Markets, Efficiency and the Public Interest

Markets, Efficiency and the Public Interest

Efficiency under Perfect Competition

EFFICIENCY UNDER PERFECT COMPETITION

Defining social efficiency

Pareto improvements Pareto optimality

Private efficiency
rational economic behaviour equating marginal benefits and marginal costs

EFFICIENCY UNDER PERFECT COMPETITION

Achieving social efficiency under perfect competition
efficiency in consumption: MU = P efficiency in production: P = MC

Maximum total surplus under perfect competition

MC

Pe

D = MU
O

Qe

Maximum total surplus under perfect competition

MC

A
Pe

B C
O

D = MU Qe
Q

EFFICIENCY UNDER PERFECT COMPETITION

Achieving social efficiency under perfect competition
efficiency in consumption: MU = P efficiency in production: P = MC assumption of no externalities

EFFICIENCY UNDER PERFECT COMPETITION

Achieving social efficiency under perfect competition
efficiency in consumption: MU = P efficiency in production: P = MC assumption of no externalities social efficiency in goods markets: MSB = MSC

Maximum total surplus under perfect competition

MC

A
Pe

B C
O

D = MU Qe
Q

EFFICIENCY UNDER PERFECT COMPETITION

Achieving social efficiency under perfect competition
efficiency in consumption: MU = P efficiency in production: P = MC assumption of no externalities social efficiency in goods markets: MSB = MSC social efficiency in factor markets: MSBf = MSCf

EFFICIENCY UNDER PERFECT COMPETITION

Achieving social efficiency under perfect competition
efficiency in consumption: MU = P efficiency in production: P = MC assumption of no externalities social efficiency in goods markets: MSB = MSC social efficiency in factor markets: MSBf = MSCf

Interdependence, efficiency and the invisible hand

The interdependence of goods and factor markets

FIRMS (suppliers of goods and services, demanders of factor services)

HOUSEHOLDS (demanders of goods and services, suppliers of factor services)

The interdependence of goods and factor markets

D1 = MU1 = MSBG1 O
Q

(1) Consumer demand

The interdependence of goods and factor markets

Goods P (2) Producer supply

S = MC = MSCG

D1 = MU1 = MSBG1 O
Q Goods

(1) Consumer demand

The interdependence of goods and factor markets

Goods P S (2) Producer supply

P1 D1

Q1 Goods

(1) Consumer demand

The interdependence of goods and factor markets

(3) Factor demand

Goods

(2) Producer supply

P S

P1 D1 = MRPF1 = MSBF1 O Q D1

Q1 Goods

(1) Consumer demand

The interdependence of goods and factor markets

(3) Factor demand

Factor services

Goods P

(2) Producer supply

S = MDUF = MSCF

P1 D1 = MRPF1 = MSBF1 O Q Factor services D1

Q1 Goods

(4) Factor supply

(1) Consumer demand

The interdependence of goods and factor markets

(3) Factor demand

Factor services

Goods P

(2) Producer supply

PF1 D1 O QF1 Q Factor services

P1 D1

Q1 Goods

(4) Factor supply

(1) Consumer demand

The interdependence of goods and factor markets

(3) Factor demand

Factor services

Goods P

(2) Producer supply

S P2 P1 D2 = MU2 = MSBG2 D1

PF1 D1 O QF1 Q Factor services

Q 1 Q2 Goods

(4) Factor supply

(1) Consumer demand

The interdependence of goods and factor markets

(3) Factor demand

Factor services

Goods P

(2) Producer supply

P PF2 PF1

S P2 P1 D2 = MU2 = MSBG2 D1

D1 O QF1QF2

D2 = MRPF2 = MSBF2

Q 1 Q2 Goods

Factor services

(4) Factor supply

(1) Consumer demand

Markets, Efficiency and the Public Interest

Social Efficiency: Intermediate Analysis

SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS

Private efficiency in goods markets
in consumption: MUX / MUY (MRS) = PX / PY in production: MCX / MCY (MRT) = PX / PY

