Economics

1. Economics Efficiency/inefficiency

2. Recall, one role for the government: • Improve efficiency • When markets cannot cope • Other ones: rules, distribution • Efficiency = cannot be improved • There are many ways one can define “improved”

3. Improvement: make at least one person better off without making anybody else worse off • = Pareto improvement • Hard to argue against, so accepted by everyone • An allocation is Pareto efficient if there is no possible change that would make at least one person better off without making anybody else worse off • = An allocation is Pareto efficient if there is no Pareto improvement

4. Improvement: make some persons better off and possibly other persons worse off, the sum of all positive changes (gains) and all negative changes (losses) is positive • = Marshall improvement • There are losers and winners • Winners together gain more than losers together lose • There is a net gain • An allocation is Marshall efficient if there is no Marshall improvement • There are usually multiple Pareto efficient allocations • There are usually few Marshall efficient allocation • Efficiency considerations depend on who counts as a “person”

5. Competitive market equilibrium is efficient • Surplus from trade • Maximized in equilibrium • Possible changes would fail to improve • Change quantity • Redistribute

6. But we started with some assumptions • “a guy walks into a store and sees a price…” • competition • information • no effect on others except through exchange payment

7. Competitive market equilibrium is efficient, IF • Perfect information • No externalities • No public good • No monopoly power • = First Fundamental Theorem of Welfare Economics

8. Externality: a direct effect on somebody who is not a part of the transaction • Dirty water down the river • Nice flowers in front of a house • May be positive or negative • May be an effect on cost or benefits

9. The true cost/benefit differs from what is taken into account • A decision maker ignores some bad/good things that come from a decision • There is a missing market • So, the policies: • Make the decision maker take it into account • regulations • Create missing markets • Taxes/subsidies • “imitating price”

10. Inventory • Increasing third party’s benefits = positive externality = inefficiently low quantity in market equilibrium = subsidy helps • Increasing third party’s costs = negative externality = inefficiently high quantity in market equilibrium = tax helps • Decreasing third party’s benefits = negative externality = inefficiently high quantity in market equilibrium = tax helps • Decreasing third party’s benefits = positive externality = inefficiently low quantity in market equilibrium = subsidy helps

11. Public good is • shareable in consumption • You consume, yet my satisfaction does not diminish • non-excludable in provision • Can’t stop people from having it • Maximizing agent • Ignore benefits • Just like in a positive externality case • Inefficiency = underproduction • Government? Usually produce/finance rather than regulate. • Why?

12. Free-Rider Problem (= sort of Prisoners’ Dilemma): • People do not pay, even though they understand that somebody has to pay • Government: collect taxes by force • Many theories of government are based on this

13. Monopoly: • Marginal revenue < price • Inefficiently low level of production • Government: • Regulation • Price • Production level • Subsidy would work but very hard to cheer for

14. Imperfect information: • Buyer thinks benefit is A but it really is B • Firm thinks cost is A but it really is B • Like an externality unknowingly imposed on oneself • Experience goods • Fibbing to win • “simply” imperfect information: government cannot do much, except maybe facilitate dissemination • Asymmetric information: gives rise to institutions, including government itself