Transcript Efficiency and Equity

Efficiency and Equity
2008/22165
A rationing system to deal with the
economic problem
Because economic resources are relatively scarce
(resources are limited, wants are unlimited) a society
can’t have everything they want. There must be a
system that rations both resources and products.
The rationing system must answer the following
questions:
1. What, and how much, to produce
2. How to produce
3. For whom to produce
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 2
Tests for a rationing system
The two basic tests for any rationing system are:
 Is the system efficient?
 Is it fair?
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 3
Efficiency and equity
1.
2.
Efficiency – is the economy getting the most of out its
scarce resources (or are they being wasted)?
1. Technical efficiency – is production being done at
lowest unit cost?
2. Allocative efficiency – are resources being used to
make products that people want?
Equity – how fair is the distribution of products between
different members of society?
1. Horizontal equity – no discrimination between
people whose economic characteristics and
performance are equal
2. Vertical equity – different treatment of different
people in order to reduce the differences between
people
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 4
Different rationing systems
The world’s dominant rationing system is the price
mechanism.
Prices are determined in markets (as a result of the
interplay of demand and supply).
Given the correct economic conditions, advocates of
market economies believe they lead to the best
allocation of resources and the highest level of net
economic welfare.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 5
Different rationing systems
But markets are not the only way to resolve
 what and how much to produce,
 how to produce, and
 for whom to produce
How else can economic activity be co-ordinated?
How can the necessary economic choices be made
and on what grounds?
Will the resulting pattern of production, distribution
and consumption be efficient?
Will it be fair?
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 6
Some options
– Ballot (lanes in Melbourne Cup)
– Central directives (in Cuba, North Korea)
– Allocate to members (finals tickets, some wine
vintages)
– Rules and regulations (water restrictions by
street number)
– Queues – first come first served (public
hospitals)
– Priority allocation (AFL draft)
– Merit – university selection
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 7
The world’s dominant rationing
system.
It has already be said that the world’s dominant
rationing system is the price mechanism.
The circular flow of income model illustrates some
of the markets that operate in the economy.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 8
Markets in the circular flow
Consumption =
demand
Goods and
services
= supply
HOUSEHOLDS
Price
PRODUCERS
Supply
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 9
Markets in the circular flow
Price
Supply
Demand
Quantity
HOUSEHOLDS
PRODUCERS
Resources (e.g. labour)
= supply
Demand for resources =
demand
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 10
The super-computer network
In a competitive free market economy the market for
each product and economic resource is connected to
the market for all other products and resources
through an ultra-complex network of prices.
This network operates ‘invisibly’ as if driven by a giant
free-market super-computer.
What is the operating system for this free-market
super-computer?
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 11
Prices as a signalling mechanism
The free-market super computer operates through an
ultra-complex network of prices. The prices provide
a messaging or signalling service for producers and
consumers in the economy.
Normally, a rise in price reflects an increase in relative
scarcity. The higher price signals
– Consumers to reassess their buying choices (are
they still getting value for money – some will buy
less)
– Producers to reassess their production choices
(could they increase profits by supplying more?)
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 12
Prices as a signalling mechanism
The system only works if consumers and producers
– get the right message
– make a rational choices when they act on the
message
Prices send the right message given the right economic
circumstances. The right circumstances create ‘a
truthful world’ where the demand curve reflects value
or benefit and the supply curve reflects costs.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 13
The correct economic conditions
What are the correct economic conditions that allow
markets to maximise welfare?
1.
2.
3.
4.
5.
No information gaps / no asymmetrical
information
No side-effects (externalities) / no effect on
bystanders
No monopoly (or scarcity power)
Good motives and incentives
No free riders or non-exclusion products
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 14
Given the right conditions markets
maximise welfare.
In these economic conditions:
Price = marginal social benefit
Price = marginal social cost
Consumers get what they want
Producers don’t waste resources
If these conditions do not exist the market becomes
distorted (price does not reflect value and cost).
Demand and supply curves are in the wrong place.
Welfare is reduced. There is a deadweight loss.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 15
Markets increase trade and trade
increases welfare
Price
Consumers only buy things if
the value of the product to
them is equal or greater than
their opportunity cost.
Consumer
surplus
Supply
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
So, people that buy something
in a market at the ruling price
are getting a bonus – the value
they receive is greater than the
price they pay.
This bonus is called consumer
surplus. It increases their
welfare or satisfaction.
Slide 16
Markets increase trade and trade
increases welfare
Price
Supply
Producers only supply things if
the price they can get is equal or
greater than the cost of
production.
