Efficiency and Equity

2008/22165

A rationing system to deal with the

economic problem
Because economic resources are relatively scarce
(resources are limited, wants are unlimited) a
society cant have everything they want. There must
be a system that rations both resources and
products.
The rationing system must answer the following
questions:
1. What, and how much, to produce
2. How to produce
3. For whom to produce
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 2

Tests for a rationing system

The two basic tests for any rationing system are:
Is the system efficient?
Is it fair?

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 3

Efficiency and equity

1.

2.

Efficiency is the economy getting the most of out its

scarce resources (or are they being wasted)?
1. Technical efficiency is production being done at
lowest unit cost?
2. Allocative efficiency are resources being used to
make products that people want?
Equity how fair is the distribution of products between
different members of society?
1. Horizontal equity no discrimination between
people whose economic characteristics and
performance are equal
2. Vertical equity different treatment of different
people in order to reduce the differences between
people
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 4

Different rationing systems

The worlds dominant rationing system is the price
mechanism.
Prices are determined in markets (as a result of the
interplay of demand and supply).
Given the correct economic conditions,
advocates of market economies believe they lead to
the best allocation of resources and the highest
level of net economic welfare.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 5

Different rationing systems

But markets are not the only way to resolve
what and how much to produce,
how to produce, and
for whom to produce
How else can economic activity be co-ordinated?
How can the necessary economic choices be made
and on what grounds?
Will the resulting pattern of production, distribution
and consumption be efficient?
Will it be fair?
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 6

Some options
Ballot (lanes in Melbourne Cup)
Central directives (in Cuba, North Korea)
Allocate to members (finals tickets, some
wine vintages)
Rules and regulations (water restrictions
by street number)
Queues first come first served (public
hospitals)
Priority allocation (AFL draft)
Merit university selection
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 7

The worlds dominant rationing

system.
It has already be said that the worlds dominant
rationing system is the price mechanism.
The circular flow of income model illustrates
some of the markets that operate in the economy.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 8

Markets in the circular flow

Consumption =
demand
Goods and
services
= supply
HOUSEHOLDS
Price

PRODUCERS
Supply

Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 9

Markets in the circular flow

Price

Supply

Demand
Quantity
HOUSEHOLDS

PRODUCERS
Resources (e.g. labour)
= supply

Demand for resources =

demand
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 10

The super-computer network

In a competitive free market economy the market for
each product and economic resource is connected to
the market for all other products and resources
through an ultra-complex network of prices.
This network operates invisibly as if driven by a
giant free-market super-computer.
What is the operating system for this free-market
super-computer?

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 11

Prices as a signalling mechanism

The free-market super computer operates through an
ultra-complex network of prices. The prices provide
a messaging or signalling service for producers and
consumers in the economy.
Normally, a rise in price reflects an increase in
relative scarcity. The higher price signals
Consumers to reassess their buying choices (are
they still getting value for money some will
buy less)
Producers to reassess their production choices
(could they increase profits by supplying more?)
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 12

Prices as a signalling mechanism

The system only works if consumers and producers
get the right message
make a rational choices when they act on the
message
Prices send the right message given the right
economic circumstances. The right circumstances
create a truthful world where the demand curve
reflects value or benefit and the supply curve
reflects costs.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 13

The correct economic conditions

What are the correct economic conditions that allow
markets to maximise welfare?
1.
2.
3.
4.
5.

No information gaps / no asymmetrical

information
No side-effects (externalities) / no effect on
bystanders
No monopoly (or scarcity power)
Good motives and incentives
No free riders or non-exclusion products

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 14

Given the right conditions markets

maximise welfare.
In these economic conditions:
Price = marginal social benefit
Price = marginal social cost
Consumers get what they want
Producers dont waste resources
If these conditions do not exist the market becomes
distorted (price does not reflect value and cost).
Demand and supply curves are in the wrong place.
Welfare is reduced. There is a deadweight loss.
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 15

Markets increase trade and trade

increases welfare

Price

Consumers only buy things if

the value of the product to
them is equal or greater than
their opportunity cost.
Consumer
surplus

Supply

Demand
Quantity

So, people that buy something

in a market at the ruling price
are getting a bonus the
value they receive is greater
than the price they pay.
This bonus is called
consumer surplus. It
increases their welfare or
satisfaction.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 16

Markets increase trade and trade

increases welfare

Price

Supply

Producers only supply things if

the price they can get is equal
or greater than the cost of
production.
Efficient producers can supply
for less than the clearance
price.

