Chapter 2 Economic Efficiency and Markets: How the Invisible Hand Works Static Efficiency, pp. 14-32

1. Chapter 2 Economic Efficiency and Markets: How the Invisible Hand WorksStatic Efficiency, pp. 14-32 © 2004 Thomson Learning/South-Western

2. The Working of the Invisible Hand • Adam Smith’s The Wealth of Nations argues that markets lead to socially efficient allocation of resources. People acting in their own best interests tend to promote the social interest. • Anti-globalization protestors counter that free markets are the root of all social evils. • The truth probably lies somewhere in between.

3. Market Fundamentals • Begin by looking at an every day private good. • The goal is to understand the differing components of a market. • After we understand how a market works, we can add the complexity associated with the impact of market activity on the environment, and the impact of the environment on market activity and society in general.

4. Figure 2.1 – Market for Blue Jeans

5. The Market for Blue Jeans: supply • The marginal cost is the cost of producing one more unit of a good. These costs include: • labor, • energy, • machinery, • and other materials. • Marginal Cost = Supply in competitive markets • Market supply is the sum of individual firm supply curves

6. The Market for Blue Jeans: supply S1 S = S1+S2 $ S2 Q Market supply is a horizontal summation of individual supply curves

7. The Market for Blue Jeans: demand • The downward sloping function is the demand curve • Demand represents how much people are willing to pay for an additional pair of jeans. Individual demand is influenced by: • tastes and preferences, • prices of substitutes and complements, • income, • and consumer expectations. • Individual demand is also interpreted as Marginal Benefit = value attached to each additional unit of the good

8. The Market for Blue Jeans: demand $ D = D1+D2 D1 D2 Market demand is a horizontal summation of individual demand curves Q

9. The Market for Blue Jeans • Equilibrium price is the price at which quantity demanded equals quantity supplied. • What happens when price is not at equilibrium? There is an automatic adjustment back to equilibrium. • If price is less than equilibrium (P*), then quantity demanded will be greater than quantity supplied and there will be pressure on price to rise (up to equilibrium). • If price is greater than equilibrium (P*), then quantity supplied will be greater than quantity demand and there will be pressure on price to fall (down to equilibrium).

10. Figure 2.1 – Market for Blue Jeans Phigh Plow

11. Why are economists so often so enamored with markets?? • The demand curve can viewed as a marginal value function based on willingness to pay. • The market demand curve is the sum of all individual demand curves. • Every individual demand curve reflects a willingness to pay based on a perceived value (or benefit) of the good. • Everybody counts! • As a result, the market demand curve reflects private benefits.

12. Measuring Net Benefits • The supply curve reflects the costs of producing the good or service. • These costs are incurred in production and can be viewed as private, since all these costs are borne by the suppliers. • As such, the supply curve embodies private costs.

13. Figure 2.1 – Market for Blue Jeans • Total benefit equals the area under the demand (marginal benefit curve) • What is the total benefit to consumers when Q* is produced? • What is the total cost to producing Q* ? A B C

14. Measuring Net Benefits • If we make two simple assumptions: • All costs associated with blue jeans are incorporated into the supply curve. • All the benefits associated with blue jeans are in the demand curve. • Then equilibrium in this market also equates marginal benefits with marginal costs. • The market maximizes total net benefits.

15. Summary: Maximizing Private and Social Benefits • Private net benefits are maximized at equilibrium. • In order for social net benefits to be maximized, it is necessary that private marginal benefits be identical to social marginal benefits and private marginal costs be identical to social marginal costs. • If this condition holds, then market forces will equate both marginal private costs and benefits and marginal social costs and benefits. • Efficiency = Maximizing social net benefits • Aren’t markets great ??

16. Market Failure: When the Invisible Hand Doesn’t Work • Market Failure occurs when the market does not allocate resources efficiently. • There are 5 categories of market failure: • Imperfect competition. • Imperfect information. • Public goods. • Inappropriate government intervention. • Externalities.

17. Imperfect Competition • Imperfect competition occurs when the individual actions of particular buyers or sellers have an impact on market price. • Monopoly = a single seller • Examples of monopoly: Ma Bell, company stores, electricity (regulated), etc. • Market failure due to imperfect competition has an impact on the study of environmental and natural resources because of the monopoly power in extractive industries such as oil and coal.

18. Monopoly – 1 Seller who controls the market $ Marginal Cost P1 Marginal Revenue Demand Q1 Q* Quantity

19. Figure 2.4. Imperfect Competition

20. Monopoly (imperfect competition) • Creates Market Failure • In imperfectly competitive markets, marginal revenue diverges from price and marginal social cost is not equal to marginal social benefit at equilibrium. • Monopoly is Inefficient • Why else don’t we like monopoly? (Why doesn’t Ralph Nader like monopoly?)

21. Imperfect Information • Imperfect information means that some segment of the market (either consumers, producers, or both) does not know the true costs or benefits associated with the good or activity. • For example: • High risk occupations where workers do not have complete information about risks (asbestos workers) • Hazards of using chemicals in your home where you may not be fully aware of dangers and potential side-effects. • Potential that farmers in developing countries are not aware of environmentally friendly alternatives to clear cutting.

22. Public Goods • Public goods are distinguished from private goods by two primary characteristics: nonrivalry and nonexcludability. • Nonrivalry means that one individual’s consumption does not diminish the amount of the public good available for other’s to consume. • Nonexcludability means that if one person has the ability to consume the public good, then others can’t be excluded from consuming it.

