Introductory Microeconomics (ES10001) Topic 8: General Equilibrium & Welfare

I.Introduction Welfare Economics; branch of economics dealing with normative issues. How well does the economy work? What do we mean by ‘well’? Equity or Efficiency??

II.Equity Horizontal equity; identical treatment of identical people Vertical equity; different treatment of different people to reduce the consequences of these innate differences Most people agree that horizontal equity is desirable (i.e. no discrimination). But very different views re. vertical equity; i.e. how many resources should be redistributed from rich to poor? Positive discrimination?

III.Efficiency Pareto Efficiency Vilfredo Pareto; Manuel D’economie Politique (1909) An allocation is Pareto-efficient if, for a given set of consumer tastes, resources and technology, it is impossible to move to another allocation which would make some people better off and nobody worse off

0 A B C E D F G q1q1 q2q2 Quantity of Goods for Person 1 Quantity of Goods for Person 2 Figure 1: Pareto Efficiency

III.Efficiency The Pareto criterion is independent of value judgements and thus can only be used to judge moves to north-east or south-west Nevertheless, it is the most we can say about efficiency without becoming entangled in value judgements

III.Efficiency Production Possibility Frontier (PPF) Points beyond frontier non-feasible Points on frontier are Pareto-efficient Points within frontier are Pareto-inefficient

0 A B C q1q1 q2q2 Figure 2: Productin Posibiity Frontier

IV.Compt. Markets & P/Eff. The ‘Invisible Hand’ (Adam Smith) If every market in the economy is a perfectly competitive free market, the resulting equilibrium though out the economy will be Pareto-efficient Cornerstone of welfare economics Individual firms and consumers, acting in own self- interest, generate a Pareto efficient general (i.e. economy wide) equilibrium as if guided to it by a benign invisible hand

IV.Compt. Markets & P/Eff. Illustration: Assume many consumers and producers but only two goods (x and y) Both markets are free, unregulated and perfectly competitive Assume that in equilibrium: Price of good x:p x = £5 Price of good y:p y = £10

IV.Compt. Markets & P/Eff. Note: Labour is the variable factor of production and workers are indifferent as regards the non-monetary aspects of employment in industry x and industry y Thus, migration of workers will ensure wages are equalised across all industries

IV.Compt. Markets & P/Eff. Stage 1 Recall that p = marginal utility (MU) Thus, last unit of x produced must yield consumers £5 extra (i.e. marginal) utility; last unit of y produced must yield consumers £10 extra (i.e. marginal) utility Implication; consumers willing to exchange 2 units of x (£10 worth of utility) for 1 unit of y (£10 worth of utility) since such an exchange will not change their total utility (i.e. MRS)

IV.Compt. Markets & P/Eff. Stage 2 Each firm produces to the point that p = MC Thus, marginal cost of the last unit of x produced must be £5 And marginal cost of the last unit of y produced must be £10

IV.Compt. Markets & P/Eff. Stage 3 Migration of workers between industries will ensure that: w x = w y = w Stage 4 In equilibrium, it must be the case that:

IV.Compt. Markets & P/Eff. Stage 5 w x = w y = w; MC x = £5; MC y = £10 Thus:

IV.Compt. Markets & P/Eff. Stage 6 Hence, decreasing the output of good y by 1 unit and transferring the labour thus freed to the production of good x would increase the output of good x by 2 units Feasible resource allocation; society is able to exchange 2 units of good x for one unit of good y

IV.Compt. Markets & P/Eff. Stage 7 Consumers willing to exchange two units of good x for one unit of good y; producers able to exchange two units of good x for one unit of good y There is thus no feasible reallocation of resources that can make society better off; Initial competitive equilibrium in both markets is Pareto efficient

IV.Compt. Markets & P/Eff. Moreover, since workers are paid their marginal product vis: Then:

IV.Compt. Markets & P/Eff. MC y = value of good x sacrificed by using last unit of labour to make good y rather than good x And if industry x is in competitive equilibrium (i.e. p x = MU x ), then MC y is also the MU that consumers would have derived from the consumption of good x sacrificed

IV.Compt. Markets & P/Eff. First Theorem of Welfare Economics Competitive equilibrium in all markets generates a Pareto efficient allocation But, there is an infinite number of Pareto efficient allocations; what determines the actual Pareto efficient outcome?

IV.Compt. Markets & P/Eff. Second Theorem of Welfare Economics Any Pareto efficient allocation can be achieved from a competitive equilibrium with appropriate adjustments to initial endowment

V.Market Failure Circumstances in which equilibrium in freely competitive unregulated markets fails to achieve an efficient allocation i.e. distortions prevent invisible hand from allocating resources efficiently

V.Market Failure Five main distortions 1. Imperfect Competition 2. Taxation 3. Externalities 4. Public goods 5. Information

V.Market Failure Imperfect Competition MB = p > MR = MC Under production; consumer’s willing to pay more for output at the margin than it costs firms to produce Pareto inefficient

V.Market Failure Taxation Purchase Tax / Sales Tax Marginal Benefit (Utility) ≠ Marginal Cost Under production

V.Market Failure Public Goods (i)Non-Diminishing (ii)Non-Excludable E.g. Defence; light-houses; street lights Free-riding

V.Market Failure Externalities An externality arises whenever an individual’s production or consumption decisions affects the production or consumption of other individuals, other than through market prices Externalities can be positive or negative depending upon whether the original production or consumption decision increases or decreases external production or consumption

MPC MSC MEC > 0 q q ** q * D = MPB = MSB p 0 B A C Figure 3: Production Externality Private Transport

MPC = MSC MEB q q * q ** D = MPB p 0 MSB B A C Figure 4: Consumption Externality Education

V.Market Failure Information Asymmetric information; one side to the contract / exchange knows more than the other Akerlof, G. (1970). ‘Adverse Selection and the Market for Lemons.’ Quarterly Journal of Economics, 84(3), pp

V.Market Failure Reservation price data

V.Market Failure Two Scenarios (i)Symmetric Information Quality is observable and known with certainty Buyers prepared to pay 10 for lemon and 20 for peach Selllers willing to accept 8 for lemon and 16 for peach Assume buyers’ reservation prices rule in equilibrium Separating Equilibrium; lemons traded at 10 and peaches at 20

V.Market Failure (ii)Asymmetric Information Quality unobservable Assume buyers ‘knows’ that a proportion q of the goods on offer are peaches Reservation Price p d = q*p Peach + (1 - q)*p Lemon = q*20 + (1 - q)*10 = 10q + 10

V.Market Failure Assume q = 0.5 p d = 10q + 10 = 10(0.5) + 10 = 15 But since the supply price of lemons (peaches) is 8 (16), then only lemons offered for sale Buyers revise q downward towards zero; p d = 10

V.Market Failure Market for lemons Adverse Selection leading to market failure; lemons drive out the peaches There is a potential Pareto improvement; both prospective buyers and sellers of peaches would like to trade Signalling: Green Flag; AA; University of Bath?