Markets, Efficiency and the Public Interest

Markets, Efficiency and the Public Interest Efficiency under Perfect Competition

EFFICIENCY UNDER PERFECT COMPETITION Defining social efficiency Pareto improvements Pareto optimality Private efficiency ‘rational’ economic behaviour equating marginal benefits and marginal costs 2

EFFICIENCY UNDER PERFECT COMPETITION Achieving social efficiency under perfect competition efficiency in consumption: MU = P efficiency in production: P = MC 3

Maximum total surplus under perfect competition £ MC D = MU Pe Qe O Q

Maximum total surplus under perfect competition £ MC A Pe B D = MU C O Qe Q

EFFICIENCY UNDER PERFECT COMPETITION Achieving social efficiency under perfect competition efficiency in consumption: MU = P efficiency in production: P = MC assumption of no externalities 3

EFFICIENCY UNDER PERFECT COMPETITION Achieving social efficiency under perfect competition efficiency in consumption: MU = P efficiency in production: P = MC assumption of no externalities social efficiency in goods markets: MSB = MSC 3

Maximum total surplus under perfect competition £ MC A Pe B D = MU C O Qe Q

EFFICIENCY UNDER PERFECT COMPETITION Achieving social efficiency under perfect competition efficiency in consumption: MU = P efficiency in production: P = MC assumption of no externalities social efficiency in goods markets: MSB = MSC social efficiency in factor markets: MSBf = MSCf 3

EFFICIENCY UNDER PERFECT COMPETITION Achieving social efficiency under perfect competition efficiency in consumption: MU = P efficiency in production: P = MC assumption of no externalities social efficiency in goods markets: MSB = MSC social efficiency in factor markets: MSBf = MSCf Interdependence, efficiency and the invisible hand 3

The interdependence of goods and factor markets FIRMS (suppliers of goods and services, demanders of factor services) HOUSEHOLDS (demanders of goods and services, suppliers of factor services)

The interdependence of goods and factor markets £ P Q O D1 = MU1 = MSBG1 £ (1) Consumer demand

The interdependence of goods and factor markets (2) Producer supply £ Goods P S = MC = MSCG D1 = MU1 = MSBG1 Goods O Q £ (1) Consumer demand

The interdependence of goods and factor markets (2) Producer supply £ Goods P S P1 Q1 D1 O Q Goods £ (1) Consumer demand

The interdependence of goods and factor markets demand (2) Producer supply £ £ Goods P Q O P S D1 = MRPF1 = MSBF1 P1 D1 O Q1 Q £ Goods £ (1) Consumer demand

The interdependence of goods and factor markets demand (2) Producer supply £ £ Factor services Goods P P S = MDUF = MSCF S P1 D1 = MRPF1 = MSBF1 D1 O Q O Q1 Q Factor services Goods £ £ (4) Factor supply (1) Consumer demand

The interdependence of goods and factor markets demand (2) Producer supply £ £ Factor services Goods P P S S PF1 P1 QF1 D1 D1 O Q O Q1 Q Factor services Goods £ £ (4) Factor supply (1) Consumer demand

The interdependence of goods and factor markets demand (2) Producer supply £ £ Factor services Goods P P S S P2 PF1 D2 = MU2 = MSBG2 P1 Q2 D1 D1 O QF1 Q O Q1 Q Factor services Goods £ £ (4) Factor supply (1) Consumer demand

The interdependence of goods and factor markets demand (2) Producer supply £ £ Factor services Goods P P S S PF2 P2 QF2 PF1 D2 = MU2 = MSBG2 P1 D2 = MRPF2 = MSBF2 D1 D1 O QF1 Q O Q1 Q2 Q Factor services Goods £ £ (4) Factor supply (1) Consumer demand

Markets, Efficiency and the Public Interest Social Efficiency: Intermediate Analysis

SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS Private efficiency in goods markets in consumption: MUX / MUY (MRS) = PX / PY in production: MCX / MCY (MRT) = PX / PY Social efficiency in goods markets between consumers: MRSa = MRSb ... = MRSn between producers: MRTg = MRTh ... = MRTn in exchange (assuming no externalities): social MRS = social MRT 4

SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS Social efficiency in factor markets The achievement of general equilibrium 5

Social efficiency under perfect competition Production possibility curve Good Y Slope = MRT O Good X

Social efficiency under perfect competition indifference curves Good Y Slope = MRS I3 I2 Slope = MRT I1 O Good X

Social efficiency under perfect competition Market price ratio MRS = PX / PY = MRT s Good Y Slope = MRS I3 Slope = PX / PY I2 Slope = MRT I1 O Good X

Markets, Efficiency and the Public Interest The Case for Government Intervention

CASE FOR GOVERNMENT INTERVENTION Externalities External costs of production MSC > MC 6

External costs in production MC = S Costs and benefits D P Q1 O Quantity

External costs in production MSC MC = S Costs and benefits P D Q2 External cost O Q1 Social optimum Quantity

CASE FOR GOVERNMENT INTERVENTION Externalities External costs of production MSC > MC External benefits of production MSC < MC 6

