Ch2 Eng

10/2/2020
2.1 Constrained Utility

Maximization The Role of Government in Making a Free
2.2 Equilibrium and Social
Market Possible
Welfare
Efficiency and Equity in • A free market consists of the voluntary interaction of
2.3 Definition and Role of
producers and consumers of goods and services.
Distribution equity
• Is it necessary to have a government?

2.4 Problems of free market
2.5 Conclusion
Positive Economics Normative Economics
What is happening? Is it good or bad?
Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 44 Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 2 of 44
CHAPTER 2 ■ THEORETICAL TOOLS OF PUBLIC FINANCE CHAPTER 2 ■ THEORETICAL TOOLS OF PUBLIC FINANCE
Constrained Utility Maximization Constrained Utility Maximization
Preferences and Indifference Curves

utility function A mathematical
function representing an individual’s set  FIGURE 2-1
of preferences, which translates her
well-being from different consumption
bundles into units that can be
compared in order to determine choice.
constrained utility maximization The

process of maximizing the well-being
(utility) of an individual, subject to her
resources (budget constraint).
models Mathematical or graphical

representations of reality.
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Preferences and Indifference Curves Preferences and Indifference Curves
indifference curve A graphical

 FIGURE 2-2
Much of the power of the
representation of all bundles of
preferences models we use in
goods that make an individual
this course derives from one
equally well off. Because these
simple assumption:
bundles have equal utility, an
non-satiation, or “more is
individual is indifferent as to
better.”
which bundle he consumes.
Indifference curves have two essential properties, both of which follow

naturally from the more-is-better assumption:
1. Consumers prefer higher indifference curves.
2. Indifference curves are always downward sloping.
Utility Mapping of Preferences Utility Mapping of Preferences
Marginal Utility
Underlying the derivation of indifference curves is the
notion that each individual has a well-defined utility
function. marginal utility The additional
increment to utility obtained by
A utility function is some mathematical representation consuming an additional unit of
a good.
U = f(X1, X2, X3, …),
where
This utility function described exhibits the important principle of
X1, X2, X3, and so on diminishing marginal utility: the consumption of each additional unit of
a good makes an individual less happy than the consumption of the
are the goods consumed by the individual previous unit.
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Utility Mapping of Preferences Utility Mapping of Preferences
Marginal Utility Marginal Rate of Substitution
marginal rate of substitution

(MRS) The rate at which a
consumer is willing to trade one
good for another. The MRS is
equal to the slope of the
indifference curve, the rate at
which the consumer will trade
the good on the vertical axis for
the good on the horizontal axis.
MRS   MU M / MU C
Utility Mapping of Preferences Budget Constraints
Marginal Rate of Substitution

budget constraint A mathematical
 FIGURE 2-4 representation of all the combinations of
goods an individual can afford to buy if she
spends her entire income.
opportunity cost The cost of any

purchase is the next best alternative use
of that money, or the forgone opportunity.
When a person’s budget is fixed, if he buys one thing he is, by definition, reducing the
money he has to spend on other things. Indirectly, this purchase has the same effect as
a direct good-for-good trade.
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2.1
Constrained Utility Maximization Putting It All Together: Constrained Choice
Budget Constraints
 FIGURE 2-5
2.1
Putting It All Together: Constrained Choice Constrained Utility Maximization
Putting It All Together: Constrained Choice
 FIGURE 2-6
Marginal analysis, the consideration of the costs and benefits of an additional unit of
consumption or production, is a central concept in modeling an individual’s choice of
goods and a firm’s production decision.
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The Effects of Price Changes: Substitution and Income Effects The Effects of Price Changes: Substitution and Income Effects
Income and Substitution Effects