Efficient producers can supply
for less than the clearance price.
Producer
surplus
When a sale is made they get a
bonus – the money they receive
is greater than their costs of
Demand
production.
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
This bonus is called producer
surplus. It increases their
welfare or profit.
Slide 17
Trade increases welfare
Price
Consumer
surplus
Supply
The sum of consumer and
producer surplus indicates the
total increase in welfare from
this market.
So markets create trade and
trade increases welfare.
Producer
surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 18
The world of truth
This is only good if the
world of truth exists
Price
Consumer
surplus
Supply
Competitive markets
create a WORLD OF TRUTH.
The demand curve is a true
indicator of the value of
the product to consumers.
Producer
surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
The supply curve is a true
indicator of the cost of
production for producers.
Slide 19
The world of truth
Price
Consumer
surplus
Supply
Competitive markets are,
therefore efficient because:
 consumers get what
they want
Producer
surplus
Demand
 producers make the
right things in the right
quantities.
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 20
Welfare is maximised at the clearance
price.
Price
Supply
Cost greater
than benefit
– trade
stops at Q1
P1
Demand
Q1
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
People will opt out of
trading if they are going to
reduce their welfare. They
will lose if cost is greater
than benefit.
Trade increases consumer
and producer welfare up to
quantity Q1. If the aim is to
maximise benefits and
profits trade should rise to
Q1.
Slide 21
The world of truth
If the market clearance price
is not charged welfare falls.
Price
Consumer
surplus
Supply
Deadweight
loss
Producer
surplus
Q2
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
If a price is set below the
clearance price producers
reduce supply (to Q2).
There is excess demand.
Producer surplus is low (the
orange area).
The consumers who can get
the product get a big bonus
(the red area), but some
potential buyers go without.
Slide 22
The world of truth
Price
Consumer
surplus
Supply
Deadweight
loss
Producer
surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
If the market clearance price
is not charged welfare falls.
If a price is set above the
clearance price consumers
reduce demand.
There is excess supply.
Consumer surplus is low
(the red area).
Producers who make a sale
get a big bonus (the orange
area), but some production
is left unsold.
Slide 23
Applying the concept to international
trade
It is easy to show that overall
welfare rises if trade between
countries is increased.
Exporters can get higher
prices for their products (we
are more efficient than the
overseas country) and sell
more. Some supply is
diverted from domestic sales
so consumers lose out.
However, overall welfare
increases .
Efficiency and Equity (c) Andrew Tibbitt 2008
Price
Consumer
surplus
Domestic
Supply
Overseas
supply
RISE IN
WELFARE
Producer
surplus
Domestic
Demand
Quantity
Slide 24
Applying the concept to international
trade
It is easy to show that overall
welfare rises if trade between
countries is increased.
Consumers can buy goods at
cheaper prices (we are less
efficient than the overseas
country). Our producers lose
out as competition from
imports increases.
However, overall welfare
increases.
Efficiency and Equity (c) Andrew Tibbitt 2008
Price
Consumer
surplus
Domestic
Supply
RISE IN
WELFARE
Overseas
supply
Producer
surplus
Domestic
Demand
Quantity
Slide 25
Applying the concept to international
trade
Taken together more
Price
exports and more imports
lead to higher welfare.
There has been a
redistribution effect
though, some producers
gain, some lose,
consumers gain if they
buy some products and
lose if they buy others. Is
this fair?
Efficiency and Equity (c) Andrew Tibbitt 2008
Domestic
Supply
RISE IN
WELFARE
Overseas
supply
Domestic
Demand
Quantity
Slide 26
Market failure
Markets sometimes fail to produce efficient results
because the necessary conditions do not exist.
They fail, for example when :
1. Externalities are not taken into account (and
bystanders suffer collateral damage)
2. Producers have scarcity or monopoly power (and
they dominate the market, raise prices and earn
excessive profits
3. Key information is not known or shared evenly
4. Income distribution is unfair.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 27
When there are externalities
Bystanders (third parties) can be affected by economic
decisions made by others. These spin-off or side
effects of an economic decision are called
externalities.
Bystanders can be affected in a good or positive way
(e.g. your neighbour has nice garden). These positive
externalities create social benefits.
Bystanders can be harmed or affected in a negative
way (e.g. people become sick from factory pollution).
These negative externalities create social costs.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 28
Ignoring externalities leads to inefficiency
If market players do not
take these negative
externalities or social
costs into account (do
not include them in
their demand and
supply decisions) the
market will not work
efficiently.
