Efficiency and Equity

1. Efficiency and Equity 2008/22165

2. A rationing system to deal with the economic problem Because economic resources are relatively scarce (resources are limited, wants are unlimited) a society can’t have everything they want. There must be a system that rations both resources and products. The rationing system must answer the following questions: • What, and how much, to produce • How to produce • For whom to produce Efficiency and Equity (c) Andrew Tibbitt 2008

3. Tests for a rationing system The two basic tests for any rationing system are: • Is the system efficient? • Is it fair? Efficiency and Equity (c) Andrew Tibbitt 2008

4. Efficiency and equity • Efficiency – is the economy getting the most of out its scarce resources (or are they being wasted)? • Technical efficiency – is production being done at lowest unit cost? • Allocative efficiency – are resources being used to make products that people want? • Equity – how fair is the distribution of products between different members of society? • Horizontal equity – no discrimination between people whose economic characteristics and performance are equal • Vertical equity – different treatment of different people in order to reduce the differences between people Efficiency and Equity (c) Andrew Tibbitt 2008

5. Different rationing systems The world’s dominant rationing system is the price mechanism. Prices are determined in markets (as a result of the interplay of demand and supply). Given the correct economic conditions, advocates of market economies believe they lead to the best allocation of resources and the highest level of net economic welfare. Efficiency and Equity (c) Andrew Tibbitt 2008

6. Different rationing systems But markets are not the only way to resolve • what and how much to produce, • how to produce, and • for whom to produce How else can economic activity be co-ordinated? How can the necessary economic choices be made and on what grounds? Will the resulting pattern of production, distribution and consumption be efficient? Will it be fair? Efficiency and Equity (c) Andrew Tibbitt 2008

7. Some options • Ballot (lanes in Melbourne Cup) • Central directives (in Cuba, North Korea) • Allocate to members (finals tickets, some wine vintages) • Rules and regulations (water restrictions by street number) • Queues – first come first served (public hospitals) • Priority allocation (AFL draft) • Merit – university selection Efficiency and Equity (c) Andrew Tibbitt 2008

8. The world’s dominant rationing system. It has already be said that the world’s dominant rationing system is the price mechanism. The circular flow of income model illustrates some of the markets that operate in the economy. Efficiency and Equity (c) Andrew Tibbitt 2008

9. Price Supply Demand Quantity Markets in the circular flow Consumption = demand Goods and services = supply HOUSEHOLDS PRODUCERS Efficiency and Equity (c) Andrew Tibbitt 2008

10. Price Supply Demand Quantity Markets in the circular flow HOUSEHOLDS PRODUCERS Resources (e.g. labour) = supply Demand for resources = demand Efficiency and Equity (c) Andrew Tibbitt 2008

11. The super-computer network In a competitive free market economy the market for each product and economic resource is connected to the market for all other products and resources through an ultra-complex network of prices. This network operates ‘invisibly’ as if driven by a giant free-market super-computer. What is the operating system for this free-market super-computer? Efficiency and Equity (c) Andrew Tibbitt 2008

12. Prices as a signalling mechanism The free-market super computer operates through an ultra-complex network of prices. The prices provide a messaging or signalling service for producers and consumers in the economy. Normally, a rise in price reflects an increase in relative scarcity. The higher price signals • Consumers to reassess their buying choices (are they still getting value for money – some will buy less) • Producers to reassess their production choices (could they increase profits by supplying more?) Efficiency and Equity (c) Andrew Tibbitt 2008

13. Prices as a signalling mechanism The system only works if consumers and producers • get the right message • make a rational choices when they act on the message Prices send the right message given the right economic circumstances. The right circumstances create ‘a truthful world’ where the demand curve reflects value or benefit and the supply curve reflects costs. Efficiency and Equity (c) Andrew Tibbitt 2008

14. The correct economic conditions What are the correct economic conditions that allow markets to maximise welfare? • No information gaps / no asymmetrical information • No side-effects (externalities) / no effect on bystanders • No monopoly (or scarcity power) • Good motives and incentives • No free riders or non-exclusion products Efficiency and Equity (c) Andrew Tibbitt 2008

15. Given the right conditions markets maximise welfare. In these economic conditions: Price = marginal social benefit Price = marginal social cost Consumers get what they want Producers don’t waste resources If these conditions do not exist the market becomes distorted (price does not reflect value and cost). Demand and supply curves are in the wrong place. Welfare is reduced. There is a deadweight loss. Efficiency and Equity (c) Andrew Tibbitt 2008

