Part IIa: Paper 1 General Equilibrium and Welfare Economics Dr Hamish Low

1. 1 Lecture 8 Part IIa: Paper 1General Equilibrium and Welfare EconomicsDr Hamish Low

2. 2 Outline Club goods (from last time) Externalities Coase Theorem Pigouvian Taxes Information problem Second best policies Common Property Resources (Nothing on imperfect competition)

3. 3 Club Goods Club good: A club good is a good that is either nonrivalrous or partly rivalrous but for which exclusion by the providers is possible The exclusion of non-members can be literal or legal The choice to join a club reveals preference Issues of preference revelation are not important for club goods

4. 4 A club must determine: The number of members to admit The quantity of the public good to provide Admitting more members: Spreads the cost of provision which benefits all member But can cause congestion of facilities which harms members Efficiency within the club is achieved by balancing these effects Club Goods

5. 5 Club Goods If amount a club is used can be chosen, a fixed fee will not ensure efficiency unless visits are restricted Without a restriction each member will use the club until private marginal benefit is zero This ignores the congestion cost on others Total visits are excessive The efficiency outcome is attained with a two-part tariff A membership fee A charge for each visit

6. 6 Clubs Goods and Pareto Efficiency Each club achieves efficiency in its own provision Does this imply overall efficiency can be achieved? exclusion of some despite non-rivalrous good multiple clubs set-up, fixed costs? overall efficiency unlikely

7. 7 Summary Private provision of public good inefficient compared to optimal provision Achieving optimal provision requires information on preferences Lindahl prices first-best mechanism for deciding on amount of public good Asymmetric information means incentive to cheat Vickery auction or Clarke-Groves tax Club goods where exclusion is possible

8. 8

9. 9 Externalities Third party effects Inefficiency because the parties involved in the transaction do not take account of the third party Example 1: price of oil rises, switch to fuel efficient car but price of car has gone up because others have also switched Example 2: price of oil rises, switch to public transport, but this is congested by others who have also switched

10. 10 Example 2 Traffic Jams Assume there are N commuters with a choice of train or car Travel by train takes 40 minutes The travel time by car increases as the number of car users increases Commuters make the choice which minimizes their personal travel time

11. 11 Example 2

12. 12 Consumption externality: third party affects utility Production externality: third party affects production Is efficiency likely to be maintained? How should the government intervene? Definitions of externality

13. 13 Example 3: Economists and Lawyers Pecuniary Externality Students choose to be economists or lawyers Income declines when more students make the same choice Pecuniary externality: an additional student choosing to be an economist lowers income for all economists Each individual ignores this externality when choosing occupation

14. 14 Example 3: Economists and Lawyers

15. 15 Efficiency and Externalities Consider a two person, two good economy Individual A�s maximisation problem, taking B�s choice of x and z as given:

16. 16 Efficiency and Externalities Individual B�s problem:

17. 17 Pareto efficiency:

18. 18 Efficiency and Externalities Social marginal benefit differs from private marginal benefit, and so social MRS differs from private MRS Individuals set private MRS equal to price, so inefficiency

19. 19 Efficiency and Externalities

20. 20 Pigouvian Taxes

21. 21 Rewriting the optimality condition Choose Pigouvian tax rate tax is positive if negative externality tax is negative (ie a subsidy) if positive externality and the individual optimisation is given by

22. 22 Pigouvian Tax

23. 23 Assessment of Pigouvian Taxes Restore first best, Pareto efficiency Social MRS condition holds Works by introducing price for the externality tax equal to marginal damage price for missing market May need to differentiate tax by consumers and firms Requires government to know marginal benefit and marginal cost curves.

24. 24 Coase Theorem Economic agents will solve externalities without intervention �In a competitive economy with complete information and zero transaction costs, the allocation of resources will be efficient and invariant with respect to legal rules of entitlement.� Legal rules of entitlement (or property rights) determine ownership in the economy Coase: externalities arise through the absence of property rights Pollution occurs when there is no right to clean air or clean water

25. 25 Coase Theorem If there was a property right anyone suffering an externality would be paid compensation (putting a price on the externality) Price of the externality in equilibrium will be the same as the optimal Pigouvian tax.

26. 26 Coase Theorem Two versions: Equilibrium is invariant to who is actually assigned property rights Equilibrium allocation will vary with who is actually assigned property rights, but equilibrium will always be efficient Version 1 assumes that income effects do not matter

27. 27 Will a firm pollute the atmosphere of a neighboring house? Only if the benefit from doing so exceeds the compensation required by the householder This applies whether the firm has the right to pollute or the householder has the right to clean air The final distribution of income will be different and depend on who is allocated the property rights Does the level of income affect the marginal benefit /marginal cost?

28. 28 Quasi-Linear Preferences

29. 29 Coase The practical limitations of the Coase theorem are: The lack of clear property rights Transaction costs in reaching compensation agreements Lack of comeptition: thin market implies bilateral bargaining and a potential inefficiency when incomplete information Potential monopoly power The Coase theorem suggests a resolution to the externality problem but there are reasons why the market may not function

30. 30 Information Pigouvian Taxes: government knows marginal benefit and marginal cost curves in order to calculate the price of the externality centralised solution Coase: government does not need to set the price and so does not need to know marginal benefit and marginal cost price set by competitive market decentralised solution

31. 31 Second best solutions Coase and Pigouvian solutions are first-best solutions, tackling the externality directly If not feasible, then may use second-best ideas: abandon remaining Pareto criterion correct externality by distorting another market Eg. cannot tax congestion directly, so tax petrol instead? Or subsidise public transport?

32. 32 Common Property Resources Non-excludable but rivalrous goods Tragedy of the commons Consider a lake that is used by local fisherman who can earn wage w if they do not fish The fishermen rent boats at cost c If B boats are hired each fisherman catches F(B) fish

33. 33 The equilibrium number of boats solves F(B*) � c = w The optimum number solves F(Bo) � c + BF�(Bo ) = w F�(Bo ) < 0 implies Bo < B* In equilibrium there are too many boats Each fisherman ignores the negative externality The tax can restore efficiency

34. 34 Summary (1) Pecuniary externality vs direct externality pecuniary externalities do not distort Pareto conditions Pigouvian solution: adjust price so that price includes marginal damage inflicted on third party Coasian solution: allocate property rights, then leave competitive market: leads to efficiency demand (marginal benefit) independent of income (no IE): always same amount of externality

35. 35 Summary (2) Instances of failure of the assumptions required for Fundamental Theorems: third party effects (externalities, public goods) information problems (ability is private information, preference over public goods is private information) can these be corrected using first best instruments (Pigou, Coase, Lindahl taxes) if not, theory of the second best, and Pareto efficiency conditions may no longer be necessary