External benefits in production MC = S Costs and benefits P D O Q1 Quantity

External benefits in production MC = S MSC External benefit Costs and benefits P D Q1 Q2 O Social optimum Quantity

External costs and benefits in production MSC MC = S MC = S MSC External benefit Costs and benefits (£) Costs and benefits (£) P D P D External cost O Q Q O Q Q 2 1 1 2 Quantity Quantity (a ) External costs (b) External benefits

CASE FOR GOVERNMENT INTERVENTION Externalities External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB 6

External costs in consumption (MB) MU = D Costs and benefits P D Q1 O Quantity

External costs in consumption (MB) MU = D External cost Costs and benefits P D Q2 MSB O Q1 Social optimum Quantity

CASE FOR GOVERNMENT INTERVENTION Externalities External costs of production MSC > MC External benefits of production MSC < MC External costs of consumption MSB < MB External benefits of consumption MSB > MB 6

External benefits in consumption (MB) MU = D Costs and benefits P D O Q1 Quantity

External benefits in consumption (MB) MU = D External benefit Costs and benefits P D Q2 MSB O Q1 Social optimum Quantity

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

CASE FOR GOVERNMENT INTERVENTION Public goods Non-rivalry Non-excludability: free-rider problem Common resources equilibrium use of a common resource 7

Fishing in open-access fishing grounds £ ARP MRP AC = MC O Number of boats

Fishing in open-access fishing grounds £ Equilibrium: well beyond the optimum The collective optimum for boat owners Beyond this point no more fish can be caught AC = MC B1 ARP O B2 B3 Number of boats MRP

CASE FOR GOVERNMENT INTERVENTION Public goods Non-rivalry Non-excludability: free-rider problem Common resources equilibrium use of a common resource the tragedy of the commons 7

CASE FOR GOVERNMENT INTERVENTION Public goods Non-rivalry Non-excludability: free-rider problem Common resources equilibrium use of a common resource the tragedy of the commons current-day examples 7

CASE FOR GOVERNMENT INTERVENTION Public goods Non-rivalry Non-excludability: free-rider problem Common resources equilibrium use of a common resource the tragedy of the commons current-day examples Market power 7

CASE FOR GOVERNMENT INTERVENTION Public goods Non-rivalry Non-excludability: free-rider problem Common resources equilibrium use of a common resource the tragedy of the commons current-day examples Market power lack of Pareto optimality 7

A monopolist producing less than the social optimum MC £ AR MR P1 Q1 MC1 O Q Monopoly output

A monopolist producing less than the social optimum £ MC = MSC P1 P2 = MSB = MSC MC1 AR = MSB MR O Q1 Q2 Q Monopoly output Perfectly competitive output

CASE FOR GOVERNMENT INTERVENTION Public goods Non-rivalry Non-excludability: free-rider problem Common resources equilibrium use of a common resource the tragedy of the commons current-day examples Market power lack of Pareto optimality deadweight loss under monopoly 7

Deadweight loss under monopoly £ MC (= S under perfect competition) Consumer surplus a Ppc Qpc Producer surplus AR = D O Q (a) Industry equilibrium under perfect competition

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

Deadweight loss under monopoly £ MC (= S under perfect competition) Perfect competition Consumer surplus a Ppc Qpc Producer surplus AR = D O Q (a) Industry equilibrium under perfect competition

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

CASE FOR GOVERNMENT INTERVENTION Ignorance and uncertainty Immobility of factors and time lags Protecting people’s interests dependants merit goods Other objectives Possible conflict between objectives Limitations of economics in assisting policy making 7

Markets, Efficiency and the Public Interest Forms of Government Intervention

FORMS OF GOVERNMENT INTERVENTION The problem of the second best the first-best world the second-best solution to market distortions Taxes and subsidies to correct externalities 8

Using taxes to correct a market distortion (“first-best” world) MC = S Costs and benefits D P Q1 O Quantity

Using taxes to correct a market distortion (“first-best” world) MSC MC = S Costs and benefits P D Q2 External cost O Q1 Social optimum Quantity

Using taxes to correct a market distortion (“first-best” world) MSC MC = S Optimum tax = MSC – MC Costs and benefits P D Q2 MC O Q1 Quantity

Using subsidies to correct a market distortion (“first-best” world) MC = S Costs and benefits P D O Q1 Quantity

Using subsidies to correct a market distortion (“first-best” world) MC = S MSC External benefit Costs and benefits P D Q1 Q2 O Social optimum Quantity

Using subsidies to correct a market distortion (“first-best” world) MC = S MSC MC Optimum subsidy = MC – MSC Costs and benefits P D O Q1 Q2 Quantity

FORMS OF GOVERNMENT INTERVENTION The problem of the second best the first-best world the second-best solution to market distortions Taxes and subsidies to correct externalities second-best tax and subsidy policies 8

Using taxes to correct for externalities: firms with monopoly power £ MC Monopoly price and output P1 D = MSB MR O Q1 Q