 FIGURE 2-7
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.
income effect A rise in the price

of a good will typically cause an
individual to choose less of all
goods because her income can
purchase less than before.
Constrained Utility Maximization Equilibrium and Social Welfare
The Effects of Price Changes: Substitution and Income Effects

welfare economics The study
Income and Substitution Effects
of the determinants of well-being,
or welfare, in society.
normal goods Goods for which
demand increases as income rises.
Demand Curves
inferior goods Goods for which
demand falls as income rises.
demand curve A curve showing
the quantity of a good demanded
by individuals at each price.
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Equilibrium and Social Welfare Equilibrium and Social Welfare
Equilibrium Equilibrium
 FIGURE 2-13
market The arena in which
demanders and suppliers interact.
market equilibrium The

combination of price and quantity
that satisfies both demand and
supply, determined by the
interaction of the supply and
demand curves.
Social Efficiency Social Efficiency
Consumer Surplus
Social efficiency represents the net gains to society from all trades that are
made in a particular market, and it consists of two components: consumer
and producer surplus.  FIGURE 2-14
Consumer Surplus
consumer surplus The benefit that

consumers derive from consuming a
good, above and beyond the price
they paid for the good.
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Producer Surplus Producer Surplus
 FIGURE 2-15
producer surplus The benefit
that producers derive from
selling a good, above and
beyond the cost of producing
that good.
Social Surplus Social Surplus
 FIGURE 2-16
total social surplus (social
efficiency) The sum of
consumer surplus and
producer surplus.
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Competitive Equilibrium Maximizes Social Efficiency From Social Efficiency to Social Welfare: The Role of Equity
First Fundamental Theorem

of Welfare Economics The social welfare The level of well-being
competitive equilibrium, where in society.
supply equals demand,
maximizes social efficiency. Pareto efficiency
Second Fundamental Theorem of
deadweight loss The Welfare Economics Society can
reduction in social efficiency attain any efficient outcome by
from preventing trades for suitably redistributing resources
which benefits exceed costs. among individuals and then allowing
them to freely trade.
It is sometimes confusing to know how to draw deadweight loss triangles. The key to
doing so is to remember that deadweight loss triangles point to the social optimum, and
grow outward from there.
2.3 2.3
From Social Efficiency to Social Welfare: The Role of Equity From Social Efficiency to Social Welfare: The Role of Equity
equity–efficiency trade-off
equity–efficiency trade-off The choice society must make
The choice society must make between the total size of the
between the total size of the economic pie and its distribution
Equity
economic pie and its distribution among individuals.

among individuals.
social welfare function (SWF) A

social welfare function (SWF) A
function that combines the utility
function that combines the utility
functions of all individuals into an
functions of all individuals into an
overall social utility function.
overall social utility function.
Efficiency

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10/2/2020

2.1 Constrained Utility

• Is it necessary to have a government?

What is happening? Is it good or bad?

Constrained Utility Maximization Constrained Utility Maximization

Preferences and Indifference Curves

constrained utility maximization The

models Mathematical or graphical

Constrained Utility Maximization Constrained Utility Maximization

Preferences and Indifference Curves Preferences and Indifference Curves

indifference curve A graphical

Indifference curves have two essential properties, both of which follow

Constrained Utility Maximization Constrained Utility Maximization

Utility Mapping of Preferences Utility Mapping of Preferences

Constrained Utility Maximization Constrained Utility Maximization

Utility Mapping of Preferences Utility Mapping of Preferences

Marginal Utility Marginal Rate of Substitution

marginal rate of substitution

Constrained Utility Maximization Constrained Utility Maximization

Utility Mapping of Preferences Budget Constraints

Marginal Rate of Substitution

opportunity cost The cost of any

Putting It All Together: Constrained Choice

Constrained Utility Maximization Constrained Utility Maximization

Income and Substitution Effects

substitution effect Holding

income effect A rise in the price

Constrained Utility Maximization Equilibrium and Social Welfare

The Effects of Price Changes: Substitution and Income Effects

Equilibrium and Social Welfare Equilibrium and Social Welfare

market equilibrium The

Equilibrium and Social Welfare Equilibrium and Social Welfare

Social Efficiency Social Efficiency

consumer surplus The benefit that

Equilibrium and Social Welfare Equilibrium and Social Welfare

Social Efficiency Social Efficiency

Producer Surplus Producer Surplus

Equilibrium and Social Welfare Equilibrium and Social Welfare

Social Efficiency Social Efficiency

Social Surplus Social Surplus

Equilibrium and Social Welfare Equilibrium and Social Welfare

First Fundamental Theorem

economic pie and its distribution among individuals.

social welfare function (SWF) A

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