Chapter 2 Theoretical Tools of Public Finance

Welfare economics The study of the determinants of wellbeing,

or welfare, in society.
Welfare economics

Demand curve a curve showing the quantity of a good

demanded by individuals at each price.
Elasticity of demand The percentage change in the quantity
demanded of a good caused by each 1% change in the price of
that good.
Supply curve a curve showing the quantity of a good that firms
are willing to supply at each price.
Marginal productivity The impact of a one-unit change in any
input, holding other inputs constant, on the firm’s output.
Marginal cost The incremental cost to a firm of producing one
more unit of a good.
Profit The difference between a firm’s revenues and costs,
maximized when marginal revenues equal marginal costs.
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.
Consumer surplus The benefit that consumers derive from
consuming a good, above and beyond the price they paid for
the good.
Producer surplus The benefit that producers derive from selling
a good, above and beyond the cost of producing that good.
Total social surplus (social efficiency) The sum of consumer
surplus and producer surplus.
First Fundamental Theorem of Welfare Economics The
competitive equilibrium, where supply equals demand,
maximizes social efficiency.
Demand curve
Created by: Acwin
Indifference curve a graphical representation of all bundles of
Preferences and Indifference Curves goods that make an individual equally well off. because these
bundles have equal utility, an individual is indifferent as to
which bundle she consumes.
Marginal utility The additional increment to utility obtained by
Supply curve consuming an additional unit of a good.
Marginal rate of substitution (MRS) The rate at which a
consumer is willing to trade one good for another. The MRS
Utility Mapping of Preferences
equals 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.
Equilibrium
Budget constraint a mathematical representation of all the
Constrained Utility Maximization combinations of goods an individual can afford to buy if she
spends her entire income.
Equilibrium and Social Welfare Budget Constraints Opportunity cost The cost of any purchase is the next best
alternative use of that money, or the forgone opportunity.
Constrained Choice
Substitution effect holding utility constant, a relative rise in the
Social Efficiency
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
The Effects of Price Changes: Substitution and Income Effects
individual to choose less of all goods because her income can
purchase less than before.

Competitive Equilibrium Maximizes Social Efficiency

Deadweight loss The reduction in social efficiency from
preventing trades for which benefits exceed costs.
Social welfare The level of well-being in society.
Second Fundamental Theorem of Welfare Economics society
can attain any efficient outcome by suitably redistributing
resources among individuals and then allowing them to freely
trade.
Equity–efficiency trade-off The choice society must make From Social Efficiency to Social Welfare: The Role of Equity
between the total size of the economic pie and its distribution
among individuals.

Social welfare function (SWF) a function that combines the

utility functions of all individuals into an overall social utility
function.