Efficiency and Equity

Efficiency and Equity

2008/22165

Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 2

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 produce2. How to produce3. For whom to produce


Tests for a rationing system

The two basic tests for any rationing system are:

Is the system efficient? Is it fair?


Efficiency and equity

1. 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?2. 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


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.


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?


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


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.


Markets in the circular flow

HOUSEHOLDS PRODUCERS

Goods and services = supply

Consumption = demand

Supply

Demand

Quantity

Price


Markets in the circular flow

HOUSEHOLDS PRODUCERS

Resources (e.g. labour) = supply

Demand for resources = demand

Supply

Demand

Quantity

Price


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?


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?)


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.


The correct economic conditions

What are the correct economic conditions that allow markets to maximise welfare?

1. No information gaps / no asymmetrical information

2. No side-effects (externalities) / no effect on bystanders

3. No monopoly (or scarcity power)4. Good motives and incentives5. No free riders or non-exclusion products


Given the right conditions markets maximise welfare.In these economic conditions:

Price = marginal social benefitPrice = marginal social cost

Consumers get what they wantProducers 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.


Markets increase trade and trade increases welfare

Consumers only buy things if the value of the product to them is equal or greater than their opportunity cost.

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.

Price

Quantity

Supply

Demand

Consumer surplus


Markets increase trade and trade increases welfare

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.

When a sale is made they get a bonus – the money they receive is greater than their costs of production.

This bonus is called producer surplus. It increases their welfare or profit.

Price

Quantity

Supply

Demand

Producer surplus


Trade increases welfare

The sum of consumer and producer surplus indicates the total increase in welfare from this market.

So markets create trade and trade increases welfare.

Price

Quantity

Supply

Demand

Consumer surplus

Producer surplus


The world of truth

This is only good if the world of truth exists

Competitive markets create a WORLD OF TRUTH.

The demand curve is a true indicator of the value of the product to consumers.

The supply curve is a true indicator of the cost of production for producers.

Price

Quantity

Supply

Demand

Consumer surplus

Producer surplus


The world of truth

Competitive markets are, therefore efficient because:

consumers get what they want

producers make the right things in the right quantities.

Price

Quantity

Supply

Demand

Consumer surplus

Producer surplus


Welfare is maximised at the clearance price.

Supply

Demand

Quantity

Price

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.

P1

Cost greater than benefit – trade stops at Q1

Q1


The world of truth

If the market clearance price is not charged welfare falls.

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.

Price

Quantity

Supply

Demand

Consumer surplus

Producer surplus

Q2

Deadweight loss


The world of truth

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.

Price

Quantity

Supply

Demand

Consumer surplus

Producer surplus

Deadweight loss


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 .

Price

Quantity

Domestic Supply

Domestic Demand

Consumer surplus

Producer surplus

Overseas supply

RISE IN WELFARE



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.

Price

Quantity

Domestic Supply

Domestic Demand

Consumer surplus

Producer surplus

Overseas supply

RISE IN WELFARE



Taken together more 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?

Price

Quantity

Domestic Supply

Domestic Demand

Overseas supply

RISE IN WELFARE


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 evenly4. Income distribution is unfair.


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.


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.

Too much will be produced and consumers will pay too low a price.

D

S airlines

Air travelPrice

Quantity

S total

Greenhouse Gases are emitted by planes. So do free markets create too many flights at too low a price?

Socia

l cos

t of 5

% o

f clim

ate

chan

ge


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.

Too little will be supplied and consumers will pay too high a price.

D

S total

Public transportPrice

Quantity

S private

Free market public transport could be too expensive if it forces people to use their cars and cause congestion

Socia

l ben

efit

of le

ss c

onge

stio

n

Ignoring externalities leads to inefficiency


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.


Monopolists restrict supply and push up prices.

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.

Price

Quantity

Supply(competitive)

Demand

New Supply(monopoly)

Deadweight loss

Consumer surplus

Producer surplus


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.


Other problems for the market economy

Income distributionDemand 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.


Other problems for the market economy

Public and collective goodsProducts– 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.


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


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 behaviour4.Regulating or legislating good behaviour5.Establishing markets to trade ‘permits to

behave badly’


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. Bureaucratic and cumbersome allocation processes2. Moral hazard3. Rent seeking behaviour (corruption)4. Lack of incentive – bottomless pots, feather bedding,

no competition5. Lack of consumer freedom or sovereignty

The trick is to intervene only when necessary.


Taxing a competitive market reduces net economic welfare.

Taxing a competitive market reduces welfare.Price

Quantity

Supply with tax

Supply without tax

Demand

REDUCTION IN NET WELFARE = DEADWEIGHT LOSS


A difference of emphasis

LEFT

Responsibilities

Entitlements

Equity

Market failure

Government intervention

RIGHT

Rights

Choice

Efficiency

Incentives

Government failure

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.

Efficiency and Equity

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