Microeconomics Level 2

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Microeconomics Level 2  Module 3

• Sandeep Kapur

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Welfare Economics  Equity and Efficiency
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EQUITY

• How fair is the distribution of goods and
  services?
• Of course, fairness is a value judgement
• In principle, we can distinguish between
• Horizontal equity equal treatment of equals
• Vertical equity different treatment of different
  people to reduce effects of inequality

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Equity of Allocations
Allocation a description of who gets what

• Starting from A, a move to E or F reflects a
  decrease in equity

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Efficiency of allocations

• Relative to initial point A
• B is better for all (and C is worse)
• D is better for one, and no worse for other
• B D are said to be Pareto improvements on A

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Pareto Efficiency

• An allocation is Pareto efficient (given tastes,
  resources and technology) if it is impossible to
  find another allocation that makes someone better
  off and nobody worse off.
• There can be more than one Pareto efficient
  allocation, and
• even inequitable allocations may be Pareto
  efficient

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Are Markets Pareto Efficient?

• Key Questions
• Do free markets always lead to Pareto efficient
  allocations?
• If not, why not?
• What are the implications for policy?

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Competitive Equilibrium Pareto Efficiency

• Consider two industries, meals and films.
  Suppose both are competitive and in equilibrium.
  Meals cost Pm and films Pf each.
• Last meal eaten yields Pm extra utility to
  consumer last film watched yielded Pf
• Pm and Pf are also the marginal costs of
  production
• This suggests that there is no way to reallocate
  production to generate a Pareto improvement

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An Example

• Suppose Pf 2Pm consumers need two meals to
  give up one film
• But producers need twice as much resources to
  'serve' a film instead of a meal
• So they could offer two meals for an extra film,
  but no net gain for consumers or producers
• PUNCH LINE Competitive equilibrium is Pareto
  efficient (The Invisible Hand Theorem!)

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AN IDEA

• If markets are efficient
• confine government intervention to
  redistribution, and
• rely on markets to achieve efficiency
• However markets may not always be efficient
• Market Failure a circumstance in which
  equilibrium in free markets fails to achieve an
  efficient allocation

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Sources of Market Failure

• Tax distortions
• Externalities
• Public goods
• Imperfect information
• Imperfect competition
• We will look at each of these in turn

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Group Work Efficiency and Equity

• Government intervention in the economy is
  pervasive. For each type of intervention listed
  below identify the possible rationale. Is it
  primarily
• (Pareto) efficiency considerations?
• a desire for greater equity?
• something else?

1. Income tax
2. Taxation of petrol
3. Windfall tax on utilities
4. Regulating electricity prices

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Group Work

1. Regulating discharge of sewage in the Thames
2. Legislation against insider trading
3. Banning the use of cocaine
4. Unemployment insurance
5. Making primary school compulsory
6. Maintaining an army
7. Running the NHS
8. Running the Post Office

Is there a trade-off between equity and
efficiency?
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MARKET FAILURE Taxation

• Suppose we have a tax only on films
• This tax wedge implies, for last film seen
• post-tax price exceeds producer's gain
• consumers value exceeds producer's value
• Implications for meals industry
• Marginal private cost of meals is below their
  marginal social cost

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Taxes distort

• Consequently, if only films are taxed,
• films are too expensive and meals too cheap
• we get too many meals relative to social optimum,
  and too few films
• IDEA a tax on meals too, to correct the
  imbalance

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THE SECOND BEST

• If there exists a price distortion, get rid of it
  to achieve the FIRST BEST (full efficiency)
• However, if you cannot get rid of the distortion
  in one market, it is not always efficient to
  arrange for other markets to be undistorted
• Rather, it helps to spread the inevitable
  distortion more thinly, by DELIBERATELY
  introducing new distortions in other markets

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MARKET FAILURE Externalities

• EXTERNALITY
• A circumstance in which an individual's
  production or consumption affects others' utility
  or productivity
• the effect is direct (and not through the market
  or prices)

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Externalities examples

• Adverse consumption externality smoking
• Beneficial consumption externality painting the
  exterior of your house
• Beneficial production externality bees and
  orchards
• Adverse production externality pollution

