Efficiency and Equity

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Efficiency and Equity
2008/22165
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A rationing system to deal with the economic
problem

• Because economic resources are relatively scarce
  (resources are limited, wants are unlimited) a
  society cant have everything they want. There
  must be a system that rations both resources and
  products.
• The rationing system must answer the following
  questions
• What, and how much, to produce
• How to produce
• For whom to produce

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Tests for a rationing system

• The two basic tests for any rationing system are
• Is the system efficient?
• Is it fair?

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Efficiency and equity

1. Efficiency is the economy getting the most of
   out its scarce resources (or are they being
   wasted)?
2. Technical efficiency is production being done
   at lowest unit cost?
3. Allocative efficiency are resources being used
   to make products that people want?
4. Equity how fair is the distribution of products
   between different members of society?
5. Horizontal equity no discrimination between
   people whose economic characteristics and
   performance are equal
6. Vertical equity different treatment of
   different people in order to reduce the
   differences between people

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Different rationing systems

• The worlds 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.

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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?

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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

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The worlds dominant rationing system.

• It has already be said that the worlds dominant
  rationing system is the price mechanism.
• The circular flow of income model illustrates
  some of the markets that operate in the economy.

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Markets in the circular flow
Consumption demand
Goods and services supply
HOUSEHOLDS
PRODUCERS
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Markets in the circular flow
HOUSEHOLDS
PRODUCERS
Resources (e.g. labour) supply
Demand for resources demand
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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?

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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?)

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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.

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The correct economic conditions

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

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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 dont 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.

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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
Supply
Consumer surplus
Demand
Quantity
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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
Supply
Producer surplus
Demand
Quantity
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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
Supply
Consumer surplus
Producer surplus
Demand
Quantity
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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
Supply
Consumer surplus
Producer surplus
Demand
Quantity
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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
Supply
Consumer surplus
Producer surplus
Demand
Quantity
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Welfare is maximised at the clearance 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.
Price
Supply
Cost greater than benefit trade stops at Q1
P1
Demand
Quantity
Q1
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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
Supply
Consumer surplus
Deadweight loss
Producer surplus
Demand
Quantity
Q2
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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
Supply
Consumer surplus
Deadweight loss
Producer surplus
Demand
Quantity
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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
Consumer surplus
Domestic Supply
Overseas supply
RISE IN WELFARE
Producer surplus
Domestic Demand
Quantity
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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.

Price
Consumer surplus
Domestic Supply
RISE IN WELFARE
Overseas supply
Producer surplus
Domestic Demand
Quantity
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Applying the concept to international trade

• 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
Domestic Supply
RISE IN WELFARE
Overseas supply
Domestic Demand
Quantity
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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.

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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.

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Ignoring externalities leads to inefficiency
S total
Air travel
Price

• 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.

S airlines
Social cost of 5 of climate change
D
Quantity
Greenhouse Gases are emitted by planes. So do
free markets create too many flights at too low a
price?
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Ignoring externalities leads to inefficiency
S private
Public transport
Price

• 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.

S total
Social benefit of less congestion
D
Quantity
Free market public transport could be too
expensive if it forces people to use their cars
and cause congestion
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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.

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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.
New Supply (monopoly)
Consumer surplus
Price
Supply (competitive)
Deadweight loss
Producer surplus
Demand
Quantity
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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 dont know the cost of production
  (like insurance companies) and consumers dont
  know the value of the product they are buying
  (like health care and second hand cars) then the
  market cant operate efficiently.

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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.

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Other problems for the market economy

• Public and collective goods
• Products
• that are non-rival products (one person using the
  good doesnt prevent another for using it as
  well)
• where the exclusion principle does not operate
  (the supplier or owner cant 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.

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Modified market economies

• As a result of market failure, nearly all
  economies are not pure free market economies but
  mixed economies.
• Governments 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

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Government modifications

• Policy measures to fix up or prevent market
  failure include
• Taxing bad behaviour, taxing high income earners
• Subsidising good behaviour, paying welfare to low
  income earners.
• Regulating or legislating against bad behaviour
• Regulating or legislating good behaviour
• Establishing markets to trade permits to behave
  badly

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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
• 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.

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Taxing a competitive market reduces net economic
welfare.

• Taxing a competitive market reduces welfare.

Supply with tax
Price
Supply without tax
REDUCTION IN NET WELFARE DEADWEIGHT LOSS
Demand
Quantity
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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.
RIGHT Rights Choice Efficiency Incentives Governme
nt failure
LEFT Responsibilities Entitlements Equity Market
failure Government intervention