Chapter 14: Economic Efficiency and the Role of Government Econ 101: Microeconomics.

Chapter 14:

Economic Efficiency and the Role of Government

Econ 101: Microeconomics

Hall & Leiberman; Economics: Principles And Applications, 2004

2

The Meaning of Efficiency What, exactly, does efficiency mean?

• Economic efficiency is achieved when there is no way to rearrange the production or allocation of goods in a way that makes one person better off without making anybody else worse off

A trade in which both parties are made better off, and no one is harmed

Named after Italian economist, Vilfredo Pareto (1848-1923)• First systematically explored the issue of economic efficiency

Helps us arrive at a formal definition of economic efficiency• Achieved when every possible Pareto improvement is exploited

Alternatively, we can look at the economy as a whole• If we discover remaining Pareto improvements that are not occurring then

we would deem the economy economically inefficient Perfectly competitive markets tend to be economically efficient


3

Side Payments and Pareto Improvements There are more complicated situations in which a Pareto

improvement will come about• Only if one side makes a special kind of payment to the other—called a side

payment

• Situations in which action will benefit one group and harm another If an action creates more total benefits for gainers than total harm to

losers• Than a side payment exists which—if transferred from gainers to losers—

would make the action a Pareto improvement Important implication for economic efficiency

• If there is an action that benefits some more than it harms others, and if an appropriate side payment can be easily arranged

• Than not taking the action is a waste of an opportunity to make everyone better off When a side payment cannot be made—or for any reason is not

made—then event of action might create greater gain than harm, it might not be considered fair


4

The Efficient Quantity of a Good Figure 3 combines supply and demand curves for guitar

lessons Whenever demand curve lies above supply curve,

producing the lesson is a Pareto improvement• Whenever demand curve lies below supply curve, producing the

lesson cannot be a Pareto improvement

• Efficient quantity of guitar lessons—the quantity at which all Pareto improvements are exploited—is where the demand curve and supply curve intersect

• At this quantity, value of the last good produced will be equal to—or possibly a tiny bit greater than—the cost of providing it

• Efficient quantity of a good is quantity at which market demand curve and market supply curves intersect


5

Figure 3: Efficiency In The Market For Guitar Lessons

$25$23$21$19$17$15$13 Demand

1. Joe would pay as much as $23 for the second lesson . . .Flo

Flo

Joe

McCollumMartin

Zoe

Supply

2. while Martin would offer it for as little as $15.

1 5

Martin

GibsonMartin

3. Four lessons is the equilibrium and the efficient quantity.

Price

Number of Lessons per Week2 3 4

Bo


6

Consumer Surplus Useful to measure the benefits that producers and

consumers receive from their economic activities A buyer’s consumer surplus on a unit of a good

• Difference between its value to buyer and what buyer actually pays for the unit

Total consumer surplus enjoyed by all consumers in a market is called market consumer surplus• Sum of consumer surplus on all units

• Market consumer surplus at any price—measured in dollars—is total area under market demand curve and above market price


7

Figure 4(a): Consumer Surplus in a Small and Large Market for Guitar Lessons

1 2 3 4 5

$25$23$21$19$17

Demand

The total shaded area is market consumer surplus.

(a)

Price

Number of Lessons per Week

1. When market price is $19, someone (Flo) gets $6 in consumer surplus on the first lesson . . .

3. and someone (Flo again) gets $2 in consumer surplus on the third.

2. someone (Joe) gets $4 in consumer surplus on the second . . .

Assumed Market Price


8

Figure 4(b): Consumer Surplus in a Small and Large Market for Guitar Lessons

4,000

$19

Market Price

(b)

Price


In a market with many buyers, market consumer surplus is the entire area under the demand curve and above the market price.

Demand


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Producer Surplus

An individual seller’s producer surplus on a unit of a good • Difference between what seller actually gets and

additional cost of providing it Total producer surplus gained by all sellers in

a market is called market producer surplus• Found by adding up producer surplus gained by all

sellers in market

• Market producer surplus at any price—measured in dollars—is total area above market supply curve and below market price


10

Figure 5(a): Producer Surplus From Selling Guitar Lessons

1 2 3 4

$21$19$17$15$13

Supply

(a)

Price


The total shaded area is market producer surplus.