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Why Externalities Matter

• THE ESSENTIAL PROBLEM
• Market mechanism aligns private costs and
  benefits
• Externalities imply divergence between social and
  private costs (or social and private benefit)
• If divergences exist, should not expect socially
  efficient allocations

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Adverse Production Externality

• For social optimum, want social marginal cost
  social marginal benefit
• At the free market equilibrium E, output Q is
  higher than social optimum Q this results in
  dead-weight loss EFG
• SOLUTION 1 (Pigou). Corrective taxation

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Property Rights

• Solution 2 (Coase)
• Assign property rights and let people trade these
  rights in pseudo-market
• Initial assignment affects distribution but gets
  an efficient outcome
• This solution does not work if there are high
  transactions costs or free riding

Efficient quantity is Q
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MARKET FAILURE Public Goods

• Consumed in same quantity by everyone
• Examples defence, safe streets, TV signal
• Characteristics
• Non-rival consumption my consumption does not
  diminish what is available for you
• Non-excludability impossible or too costly to
  prevent people from consuming it

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Why free markets cant get public goods right

• Possible solutions
• The problem of free-riding
• Note that government needs to ensure right
  quantity, but does not need to produce it itself

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MARKET FAILURE Imperfect information

• In reality, information in markets is less than
  perfect (e.g. we often need to search)
• Often there is asymmetry of information between
  buyers and sellers
• Resulting in the problems of adverse selection
  and moral hazard
• This may result in incomplete markets or even
  missing markets
• Solutions mitigate informational problems or
  provide goods directly

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Moral hazard

• If you are fully insured against losses, you have
  little incentive to be careful
• insurance company bears the loss, not you
• increased carelessness increases risk of loss
  this is moral hazard
• The usual solution
• Insurance company forces you to bear some risk
  (excess payments or coinsurance) to maintain
  incentives to be careful
• Here you can buy only partial insurance. In some
  cases, no market at all

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MARKET FAILURE Imperfect Competition

• The essential problem
• With market power, price exceeds marginal cost,
• so social marginal benefit exceeds social
  marginal cost,
• leading to Pareto inefficiency
• Importantly, it is the restriction of output that
  is costly
• First-best solution align price marginal costs

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MONOPOLY benefits

• Dynamic efficiency more RD?
• Better coordination of decisions
• Economies of scale
• With natural monopolies, economies of scale so
  strong that it is cheaper to have one producer
  rather than duplicate fixed costs.
• Here, imposing the first-best solution
  (i.e., price marginal cost) results in losses

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MONOPOLY Solutions

• Solution 1. Nationalize and finance losses
  through taxes
• politically not very feasible
• Solution 2. Break monopoly e.g. anti-trust
  legislation in US
• However, no good for natural monopolies

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MONOPOLY Solutions

• Solution 3. Regulate Prevent abuse of monopoly
  power through price and non-price controls (UK
  approach)Practical issues when is regulation
  necessary? What form?
• Solution 4. Nurture competition Encourage new
  entrants, (but will they enter and will it only
  lead to cream skimming?)
• In general, difficulties with the mix of remedies

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Group Work Pollution control

• You are the National Rivers Regulator, tackling
  the problem of a chemical firm that is polluting
  the Thames
• If everything could be quantified and valued,
  show in a diagram how a pollution tax can induce
  the firm to behave in a socially efficient
  manner.
• Instead of the tax you offer the firm a pollution
  quota (specifying the maximum pollution it can
  discharge in any year). Show the size of the
  quota in the diagram. What difference does it
  make to the efficient quantity of pollution?
• Now suppose information is harder to come by. As
  the regulator, you are not entirely certain about
  the firm's cost curve. Does this affect your
  choice between tax and quotas?
• Lastly, suppose there are two chemical firms
  discharging into the river, one cleaner than the
  other. Is it better to
• set a pollution tax? (same rate per unit polluted
  for both?)
• set each a quota?
• auction pollution quotas?

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INDUSTRIAL POLICY

• Central idea market failure calls for an active
  role for the government
• Based on the idea that intervention can
• Correct failures in markets for knowledge
• Assist in the diffusion of new technologies
• Correct for excessive risk aversion
• Circumvent coordination failures, etc.
• However, the possibility of government failure

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Research Development

• PROBLEM Inventions are a public good, so that
  unregulated markets may not produce enough
• RD activity equals 2-3 of GDP in OECD
• THREE SOLUTIONS
• Patents confer time-bound legal monopoly on the
  inventor
• Procurement use government research labs e.g.
  defence
• Patronage provide subsidies to universities

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New technologies and standards

• Problem uncertainty about new technologies and
  standards may cause
• lock-in in to poor standards (QWERTY?)
• delays in adoption (VHS and Betamax)
• Solution guide technological choices?

