Economics Efficiency/inefficiency 1

 Recall, one role for the government:  Improve efficiency  When markets cannot cope  Other ones: rules, distribution  Efficiency = cannot be improved  There are many ways one can define “improved” 2

 Improvement: make at least one person better off without making anybody else worse off  = Pareto improvement  Hard to argue against, so accepted by everyone  An allocation is Pareto efficient if there is no possible change that would make at least one person better off without making anybody else worse off  = An allocation is Pareto efficient if there is no Pareto improvement 3

 Improvement: make some persons better off and possibly other persons worse off, the sum of all positive changes (gains) and all negative changes (losses) is positive  = Marshall improvement  There are losers and winners  Winners together gain more than losers together lose  There is a net gain  An allocation is Marshall efficient if there is no Marshall improvement  There are usually multiple Pareto efficient allocations  There are usually few Marshall efficient allocation  Efficiency considerations depend on who counts as a “person” 4

 Competitive market equilibrium is efficient  Surplus from trade  Maximized in equilibrium  Possible changes would fail to improve  Change quantity  Redistribute 5

 But we started with some assumptions  “a guy walks into a store and sees a price…”  competition  information  no effect on others except through exchange payment 6

 Competitive market equilibrium is efficient, IF  Perfect information  No externalities  No public good  No monopoly power  = First Fundamental Theorem of Welfare Economics 7

 Externality: a direct effect on somebody who is not a part of the transaction  Dirty water down the river  Nice flowers in front of a house  May be positive or negative  May be an effect on cost or benefits 8

 The true cost/benefit differs from what is taken into account  A decision maker ignores some bad/good things that come from a decision  There is a missing market  So, the policies:  Make the decision maker take it into account  regulations  Create missing markets  Taxes/subsidies  “imitating price” 9

 Inventory  Increasing third party’s benefits = positive externality = inefficiently low quantity in market equilibrium = subsidy helps  Increasing third party’s costs = negative externality = inefficiently high quantity in market equilibrium = tax helps  Decreasing third party’s benefits = negative externality = inefficiently high quantity in market equilibrium = tax helps  Decreasing third party’s benefits = positive externality = inefficiently low quantity in market equilibrium = subsidy helps 10

 Public good is  shareable in consumption  You consume, yet my satisfaction does not diminish  non-excludable in provision  Can’t stop people from having it  Maximizing agent  Ignore benefits  Just like in a positive externality case  Inefficiency = underproduction  Government? Usually produce/finance rather than regulate.  Why? 11

 Free-Rider Problem (= sort of Prisoners’ Dilemma):  People do not pay, even though they understand that somebody has to pay  Government: collect taxes by force  Many theories of government are based on this 12

 Monopoly:  Marginal revenue < price  Inefficiently low level of production  Government:  Regulation  Price  Production level  Subsidy would work but very hard to cheer for 13

 Imperfect information:  Buyer thinks benefit is A but it really is B  Firm thinks cost is A but it really is B  Like an externality unknowingly imposed on oneself  Experience goods  Fibbing to win  “simply” imperfect information: government cannot do much, except maybe facilitate dissemination  Asymmetric information: gives rise to institutions, including government itself 14