Transcript Chapter 14 - Economic Efficiency and the Role of Government

Economic Efficiency and the Role of Government 1
Hall & Lieberman Chapter 14
 Defining Economic Efficiency
Pareto improvement
 Measuring Losses in Efficiency
Consumer Surplus
Producer Surplus
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Economic Efficiency and the Role of
Government
• Virtually every disagreement about the economy ultimately leads to
government
– Some disagreements start there as well
• All these disagreements tend to obscure a remarkable degree of
agreement about the economy, and government’s role in it
– Vast majority of goods and services that you buy in stores, over the
internet, or obtain in other ways
• Are provided by private firms—and almost everyone agrees that’s how it should
be
• Widespread agreement that certain goods and services should be
provided by government
– Such as general police protection, the court system, and national defense
• Much of this agreement is based on ideas about economic efficiency
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The Meaning of Efficiency
• Economists define efficiency in terms of the absence of
waste:
– Waste of an opportunity to make someone better off without
harming anyone else.
– 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
• Notice that efficiency is very minimal requirement
– An efficient economy is not necessarily a fair economy
– Under this criteria, an efficient allocation of resources would
include having a single person own and control everything.
• Economics can make a major contribution to our material
well being by
– Helping us understand the preconditions for economic efficiency,
– Teaching us how we can bring about those preconditions
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Pareto Improvements
• A pareto improvement is a trade in which both
parties are made better off, and no one is harmed
– Pareto improvements provide the basic reason for trade
– Named after Italian economists, Vifredo Pareto (18481923)
– First systematically explored the issue of economic
efficiency
• Economic efficiency is achieved when every
possible Pareto improvement is exploited
• Perfectly competitive markets tend to be
economically efficient, and
– Well-functioning market economics tend to lie close to
the economically efficient end of the spectrum
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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
• What are some examples in which side payments are made?
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Markets and Economic Efficiency
• In a market system, firms and consumers
are largely free to produce and consume as
they wish, without anyone orchestrating the
process from above
• As long as trading takes place in perfectly
competitive markets, we can expect
economic efficiency to result
– To demonstrate this, we’ll return to Demand
and supply curves
• But we’ll look at them in a slightly different way
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Reinterpreting the Demand Curve
• Figure 1 shows a market demand curve for guitar lessons
– Quantity demanded per week at each price
• Also indicates who would be taking each lesson
• Both the individual and market demand curves indicate the quantity of
a good that would be demanded at a given price
• But we can also view the curve in a different way
– Maximum price someone would be willing to pay for each unit of good
– Tells us how much that unit is worth to the person who buys it
• Each guitar lesson in the market has a different value
– In part, this is because consumers differ in their incomes and tastes
• But also—for each individual—value of additional lessons declines as
more lessons are taken
– Height of market demand curve at any quantity shows us value—to
someone—of last unit of good consumed
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Figure 1: The Marginal Benefit From
Guitar Lessons
Price
$25
$23
$21
$19
$17
While the first lesson is worth $25
to some consumer (Flo) . . .
Flo
Joe
Flo (again)
Bo
Zoe
the second lesson is
worth only $23 . . .
and the third is worth $21.
Demand
1
2
3
4
5
Number of Lessons per Week
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Reinterpreting the Supply Curve
• Now let’s look at supply side of the market
– Figure 2 shows supply curve for guitar lessons—quantity offered each
week at various prices
– Indicates who would be supplying each lesson
• Supply curve also tells us the minimum price a seller must get in order
to supply that lesson
• Height of market supply curve at any quantity shows additional cost—
to some producer—of each unit of good supplied
• Why does it take higher prices to get more lessons?
– As any one teacher devotes more and more time to giving lessons,
opportunity cost of his time will rise
– Giving more lessons means less time left for other activities
– As leftover time becomes scarcer, value of each remaining hour rises
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Figure 2: The Marginal Costs of
Guitar Lessons
Price
Supply
$21
$19
$17
$15
$13
McCollum
Martin (again)
Gibson
Martin (again)
Martin
1
2
3
4
5
The smallest cost for this
first lesson is $13 . . .
but it's $15 for the second . . .
and $17 for the third.
Number of Lessons per Week
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The Efficient Quantity of a Good
• Figure 3 combines supply and demand curves for guitar lessons
– Whenever—at some quantity—demand curve is higher than supply curve
• Value of last unit to consumer is greater than its additional cost to some
producer
• 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
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Figure 3: Efficiency In The Market
For Guitar Lessons
Price
$25
$23
$21
$19
$17
$15
$13
Flo
Joe
Supply
1. Joe would pay as much as
$23 for the second lesson . . .
