this doesn't help us chose between the two allocations. Also they still cannot prevent people from trading, they will end up back on the contract curve.What does the contract curve tell us (and not tell us)?That letting people engage in voluntary trade will be good, people will fix misallocations of resources by themselves if initial endowments were not Pareto-optimal. It doesn't tell is which allocations should be chosen.What are some real life examples of pareto-optimums and how it can make some groups of people worse off and some better?A tax increase and higher welfare payments. Richer people are made worse off and poorer people are made better off. Building an additional runway at an airport. This makes some people better off because of the higher capacity and some people who life close to the airport worse off as their house loses value.What are ways to rank allocations and outcomes in cases/endowment?We use the social welfare function, this is like an individual preference ranking but for the while of society.What did Kennith Arrow prove?That it is impossible to construct a social ranking of alternatives - as long as there are 3 or more - through the aggregation of individual rankings while meeting a range of criteria.Example: There are 3 students. If every student thinks Monday is better than Tuesday, the aggregate ranking should show Monday being better than Tuesday. This should then remain stable even if individuals change there rankings of other days. How does this cause problems?If we compare this to there individual ranking preferences, Monday vs Tuesday means Monday wins. Tuesday vs. Wednesday means Tuesday wins. Wednesday vs. Monday means Wednesday wins. This results in: Monday>Tuesday>Wednesday>Monday This cannot be as it is intransitive. This is the same fi the full results ranking where the alternatives are considered as well.What can we say about establishing rankings in society?That it is very difficult to make it not turn out circular. Pareto-optimality works in cases were it is applied but there is only limited applicability. This makes it hard for a dictator to decide which allocations to pursue.What are examples in real life are there of choices that depend on other peoples pareto-optimum as well as your own?Pricing for Apple's iPad vs. Samsung Tablet.What are the tools economists/militarists use to study decision making in strategic interactions?Game theoryWhat's a static game?Where players act once and simultaneously, they cant observe the other players move.What's a dynamic game?Where events are sequential or moves act repeatedly.Example: Two people have jointly committed a crime, they robbed a bank. They're caught by the police. The police however, does not have enough evidence to charge them with the bank rob unless one of them confesses. They can charge them with a minor crime for speeding and possession of a firearm. The prosecutor separates them and offers each of them a more lenient punishment if they confess (and the other doesn't). What does the normal form of the game look like and what are the consequences of each action?The table is called the normal form of a game. It specifies the players and their strategies and playoffs with each one. If both confess they get 8 years. If non confess they get 1 year. If only one confess they go free and the other gets 20 years. Collectively the best outcome is one year each, but can this be reached?What is the the prisoners dominant strategy?A dominant strategy equilibrium is reached when each player chooses their own dominant strategy. For this example it is for them to confess, in both cases it leads to the lowest prison sentence. E.g if the other person doesn't confess and you confess you walk free and if they confess and you confess you get 8 years, (rather than 20 if you dont). If they cooperate there could be an outcome which benefits both together the most but this isn't allowed.When is game theory used in economics?In oligopolies and duopolistic, firms can collude on price however each firm has an incentive to undercut the other firm and capture more (the whole) market share.What's duopoly game theory like?It leads to the same outcome as before, cooperation is unstable as each firms has an incentive to defect. This can explain why there are occasionally firms that leave cartels and inform competition authorities about them.Why will a duopoly never be possible with finite number of periods in the long run?In reality firms will meet more than once, but the game has a finite number of periods, e.g both firms know they will meet for 30 periods. In the first periods the firms have incentive to cooperate with each other has it allows for cooperation. In the last period there will be no room for future cooperation regardless of the firms behaviour. This is effectively a one-shot game in the last period. In the second last period both firms know that both firms will defect in period 30, regardless of 29 behaviour. So period 29 effectively becomes a one-shot game as well and both firms defect. This goes on all the way down to one, this is called backwards induction. In the end firms will defect in every possible period and never cooperate.What happens in a finite number of time periods on duopoly behaviour?The process of backwards induction will not start. Cooperation will then be possible under certain circumstances. For instance, the payoffs for cooperation need to be high enough relative to the the payoffs under defection and the initial gain in the first defection period.