3. and someone (Gibson) gets $2 on the third.

1.When market price is $19, someone (Martin) gets $6 in producer surplus on the first lesson . . .

2. someone (Martin again) gets $4 in producer surplus on the second . . .

Assumed Market Price

5


11

Figure 5(b): Producer Surplus From Selling Guitar Lessons

4,000

$19

In a market with many sellers, market producer surplus is the entire area above the market supply curve and below the market price.

Price

(b)


Supply

Market Price


12

Figure 6: Total Net Benefits in aCompetitive Market for Guitar Lessons

$19

4,000

S

D

Equilibrium Price

Price

Equilibrium Quantity

Market producer

surplus

Market consumer

surplus Total net benefits - Sum of consumer and producer surplus in that market.


13

Perfect Competition and Efficiency: The Total Benefits View

Each time we make a Pareto improvement in a market

• We make at least one party better off and make no one else worse off

• Therefore, a Pareto improvement will increase total net benefits available in a market

• Thus, we have a new way of viewing efficiency

• A market is efficient when sum of producer and consumer surplus is maximized in that market

In a well-functioning, perfectly competitive market

• Equilibrium quantity provides maximum possible benefit to buyers and sellers combined, and is the efficient quantity


14

A Price Ceiling Creates greater harm for sellers than gains for

buyers• Reduces total net benefits in the market in a perfectly

competitive market Welfare loss in a market is dollar value of

potential benefits not achieved due to inefficiency in that market

Although a price ceiling may benefit consumers as a group it will always reduce total net benefits in the market


15

Figure 7(a): Why Price Ceilings and Price Floors Are Inefficient

$19

4,000

S

$15

6,0002,000

D

Price

1. A price ceiling of $15 . . .

3. It also decreases market quantity, taking away some consumer surplus

A

B D

E

C$23

2. transfers surplus from producers to consumers.

4 . . . . and some producer surplus, which are not transferred to anyone.


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Figure 7(b): Why Price Ceilings and Price Floors Are Inefficient

3. It also decreases market quantity, taking away some consumer surplus

$19

4,000

S

$21

3,000

D

Price

1. A price floor of $21 . . .

A

B

D

E

C

2. transfers surplus from consumers to producers.

$17

5,000

4 . . . . and some producer surplus, which are not transferred to anyone.


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Calculating the Welfare Loss Let’s calculate dollar value of welfare loss caused

by price ceiling• Area of unshaded triangle formed by areas D and E together

• From high school algebra, area of any triangle is ½ x base x height

Welfare loss = ½ x base x height = ½ x $8 x 2,000 = $8,000

When this market is delivering only 2,000 lessons per week instead of the efficient 4,000• Guitar teachers and students together lose $8,000 in

potential benefits per week or• Welfare loss would be 52 weeks x $8,000 per week =

$416,000 per year


18

A Price Floor

In a perfectly competitive market, the price floor will always shrink total net benefits

Reduces total benefits in market (causes a welfare loss)


19

The Efficiency Role of Government When a well-functioning, perfectly competitive market is

permitted to reach its equilibrium, the outcome is efficient• No opportunities for mutual gain remain unexploited• Any government intervention that changes the market

quantity (say, a price ceiling or a price floor) will create inefficiency—a welfare loss

But government can—and does—contribute to the economic efficiency of markets• Provides infrastructure that permits markets to function

• Physical infrastructure—bridges, airports, waterways, and buildings

• Institutional infrastructure—laws, courts, and regulatory agencies

• Stepping in when markets are not working properly• When they leave Pareto improvements unexploited and

therefore fail to achieve economic efficiency


20

Market Failures Another vitally important role for government

• To intervene in situations of market failure• When a market equilibrium—even with the proper

institutional support—is economically inefficient General types of market failures to which

economists have devoted a lot of attention• Monopoly power• Externalities• Public goods