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Risk

• Problem Markets may display excessive risk
  aversion
• Collectively, society can pool risks across
  projects spread risks across population
• Solution underwrite private sector losses?
  venture capital?

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Coordination of economic activity

• Location externalities and new lessons in
  economic geography
• Sunrise industries correct deficient incentives
  to acquire skills and imperfection in markets for
  loans to new firms
• Sunset industries managing the transition
  prevent survival of an inefficiently large number
  of firms

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Government Failure

• However, we must beware of the possibility of
  government failure.
• For instance, the possibility that governments
  may face the same informational constraints as
  markets.
• If so, government intervention may just replace
  market failure with government failure

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Taxation and Public Spending
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Taxation

• Variety of taxes
• Direct taxes income tax, corporation tax
• Indirect taxes on expenditure, VAT

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Desirable Characteristics of Tax System

• Equity
• Efficiency
• Administrative simplicity
• Cost of ensuring compliance
• Responsiveness to changing economic circumstances

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Progressivity of taxation

• Proportional average tax rate constant
• Progressive average tax rate rises with income
• Regressive average tax rate falls with income
• We must assess progressiveness carefully
  incidence of taxes, benefits, direct provision of
  goods

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Tax incidence who really bears the tax
Tax incidence diagrams either (as here) at
consumer prices (supply curve shifts) or at
producer prices (demand curve shifts)
Relative to original equilibrium, gross price
goes up but less than tax (i.e., net price goes
down)
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Tax incidence who really bears the tax

• Regardless of who the tax is levied on, its
  INCIDENCE depends on elasticity of supply and
  demand
• Inelastic supply/demand means bear the tax
• Elastic supply/demand escape the burden

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Principles of Optimal Taxation

• EFFICIENCY
• aim to minimise harmful effects on choice
• use lump-sum taxes wherever sensible
• if choosing variable taxes, choose tax rates to
  minimise distortion
• Ramsey principle tax rate higher if supply or
  demand is inelastic
• of course, taxes often help correct other
  distortions pollution taxes, and sin taxes on
  cigarettes, alcohol

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Principles of Optimal Taxation
EQUITY Two principles Ability to pay take
more from the rich Benefits principle
beneficiaries of public provision to pay more
Vertical equity suggests progressive tax system
but this may conflict with efficiency
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Public Spending

• Government expenditure around 40 of GDP
• Social insurance contributory benefits such as
  unemployment, sickness, pensions benefits
• Equity non-contributory benefits, such as income
  support, housing benefit, family support
• Merit goods what society believes all should
  have (externalities or paternalism) benefits-in
  kind, education, health
• Public goods law and order, defence

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Public Spending

• The big three
• Social security
• Health
• Education
• account for 3/5 of all public spending.
• We shall study these more carefully

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Health care
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Health Care a merit good?

• Sources of muddled thinking
• an emotional issue
• is health a basic right? But so is food
• is health care a commodity like any other? like
  cars, houses, etc.

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Health Care the issues

• Is a private market for health care efficient?
• Is it equitable?
• Is public production and allocation more
  efficient? More equitable?
• Efficiency
• macro what fraction of GDP on health
• micro how to allocate resources within system
• Equity but of what?

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Health Care the product

• Health care is only an input. Output -- improved
  health outcomes -- also depends on diet,
  environment, lifestyle
• Does health care reduce suffering? prolong life?
  improve life?
• And how valuable is improved health? Impact on
  output, earnings, income? Impact on happiness

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Why intervene in health care

• Would a private health care market be efficient?
• Imperfections in competition
• Imperfections due to asymmetric information and
  insurance
• Externalities and public goods aspects
• In addition to efficiency issues
• equity issues
• ethical issues

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Imperfect competition

• Would a private health care market be perfectly
  competitive?
• monopoly power of medical associations
• market power of drug companies
• Possible solutions
• Regulation
• Countervailing power (say, drug purchases by the
  NHS)

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Imperfect information

• Do people know if they are ill? What treatment do
  they need? What is available?
• Here seller (doctor) knows more than buyer
• technical complexity of information
• patients' inability to weigh alternatives
• high cost of errors
• In sum, this is hardly rational consumer choice
• Solutions provision of information and
  regulation but both are costly
• Public provision?