23. Public Good • National defense is an example of a pure public good. • Nonexcludability holds because in protecting one citizen in a region from missile attack, every citizen is protected. • Nonrivalry holds because one citizen’s consumption of protection does not reduce the level of protection available to other citizens.

24. Public Good • Not all public goods are pure public goods. • It is possible to build a long fence around the Grand Canyon to exclude people. • It is also true that beyond some point, more people at the Grand Canyon reduces the quality of the experience for everyone.

25. Figure 2.5 Spectrum of public goods

26. Public goods: Demand Market Demand = VERTICAL sum of demands $ DA DB Marginal Cost QB QA Q* Quantity

27. Public Goods, inefficient outcome of free market • Generally, too FEW public goods provided by free market • Free riding = get enjoyment out of public good provided by others without paying for it • Does this happen? • Government provision of public goods with taxation to pay for them is often justified based on these inefficiency arguments

28. Inappropriate Government Intervention • Government intervention is a potential source of disparity between private and social values. • Government action to address an alternative issue may create a divergence. • Government policy regarding leasing of timbering has created a greater than socially optimal level of timber harvest.

29. Figure 2.6 – Inappropriate Government Intervention

30. Unintended Consequences By STEPHEN J. DUBNER and STEVEN D. LEVITT, NY Times Magainze: January 20, 2008The Case of the Red-Cockaded Woodpecker • Endangered Species Act unintended effects on habitat?

31. Externalities • A common cause of market failure is the divergence externalities create between private and social costs. • Consider a production process which reflects all the private costs of production but does not reflect all the social costs associated with production (for example, if the process generates air pollution). • Now, marginal social cost is different from marginal private cost

32. Externality: Pollution from a factory $ Marginal Damage from pollution Quantity of Steel Output

33. Figure 2.3. Steel Production Example MSC = MPC + Marginal Damage from pollution

34. Market Failure • Market forces generate an equilibrium production level and price associated with private costs (Q1 and P1). • This output level is greater than the socially optimal level of Q* (which considers additional cost from pollution). • The shaded area in Figure 2.3 represents the costs to society of having this higher than optimal level of output. TOO MUCH output is generated by the free market • Shaded area = “deadweight loss” or lost social “net benefits” from too much production

35. Externalities • Externalities are best described as “spillover costs or benefits”, unintended consequences or side effects, associated with market transactions. • These unintended costs or benefits will result in a divergence between private and social benefits and costs • Externalities are perhaps the most important class of market failures for the field of environmental and resource economics.

36. Externalities • A more complete definition is provided by Baumol and Oates (1988, p.17) • “An externality is present whenever some individual’s (say A’s) utility or production relationships include real (that is nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A’s welfare.”

37. Unintended Effects • If you were intentionally blowing cigar smoke in someone’s face, that is not an externality. • If your cigar smoke drifts from your table to someone else’s, then this is an externality. • Intent is important.

38. Real Variables • Real variables are not prices. • Unintended price change is not an externality. • Price changes are viewed as “pecuniary externalities”, not real.

39. Production and Utility Relationships • Air pollution has the potential to impact both production and utility relationships. • Air pollution may create a less ideal growing condition and impact yields. • Air pollution may also make outdoor activities less enjoyable (reduce utility). • These are examples of technological externalities.

40. Technological vs. Pecuniary Externalities • Consider Figure 2.8 which represents a production possibilities frontier for two goods: cotton and steel. • The production possibilities frontier shows all feasible production points. • Consumer preferences determine the actual combination of cotton and steel produced. • A change in consumer preferences will result in a change in demand, which changes prices and profit potential, which, in turn, will cause a change in production levels of both goods (along the same production possibilities frontier). This is a pecuniary externality. NOT A CAUSE FOR GOVERNMENT INTERVENTION, just the free market at work!

41. Figure 2.8- Production Possibilities Frontier

42. Technilogical vs. Pecuniary Externalities • What happens if cotton production was damaged by steel generation? • Suppose pollution reduces the yield per acre of cotton with the existing resource base. • A new lower production possibilities curve results from this externality. • This is a technological externality. Technological externalities can be a cause for government intervention --- market failure

43. Externalities as Public Goods • Referred to as nondepletable externalities, these are characterized by the public good property of nonrivalry. • Air pollution that obscures a beautiful view is a good example where one person’s consumption of the externality (seeing the pollution) does not reduce the amount of pollution to which others are exposed (next guy that drives by still see cruddy view).

44. Market Failure and Property Rights: Open-access probolems • A special class of externality that is generated by the lack of property rights (or the inability to enforce property rights) is the open-access externality. • In this case property rights are insufficient to prevent general use of a resource and uncontrolled use leads to destruction or damage of the resource. • We will discuss this type of externality in detail later when we discuss renewable resource problems, fisheries and wildlife very susceptible to open-access problems

45. The Invisible Hand and Equity • Market allocation of resources, absent of market failure, is efficient. • An efficient allocation maximizes the difference between social benefits and social costs. • An efficient allocation, however, does not imply equitable allocation. • The “best” distribution depends on what view of equity or fairness is held. • Some (many?) arguments for government intervention relate to equity, what we have studied here are arguments based on efficiency, getting the most value for the most people

46. Conclusion • The bulk of this chapter focuses on markets and how markets efficiently allocate goods and services. • When market failure occurs, marginal private benefits diverge from marginal social benefits and marginal private costs diverge from marginal social costs. • Market failure results from externalities, public goods, imperfect information, imperfect competition, and inappropriate government intervention.