While economists and policy-makers agree in theory on what causes a market failure• Dealing with real-world market failures remains one of

the most controversial aspects of government policy


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Externalities

When a private action has side effects that affect other people in important ways, we have the problem of externalities• By-product of a good or activity that affects

someone not immediately involved in transaction


22

The Private Solution to a Negative Externality

Under certain conditions, inefficiency that would be caused by a negative externality will automatically be resolved by the parties themselves• The outcome is the efficient outcome

• Achieves maximization of total net benefits possible in the situation


23

The Coase Theorem What if building a theater would create $100,000 of benefits for

some but $70,000 worth of harm for others? Whether the theater will or will not be built depends entirely on

whether it is the efficient or inefficient outcome• Regardless of who holds the legal rights

• Negative externality is solved by market

• No government intervention is required, other than the initial assignment of legal rights

Rather surprising result is known as the Coase Theorem—named after economist Ronald Coase• States that private market will solve externality problem on its own,

always arriving at the efficient outcome• When side payments can be negotiated and arranged without cost

• While initial distribution of legal rights will determine allocation of gains and losses among the parties, it will not affect action taken


24

The Coase Theorem Requires that side payments can be arranged without cost—or, in

practice, that cost is so low relative to gains or losses at stake that it doesn’t matter• This requirement is most likely to be satisfied when all of the following

conditions are present• Legal rights are clearly established

• Legal rights can be easily transferred

• The number of people involved is very small

Unfortunately, many real world situations do not satisfy these conditions

Biggest problem is applying Coase theorem to many real-world externalities is the third condition• Often, a large number of people are involved

When many people are involved, achieving efficiency with side payments is plagued by an often insoluble problem• Free rider problem


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The Free Rider Problem Occurs when efficient outcome requires a side

payment but individual gainers—each obligated to pay a small share of the side payment—will not contribute

If extensive enough—can shrink the side payment until it isn’t large enough to compensate losers and still leave gainers better off

Stands in the way of many Pareto improvements• One of the main reasons why we typically turn to

government to deal with important externalities that affect many people


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Market Externalities and Government Solutions

A competitive market has many buyers and sellers• When a negative externality affects a market, the private solution

is unlikely to work A market with a negative externality associated with producing

or consuming a good will produce more than the efficient quantity• Creating a welfare loss

Unfortunately, with so many people involved, it would take too much time and trouble for individual producers and consumers to arrange appropriate side payments and production cutbacks• In any case, free rider problem would effectively destroy the

arrangement

• Efficient outcome requires government intervention in the market


27

Figure 11a: A Tax on Producers to Correct a Negative Externality

100 125

D

S

$1.00A

MSC

C $0.50B

(a)

Millions of Gallons per Period

Dollars

2. The efficient quantity is here . . .

3. but the equilibrium quantity is here.

4. In equilibrium, the welfare loss is triangle ABC.

1. This market has a negative externality of $0.50 per unit.


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Figure 11b: A Tax on Producers to Correct a Negative Externality

100 125

D

$1.00

$0.50B

(b)

Millions of Gallons per Period

Dollars

$1.30

$0.80

SBefore Tax

SAfter Tax

6. shifts the supply curve upward . . .

7. and moves the equilibrium to the efficient quantity.

5. A tax per unit on producers, equal to the negative externality per unit,

A


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Taxing a Negative Externality Government could use a tax on producers to move gasoline market to

point B Payment of the externality tax is shared between consumers and

producers, as is the payment of any tax, and will depend on elasticities of supply and demand• A tax on each unit of a good, equal to the external harm it causes, can correct a

negative externality and bring market to an efficient output level Consider the logic of this result

• Tax cures the inefficiency because it forces market to internalize the externality• To take account of the harm caused by gasoline

Suggests that a tax on consumers of gasoline would work just as well as a tax on producers

Taxes to correct negative externalities have been used in countries around the world• In United States, however, taxes designed to correct negative externalities are

less common


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Dealing with a Positive Externality

What about the case of a positive externality?• By-product of an activity or a service benefits other parties, rather than

harms them A market with a positive externality associated with producing or

consuming a good will produce less than the efficient quantity, creating a welfare loss

A subsidy on each unit of a good, equal to the external benefits it creates, can correct a positive externality and bring the market to an efficient output level

If a good is rivalrous, efficiency requires that people pay a price for its use• In the absence of any market failure, private provision will lead to efficient

level of production If a good is excludable, it can be provided by private market


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Figure 12a: A Subsidy for Consumers to Correct a Positive Externality

800,000 1,000,000

D

S

$100,000MSBC

A

$30,000

2. The equilibrium quantity is here . . .

3. but the efficient quantity is here.