Price
Air travel
S total
S
airlines
D
Too much will be
produced and
consumers will pay too
low a price.
Efficiency and Equity (c) Andrew Tibbitt 2008
Quantity
Greenhouse Gases are emitted by planes.
So do free markets create too many flights
at too low a price?
Slide 29
Ignoring externalities leads to inefficiency
In a similar way, if market
players do not take
positive externalities or
social benefits into
account (do not include
them in their demand and
supply decisions) the
market will not work
efficiently.
Price
Public transport S
private
S total
D
Too little will be supplied
and consumers will pay
too high a price.
Efficiency and Equity (c) Andrew Tibbitt 2008
Quantity
Free market public transport could be
too expensive if it forces people to
use their cars and cause congestion
Slide 30
Scarcity or monopoly power
If one of the players in a market has power over the
other then the market outcome becomes distorted
and the result can be inefficient. If a producer has
monopoly power in a sense they have scarcity power.
Monopoly power comes from a lack of competition.
Producers can deliberately minimise competition (e.g.
by branding, innovation, take overs). Producers with
monopoly power can restrict supply or push up prices.
The price no longer reflects the costs of production.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 31
Monopolists restrict supply and push up
prices.
Price
Consumer
surplus
New Supply
(monopoly)
Supply
(competitive)
Deadweight
loss
Producer
surplus
Monopolists have the
power to control supply
in the market. This can
lead to prices that are
higher than those set in
competitive markets.
The result is inefficiency.
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 32
Information gaps
Competitive free markets only produce efficient
outcomes if
 Demand curves reflect the true level of consumer
value or marginal benefit
 Supply curves reflect true costs of production
(the opportunity of using the resource inputs)
If producers don’t know the cost of production (like
insurance companies) and consumers don’t know the
value of the product they are buying (like health care
and second hand cars) then the market can’t operate
efficiently.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 33
Other problems for the market economy
Income distribution
Demand curves reflect effective demand.
Effective demand exists if a need or want can be
backed up by the ability to pay for it.
If income distribution is unfair (lacks equity) the
pattern of effective demand will be unfair.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 34
Other problems for the market economy
Public and collective goods
Products
– that are non-rival products (one person using the
good doesn’t prevent another for using it as well)
– where the exclusion principle does not operate
(the supplier or owner can’t prevent non-payers or
free-riders from using the product)
– where individual demand is unrealistic (such as
national defence)
will not be efficiently produced in a free market
economy.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 35
Modified market economies
As a result of market failure, nearly all economies are not
pure free market economies but mixed economies.
Government’s modify markets or override the market
altogether by influencing:
 the allocation of resources (e.g. through taxes, subsidies,
or directives) – allocative role
 business behaviour (e.g. through regulations and
legislation) – regulatory role
 the distribution of household incomes (e.g. through
taxation and welfare) – redistribution role
 the overall level of aggregate demand (e.g. through fiscal
and monetary policy) – demand management role
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 36
Government modifications
Policy measures to fix up or prevent market failure
include:
1. Taxing bad behaviour, taxing high income earners
2. Subsidising good behaviour, paying welfare to low
income earners.
3. Regulating or legislating against bad behaviour
4. Regulating or legislating good behaviour
5. Establishing markets to trade ‘permits to behave
badly’
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 37
Government failure
In some situations government intervention does prevent or
fix up market failure. But overall central planning does not
provide a more efficient and fairer rationing system.
Government run economies suffer from:
1.
2.
3.
4.
5.
Bureaucratic and cumbersome allocation processes
Moral hazard
Rent seeking behaviour (corruption)
Lack of incentive – bottomless pots, feather bedding,
no competition
Lack of consumer freedom or sovereignty
The trick is to intervene only when necessary.
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 38
Taxing a competitive market reduces
net economic welfare.
Supply with
tax
Price
Taxing a
competitive market
reduces welfare.
Supply
without tax
REDUCTION IN NET
WELFARE =
DEADWEIGHT LOSS
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 39
A difference of emphasis
When to intervene and modify a market is a matter of
judgement for governments. Economists can use the
concepts of consumer surplus, producer surplus and net
economic welfare to inform the policy debate.
LEFT
RIGHT
Responsibilities
Rights
Entitlements
Choice
Equity
Efficiency
Market failure
Incentives
Government intervention
Government failure
Efficiency and Equity (c) Andrew Tibbitt 2008
Slide 40