Efficient Markets and Government

1. Efficient Markets and Government Chapter 2

2. A useful starting point for analyzing government activities is the study of the role of market in allocating resources. • Market facilitates – exchange g&s and inputs • However, markets cannot be relied upon to supply all useful g&s – sometimes mkt transactions have undesirable side effects – such as pollution.

3. Topics will be covered: • Defining the concept of efficiency • Condition under which markets operate efficiently • And examine some examples in which they fail to do so • Also show how government subsidies and taxes can distort resource allocation • And can cause losses in output and efficiency in markets

4. Positive Economics • Positive Economics explains “what is,” without making judgments about the appropriateness of “what is.” • Establishes cause-and effect relationship among economic variables • More objectives

5. Normative Economics • Normative Economics: designed to formulate recommendations about what “should be.” • It based on values approach • It can evaluate alternatives policies and action-only on basis of underlying value judgements

6. Normative Evaluation of Resource Use: The Efficiency Criterion • Efficiency is a normative criterion for evaluating the effects of resource use on the well-being of individuals. • Pareto Optimality- developed by Italian Economist (Vilfredo Pareto)

7. The efficiency criterion • The efficiency criterion is satisfied when resources are used over any given period of time - in such a way as to make it impossible to increase any one person’s well-being without reducing any other person’s well-being.

8. In general, Efficiency means- producing a desired result with a minimum of effort or expenses • Or the minimization of waste effort – that which produces no useful result

9. The efficiency criterion (CE): 1. assume that well-being of any individual increases with the amount of g&s –that he/she consumes per year • Eg. Given the amount of productive resources and the existence of technical knowledge in an economy =>elimination of waste effort – will allow more production from available resources • The extra production – will make it possible for some persons to consume more without reducing the amounts consumed by others. • As a results, it would be possible to make some individuals better off without anyone else – by avoiding waste in production

10. The efficiency criterion (CE): 2. Freedom to engage in mutually advantageous exchanges • If you are free to engage in transaction for gain – you can obtain more satisfaction out of your income. • Freedom to trade – an important aspect of efficiency • Both buyers & sellers can gain in markets when the value a buyers places on an item exceeds the cost the seller incurs –by making it available for sale

11. However, many argues that not all mutually gainful trades should be allowed • Eg. Individuals demand that the powers of government be used to prevent exchanges they find morally objectionable • They argue that G should exercise paternalistic powers over the choice of its citizens. • Thus, it is common to observe laws banning the sale of certain drugs, gambling services, prostitution, and other activities - in which some persons might wish to engage by some other find morally objectionable.

12. Thus, the CE- is based on underlying value judgment – that individuals should be allowed to pursue their self-interest as they see fit • provided that no one is harmed in the process.

13. Marginal Conditions for Efficiency • Total Social Benefit(TSB) – any given quantity of an economic good available – will provide a certain amount of satisfaction to those who consume it • Marginal Social Benefit (MSB) – the extra benefit of the obtained by making one more unit of that good available per one period given. • MSB can be measured as the max. amount of money given up by people to obtain the extra unit of good. • MSB of a good is assumed to decline as more of that good is made available each month.

14. Marginal Conditions for Efficiency • Total Social Cost (TSC) – the value of all resources necessary to make a given amount of the good available per month. • The Marginal Social Cost (MSC) – the minimum sum of money required to compensate the owners of inputs used in producing the good for making an extra unit of the good available. • It is assumed that output is produced at minimum possible cost-given available technology. • Net Benefit = TSB – TSC • Maximum Net Benefit occurs where MSB = MSC

15. Figure 2.1 Efficient Output A MSC B 2.00 = P C E Price, Benefit, and Cost (Dollars) 1.50 = P* 1.00 = P2 D A MSB Q1 = 10,000 Q2 = 20,000 TSC Q* = 15,000 B TSB Z Total Social Benefit and Cost TSB – TSC 0 Q* Loaves of Bread per Month MSB- max. amnt of $ given up by people to obtain the extra unit of good In MSC, out put is produced at min $1

16. Figure 2.1 Efficient Output A MSC B 2.00 = P C E Price, Benefit, and Cost (Dollars) 1.50 = P* 1.00 = P2 D A MSB Q1 = 10,000 Q2 = 20,000 TSC Q* = 15,000 B TSB Z Total Social Benefit and Cost TSB – TSC 0 Q* Loaves of Bread per Month Output is inefficient

17. At Q1= 10,000 • MSB ($2) > MSC ($1) • Maximum amount of money consumers would give up to obtain an additional loaf of bread > the minimum amount of money necessary to make input owners (whose resources are used to produce bread) • Thus , no worse off. • Because marginal benefit is $2