Using taxes to correct for externalities: firms with monopoly power MSC £ MC P2 Optimum price and output Q2 P1 D = MSB MR O Q1 Q

Using taxes to correct for externalities: firms with monopoly power MC + tax £ MSC MC P2 Optimum tax on the monopoly P1 Optimum tax D = MSB MR O Q2 Q1 Q

Using taxes to correct for externalities: firms with monopoly power £ MSC MC + tax MC P2 P1 Continuing excess profits can be reduced by a further lump-sum tax Optimum tax D = MSB MR O Q2 Q1 Q

FORMS OF GOVERNMENT INTERVENTION The problem of the second best the first-best world the second-best solution to market distortions Taxes and subsidies to correct externalities second-best tax and subsidy policies to correct for monopoly 8

FORMS OF GOVERNMENT INTERVENTION The problem of the second best the first-best world the second-best solution to market distortions Taxes and subsidies to correct externalities second-best tax and subsidy policies to correct for monopoly use of lump-sum taxes plus subsidies 8

Using a lump-sum tax to reduce monopoly profits £ MC P =AR AR = MSB MR O Q1 Q

Using a lump-sum tax to reduce monopoly profits £ MC P =AR AC Profit (no tax) AC AR = MSB MR O Q1 Q

Using a lump-sum tax to reduce monopoly profits £ 1. Acceptable profit 2. Lump sum tax necessary to achieve acceptable profit MC AC + lump-sum tax P1 AC 1 AC + tax 2 AC AR = MSB MR O Q1 Q

FORMS OF GOVERNMENT INTERVENTION The problem of the second best the first-best world the second-best solution to market distortions Taxes and subsidies to correct externalities second-best tax and subsidy policies to correct for monopoly use of lump-sum taxes plus subsidies advantages and disadvantages of taxes and subsidies 8

Deadweight loss from an indirect tax £ Before-tax situation S P1 D O Q1 Q

Deadweight loss from an indirect tax £ Before-tax situation S Consumer surplus P1 D O Q1 Q

Deadweight loss from an indirect tax £ Before-tax situation S Consumer surplus P1 Producer surplus D O Q1 Q

Deadweight loss from an indirect tax £ S + tax S P2 Q2 P1 P2 - tax D O Q1 Q

Deadweight loss from an indirect tax £ S + tax S 1 P2 2 3 P1 4 5 P2 - tax 6 D O Q2 Q1 Q

Deadweight loss from an indirect tax £ S + tax S 1 P2 2 3 P1 4 5 P2 - tax 6 D O Q2 Q1 Q

Deadweight loss from an indirect tax £ S + tax S 1 P2 2 3 P1 4 5 P2 - tax 6 D O Q2 Q1 Q

Deadweight loss from an indirect tax £ S + tax Tax revenue for government S 1 P2 2 3 P1 4 5 P2 - tax 6 D O Q2 Q1 Q

Deadweight loss from an indirect tax £ S + tax Deadweight loss from tax S 1 P2 2 3 P1 4 5 P2 - tax 6 D O Q2 Q1 Q

FORMS OF GOVERNMENT INTERVENTION Changes in property rights the problem of limited property rights extending property rights the Coase theorem limitations of this solution Legal controls laws prohibiting behaviour that imposes external costs laws to regulate monopoly power laws to prevent firms from exploiting people’s ignorance 9

FORMS OF GOVERNMENT INTERVENTION Regulatory bodies Price controls high minimum prices low maximum prices Provision of information The direct provision of goods and services providing public goods other goods making rational decisions Public ownership 10

Markets, Efficiency and the Public Interest Cost–Benefit Analysis

COST–BENEFIT ANALYSIS The procedure Identifying costs and benefits costs direct private monetary external monetary external non-monetary benefits private non-monetary 11

Private non-monetary benefits (consumer surplus) £ 50p D O Q1 Q

Private non-monetary benefits (consumer surplus) £ Private non-monetary benefit Consumer surplus 50p D O Q1 Q

COST–BENEFIT ANALYSIS The procedure Identifying costs and benefits costs direct private monetary external monetary external non-monetary benefits private non-monetary external 11

COST–BENEFIT ANALYSIS Measuring costs and benefits direct private monetary costs and benefits non-monetary private benefits monetary externalities non-monetary externalities Risk and uncertainty sensitivity analysis 12

COST–BENEFIT ANALYSIS Discounting working out the NPV choosing the discount rate The distribution of costs and benefits the strict Pareto criterion the Hicks–Kaldor criterion taking specific account of redistributive consequences 13

Markets, Efficiency and the Public Interest The Case for Laissez-Faire

THE CASE FOR LAISSEZ-FAIRE The growth of libertarian thinking the neo-Austrian school and its influence on radical-right thinking libertarian policies of governments Drawbacks of government intervention shortages and surpluses poor information bureaucracy and inefficiency lack of market incentives shifts in government policy lack of freedom for the individual 14

THE CASE FOR LAISSEZ-FAIRE Advantages of the free market automatic adjustments dynamic advantages of capitalism high degree of competition even under monopoly/oligopoly Judging the arguments 16