ERE4: Efficiency, optimality, market failure & public policy

1. ERE4: Efficiency, optimality, market failure & public policy • Efficiency and optimality • Static efficiency • Optimality • Dynamic efficiency and optimality • Market efficiency • Market failure & public policy • Externalities • Public policy

2. Last week • Ethics • Why is ethics so important? • Alternative views, including the standard economic position • Time dimensions • Discounting • Sustainability

3. Static Economic Efficiency • Efficiency = Pareto optimality = For some initial distribution of endowments, an allocation is efficient if it is not possible to make one or more persons better off without making at least one person worse off

4. Static Efficiency: Notation Two persons (A,B), two goods (X,Y), two inputs (L,K)

5. Efficiency in Consumption • Equal marginal utility ratios • If not, then the two consumers can exchange commodities at the margin such that both gain

6. Efficiency in Consumption (2) BY AXb AXa A0 S AX IB1 IB0 IA a . BYa AYa b BYb . AYb IB1 IB0 IA BX B0 BXa BXb T AY

7. Efficiency in Production • Equal marginal production ratios • If not, it would be possible for producers to exchange some K for some L so that the total production of both goods could be increased from the same total volume of inputs

8. Efficiency in Production (2) KY LXb LXa X0 LX IY1 IY0 IX a . KYa KXa b KYb . KXb IY1 IY0 IX LY Y0 LYa LYb KX

9. Efficiency in Product-Mix • Marginal utility ratio equals marginal production cost ratio • If not, inputs could be reallocated to make alternative output such that each consumer would be better off

10. Efficiency in Product-Mix Y I YM a Ya b Yb c Yc I XM X 0 Xa XC Xb

11. Is the solution unique? There are many efficient solutions, depending on the initial distribution

12. Social Welfare & Optimality • Social welfare function • Optimality

13. Intertemporal Efficiency and Optimality • Three approaches • Individual with finite life span • Overlapping generations • Infinitely lived agent • Condition 1: The real rate of return is equalised across all sectors and assets • Condition 2: The consumption discount rate is equalised across all agents • Condition 3: The real rate of return on investment is equal to the consumption discount rate • To choose among the intertemporally efficient allocations requires a SWF

14. Markets are efficient, iff • Markets exist for all goods and services • Property rights are fully assigned • All goods and services are private • No externalities exist • All markets are perfectly competitive • Long run average costs are non-decreasing • All agents have perfect information

15. Market efficiency (1) • Ratio of marginal utilities equals price ratio • In a competitive market, consumers face the same prices • So, the market establishes efficiency of consumption

16. Market efficiency (2) • Ratio of marginal production equals input price ratio • In a competitive market, producers face identical input prices • So, the market establishes efficiency of production

17. Market efficiency (3) • Price equals ratio of input price and marginal productivity • In a competitive market, producers supply at marginal cost • So, the market establishes efficiency of product-mix

18. Resources and Markets • Many environmental resources are not transacted at markets • Atmosphere, oceans, wilderness • Many resources are public goods or open access • Other resources are traded • Land, minerals, energy • Markets are often far from perfect

19. Property Rights • Property is • The right to use • The right to exclude • The right to destroy • Property rights are often attenuated • Property rights can be • Private • Common • Public • Absent (open access) • Environmental resources are seldom privately owned

20. Environmental Services and Property Rights • Different kind of environmental services • Renewable and non-renewable resources • Open-access resources • Common-property resources • Waste sink • From open access to a common-property resource • Amenity services • Life-support services

21. Public Goods • Public goods are indivisible and, according to some, non-excludable, in consumption • E.g., lighthouses, national defence, biodiversity, and, provide that use is not excessive, atmosphere, ocean

22. Public Goods and Economic Efficiency • Product mix efficiency with private goods: • Can consume different amounts of the goods • Product mix efficiency with public goods: • Can value goods differently at the margin • Will not be satisfied in a market economy • Free-rider problem

23. Externalities • External effect is said to occur when the production or consumption of one agent affects the utility of another agent in an unintended way, and when no compensation is made • External effect = externality = external cost = external diseconomy • External effect may be beneficial or adverse, consumption or production related • If compensated, the externality is said to be internalised

24. Public policy • Government instruments to correct market failure • Create property rights • Provide information • Command-and-control • Fiscal instruments • Is the instrument appropriate to increase efficiency • Lack of information • More than one source of market failure