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Problems with Health Insurance

• Pattern of demand small probability of major
  expenditure
• Usually buy insurance in such situations but
  insurance markets suffer from many problems
• adverse selection attract especially sick
• moral hazard tendency to over-treat
• correlated risk are hard to insure epidemics
• missing markets for congenital problems
• Can intervene to reduce these problems, but
  causes other problems.
• Social insurance?

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Externalities and public good
Problem Communicable diseases are a negative
externality A solution to subsidise treatment In
general, the public good aspect of basic
healthcare
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Other reasons for intervention

• Equity arguments
• Moral and ethical arguments
• babies, organs should not be sold

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How to intervene?

• EFFICIENCY who should PRODUCE health care?
  private, public, or mixed production?
• Equity how should we PAY for it?
• tax (payments based on ability or need?)
• tax private (help for the poor?)
• private insurance (compulsory?)
• Should production and finance be handled
  together? e.g. health maintenance organisations

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Other questions

• Macro-economic issue
• How much should we spend on health? rising cost
  of health care
• ageing population
• more sophisticated (and expensive) treatment

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Health care in the UK case notes

• THE PATIENT NHS
• GPs provide primary care guide and gatekeeper
• Since 2003, Foundation Trusts, with financial and
  managerial autonomy run hospitals
• Primary Care Trusts purchase hospital care,
  community services
• Strategic Health Authorities to oversee Primary
  Care Trusts and NHS Trusts
• Department of Health

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THE CASE HISTORY

• Universal and virtually free access
• Publicly financed
• Good health outcome
• Cheap expenditure is 7-8 of GDP,
• But rising (up by 70 in real terms 1979-96, due
  to bulges in birth rate in post-war period,
  ageing population new, costly treatments)
• A recurrent crisis of confidence queues, alleged
  inefficiencies

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Health Spending, 2001
Spending per head, USPPP Spending, per cent of GDP
Australia 2350 8.9
France 2561 9.5
Japan 1984 7.6
Germany 2808 10.7
UK 1992 7.6
USA 4887 13.9
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DIAGNOSIS?

• Inefficient or under-funded?
• If inefficient, why?
• skills shortages?
• bureaucratic inefficiency?
• absence of choice for patients?
• If under-funded,
• more public money or private resources?

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PREVIOUS TREATMENT

• 1989 White Paper called for an internal market
• invisible hand rather than central control
• separation of funding from provision purchaser
  can buy from competing providers
• GP fund-holders to manage own budgets
• Hospital Trusts, with greater managerial control
  and financial autonomy
• Were the objectives genuine, or just a response
  to fiscal crisis?

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SWITCHING PROTOCOL

• Prior to 1991, central planning
• 1991-97 quasi markets
• 1997-2003 move away from markets
• 2003- competition and choice

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LONG-TERM CARE

• More public money or is privatisation inevitable?
• Will this create a dual structure, for rich and
  poor? Implications for life expectancy?
• Private health care currently cheap (residual use
  only, complicated treatment done by NHS, high
  number of young in privately insured, low cost of
  medical services in the UK), but will this last?

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Group Work Education

1. Identify the salient characteristics of education
   as a commodity. Is it a merit good?
2. Do you expect private markets for education to be
   efficient? Identify reasons for any market
   failures.
3. Private markets for education are likely to be
   inequitable. Should we worry about this?
4. If a university degree has any worth,
   individuals will be prepared to pay for it. This
   makes a case for more private finance in higher
   education. Comment.

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The Welfare State
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Public versus Private Sector

• When comparing public with private sector, it is
  important to remember that
• public sector losses were sometimes intentional
• cost structures differ Post Office vs private
  couriers

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Are governments less efficient than markets?