18. KEADAAN KETIDAKCEKAPAN Price, Benefit and Cost, RM • MSB>MSC • At Q1= 10,000 • MSB ($2) > MSC ($1) • Maximum amount of money consumers would give up to obtain an additional loaf of bread > the minimum amount of money necessary to make input owners (whose resources are used to produce bread) • Thus , no worse off. • Because marginal benefit is $2 MSC B E F 1.50 A MSB Qty 10 15 Disediakan oleh :RZA Jan 2007

19. At Q=20,000 • MSC>MSB • Th eoutput is ineffcient • Aditional gains that possible by reducing output from Q2 to Q* loaves per month is the area of CED

20. KEADAAN KETIDAKCEKAPAN Price, Benefit and Cost, RM MSC>MSB • At Q=20,000 • MSC>MSB • The output is inefficient • Additional gains that possible by reducing output from Q2 to Q* loaves per month is the area of CED MSC C E F 1.50 D MSB Qty 15 20 Disediakan oleh :RZA Jan 2007

21. Q=15,000 • MSB = MSC • Efficient output • Consumer will unwilling to sacrifice enough to compensate input owners for all the cost involved in making the extra units of bread available.

22. summary • At Q1=10,000 ( output level is inefficient because MSB > MSC = resources used to produced bread is NO WORSE OFF ) • At Q2= MSC > MSB = inefficient • MARGINAL NET BENEFIT MNB= MSB-MSC • If MNB +ve = MSB > MSB = additional gains from allocating more resources to production of a good are possible • MNB –ve = MSB < MSC • THE MARGINAL CONDITION FOR EFFICIENT for resources allocation MSB =MSC or TSB – TSC maximum

23. Conditions under which the Market is Pareto Optimal • A system of perfectly competitive markets can result in efficient resource use in an economy. • A Perfectly competitive market system exists if: 1. All productive resources are privately owned. 2. All transactions take place in markets, and in each separate market many competing sellers offer a standardized product to many competing buyers. 3. Economic power is dispersed in the sense that no buyers or sellers alone can influence prices. 4. All relevant information is freely available to buyers and sellers. 5. Resources are mobile and may be freely employed in any enterprise.

24. If These Conditions are MetP = MPB = MSB • The market price that emerge reflect the free interplay of supply and demand. • Neither businesses nor buyers can control prices- they can only react them. • Consumer trade until they adjust to Marginal private benefit received from consuming a good per month – to what they must forgo to purchase one more unit of the good /month • What they forgo – measure by PRICE – the amount money they give up that could have spent on other items • If this amount money > marginal private benefit (MPB) – they would be worse off by trading dollars. • Therefore, the maximize their gains from trading – by adjusting the amount of any good they consume /month UNTIL MPB = P

25. P=MPC=MSC • Producer maximize their gains from trading each month when they maximize profits. • Profits are maximized when there is no longer possible to add any gain by selling one more unit • The firm increase the profit – when the revenue obtained from selling an additional units> the cost of producing and selling that extra unit • MPC – marginal private cost – the cost incurred by sellers to make an additional unit of output available for sale • The firm will maximize profits when it adjusts its output sold per month – to the point at which P = MPC • If MPC > P => profit would decline • Thus the producers maximize gains from trade at the point : P = MPC = MSC

26. P=MPBi=MPC=MSB =MSC • A perfectly competitive market ( both buyers & sellers maximize their gain from trade) – result in a level of output for which MPV = MPC • If consumers are the only recipients of benefits – sellers bear all the cost of making that good -=> MSB = MSC • The market equilibrium will achieve the efficient output • If this condition are met- overall allocation of resources in the economy will satisfy the efficiency criterion. • When P of all g&s = MSB + MSC = the market system achieves an efficient outcome.

27. When Does Market Interaction Fail to Achieve Efficiency? • Monopoly • Taxes • Subsidies

28. Monopolistic Power • Market will fail to result in efficient levels of output when monopolistic power is exercised • A firm has monopolistic power – when it influence the price of product it sells – by reducing output to a level; at which P>MSC • A firm maximize profit at a level of MR = MPC

29. Figure 2.2 Loss in Net Benefits Due to Monopolies B MSB = P MSC E Price, Benefit, and Cost (Dollars) Loss in Net Benefits MSCM A D = MSB MR QM Q* 0 Output per Month At Qm: MSB > MSC

30. summary • Monopoly firm produce at Qm , at point A ; MSC=MR • At Qm: P = MSB > MSC • Efficiency is not attained because MSB > MSC at Qm • Efficiency could be obtained – by forcing qty (Qm to Q*) where MSC = MSB • This give extra social benefit over extra social cost (area ABE)

31. How taxes can cause losses in efficiency in competitive markets • When the product or services is taxed, the amount that is traded is influenced by the tax paid per unit. • The tax distorted the decisions of market participants. • Eg. Income tax influence the decision workers make about – the allocation of their time- between work and leisure • The more you work, you receives less than the gross amount of wages paid to you. • If you decide to work more – when you have opportunity to do so – you weigh the extra income after taxes against the value of the leisure time you give up. • Taxes influences your decision to work by reducing the net gain from working • Eg. Suppose the market for long distance telephone services is perfectly competitive.

