Economic Efficiency and Markets Lecture 4

Objectives Develop the idea of economic efficiency We should be evaluating social performance of the firms and hence, should take into account all the social values and consequences of any economic decision, in particular environmental consequences Can a market system, if left to itself, produce results that are socially efficient? In terms of environmental quality, What output should be produced? (Economic Efficiency) What output is in fact being produced? (Markets normally functions)

Relationship between output and Marginal WTP? Relationship between output and Marginal Costs? In order to find the efficient output level from society’s viewpoint, it is necessary to bring these elements together When dealing with MC, all costs of production have to be taken into account When dealing with MWTP, we have to make sure there are no missing sources of value. So, MWTP should reflect all of the value that people in the society place on the item. MC MWTP P*

Identify socially efficient rate of output MC = MWTP [MC = P* and MWTP = P*] The equality of MWTP and MC is a test for determining if output is at the socially efficient level Alternative way: Look at the net value = TWTP – TC It has to be the maximum MC MWTP TWTP = a + b + c TC = c Net value or surplus amount = a + b a P* b c

MWTP curve is assumed to represent accurately all the benefits that people experience when the good is made available MC is assumed to consider all the true opportunity costs, no matter to whom they accrue. Q* is efficient output according to the graph because it produces a balance between the two sides: Marginal worth of a good – as indicated by the consumers’ willingness to pay What it costs to society to produce it – as indicated by marginal costs

Efficiency and Equity From society’s view point, an efficient level of production is where MB = MC or when net benefits are maximized no matter to whom those net benefits accrue! In real world, if an efficient production level that benefits rich people at the expense of poor people need not be necessarily equitable. Equity is tied closely to distribution of wealth in society. If it is fair, judgments about alternative output levels may justifiably be made using efficiency criterion only Relative emphasis put on efficiency and equity is a matter of controversy.

Markets: If we rely on market system completely, can it produce q*? But… Why are we even worried about this question? We are a market-based economy For all its faults, a market system will normally produce better economic results overall than any other system A competitive market system can produce structure of incentives such as cost-minimization Through reward system, less expensive technical and organizational means of production could be a result

Underlying factors of Demand Curve? The Market Model D S $ pm qm Quantity Underlying factors of Demand Curve? Income, tastes and preferences, number of potential customers Underlying factors of Supply Curve? Input prices and level of technology inherent in the production process

There is only one level of P and Q that buyers and suppliers are consistent with and that is pm and qm. Why? Price adjustment mechanism? At qm, there is equality between MWTP and MC reflected by pm Hence, if prices are allowed to adjust freely and competition does exist, this equality would arise through normal interaction of buyers and sellers

Markets and Social Efficiency Market efficiency  qm = pm Social efficiency q* = p* Is q* = qm ? Why or why not? If it is not the case, then market failure occurs Public intervention then comes in two forms On the supply side whereby market supply curves are compared with true marginal social supply curves  External costs On the demand side, whereby environmental effects can create differences between market demand curves and true social marginal willingness to pay  External benefits

External Costs Private costs, which are costs of employing labor, using or renting land, installing capital and so on. These are reflected in the profit-loss-statement of the firm but External costs are not. Consider an example Paper mill constructed upstream near a river. Wastewater, produced in the process of converting wood to paper, dumped in the river. River has some assimilative capacity But before that happens  river will be polluted, fish life affected, scenic beauty of the river will be destroyed… But from mill’s view, the downstream costs are EXTERNAL to their operations!

A socially efficient rate of output must include all the private costs and external costs arise due to adverse environmental impacts Social costs = Private costs + External (Environmental) costs Marginal Social Costs (MPC + MEC) Demand for Paper Marginal Private Costs (MPC) Marginal External Costs (MEC) p* pm q* qm

External costs could be: From a single polluter and single person suffering damages Example: upstream paper mill and downstream firm using the river as its source of water Single polluter and multiple damagers Example: power plant emitting SO2 Multiple polluters and single damager Multiple polluters and multiple damagers, could be a global pollutant!

If your neighbors listen to music loudly, your life style suffers If your neighbors listen to music loudly, your life style suffers. Hence, it is an external cost! But can you legitimately claim it? If people in Lahore think that Canal Water is being polluted, can they claim that they have been made worse off? Answer hinges on notion of WTP The presence or absence of WTP is the economic index of whether an action affects someone or not

Open Access resources: Open to everyone, for example a lake or some public parks For such resources, what would be the socially efficient rate of use? Consider an example: Lake water being used by 4 firms both in production process and for discharging emissions Polluted lake water is treated through a treatment plant at a cost of $40000 per year for each firm. If 5th firm comes in, more emissions will be discharged, water treatment costs increases to $60000 per year for each firm.

External costs not being recognized lead to market failure. Another source of market failure is the notion of external benefits Accrue to someone outside, or external to the decision about consuming and using a resource. Example: Buying a quieter lawn mower will give me $50 worth of benefits so that is my MWTP External benefits could be received by my neighbor as well and suppose they are worth $20… So Social Benefits = ?

Marginal Willingness to Pay ($ per year) Public Goods Consider a lighthouse which is a service given to mariners at sea But such services are non-excludable Environmental quality is essentially a public good… Why? Marginal Willingness to Pay ($ per year) Level of Contaminant (ppm) Homeowner A B C Total MC of cleanup 4 110 60 30 200 50 3 85 35 20 140 65 2 70 10 15 95 1 55 150 45 5 240

Could we rely on the market system to supply this public good? Person A might not give true data on her marginal willingness to pay A has an incentive to underpay – problem of free rider Because of this free-riding impulse, profit-motivated private firms cannot cover their costs because people have incentive to underpay. Result  Undersupply public goods