4. In equilibrium, the welfare loss is triangle ABC.

(a)

Number of Degrees per Year

Dollars

1.This market has a positive externality of $30,000 per college degree.

B


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Figure 12b: A Subsidy for Consumers to Correct a Positive Externality

S

800,000 1,000,000

$100,000

B

A

$30,000

Number of Degrees per Year

Dollars

(b)

$114,000

$84,000

DBefore Subsidy

DAfter Subsidy

6. shifts the demand curve upward . . .

5. A subsidy per unit for consumers equal to the positive externality per unit . . .

7. and moves the market to the efficient quantity


33

Public Goods Pure private good

• One that is both rivalrous and excludable• In absence of any significant market failure, private firms will provide

these goods at close to efficient levels When a good is nonexcludable, people have an incentive to

become free riders• To let others pay for the good, so they can enjoy it without paying

When a good is nonexcludable, private sector will generally be unable to provide it• In most cases, if we want such a good, government must provide it

When a good or service is nonrivalrous, market cannot provide it efficiently• Rather, to achieve economic efficiency, good or service would have to

be provided free of charge Pure public good

• One that is both nonrivalrous and nonexcludable


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Figure 13: Pure Private, Pure Public and Mixed Goods

More Nonexcludable

More Excludable

More Rival More Nonrival

Mixed Good

Pure Private Good Mixed Good

Pure Public Good

• food, clothing, housing

• sold-out movie

• crowded highway

• newspaper

• software

• movie with empty seats

• uncrowded highway

• downloaded music file

• cable television

• urban park

• national defense, legal system

• police and fire protection• crowded

city streets• fish in international

waters


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Mixed Goods

Goods that appear in upper right and lower left corners of Figure 13 can be called mixed goods• Share features of both public and private goods

These goods are becoming increasingly important in our society• Are responsible for some growing tension and

controversy


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Excludable But Nonrivalrous Goods Goods near lower left hand corner are excludable but nonrivalrous

• Includes most information products

• Software is an essentially nonrivalrous good, but an excludable one• Neither pure public nor pure private

• Digital music files are another example of this type of mixed good• Currently, music remains somewhat excludable

• It is against the law to make copyrighted music available online

• Many people—either because of respect for the law, fear of getting caught, lack of technical expertise, or scarce time—still prefer to buy their music from a store or online shipping service

• Music industry is desperately looking for ways to achieve greater excludability• Has not yet found a good solution


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Nonexcludable But Rivalrous Goods

Tragedy of commons occurs when rivalrous but nonexcludable goods are overuse to detriment of all

An economy with well-functioning, perfectly competitive markets tends to be economically efficient• Many types of government involvement are needed to ensure that

markets function well and to deal with market failures Cases of government involvement are not without controversy

• Debates about public education, Social Security, international trade, and immigration center on questions of proper role for government

Some of the disagreement is over government’s role in bringing about a more fair economy• Also debate about the government’s role in bringing about economic

efficiency


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Nonexcludable But Rivalrous Goods

Information problems• While government may be able to move us closer to efficiency, it can also fall

short or overshoot based on inaccurate information Incentive problems for government

• Government officials are agents of the general public, and are supposed to serve public interest

• However, they can be influenced by lobbies for special interest groups

In order for government to have the funds it needs to support markets and do other things, it must raise revenue through taxes

Inherent problem with provision of public goods that almost guarantees dissatisfaction about them

Other important roles for government besides fostering efficiency• Equity, fairness, justice, and more

Anyone studying role of government in the economies is struck by one glaring fact• Most economic activity is carried out among private individuals

Chapter 14: Economic Efficiency and the Role of Government Econ 101: Microeconomics.

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Transcript of Chapter 14: Economic Efficiency and the Role of Government Econ 101: Microeconomics.