Lecture 10: Welfare Economics and Market Intervention

1. Lecture 10: Welfare Economics and Market Intervention Reading: Ch. 13, 14 (especially 13.1-13.5; 14.1-14.3) in Begg et al or Ch. 11, Sloman and Wride And Notes, Ec111 Lecture 10

2. Outline Welfare Economics: Pareto Efficiency: Definition Achievement of Pareto Efficiency by Competitive Markets Welfare theorems: An Argument for Limited Government Intervention Market Failure: Externalities and remedies Public Goods and public provision Information Failures and Missing Markets The Case for Laissez Faire vs. the Case For Government Intervention: A Synthesis.

3. Welfare economics The branch of economics dealing with normative issues. Its purpose is not to describe how the economy works, but to assess how well it works.

4. Social, Legal, Political Environment industry Input markets Output markets Profit maximising

5. Social, Legal, Political Environment industry Input markets Output markets Profit maximising So far…we have described but not evaluated the behaviour of this system

6. Social, Legal, Political Environment industry Input markets Output markets owners of labour capital land consumers Profit maximising How well does this system serve its constituents? If the answer is “not well”, how do we change it to make it perform better? shareholders

7. Pareto efficiency An allocation is Pareto-efficient for a given set of consumer tastes, resources and technology, if it is impossible to move to another allocation which would make some people better off and nobody worse off. It will be our criterion for “performing well”

8. All points on or inside the frontier are feasible. At point B, we can make one person better off without making the other worse off. It is not Pareto Efficient. At point A, we cannot make one better off without making the other worse off. It is Pareto Efficient. UA • A • Utility Possibility Frontier B • C UB

9. Perfect competition and Pareto efficiency If every market in the economy is a perfectly competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient. As expressed in Adam Smith’s notion of the Invisible Hand We’ll show this for two goods and two consumers

10. Pareto Efficiency and Competition Consumer Equilibrium For all consumers in the market, we know that MRS = PX/PY It must also follow that the MRS for all consumers must be equal: MRSA = MRSB = PX/PY If this were not true, then the consumers could trade with each other (via the market) and reap gains from trade – meaning that at least one consumer could be made better off without making the other worse off -- so the allocation could not have been Pareto Efficient. Hence, perfect competition generates behaviour that results in Pareto Efficiency on the consumer side of the market…

11. Pareto Efficiency and Competition Producer Equilibrium For all producers in the market, we know that MRTS= w/r It must also follow that the MRTS for all producers must be equal: MRTSX = MRTSY = w/r If this were not so, producers could trade with each other (via the market) and exploit the gains from trade to make at least one better off without making the other worse off…so the allocation of resources could not have been Pareto Efficient. Hence, perfect competition generates conditions that lead the producer side of the market to Pareto Efficiency.

12. Pareto Efficiency and Competition Sectoral Equilibrium For Pareto Efficiency in the entire economy, we also need it to be the case that reallocating outputs across sectors cannot result in gains from trade. Recall that the slope of the production possibility frontier, the MRT, tells us the rate at which we can efficiently shift production across sectors. We require MRT = PX/PY for there to be no gains from trade that could be achieved by reallocating resources (via the market) across sectors.. Y The market value of goods produced by the economy is PXX + PYY = Value, so that shifting the isovalue line out as much as possible subject to the PPF production constraint yields the production point that achieves this (tangency) condition. Isovalue line • PPF -PX/PY X

13. Pareto Efficiency and Competition Does perfect competition achieve this equality? What is the slope of the PPF under perfect competition? Recall our example of a PPF generated from a labour input to sectors of clothing and food: Resource constraint: L = aFF + aCC  PPF: C = (-aF/aC)F + L/aC What is aF? It is the increase in labour necessary to produce one more unit of food…or… ΔL/ΔF…or… Remember from lecture 8 that MC = w/MPL. Hence, we can write: -aF /aC = = -MCF/MCC

14. Pareto Efficiency and Competition But… In perfect competition, MC = P. Hence, we have: MRT = MCX/MCY = PX/PY = MRS Y Indifference curve of representative consumer • PPF Isovalue line X This point of tangency is Pareto Efficient (first best)

15. Equity and efficiency The case for no government intervention, other than to facilitate perfect competition, is that the competitive equilibrium is (Pareto) efficient. The market, in a completely decentralised way, achieves this through the price mechanism. There is a role for government, but it is to “remove barriers to competitive trade”. First Welfare Theorem: “If a general competitive equilibrium exists, it must be Pareto Efficient”

16. Equity and efficiency Pareto Efficient points are not necessarily points of equitable treatment: Second Welfare Theorem: Any Pareto Efficient allocation can be obtained via a general competitive equilibrium, provided the government is able to implement the required system of lump-sum transfers.