Producer
surplus

When a sale is made they get a

Demand bonus the money they
receive is greater than their
Quantity
costs of production.
This bonus is called producer
surplus. It increases their

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 17

Trade increases welfare

Price
Consumer
surplus

Supply

The sum of consumer and

producer surplus indicates
the total increase in welfare
from this market.
So markets create trade and
trade increases welfare.

Producer
surplus
Demand
Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 18

The world of truth

This is only good if the
world of truth exists
Price
Consumer
surplus

Supply

Producer
surplus
Demand
Quantity

Competitive markets
create a WORLD OF
TRUTH.
The demand curve is a
true indicator of the
value of the product to
consumers.
The supply curve is a true
indicator of the cost of
production for producers.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 19

The world of truth

Price
Consumer
surplus

Supply

Competitive markets are,

therefore efficient
because:
consumers get what
they want

Producer
surplus
Demand
Quantity

producers make the

right things in the right
quantities.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 20

Welfare is maximised at the clearance

price.

Price

Supply
Cost
greater
than benefit
trade
stops at Q1
Demand

P1

Q1

Quantity

People will opt out of

trading if they are going
to reduce their welfare.
They will lose if cost is
greater than benefit.
Trade increases consumer
and producer welfare up to
quantity Q1. If the aim is to
maximise benefits and
profits trade should rise to
Q1.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 21

The world of truth

If the market clearance
price is not charged welfare
falls.

Price
Consumer
surplus

Supply

Deadweight
loss

Producer
surplus

Q2

Demand
Quantity

If a price is set below the

clearance price producers
reduce supply (to Q2).
There is excess demand.
Producer surplus is low (the
orange area).
The consumers who can get
the product get a big bonus
(the red area), but some
potential buyers go without.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 22

The world of truth

Price
Consumer
surplus

Supply

Deadweight
loss
Producer
surplus
Demand
Quantity

If the market clearance

price is not charged welfare
falls.
If a price is set above the
clearance price consumers
reduce demand.
There is excess supply.
Consumer surplus is low
(the red area).
Producers who make a sale
get a big bonus (the
orange area), but some
production is left unsold.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 23

Applying the concept to international

trade
It is easy to show that overall
welfare rises if trade
between countries is
increased.
Exporters can get higher
prices for their products (we
are more efficient than the
overseas country) and sell
more. Some supply is
diverted from domestic sales
so consumers lose out.

Price

Consumer
surplus
Domestic
Supply
Overseas
supply
RISE IN
WELFARE

Producer
surplus

Domestic
Demand
Quantity

However, overall welfare

increases .
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 24

Applying the concept to international

trade
It is easy to show that
overall welfare rises if trade
between countries is
increased.
Consumers can buy goods at
cheaper prices (we are less
efficient than the overseas
country). Our producers lose
out as competition from
imports increases.

Price

Consumer
surplus
Domestic
Supply

RISE IN
WELFARE
Overseas
supply
Producer
surplus

However, overall welfare

increases.
Efficiency and Equity (c) Andrew Tibbitt 2008

Domestic
Demand
Quantity

Slide 25

Applying the concept to international

trade
Taken together more
Price
exports and more imports
lead to higher welfare.
There has been a
redistribution effect
though, some producers
gain, some lose,
consumers gain if they
buy some products and
lose if they buy others. Is
this fair?
Efficiency and Equity (c) Andrew Tibbitt 2008

Domestic
Supply

RISE IN
WELFARE
Overseas
supply
Domestic
Demand
Quantity

Slide 26

Market failure
Markets sometimes fail to produce efficient results
because the necessary conditions do not exist.
They fail, for example when :
1. Externalities are not taken into account (and
bystanders suffer collateral damage)
2. Producers have scarcity or monopoly power
(and they dominate the market, raise prices
and earn excessive profits
3. Key information is not known or shared evenly
4. Income distribution is unfair.
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 27

When there are externalities

Bystanders (third parties) can be affected by
economic decisions made by others. These spin-off
or side effects of an economic decision are called
externalities.
Bystanders can be affected in a good or positive way
(e.g. your neighbour has nice garden). These
positive externalities create social benefits.
Bystanders can be harmed or affected in a negative
way (e.g. people become sick from factory pollution).
These negative externalities create social costs.
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 28

Ignoring externalities leads to

inefficiency

Too much will be

produced and
consumers will pay too
low a price.