32. Figure 2.3 Taxes and Efficiency MPC + T > MSC New Supply = MSC = MPC Supply = E' 6 E 5 Price (Cents per Message Unit) 4 B MSB Demand = 0 3 4 Billions of Message Units per Month

33. summary • When Govt. imposed tax – SS would be decreased • At new equilibrium price, Qty is decreased • Loss in net benefit = who much Govt. collected the tax revenue

34. How government subsidies can cause losses in efficiency • Government often subsidizes private enterprises or operate their own enterprises at a loss- using taxpayer funds- to make up difference • Subsidy also can impair market efficiency • The case: suppose the government guarantees farmers a certain price for their crops • When the market P falls – below the ‘target’ P guaranteed by the G • The G will pay eligible farmers a subsidy equal to the difference the market P of the product and the target P.

35. Figure 2.4 Subsidies and Efficiency MSC Supply = 5 A E 4 Price (Dollars per Bushel) C 3 MSB Demand = Q* QS 0 Bushels of Wheat per Year MC producing

36. summary • In the case that farmer to be received a min $5 per bushel of wheat • Result Qs > Q* (efficient amount) • MSC >MSB • Effect= the loss in benefit from resources • Overproduction of wheat relative to the efficient level – depress the mkt price ($3) • Over production of wheat – should be cheaper without any subsidies • Solution: Consumer end up paying only $3 while MC of producing at $5- Thus, the difference $2 is paid by G.

37. Market Failure: A Preview of the Basis for Government Activity • Market failure – to make g&s available in cases for which MSB outweigh MSB – and always results in demand for government action Exercise of monopoly power in markets • In the case market are dominated by a single firm • Monopoly power → add their profits by adjusting p to the point at which MR=MPC without fear of new entrants into the market • To prevent monopoly control over price – government typically monitor markets to ensure that barriers to entry do not encourage the exercise of monopoly power • G regulates the pricing policies of monopoly power • Eg. Monopoly firm = electric power, natural gas and water

38. How taxes can cause losses in efficiency in competitive markets • When product /services is taxed • The amount that is traded is influenced by the tax paid per unit • As well as by the MSB and MSC • Tax distort the decisions of market participants

39. Eg. Income influence the decision workers make about allocation income • Esp. If you work more hours; but receive less than gross amount of wages paid to you • In deciding to work more (if you have opportunity to do so) and pay taxes (by given up leisure time to go to work) • Thus, taxes influence your decision to work by reducing the net gain from working.

40. Effects of market transactions on third parties • Market transactions – results in damaging or beneficial effects on 3rd parties (who do not participate ) – results in inefficiency • Eg of third party – trucks, cars buses, factories, power plant – decrease air quality- that impair public health • Government policies – through education, fire protection

41. Incomplete information • We often demand that government intervene in market because – we have incomplete information- related to the risks of purchasing certain product or working in certain occupation • Eg. We rely on G to test new drugs • To prevent hazardous products from being sold • To establish standards for safety in the workplace

42. Equity vs. Efficiency • Equity: perceived fairness of an outcome. • Horizontal equity is achieved when equal people are treated equally. • Vertical equity is achieved when people are treated fairly along the socio-economic continuum.

43. Figure 2.5 Utility Possibility Curve UA Z E1 UA2 Annual Well-Being of A X E2 UA1 E3 UB1 UB2 UB 0 Annual Well-Being of B

44. Positive Analysis Trade-off Between Equity and Efficiency • When making choices about public policy issues, we are usually faced with the inevitable situation that you make one person worse off while making another better off. (Taxes must be paid by some in order that public goods can be purchased; these benefits accrue to people other than taxpayers.) Some economists attempt to overcome this with the Compensation Criteria.

45. Compensation Criteria • An attempt is made to compare the dollar value of the gain to the gainers and the dollar value of the loss to the losers. • If the gainers gain more than the losers lose, then the gainers can pay the losers enough to compensate the losers for their loss. • Everyone can be made at least as well off as they were without the change as long as compensation is paid.

46. International View: Agricultural Subsidies, International Trade Restrictions and Global Efficiency • Many nations subsidize farmers with: • Production subsidies. • Export subsidies. • Import constraints. • This results in reduced agricultural efficiency. • Since WTO agreements, such subsidies and import constraints have been reduced.