17. Market failure … occurs when equilibrium in free unregulated markets will fail to achieve an efficient allocation. Imperfect competition Externalities Missing markets future goods, risk, information public goods

18. Monopoly Deadweight welfare loss b Pm MR Qm MC (= S under perfect competition) £ Deadweight loss under monopoly Consumer surplus a Ppc Producer surplus AR = D O Qpc Q (b) Industry equilibrium under monopoly

19. Externalities An externality arises whenever an individual’s production or consumption decision directly affects the production or consumption of others, other than through market prices e.g. a chemical firm discharges waste into a lake & ruins the fishing for anglers

20. Marginal External benefit Marginal External cost External costs and benefits in production MSC MC = S MSC MC = S Costs and benefits (£) P Costs and benefits (£) P P P O O Q Q Q Q 2 1 2 1 Quantity Quantity (b) External benefits (a ) External costs (e.g. polluting process (e.g. planting trees) like paper production)

21. Marginal External benefit Marginal External cost Q Q Q Q 2 2 1 1 External costs and benefits in consumption Costs and benefits (£) Costs and benefits (£) P P P P MSB MB MB MSB O O vaccinations Car miles (b) External benefits (a ) External costs

22. Optimum tax = MSC–MC (= marginal external cost) MC Q2 MSC MC = S Using taxes to correct a market distortion Alternatively, we Could limit output To Q2 Costs and benefits P P O Q1 Quantity

23. MC Optimum subsidy = MC – MSC = marginal external benefit MC = S MSC Using subsidies to correct a market distortion Costs and benefits P P O Q2 Q1 Quantity

24. Using Property Rights to Correct Market Distortion £ MEC = Marginal External Cost Marginal (Private) Benefit Externality Produced, eg. smoke 0 S* S0

25. Let benefits and costs be as shown above, with no private cost of production of the externality (so that MC of production = 0). Efficiency requires MEC = MB, so production at S* (not zero!). Can property rights achieve this? If right to clean air given to recipient of externality, production will not be at S*. Acting unilaterally, recipient sets production at zero. If right to pollute given to emitter, production will not be at S*. Acting unilaterally, emitter sets production at S0 Hence, property rights by themselves do not solve the problem… If the emitter and recipient can bargain efficiently, however, they can agree on a transfer that achieves S*. (“Coase Theorem”) so bargaining plus property rights does solve the problem.

26. Using Property Rights to Correct Market Distortion £ MEC = Marginal External Cost MB d c Externality Produced, eg. smoke 0 S* S0 Let emitter have right to pollute…Payment between c and c+d achieves S*.

27. Using Property Rights to Correct Market Distortion £ MEC = Marginal External Cost MB b a Externality Produced, eg. smoke 0 S* S0 Let recipient have right to clean air…Payment between a and a+b achieves S*.

28. PUBLIC GOODS A good is described as Rival if its consumption by one agent precludes its consumption by another agent. Hence, an apple is a rival good, but an idea is not. Air is usually considered non-rival. A good is described as Excludable if it is possible to select agents who can consume it. In practice, one can think of ways to make most goods excludable so the criterion is whether such exclusion is not too costly. In that sense, national defense is clearly not excludable but access to a public park might or might not be. Pure Private Goods are both rival and excludable, while pure Public Goods are neither.

29. Provision of Public Goods tends to be inefficient. Why? Because trade usually ensures efficiency. If X is a public good, and A has it to “trade”, then B surely has access to the same amount. So why should B trade away any of its private goods (or money) to get X? Why not just be a “free rider”?  A market economy cannot generally ensure the efficient provision of public goods because the trading mechanism “fails”. This suggests a role for government provision…

30. Efficient Supply for a Public Good £ MWTPA + MWTPB = DA + DB = “MB” for society MC DB In order to ensure full payment for public good, government could request that each agent pay his/her marginal willingness to pay, such that the sum generates X*. This would occur through tax system, for example. DA X 0 X* Recall that aggregate demand usually is the horizontal sum of individual demands. Here, it is the vertical sum.

31. The Preference Revelation Problem The agents’ preferences with respect to public and private goods are not public knowledge. In an economy with private goods only, this is not a problem as the market mechanism only requires that each agent knows his or her own preferences. Trading behaviour reveals and reflects these preferences, as do prices. To achieve efficiency with public goods, or to set taxes appropriately in the case of externality, one needs some other mechanism leading agents to truthfully reveal their preferences. Much preference revelation happens through voting, but this system is imperfect…

32. Government Intervention in the Market -- Instruments • Taxes and subsidies • to correct for monopoly • use of lump-sum taxes plus subsidies • advantages of taxes and subsidies • can vary the rate according to the size of the market distortion • disadvantages of taxes and subsidies • infeasible to use different tax and subsidy rates • lack of knowledge

33. Government Intervention in the Market -- Instruments • Changes in property rights • limitations of Coase Theorem • impractical in many situations • problems of litigation • questions of equity • Laws prohibiting behaviour that imposes external costs • advantages of legal restrictions • disadvantages of legal restrictions • Regulatory bodies and direct government provision

34. But…Government Failure Market failure may not be enough to justify governmental intervention. This is because, the government can itself be inefficient. Reasons for governmental inefficiency include: • Lack of information • Incompetence • Organizational inefficiencies (bureaucracy) • Governments are not necessarily benevolent (political economy)  In case of market failure, the choice is between two imperfect solutions. The theory of the “second best”.

35. The Case for Laissez-faire • Drawbacks of government intervention • shortages and surpluses • poor information • bureaucracy and inefficiency • lack of market incentives • shifts in government policy • voters’ ignorance • unrepresentative government

36. The Case For Government Intervention • Externalities, Public Goods, Market Distortions can be severe. • But may not be present in all markets  targetted intervention when market cannot be adjusted to “fix” market failure using a variety of instruments. • intervention in the form of redistribution to adjust market activity when it does not achieve other social goals (such as equity).

37. Well Being Pareto Efficiency if economy Perfectly Competitive Material Well Being Efficiencies in production Efficiencies in allocation Production Markets When market failure and subject to Second Best considerations Redistribute for non- efficiency purposes Regulation Resources Government Policy