Big Issues in Economics and Finance
1. Measuring wellbeing
a. Positive vs Normative
i.
Positive: how things are
ii.
Normative: how things should be
b. Preferences
i.
Complete: any pair of groups or bundles can be compared
ii.
Transitive: If 𝑋≻𝑋′ and 𝑋′≻𝑋′′ then 𝑋≻𝑋′′
iii.
Reflexive: any good, or bundle, is at least as good as itself
iv.
c.
Preferences are stable: not affected by the other options of the choice
set (the set of affordable bundles) or the circumstances under which the
choice is made
Utility: measures individual satisfaction, represented by u(x)
i.
Ordinal Utility: only comparable with “more” or “less”
ii.
Cardinal Utility: can be compared with numerical values
d. Utility Maximization
i.
Local non-satiation: more consumption of either good is preferred to
less consumption
e. Revealed preference
i.
Preference revealed by consumption behavior, required ordinal utility
only
f. Measuring wellbeing: measuring u(x), but not directly observable, need
proxies
i.
Proxy’s correlation with wellbeing measures (GDP per capita with
others)
g. Equivalent income/equivalent consumption
i.
People have different preferences, so compare with corrected
income/consumption: the extra income or consumption needed for
someone in one country to live in another country
h.
Composite indices: e.g. HDI, based on measurements of multiple wellbeing
indicators
i.
Functionings: beings and doings
ii.
Capabilities: the freedom to choose from available combinations of
functionings
i. Surveys on wellbeing/hapiness
2. Inequality and Welfare
a. Pareto
i.
Improvement: making some better-off and none worse-off
ii.
Preference: If a change makes Pareto improvement, then it is Pareto
preferred
iii.
Pareto efficiency: the state where no one can be better-off without
making some worse-off
b. Social Welfare Functions
i.
Utilitarian: SWF = ∑𝑁
𝑖=1 𝑈𝑖
1)
2)
3)
Maximize the sum of utilities of all
Not egalitarian: redistribute income to those with higher marginal
utility until marginal utilities are equalized
Nozick’s Utility Monster: when one has much higher marginal
utility, all resources will be redistributed to him/her as
redistribution in utilitarianism is based on diminishing marginal
utility, not egalitarianism
Rawlsian: SWF = 𝑚𝑖𝑛𝑖 (𝑢1 , 𝑢2 , … , 𝑢𝑛 )
1) Every individual should have complete freedom to choose their
own objectives in life
2) Those who are worst off are as well off as possible
3) Egalitarian: evaluates welfare based on the utility of the worst-off
person
Inequality of opportunity:
ii.
c.
i.
Outcomes depend on
1) Circumstances: beyond individual control
2) Effort: at least partly within individual control
ii.
Equality of opportunity” neutralizing the effect of circumstances on
outcomes but keeping untouched the effect of effort on outcomes
d. Pigou-Dalton Principle of Transfers: any measure of inequality index must
decrease if there is a transfer of income from a richer household to a poorer
household which preserves the ranking of the two households in the income
distribution and leaves total income unchanged
e.
f.
Stock vs flow variables: income is the flow that feeds wealth (a stock)
Functional distribution of income
i.
Income share of capital: ⍺ = 𝑌𝐾/𝑌𝑑
ii.
1) Increasing since 1970s
Income share of labor: (1 − ⍺) = 𝑌𝐿/𝑌𝑑
iii.
1) Decreases
Wealth to income ratio: 𝜷 = 𝐾/ 𝑌𝑑
1)
Historically high
iv.
Average rate of return to wealth: 𝒓 = 𝑌𝐾/𝐾
v.
1) Relatively stable
Why the trend?
1)
market power ↑, less competition, stock prices ↑. Effect largely
driven by firms in the upper tail of the mark-up distribution
2) firms invest in intangibles: intellectual properties  lower
expenditure on labor
3) substitution of labor by capital
3. INEQUALITY - GENDER AND DISCRIMINATION
a. Demand and Supply of Labor
i.
ii.
b.
Potential Outcome framework
i.
Observed difference: Avg[ 𝑌1,𝑖 ∣ 𝐷𝑖 = 1 ] − Avg[ 𝑌0,𝑖 ∣ 𝐷𝑖 = 0 ] = [𝑘 + Avg[ 𝑌0,𝑖 ∣ 𝐷𝑖 = 1 ]] −
Avg[ 𝑌0,𝑖 ∣ 𝐷𝑖 = 0 ] = 𝑘 + Avg[ 𝑌0,𝑖 ∣ 𝐷𝑖 = 1 ] − Avg[ 𝑌0,𝑖 ∣ 𝐷𝑖 = 0 ]
ii.
Y: outcome of i, with 1 = being treated and 0 = not being treated
iii.
D: if i is treated, 1, if not, 0
c. Randomization removes selection bias
4. Climate Change and the Environment
a. Discounting: converting future value into present value
i.
Income:
ii.
Hedonic pricing: estimate price using things of similar characteristics
1) Revealed preferences: e.g. price of hotel rooms to estimate value
of view
iii.
Contingent valuation: valuation based on survey scenarios
b. Missing markets: markets that don’t exist due to the lack of clearly defined
property rights
c. Coase Theorem: Assuming no bargaining costs, and if the property rights
are clearly defined, then private bargaining will result in a Pareto-efficient
allocation
d.
e.
Equimarginal principle: firms should choose their level of carbon abatement
such that the marginal cost of abatement is equalized across all firms
Cap and trade: limited pollution allowance but can trade
5. Money and Banking
a.