16. Markets increase trade and trade increases welfare Consumers only buy things if the value of the product to them is equal or greater than their opportunity cost. So, people that buy something in a market at the ruling price are getting a bonus – the value they receive is greater than the price they pay. This bonus is called consumer surplus.It increases their welfare or satisfaction. Price Consumer surplus Supply Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

17. Markets increase trade and trade increases welfare Producers only supply things if the price they can get is equal or greater than the cost of production. Efficient producers can supply for less than the clearance price. When a sale is made they get a bonus – the money they receive is greater than their costs of production. This bonus is called producer surplus. It increases their welfare or profit. Price Supply Producer surplus Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

18. Trade increases welfare The sum of consumer and producer surplus indicates the total increase in welfare from this market. So markets create trade and trade increases welfare. Price Consumer surplus Supply Producer surplus Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

19. The world of truth This is only good if the world of truth exists Competitive markets create a WORLD OF TRUTH. The demand curve is a true indicator of the value of the product to consumers. The supply curve is a true indicator of the cost of production for producers. Price Consumer surplus Supply Producer surplus Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

20. The world of truth • Competitive markets are, therefore efficient because: • consumers get what they want • producers make the right things in the right quantities. Price Consumer surplus Supply Producer surplus Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

21. Welfare is maximised at the clearance price. People will opt out of trading if they are going to reduce their welfare. They will lose if cost is greater than benefit. Trade increases consumer and producer welfare up to quantity Q1. If the aim is to maximise benefits and profits trade should rise to Q1. Price Supply Cost greater than benefit – trade stops at Q1 P1 Demand Quantity Q1 Efficiency and Equity (c) Andrew Tibbitt 2008

22. The world of truth If the market clearance price is not charged welfare falls. If a price is set below the clearance price producers reduce supply (to Q2). There is excess demand. Producer surplus is low (the orange area). The consumers who can get the product get a big bonus (the red area), but some potential buyers go without. Price Consumer surplus Supply Deadweight loss Producer surplus Demand Quantity Q2 Efficiency and Equity (c) Andrew Tibbitt 2008

23. The world of truth If the market clearance price is not charged welfare falls. If a price is set above the clearance price consumers reduce demand. There is excess supply. Consumer surplus is low (the red area). Producers who make a sale get a big bonus (the orange area), but some production is left unsold. Price Consumer surplus Supply Deadweight loss Producer surplus Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

24. Applying the concept to international trade It is easy to show that overall welfare rises if trade between countries is increased. Exporters can get higher prices for their products (we are more efficient than the overseas country) and sell more. Some supply is diverted from domestic sales so consumers lose out. However, overall welfare increases . Price Consumer surplus Domestic Supply Overseas supply RISE IN WELFARE Producer surplus Domestic Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

25. Applying the concept to international trade It is easy to show that overall welfare rises if trade between countries is increased. Consumers can buy goods at cheaper prices (we are less efficient than the overseas country). Our producers lose out as competition from imports increases. However, overall welfare increases. Price Consumer surplus Domestic Supply RISE IN WELFARE Overseas supply Producer surplus Domestic Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

26. Applying the concept to international trade Taken together more exports and more imports lead to higher welfare. There has been a redistribution effect though, some producers gain, some lose, consumers gain if they buy some products and lose if they buy others. Is this fair? Price Domestic Supply RISE IN WELFARE Overseas supply Domestic Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

27. Market failure Markets sometimes fail to produce efficient results because the necessary conditions do not exist. They fail, for example when : 1. Externalities are not taken into account (and bystanders suffer collateral damage) 2. Producers have scarcity or monopoly power (and they dominate the market, raise prices and earn excessive profits 3. Key information is not known or shared evenly 4. Income distribution is unfair. Efficiency and Equity (c) Andrew Tibbitt 2008

28. When there are externalities Bystanders (third parties) can be affected by economic decisions made by others. These spin-off or side effects of an economic decision are called externalities. Bystanders can be affected in a good or positive way (e.g. your neighbour has nice garden). These positive externalities create socialbenefits. Bystanders can be harmed or affected in a negative way (e.g. people become sick from factory pollution). These negative externalities create social costs. Efficiency and Equity (c) Andrew Tibbitt 2008