• Evidence
• Private sector firms are more efficient PROVIDED
  they operate in markets with strong competition
• Key issue not ownership, but severity of
  competition (or competition policy)
• E.g., many UK utilities improved in RUN-UP to
  privatisation, while they were still in public
  hands
• But this is not to deny that there have been
  serious inefficiencies

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Agency theory and incentives

• Imagine a project where
• the agent's effort affects probability of success
• effort is unobservable or hard to measure
• If so,
• the principal needs to provide incentives (carrot
  or stick) to induce effort
• without incentives, individuals may slack-off
• Lesson incentives matter

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Why is the public sector less efficient?

• 1. The incentives problem
• At the organisational level no fear of
  bankruptcy, no competition
• At the individual level not enough carrot
  (relatively fixed salary) or stick (relative
  security of tenure)
• In sum, incentive structures are relatively flat
• Why not use better incentive schemes in the
  public sector?
• Mostly because measuring success is harder due
  multiplicity of objectives and poor information
• 2. Institutional aspects what DO civil servants
  do?

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Lessons for policy makers

• Market failure does not make an automatic case
  for intervention
• Sometimes government intervention makes matters
  worse. Informational problems affect both public
  and private sectors.
• regulation often has perverse effects
• vulnerability of civil servants to rent-seeking
  behaviour
• Weigh existing inefficiencies against risk of
  government failure

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Supply-side economics

• Central idea
• Force government OUT of market place, to unleash
  private sector dynamism.
• Use microeconomic incentives to increase
  productivity
• Origins
• disenchantment with Keynesian, demand-side
  thinking
• tax fatigue of the 1970s

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Supply-side economics suggestions

• Cut marginal tax rates to provide incentive for
  hard work). Cut the dole, to increase labour
  participation. If output goes up, so might tax
  revenue (Laffer curve)
• Cut taxes on savings, dividends, to reduce
  distortions
• Cut business tax, allow more depreciation to
  induce new investment
• Rein in the state, cut govt spending (cut real
  interest rates), encourage privatisation
• Reform labour market (curb the Trade Unions)
  Encourage profit-sharing schemes to incentivise
  workers. Vocational training, etc.

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Evaluation of Supply-side economics

• did well on the inflation front
• tax cuts may not induce more workSubstitution
  effect (work more because work is rewarded more),
  vs income effect (work less as you can get goods
  you want with fewer hours of work). Evidence
  inconclusive
• likewise, cutting taxes on interest raises the
  return on saving, but may not induce people to
  save more
• budgetary troublesUS government found it easier
  to reduce public investment but not current
  expenditure (wages of civil servants). Laffer was
  off the mark
• aggregate investment did not expand much, once
  you correct for the business cycle
• incentive effects of some US tax cuts were
  perverse

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In sum

• Implications for efficiency
• Claims about likely efficiency gains were
  exaggerated
• Implications for equity
• Given that they aim to increase incentive to work
  and invest, supply-side policies -- if successful
  -- will inevitably widen the gap between those
  who succeed and those that fail.
• Did alter income distribution (tax cuts were
  deeper for the rich public spending on poor fell)
  

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THE WELFARE STATE

• Designed for both equity and efficiency
• Equity
• reduce poverty (insurance) and create a more
  equal distribution of wealth
• not just altruism, also desire for social
  cohesion
• Efficiency
• provide insurance against risks that market do
  not cover well (unemployment, illness)
• provide social services to correct for market
  failures in health, education, housing, pensions

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LESSONS OF HISTORY

• Dynamics of welfare state provision
• welfare state disconnects relationship between
  effort and reward
• but habits die hard habit-restrained lags
  between welfare provision and deterioration of
  incentives
• overshooting of welfare provision, leading to
  potential fiscal crises

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LESSONS OF HISTORY

• Is the welfare state viable?
• Thatcher's contribution linking payments to
  inflation not earnings
• Should benefits be targeted or universal?