Social efficiency in goods markets

between consumers: MRSa = MRSb ... = MRSn

between producers: MRTg = MRTh ... = MRTn

in exchange (assuming no externalities): social MRS = social MRT

SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS

Social efficiency in factor markets

The achievement of general equilibrium

Social efficiency under perfect competition

Production possibility curve

Good Y

Slope = MRT
O Good X

Social efficiency under perfect competition

Social indifference curves

Good Y

Slope = MRS

I3 I2

Slope = MRT
O Good X

I1

Social efficiency under perfect competition

Market price ratio

MRS = PX / PY = MRT
Good Y

s
Slope = MRS

Slope = PX / PY Slope = MRT

O Good X

I3 I2 I1

Markets, Efficiency and the Public Interest

The Case for Government Intervention

CASE FOR GOVERNMENT INTERVENTION

Externalities
External costs of production MSC > MC

External costs in production

MC = S

Costs and benefits

O Quantity

Q1

External costs in production

MSC MC = S

Costs and benefits

P External cost

Q2

Q1

Social optimum

Quantity

CASE FOR GOVERNMENT INTERVENTION

Externalities
External costs of production MSC > MC

External benefits of production MSC < MC

External benefits in production

MC = S

Costs and benefits

Q1 Quantity

External benefits in production

MC = S MSC

Costs and benefits

External benefit P

Q1 Quantity

Q2

Social optimum

External costs and benefits in production

MSC MC = S
Costs and benefits () Costs and benefits ()

MC = S MSC

External benefit P

P External cost

Q2 Quantity

Q1

Q1 Quantity

Q2

(a ) External costs

(b) External benefits

CASE FOR GOVERNMENT INTERVENTION

Externalities
External costs of production MSC > MC

External benefits of production MSC < MC

External costs of consumption MSB < MB

External costs in consumption

Costs and benefits

(MB) MU = D

Q1 Quantity

External costs in consumption

Costs and benefits

External cost

(MB) MU = D MSB
O Q2 Q1 Quantity

Social optimum

CASE FOR GOVERNMENT INTERVENTION

Externalities
External costs of production MSC > MC

External benefits of production MSC < MC

External costs of consumption MSB < MB External benefits of consumption MSB > MB

External benefits in consumption

Costs and benefits

(MB) MU = D

Q1 Quantity

External benefits in consumption

External benefit Costs and benefits

MSB
(MB) MU = D

Q1 Quantity

Q2

Social optimum

External costs and benefits in consumption

Costs and benefits ()

Costs and benefits ()

External benefit

External cost P

P MSB

MB MSB
O
Q2

MB

Q1 Car miles

Q1 Rail miles

Q2

(a ) External costs

(b) External benefits

CASE FOR GOVERNMENT INTERVENTION

Public goods
Non-rivalry Non-excludability: free-rider problem

Common resources
equilibrium use of a common resource

Fishing in open-access fishing grounds

AC = MC

ARP
O
Number of boats

MRP

Fishing in open-access fishing grounds

Equilibrium: well beyond Thethe optimum collective optimum Beyond this point no for boat owners more fish can be caught

AC = MC

ARP
O
B1 B
2

Number of boats

MRP

CASE FOR GOVERNMENT INTERVENTION

Public goods
Non-rivalry Non-excludability: free-rider problem

Common resources
equilibrium use of a common resource the tragedy of the commons

CASE FOR GOVERNMENT INTERVENTION

Public goods
Non-rivalry Non-excludability: free-rider problem

Common resources
equilibrium use of a common resource the tragedy of the commons current-day examples

CASE FOR GOVERNMENT INTERVENTION

Public goods
Non-rivalry Non-excludability: free-rider problem

Common resources
equilibrium use of a common resource the tragedy of the commons current-day examples

Market power

CASE FOR GOVERNMENT INTERVENTION

Public goods
Non-rivalry Non-excludability: free-rider problem

Common resources
equilibrium use of a common resource the tragedy of the commons current-day examples