29. Ignoring externalities leads to inefficiency S total Air travel Price If market players do not take these negative externalities or social costs into account (do not include them in their demand and supply decisions) the market will not work efficiently. Too much will be produced and consumers will pay too low a price. S airlines Social cost of 5% of climate change D Quantity Greenhouse Gases are emitted by planes. So do free markets create too many flights at too low a price? Efficiency and Equity (c) Andrew Tibbitt 2008

30. Ignoring externalities leads to inefficiency S private Public transport Price In a similar way, if market players do not take positive externalities or social benefits into account (do not include them in their demand and supply decisions) the market will not work efficiently. Too little will be supplied and consumers will pay too high a price. S total Social benefit of less congestion D Quantity Free market public transport could be too expensive if it forces people to use their cars and cause congestion Efficiency and Equity (c) Andrew Tibbitt 2008

31. Scarcity or monopoly power If one of the players in a market has power over the other then the market outcome becomes distorted and the result can be inefficient. If a producer has monopoly power in a sense they have scarcity power. Monopoly power comes from a lack of competition. Producers can deliberately minimise competition (e.g. by branding, innovation, take overs). Producers with monopoly power can restrict supply or push up prices. The price no longer reflects the costs of production. Efficiency and Equity (c) Andrew Tibbitt 2008

32. Monopolists restrict supply and push up prices. Monopolists have the power to control supply in the market. This can lead to prices that are higher than those set in competitive markets. The result is inefficiency. New Supply (monopoly) Consumer surplus Price Supply (competitive) Deadweight loss Producer surplus Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

33. Information gaps Competitive free markets only produce efficient outcomes if • Demand curves reflect the true level of consumer value or marginal benefit • Supply curves reflect true costs of production (the opportunity of using the resource inputs) If producers don’t know the cost of production (like insurance companies) and consumers don’t know the value of the product they are buying (like health care and second hand cars) then the market can’t operate efficiently. Efficiency and Equity (c) Andrew Tibbitt 2008

34. Other problems for the market economy Income distribution Demand curves reflect effective demand. Effective demand exists if a need or want can be backed up by the ability to pay for it. If income distribution is unfair (lacks equity) the pattern of effective demand will be unfair. Efficiency and Equity (c) Andrew Tibbitt 2008

35. Other problems for the market economy Public and collective goods Products • that are non-rival products (one person using the good doesn’t prevent another for using it as well) • where the exclusion principle does not operate (the supplier or owner can’t prevent non-payers or free-riders from using the product) • where individual demand is unrealistic (such as national defence) will not be efficiently produced in a free market economy. Efficiency and Equity (c) Andrew Tibbitt 2008

36. Modified market economies • As a result of market failure, nearly all economies are not pure free market economies but mixed economies. • Government’s modify markets or override the market altogether by influencing: • the allocation of resources (e.g. through taxes, subsidies, or directives) – allocative role • business behaviour (e.g. through regulations and legislation) – regulatory role • the distribution of household incomes (e.g. through taxation and welfare) – redistribution role • the overall level of aggregate demand (e.g. through fiscal and monetary policy) – demand management role Efficiency and Equity (c) Andrew Tibbitt 2008

37. Government modifications Policy measures to fix up or prevent market failure include: • Taxing bad behaviour, taxing high income earners • Subsidising good behaviour, paying welfare to low income earners. • Regulating or legislating against bad behaviour • Regulating or legislating good behaviour • Establishing markets to trade ‘permits to behave badly’ Efficiency and Equity (c) Andrew Tibbitt 2008

38. Government failure In some situations government intervention does prevent or fix up market failure. But overall central planning does not provide a more efficient and fairer rationing system. Government run economies suffer from: • Bureaucratic and cumbersome allocation processes • Moral hazard • Rent seeking behaviour (corruption) • Lack of incentive – bottomless pots, feather bedding, no competition • Lack of consumer freedom or sovereignty The trick is to intervene only when necessary. Efficiency and Equity (c) Andrew Tibbitt 2008

39. Taxing a competitive market reduces net economic welfare. Taxing a competitive market reduces welfare. Supply with tax Price Supply without tax REDUCTION IN NET WELFARE = DEADWEIGHT LOSS Demand Quantity Efficiency and Equity (c) Andrew Tibbitt 2008

40. A difference of emphasis When to intervene and modify a market is a matter of judgement for governments. Economists can use the concepts of consumer surplus, producer surplus and net economic welfare to inform the policy debate. RIGHT Rights Choice Efficiency Incentives Government failure LEFT Responsibilities Entitlements Equity Market failure Government intervention Efficiency and Equity (c) Andrew Tibbitt 2008