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

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

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

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

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

.. a B Xa b A Xa A Xb AXAX A Ya A Yb B Xb B Yb B Ya I B0 I B1 I B0 IAIA IAIA B0B0 A0A0 BXBX BYBY AYAY T S Efficiency in Consumption (2)

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

.. a L Ya b L Xa L Xb LXLX K Xa K Xb L Yb K Yb K Ya I Y0 I Y1 I Y0 IXIX IXIX Y0Y0 X0X0 LYLY KYKY KXKX Efficiency in Production (2)

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

a XaXa b XCXC YbYb YaYa I I c YMYM 0 X Y XbXb XMXM YcYc Efficiency in Product-Mix

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

Social Welfare & Optimality Social welfare function Optimality

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

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

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

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

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

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

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

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

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

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

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

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