Market power
lack of Pareto optimality

A monopolist producing less than the social optimum

MC

P1

MC1

AR MR
O Q1

Monopoly output

A monopolist producing less than the social optimum

MC = MSC

P1 P2 = MSB
= MSC

MC1

AR = MSB MR
O Q1 Q2

Q
Perfectly competitive output

Monopoly output

CASE FOR GOVERNMENT INTERVENTION

Public goods
Non-rivalry Non-excludability: free-rider problem

Common resources
equilibrium use of a common resource the tragedy of the commons current-day examples

Market power
lack of Pareto optimality deadweight loss under monopoly

Deadweight loss under monopoly

MC
(= S under perfect competition)

Consumer surplus

Ppc

a
Producer surplus

AR = D

Qpc Q (a) Industry equilibrium under perfect competition

Deadweight loss under monopoly

MC
(= S under perfect competition)

Pm Ppc

Consumer surplus

Deadweight welfare loss

b a

Producer surplus

MR
O Qpc

AR = D
Qpc

(b) Industry equilibrium under monopoly

Deadweight loss under monopoly

Perfect competition

MC
(= S under perfect competition)

Consumer surplus

Ppc

a
Producer surplus

AR = D

Qpc Q (a) Industry equilibrium under perfect competition

Deadweight loss under monopoly

MC

Monopoly

(= S under perfect competition)

Pm Ppc

Consumer surplus

Deadweight welfare loss

b a

Producer surplus

MR
O Qpc

AR = D
Qpc

(b) Industry equilibrium under monopoly

CASE FOR GOVERNMENT INTERVENTION Ignorance and uncertainty Immobility of factors and time lags Protecting peoples interests
dependants

merit goods

Other objectives

Possible conflict between objectives

Limitations of economics in assisting policy making

Markets, Efficiency and the Public Interest

Forms of Government Intervention

FORMS OF GOVERNMENT INTERVENTION

The problem of the second best

the first-best world the second-best solution to market distortions

Taxes and subsidies

to correct externalities
the first-best world

Using taxes to correct a market distortion (first-best world) MC = S

Costs and benefits

O Quantity

Q1

Using taxes to correct a market distortion (first-best world) MSC MC = S

Costs and benefits

P External cost

Q2

Q1

Social optimum

Quantity

Using taxes to correct a market distortion (first-best world) MSC MC = S

Costs and benefits

Optimum tax = MSC MC

MC

Q2 Quantity

Q1

Using subsidies to correct a market distortion (first-best world)

MC = S

Costs and benefits

Q1 Quantity

Using subsidies to correct a market distortion (first-best world)

MC = S MSC

Costs and benefits

External benefit P

Q1 Quantity

Q2

Social optimum

Using subsidies to correct a market distortion (first-best world)

MC = S MSC
MC Costs and benefits Optimum subsidy = MC MSC P

Q1 Quantity

Q2

FORMS OF GOVERNMENT INTERVENTION

The problem of the second best

the first-best world the second-best solution to market distortions

Taxes and subsidies

to correct externalities
the first-best world second-best tax and subsidy policies

Using taxes to correct for externalities: firms with monopoly power

MC

P1

Monopoly price and output

D = MSB MR

Q1

Using taxes to correct for externalities: firms with monopoly power

MSC MC

P2 P1

Optimum price and output

D = MSB MR

Q2 Q1

Using taxes to correct for externalities: firms with monopoly power

MSC MC + tax MC

P2 P1

Optimum tax on the monopoly

Optimum tax MR

D = MSB

Q2 Q1

Using taxes to correct for externalities: firms with monopoly power

MSC MC + tax MC

P2 P1

Continuing excess profits can be reduced by a further lump-sum tax Optimum tax MR

D = MSB

Q2 Q1

FORMS OF GOVERNMENT INTERVENTION

The problem of the second best

the first-best world the second-best solution to market distortions

Taxes and subsidies

to correct externalities
the first-best world second-best tax and subsidy policies

to correct for monopoly

FORMS OF GOVERNMENT INTERVENTION

The problem of the second best

the first-best world the second-best solution to market distortions

Taxes and subsidies

to correct externalities
the first-best world second-best tax and subsidy policies

to correct for monopoly

use of lump-sum taxes plus subsidies

Using a lump-sum tax to reduce monopoly profits

MC

P =AR

AR = MSB MR
O Q1

Using a lump-sum tax to reduce monopoly profits

MC

P =AR

AC

Profit (no tax)