S
airlines

co
st
o

f5
%

of

cli
m

at
e

ch
a

ng
e

Price

So
cia
l

If market players do not

take these negative
externalities or social
costs into account (do
not include them in their
demand and supply
decisions) the market
will not work efficiently.

S total

Air travel

Quantity
Greenhouse Gases are emitted by planes.
So do free markets create too many flights
at too low a price?
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 29

Ignoring externalities leads to

inefficiency

Too little will be supplied

and consumers will pay
too high a price.

private

of
le
ss

co
ng
es

tio

S total

be
ne
fit

Price

So
cia
l

In a similar way, if
market players do not
take positive
externalities or social
benefits into account (do
not include them in their
demand and supply
decisions) the market will
not work efficiently.

Public transport S

Quantity
Free market public transport could be
too expensive if it forces people to
use their cars and cause congestion
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 30

Scarcity or monopoly power

If one of the players in a market has power over the
other then the market outcome becomes distorted and
the result can be inefficient. If a producer has
monopoly power in a sense they have scarcity
power.
Monopoly power comes from a lack of competition.
Producers can deliberately minimise competition (e.g.
by branding, innovation, take overs). Producers with
monopoly power can restrict supply or push up prices.
The price no longer reflects the costs of production.
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 31

Monopolists restrict supply and push

up prices.

Price

Consumer
surplus

New Supply
(monopoly)
Supply
(competitive)

Deadweight
loss

Producer
surplus

Monopolists have the

power to control supply
in the market. This can
lead to prices that are
higher than those set in
competitive markets.
The result is inefficiency.

Demand
Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 32

Information gaps
Competitive free markets only produce efficient
outcomes if
Demand curves reflect the true level of
consumer value or marginal benefit
Supply curves reflect true costs of production
(the opportunity of using the resource inputs)
If producers dont know the cost of production (like
insurance companies) and consumers dont know
the value of the product they are buying (like health
care and second hand cars) then the market cant
operate efficiently.
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 33

Other problems for the market

economy
Income distribution
Demand curves reflect effective demand.
Effective demand exists if a need or want can be
backed up by the ability to pay for it.
If income distribution is unfair (lacks equity) the
pattern of effective demand will be unfair.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 34

Other problems for the market

economy
Public and collective goods
Products
that are non-rival products (one person using the
good doesnt prevent another for using it as well)
where the exclusion principle does not operate
(the supplier or owner cant prevent non-payers
or free-riders from using the product)
where individual demand is unrealistic (such as
national defence)
will not be efficiently produced in a free market
economy.
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 35

Modified market economies

As a result of market failure, nearly all economies are not
pure free market economies but mixed economies.
Governments modify markets or override the market
altogether by influencing:
the allocation of resources (e.g. through taxes,
subsidies, or directives) allocative role
business behaviour (e.g. through regulations and
legislation) regulatory role
the distribution of household incomes (e.g. through
taxation and welfare) redistribution role
the overall level of aggregate demand (e.g. through
fiscal and monetary policy) demand management
role
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 36

Government modifications
Policy measures to fix up or prevent market failure
include:
1. Taxing bad behaviour, taxing high income
earners
2. Subsidising good behaviour, paying welfare to
low income earners.
3. Regulating or legislating against bad behaviour
4. Regulating or legislating good behaviour
5. Establishing markets to trade permits to
behave badly
Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 37

Government failure
In some situations government intervention does prevent
or fix up market failure. But overall central planning does
not provide a more efficient and fairer rationing system.
Government run economies suffer from:
1.
2.
3.
4.
5.

Bureaucratic and cumbersome allocation processes

Moral hazard
Rent seeking behaviour (corruption)
Lack of incentive bottomless pots, feather bedding,
no competition
Lack of consumer freedom or sovereignty

The trick is to intervene only when necessary.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 38

Taxing a competitive market reduces

net economic welfare.
Supply with
tax
Price

Taxing a
competitive market
reduces welfare.

Supply
without tax

REDUCTION IN NET
WELFARE =
DEADWEIGHT LOSS
Demand
Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 39

A difference of emphasis
When to intervene and modify a market is a matter of
judgement for governments. Economists can use the
concepts of consumer surplus, producer surplus and net
economic welfare to inform the policy debate.
LEFT

RIGHT

Responsibilities

Rights

Entitlements

Choice

Equity

Efficiency

Market failure

Incentives

Government intervention

Government failure

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 40