Flo
Bo
McCollum
Martin
Gibson Zoe
Martin
Demand
Martin
3. Four lessons is the equilibrium
and the efficient quantity.
2. while Martin would offer
it for as little as $15.
1
2
3
4
5
Number of Lessons per Week
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Perfect Competition and Efficiency
• In a well-functioning, perfectly competitive market,
equilibrium quantity is also efficient quantity
– If we leave producers and consumers alone to trade
with each other as they wish
– Market will exploit every opportunity to make someone
better off that doesn’t harm anyone else
• As long as market is working well, and it’s perfectly competitive
• Types of goods produced in competitive markets
will reflect consumer preferences
– If a good has such low value—relative to its cost—that
demand curve lies below supply curve at all quantities,
it will not be provided
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Perfect Competition and Efficiency
• The notion that perfect competition—where many
buyers and sellers each try to do the best for
themselves—actually delivers an efficient
economy is one of the most important ideas in
economics
– Adam Smith coined term ‘invisible hand’ to describe the
force that leads a competitive economy relentlessly and
automatically toward economic efficiency
• Recognize the end promoted by invisible hand as
economically efficient outcome
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Property Rights
 One of the key elements needed for a well-functioning
market is a well-defined set of property rights, including
four key charateristics:
- Universality:requires that all resources are privately
owned and all entitlements completely specified.
- Exclusivity:requires that all benefits and costs accrued as
the result of owning and using the resources should
accrue to the owner, and only the owner, either directly or
indirectly by sale to others.
- Transferability:requires that all property rights should be
transferable from one owner to another in a voluntary
exchange.
- Enforceability:requires that property rights should be
secure from seizure or encroachment by others.
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Consumer Surplus
• It is 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
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Figure 4(a): Consumer Surplus in a Small
and Large Market for Guitar Lessons
(a)
1. When market price is $19, someone (Flo) gets
$6 in consumer surplus on the first lesson . . .
Price
2. someone (Joe) gets $4 in consumer
surplus on the second . . .
$25
$23
$21
$19
$17
3. and someone (Flo again) gets $2
in consumer surplus on the third.
Demand
The total shaded area is
market consumer surplus.
Assumed
Market Price
1
2
3
4
5
Number of Lessons per Week
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Figure 4(b): Consumer Surplus in a Small
and Large Market for Guitar Lessons
(b)
Price
In a market with many buyers, market
consumer surplus is the entire area
under the demand curve and above
the market price.
$19
Market Price
Demand
4,000
Number of Lessons per Week
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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
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Figure 5(a): Producer Surplus From
Selling Guitar Lessons
(a)
Price
1.When market price is $19, someone (Martin) gets
$6 in producer surplus on the first lesson . . .
Supply
$21
$19
$17
$15
$13
2. someone (Martin again) gets $4 in
producer surplus on the second . . .
3. and someone (Gibson) gets $2 on the third.
Assumed
Market Price
The total shaded area is
market producer surplus.
1
2
3
4
5
Number of Lessons per Week
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Figure 5(b): Producer Surplus From
Selling Guitar Lessons
(b)
Price
Supply
Market Price
$19
In a market with many sellers, market
producer surplus is the entire area
above the market supply curve and
below the market price.
4,000
Number of Lessons per Week
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Total Net Benefits in a Market
• Measure total net benefits gained in a
market as
– Sum of consumer and producer surplus in that
market
• In Figure 6
– Blue shaded area represents market consumer
surplus
– Pink shaded area is market producer surplus
– Total shaded area represents total net benefits
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Figure 6: Total Net Benefits in a
Competitive Market for Guitar Lessons
Price
S
Equilibrium
Price
$19
D
4,000
Equilibrium Quantity
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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
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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
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Figure 7(a): Why Price Ceilings and
Price Floors Are Inefficient
1. A price ceiling of $15 . . .
2. transfers surplus from
producers to consumers.
Price
S
$23
C
3. It also decreases market
quantity, taking away
some consumer surplus
E
$19
B
D
$15
D
A
4 . . . . and some producer
surplus, which are not
transferred to anyone.
2,000
4,000
6,000
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Figure 7(b): Why Price Ceilings and
Price Floors Are Inefficient
1. A price floor of $21 . . .
Price
2. transfers surplus from
consumers to producers.
S
C
$21
$19
$17
B
3. It also decreases market
quantity, taking away
some consumer surplus
E
D
A
D
4 . . . . and some producer
surplus, which are not
transferred to anyone.
3,000
4,000
5,000
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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
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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)
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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
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