Introductory Microeconomics (ES10001)

1. Introductory Microeconomics (ES10001) Topic 8: General Equilibrium & Welfare

2. I. Introduction • Welfare Economics; branch of economics dealing with normative issues. • How well does the economy work? • What do we mean by ‘well’? • Equity or Efficiency??

3. II. Equity • Horizontal equity; identical treatment of identical people • Vertical equity; different treatment of different people to reduce the consequences of these innate differences • Most people agree that horizontal equity is desirable (i.e. no discrimination). • But very different views re. vertical equity; i.e. how many resources should be redistributed from rich to poor? Positive discrimination?

4. III. Efficiency • Pareto Efficiency • Vilfredo Pareto; Manuel D’economie Politique (1909) • An allocation is Pareto-efficient if, for a given set of consumer tastes, resources and technology, it is impossible to move to another allocation which would make some people better off and nobody worse off

5. Figure 1: Pareto Efficiency q2 G B E Quantity of Goods for Person 2 A D C F q1 0 Quantity of Goods for Person 1

6. III. Efficiency • The Pareto criterion is independent of value judgements and thus can only be used to judge moves to north-east or south-west • Nevertheless, it is the most we can say about efficiency without becoming entangled in value judgements

7. III. Efficiency • Production Possibility Frontier (PPF) • Points beyond frontier non-feasible • Points on frontier are Pareto-efficient • Points within frontier are Pareto-inefficient

8. Figure 2: Productin Posibiity Frontier q2 A C B q1 0

9. IV. Compt. Markets & P/Eff. • The ‘Invisible Hand’ (Adam Smith) If every market in the economy is a perfectly competitive free market, the resulting equilibrium though out the economy will be Pareto-efficient • Cornerstone of welfare economics • Individual firms and consumers, acting in own self-interest, generate a Pareto efficient general (i.e. economy wide) equilibrium as if guided to it by a benign invisible hand

10. IV. Compt. Markets & P/Eff. • Illustration: Assume many consumers and producers but only two goods (x and y) • Both markets are free, unregulated and perfectly competitive • Assume that in equilibrium: Price of good x : px = £5 Price of good y : py = £10

11. IV. Compt. Markets & P/Eff. • Note: • Labour is the variable factor of production and workers are indifferent as regards the non-monetary aspects of employment in industry x and industry y • Thus, migration of workers will ensure wages are equalised across all industries

12. IV. Compt. Markets & P/Eff. • Stage 1 • Recall that p = marginal utility (MU) • Thus, last unit of x produced must yield consumers £5 extra (i.e. marginal) utility; last unit of y produced must yield consumers £10 extra (i.e. marginal) utility • Implication; consumers willing to exchange 2 units of x (£10 worth of utility) for 1 unit of y (£10 worth of utility) since such an exchange will not change their total utility (i.e. MRS)

13. IV. Compt. Markets & P/Eff. • Stage 2 Each firm produces to the point that p = MC Thus, marginal cost of the last unit of x produced must be £5 And marginal cost of the last unit of y produced must be £10

14. IV. Compt. Markets & P/Eff. • Stage 3 Migration of workers between industries will ensure that: wx = wy = w • Stage 4 In equilibrium, it must be the case that:

15. IV. Compt. Markets & P/Eff. • Stage 5 wx = wy = w; MCx = £5; MCy= £10 Thus:

16. IV. Compt. Markets & P/Eff. • Stage 6 Hence, decreasing the output of good y by 1 unit and transferring the labour thus freed to the production of good x would increase the output of good x by 2 units Feasible resource allocation; society is able to exchange 2 units of good x for one unit of good y

17. IV. Compt. Markets & P/Eff. • Stage 7 Consumers willing to exchange two units of good x for one unit of good y; producers able to exchange two units of good x for one unit of good y There is thus no feasible reallocation of resources that can make society better off; Initial competitive equilibrium in both markets is Pareto efficient

18. IV. Compt. Markets & P/Eff. • Moreover, since workers are paid their marginal product vis: • Then:

19. IV. Compt. Markets & P/Eff. • MCy = value of good x sacrificed by using last unit of labour to make good y rather than good x • And if industry x is in competitive equilibrium (i.e. px= MUx), then MCy is also the MU that consumers would have derived from the consumption of good x sacrificed

20. IV. Compt. Markets & P/Eff. • First Theorem of Welfare Economics Competitive equilibrium in all markets generates a Pareto efficient allocation • But, there is an infinite number of Pareto efficient allocations; what determines the actual Pareto efficient outcome?

21. IV. Compt. Markets & P/Eff. • Second Theorem of Welfare Economics Any Pareto efficient allocation can be achieved from a competitive equilibrium with appropriate adjustments to initial endowment

22. V. Market Failure • Circumstances in which equilibrium in freely competitive unregulated markets fails to achieve an efficient allocation • i.e. distortions prevent invisible hand from allocating resources efficiently

23. V. Market Failure • Five main distortions 1. Imperfect Competition 2. Taxation 3. Externalities 4. Public goods 5. Information

24. V. Market Failure • Imperfect Competition • MB = p > MR = MC • Under production; consumer’s willing to pay more for output at the margin than it costs firms to produce • Pareto inefficient

25. V. Market Failure • Taxation • Purchase Tax / Sales Tax • Marginal Benefit (Utility) ≠ Marginal Cost • Under production

26. V. Market Failure • Public Goods (i) Non-Diminishing (ii) Non-Excludable • E.g. Defence; light-houses; street lights • Free-riding

27. V. Market Failure • Externalities • An externality arises whenever an individual’s production or consumption decisions affects the production or consumption of other individuals, other than through market prices • Externalities can be positive or negative depending upon whether the original production or consumption decision increases or decreases external production or consumption

28. Figure 3: Production Externality Private Transport p MSC B C MEC > 0 MPC A D = MPB = MSB q 0 q**q*

29. Figure 4: Consumption Externality Education p B MPC = MSC C A MEB MSB D = MPB q 0 q*q**

30. V. Market Failure • Information • Asymmetric information; one side to the contract / exchange knows more than the other • Akerlof, G. (1970). ‘Adverse Selection and the Market for Lemons.’Quarterly Journal of Economics, 84(3), pp. 488-500.

31. V. Market Failure • Reservation price data

32. V. Market Failure • Two Scenarios • (i) Symmetric Information • Quality is observable and known with certainty • Buyers prepared to pay 10 for lemon and 20 for peach • Selllers willing to accept 8 for lemon and 16 for peach • Assume buyers’ reservation prices rule in equilibrium • Separating Equilibrium; lemons traded at 10 and peaches at 20

33. V. Market Failure • (ii) Asymmetric Information • Quality unobservable • Assume buyers ‘knows’ that a proportion q of the goods on offer are peaches • Reservation Price • pd= q*pPeach + (1 - q)*pLemon = q*20 + (1 - q)*10 = 10q + 10

34. V. Market Failure • Assume q = 0.5 • pd= 10q + 10 = 10(0.5) + 10 = 15 • But since the supply price of lemons (peaches) is 8 (16), then only lemons offered for sale • Buyers revise q downward towards zero; pd= 10

35. V. Market Failure • Market for lemons • Adverse Selection leading to market failure; lemons drive out the peaches • There is a potential Pareto improvement; both prospective buyers and sellers of peaches would like to trade • Signalling: Green Flag; AA; University of Bath?