AC

AR = MSB MR
O Q1

Using a lump-sum tax to reduce monopoly profits

1. Acceptable profit 2. Lump sum tax necessary to achieve acceptable profit

MC

AC
P1

+ lump-sum tax

AC 1

AC + tax

2
AC

AR = MSB MR
O Q1

FORMS OF GOVERNMENT INTERVENTION

The problem of the second best

the first-best world the second-best solution to market distortions

Taxes and subsidies

to correct externalities
the first-best world second-best tax and subsidy policies

to correct for monopoly

use of lump-sum taxes plus subsidies

advantages and disadvantages of taxes and subsidies

Deadweight loss from an indirect tax

Before-tax situation

P1

D
O
Q1

Deadweight loss from an indirect tax

Before-tax situation Consumer surplus

P1

D
O
Q1

Deadweight loss from an indirect tax

Before-tax situation Consumer surplus

P1

Producer surplus D
O
Q1

Deadweight loss from an indirect tax

S + tax S

P2 P1 P2 - tax

D
O
Q2 Q1

Deadweight loss from an indirect tax

S + tax S 1
P2 P1 P2 - tax

2 4
6

3 5

D
O
Q2 Q1

Deadweight loss from an indirect tax

S + tax S 1
P2 P1 P2 - tax

2 4
6

3 5

D
O
Q2 Q1

Deadweight loss from an indirect tax

S + tax S 1
P2 P1 P2 - tax

2 4
6

3 5

D
O
Q2 Q1

Deadweight loss from an indirect tax

Tax revenue for government

S + tax S

1
P2 P1 P2 - tax

2 4
6

3 5

D
O
Q2 Q1

Deadweight loss from an indirect tax

S + tax Deadweight loss from tax 1

P2 P1 P2 - tax

2 4
6

3 5

D
O
Q2 Q1

FORMS OF GOVERNMENT INTERVENTION Changes in property rights

the problem of limited property rights extending property rights the Coase theorem limitations of this solution

Legal controls
laws prohibiting behaviour that imposes external costs laws to regulate monopoly power laws to prevent firms from exploiting peoples ignorance

FORMS OF GOVERNMENT INTERVENTION

Regulatory bodies
Price controls
high minimum prices

low maximum prices

Provision of information The direct provision of goods and services

providing public goods
other goods making rational decisions

Public ownership

Markets, Efficiency and the Public Interest

CostBenefit Analysis

COSTBENEFIT ANALYSIS

The procedure
Identifying costs and benefits
costs
direct private monetary
external monetary external non-monetary

benefits
direct private monetary private non-monetary

Private non-monetary benefits (consumer surplus)

50p

Q1

Private non-monetary benefits (consumer surplus)

Consumer surplus
50p

Private non-monetary benefit

Q1

COSTBENEFIT ANALYSIS

The procedure
Identifying costs and benefits
costs
direct private monetary
external monetary external non-monetary

benefits
direct private monetary private non-monetary external

COSTBENEFIT ANALYSIS

Measuring costs and benefits

direct private monetary costs and benefits non-monetary private benefits monetary externalities non-monetary externalities

Risk and uncertainty

sensitivity analysis

COSTBENEFIT ANALYSIS

Discounting
working out the NPV choosing the discount rate

The distribution of costs and benefits

the strict Pareto criterion the HicksKaldor criterion taking specific account of redistributive consequences

Markets, Efficiency and the Public Interest

The Case for Laissez-Faire

THE CASE FOR LAISSEZ-FAIRE

The growth of libertarian thinking

the neo-Austrian school and its influence on radical-right thinking libertarian policies of governments

Drawbacks of government intervention

shortages and surpluses poor information bureaucracy and inefficiency lack of market incentives shifts in government policy lack of freedom for the individual

THE CASE FOR LAISSEZ-FAIRE Advantages of the free market

automatic adjustments

dynamic advantages of capitalism

high degree of competition even under monopoly/oligopoly

Judging the arguments