Functions of money
i.
Unit of account
ii.
Means of payment
1) Avoid the double coincidence of wants
iii.
Store of value
1) Transfers purchasing power over time
b. Centralized vs decentralized money: centralized in the sense that there’s no
anonymity of payments
c. Why do we need banks?
i.
Direct financing: without using intermediary
ii.
Credit and banking
d. Money creation:
i.
Base money: notes and coins + central bank reserves
ii.
iii.
iv.
Bank deposits: created by banks each time they lend money
When loans are paid, money destroyed
Limits on money creation
1) Monetary policy: setting ir influencing the ir in loans between
bank and the amount of money firms and households are willing
to borrow
2) How fast loans are repaid
3)
e.
Market conditions: expected profitability and risk determine how
much banks are willing to lend
Inflation
i.
Why bad?
1) Redistributes gains and losses, which is arbitrary and no social
welfare consideration
2) Confusion regarding the value of the unit of account
3) Menu costs
f.
Money market
g.
Arbitrage / Non-Arbitrage Principle
i.
Arbitrage:
ii.
Non-Arbitrage
h.
Quantitative easing and effective lower bound
i.
Fisher equation:
j.
Monetary Policy: estimate r* and set i
i.
Taylor rule:
ii.
iii.
(r: real net return)
Taylor principle: central banks must choose 𝝍 > 1 so that inflation falls
when above target and rises when below
Combining Fisher Equation and Taylor Rule:
1)
role of expectations – expected high inflation is a self-fulfilling
prophecy. Credibility of central banks can change 𝜋 𝐸
communication is key
6. International Trade and Globalization
a. Ricardian Model
i.
Opportunity Cost
ii.
Absolute advantage
iii.
Comparative advantage: lower opportunity cost, and specialize on
comparative advantage
iv.
PPF
v.
Autarky: no trade
vi.
World supply and demand:
vii.
If one country is very big, then big L, so the first horizontal part
extends long and may cross the world demand. This leads to the big
country not specializing since being indifferent, so no gains from trade.
Gravity model of trade:
b.
i.
ii.
c.
d.
Distance means more than distance, such as cultural differences, ease
of crossing borders, etc.
Trade agreements reduce border effects
Skills premium: inequality fueled by skill premium
Compensation and retraining to pay back those worse-off due to
globalization
7. Behavioral Insights
a. Endowment effect: values those you own more
b. Decision utility vs experienced utility
i.
Decision utility: perception of utility before experiencing it, often in
the hot state, overconfidence, etc.
ii.
iii.
Experienced utility: actual utility arising from the decision, in the cold
state
Solutions:
1) Taxing or banning: not Pareto efficient, still some rational
thinkers
2) Nudge theory: Libertarian paternalism – consumers are still free
to choose
a) Default options
b) Decoy effect: the presence of a third, less attractive option
(the "decoy") influences consumers' preferences between two
other options. The decoy is designed to make one of the
3)
c.
d.
e.
original options (the "target") more attractive compared to
the other
Cooling-off clauses
Risk
i.
ii.
Lotteries and expected utilities
Risk aversion
1) Utility functions
a) Concave  risk averse
b) Convex  risk loving
c) Linear  risk neutral
iii.
Hedging: combining lotteries to reduce overall risk
1) Risk sharing
2) Risk pooling
Overconfidence: “re-weighting” probabilities in favor of some outcomes
Loss aversion and Prospect Theory
i.
Framing: how you present a choice to decision-makers matters
ii.
Loss aversion: response to losses is more extreme than to gains,
relative to a reference point
iii.
Prospect Theory: loss aversion
8. Epistemology of Economics and Finance
a. Economics as a domain vs as an approach
i.
Domain: e.g. study of the production, distribution and consumption of
wealth
ii.
Approach: study of how changes in the circumstances of scarcity affect
optimal choice
b. Instrumentalism: The view that only prediction matters to label a model
“good” or “bad” (not considering the assumptions)
c. Auctions
i.
English auctions
1)
ii.
Reserve price and bidders offer sequentially, with successively
higher prices; generally, there is a minimal bid increment
2) Pareto efficient when reservation price equals the seller’s
valuation
3) Not profit maximization: since the final price may not be the most
that the buyer is willing to accept
Dutch auctions
1) Auctioneer starts with a high price and gradually lowers it until
someone is willing to buy the item
Not Pareto efficient: depends on the bidders’ beliefs about the
values of other bidders, and no guarantee that good will be
awarded to the person with the highest valuation
Sealed-billed auctions
1) Each bidder places their bid in a sealed envelope. Envelopes are
collected and opened, and the goods are awarded to the highest
bidder.
2)
iii.
2)
Not Pareto efficient: depends on the bidders’ beliefs about the
values of other bidders
Vickrey auctions
1) Similar to a sealed-bid auction in that the winner is the highest
bidder, but the winner pays the amount bid by the second highest
bidder!
2) If everyone bids their true valuation, then the winner will be the
person with the highest valuation  Pareto efficient
a) Why always true valuation?
iv.
d.
RCT
i.
ii.
iii.
iv.
INUS causality: Insufficient, but Non-redundant, part of an
Unnecessary but Sufficient condition
Internal validity: how well a study is conducted (its structure) and how
accurately its results reflect the studied group
External validity: how applicable the findings are in the real world
RCTs have internal validity but not external validity
1) Shows that a policy worked but does not prove that it always
works outside the confluence of factors that is present
2)
Policy worked, but is it the best?