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Cost-Benefit Analysis
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COST-BENEFIT ANALYSIS

• Analysis of costs and benefits useful for
• Capital projects
• Policy and programme development
• Use or disposal of existing assets
• Environmental standards, health and safety
• Procurement decisions

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THE PROCESS

• Justify action and set objectives
• Appraise the options including the do minimum
  and so-called politically infeasible
  onesIdentify costs and benefits of each option
• Adjustments
• non-market impacts
• risk and optimism
• distributional impacts
• Develop and implement solutions
• Evaluation

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FORMS OF APPRAISAL

• Financial Appraisal
• Compare revenue with costs, as private firm does
• (Social) Cost-benefit analysis
• Quantify costs and benefits of each option,
  including costs and benefits that the market does
  not value
• Cost-effectiveness analysis
• If benefits are hard to quantify, compare the
  costs of achieving some target level of benefits

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SOME TECHNICALITIES

• TIME PREFERENCE
• People prefer 1 today to 1 tomorrow
• demand a premium to postpone consumption
• OPPORTUNITY COST OF CAPITAL
• cost in terms of opportunities foregone
• rate r at which you borrow
• DISCOUNTING AND NET PRESENT VALUE
• What discount rate should we use?
• INFLATION erodes future values
• either all values real or all values nominal

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Decision rule Net Present Value Criterion

• Forecast the cash flow generated by the project
  over its lifetime
• Assess opportunity cost of capital, and discount
  future cash flows
• Calculate the net present value (NPV) sum of
  discounted net flows
• Decision Rule
• ONE OPTION Invest if NPV is positive
• MANY OPTIONS Invest in project with highest NPV
• All this is easier said than done

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SOCIAL COST-BENEFIT ANALYSIS

• While private sector cares about profits,
  government must consider a larger of benefits
  and costs
• The government uses the Net Present Value
  criterion but, to the extent social benefits and
  costs diverge from private benefits and costs,
  estimates of NPV could differ
• Social rate of time preference may differ from
  market rates of interest

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VALUING NON-MARKET IMPACTS

• Evaluate non-market consequences
• externalities, including environmental ones
• consumers surplus
• saving of time, human life
• possibilities of catastrophic risk
• Often hard to value these. Can use
• Willingness to Pay (WTP)
• Willingness to Accept (WTA)
• Contingent Valuation Methods (CVM)

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Some caveats

• Macroeconomic effects
• Need not make allowances for broader effects,
  such as tax flow-backs, savings in benefit
  payments, etc. These may happen even if the
  proposed project is rejected and some other is
  accepted
• What prices should the government use?
• Best to use MARKET PRICES. The use of so-called
  shadow prices can be justified only if there is
  severe market failure.

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Other issues

• What if the project has irreversible consequence?
• Be cautious. Raise the threshold of acceptance
  for a project to compensate for the
  irreversibility.
• Distributional impact
• see how costs and benefits affect different groups

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The effect of the chosen discount rate

• Consider stream of positive returns NPV falls as
  we use a higher discount rate

Choice of too high a discount rate will reject
good projects Choice of too low a discount rate
will accept bad ones
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What discount rate should the government use?

• Should it use the market rate at which private
  firms attract finance?
• In THEORY, the answer depends on aggregate impact
  of all public investment on private investment
  and consumption
• In PRACTICE, government uses a fixed rate of
  social time preference for consistency.
• was set at 6 pa in real terms
• now has been stripped down to 3.5
• Lower rates for long-term projects

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Risk and Uncertainty

• What if benefits or cost are uncertain?
• Private firms add some risk premium to the
  discount rate this lowers NPV, making acceptance
  of risky project less likely
• Should the government discount risk?In
  principle, if the government can spread risk very
  thinly across the population, answer is NO.
• In practice, risk evaluation and management is an
  important part.

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Managing and Evaluating Risk

• IDENTIFY all risks
• Assess what can be transferred, at low cost, to
  the private sector
• Use of pilot projects to learn more about costs
  and benefits. Use flexible designs avoid the risk
  of being hostage to fortune.
• Eliminate optimism bias
• Monte Carlo analyses sensitivity analyses to
  look at NPV of project under alternative
  assumptions about the value of uncertain
  parameters

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Green Accounting A Case Study
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Further reading

• Begg, Fisher and Dornbush, Economics, 7th
  edition, PART 3
• John Kay, The Truth about Markets their genius,
  their limits, their follies, Allen Lane, 2003
• Nicholas Barr, The Economics of the Welfare
  State, 4th edition, Oxford University Press, 2004
• This is a good manual for many aspects of public
  finance and the welfare state. See especially
• chapter 3 social theory and the state
• chapter 4 state intervention
• chapter 12health and health-care
• chapter 13 housing

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MicroeconomicsLevel 2

• Sandeep Kapur