Economics_-_market_efficiency_equity_and _failure.ppt

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 produce
2. How to produce
3. 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 incentives
5. No free riders or non-exclusion products

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 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

Content
• Market power
• Externalities in Production and Consumption:
– Positive
– Negative
• Public goods
• Merit goods & Demerit goods
• Common Propoperty resources
• Inequalities in:
– Wealth distribution
– Income distribution

Market failure
Markets sometimes fail to produce efficient results because
the necessary conditions do not exist.
They fail, for example when :
1. Producers have scarcity or monopoly power (and they
dominate the market, raise prices and earn excessive
profits
2. Externalities are not taken into account (and bystanders
suffer collateral damage)
3. Key information is not known or shared evenly
4. Income distribution is unfair.

30
Market Power-general characteristics
• Four types of markets (generalised competitive
forms)
Perfect
competition
Monopolistic
competition
Oligopoly Monopoly
less competitive
more competitive
What criteria determine competitiveness?

31
To understand competitiveness ..
• numbers of buyers and sellers
• degree of product differentiation
• barriers to entry
• degree of control over price
• competitive methods
Economists describe, measure and analyse:

32
Perfect competition
A market structure which features
1 a large number of small firms
2 Very little product differentiation
3 very easy entry into or exit from the market.
4 Perfectly mobile resources
5 Perfect knowledge

Oligopoly
• Competition between the few
– May be a large number of firms in the industry but the
industry is dominated
by a small number of very large producers
• Concentration Ratio – the proportion of total
market sales (share) held by the top 3,4,5, etc
firms:
– A 4 firm concentration ratio of 75% means the top 4
firms account for 75% of all
the sales in the industry

Oligopoly
• Example:
• Music sales –
The music industry has
a 5-firm concentration
ratio of 75%.
Independents make up
25% of the market but
there could be many
thousands of firms that
make up this
‘independents’ group.
An oligopolistic market
structure therefore may
have many firms in the
industry but it is
dominated by a few
large sellers.
Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html

Oligopoly
• Features of an oligopolistic market structure:
• A few firms selling similar product
• Each firm produces branded products
• High barriers to entry
• Price may be relatively stable across the industry –
possible kinked demand curve?
• Potential for collusion (Game theory)
• Behaviour of firms affected by what they believe their
rivals might do – interdependence of firms
• Branding and brand loyalty may be a potent source of
competitive advantage
• Non-price competition may be prevalent

Oligopoly
The kinked demand curve - an explanation for price stability?
Price
Quantity
D = elastic
D = Inelastic
$5
100
Kinked D Curve
The principle of the kinked demand
curve rests on the principle
that:
a. If a firm raises its price, its
rivals will not follow suit
b. If a firm lowers its price, its
rivals will all do the same
Assume the firm is charging a price of
$5 and producing an output of 100.
If it chose to raise price above $5, its
rivals would not follow suit and the firm
effectively faces an elastic demand
curve for its product (consumers would
buy from the cheaper rivals). The %
change in demand would be greater
than the % change in price and TR
would fall.
Total Revenue A
Total
Revenue B
If the firm seeks to lower its price to
gain a competitive advantage, its rivals
will follow suit. Any gains it makes will
quickly be lost and the % change in
demand will be smaller than the %
reduction in price – total revenue
would again fall as the firm now faces
a relatively inelastic demand curve.
Total Revenue B
Total Revenue A
The firm therefore, effectively faces
a ‘kinked demand curve’ forcing it to
maintain a stable or rigid pricing
structure. Oligopolistic firms may
overcome this by engaging in non-
price competition.

THEORIES ABOUT OLIGOPOLY PRICING
There are four major theories about oligopoly pricing:
(1) Oligopoly firms collaborate to charge the monopoly price and get
monopoly profits
(2) Oligopoly firms compete on price so that price and profits will be
the same as a competitive industry
(3) Oligopoly price and profits will be between the monopoly and
competitive ends of the scale
(4) Oligopoly prices and profits are "indeterminate" because of the
difficulties in modelling interdependent price and output decisions

Oligopoly - Game Theory
Prisoner’s dilemma
Scenario
- Two suspects
- Insufficient evidence to charge them
- Cops need one criminal to rat out the other to
charge them
- Offer a deal

The Deal
Slide 40
If no one confesses (stays silent) that is if they cooperate with
each.
∴ Lack of evidence
•1 year in jail each
If one confesses (defects) and betrays the other
•0 years for the rat
•10 years for the quiet one
If both confess- testimony isn’t as valuable
•5 years each

Assumptions
Slide 41
 Each cares about minimising own jail time
 Each wants to maximise their pay-off – no concern for the other. –
(zero-sum games: pure competition -- one party better off only if
other is worse off).
 Rational choice leads to both defecting (betraying)
 Even though individual reward greater if both co-operated with
each other.

Let the Games begin
Slide 42
Prisoner B
Stays silent
Prisoner B
Confesses
Prisoner A
Stays Silent
PA – 1 year
PB – 1 year
PA – 10 years
PB – 0 Years
Prisoner A
Confesses
PA – 0 years
PB - 10 years
PA – 1 year
PB - 1 year
If prisoner A believes PB is going to stay silent his best option is to betray no
matter what.
If PA stays silent he will get 1 year in jail, if PA betrays he gets to walk free.

The payoff
Higher payoff for betraying
 No Matter what PB does I am personally better off ∴ I should
betray
However if Prisoner B acts in the same way and betrays PA the
outcome is the same for both.
∴ both get a lower pay off than staying silent (co-operating)
Game theory
Rational self-interest decisions result in each being worse off than
if each had chosen to cooperate.

44
The monopoly
market structure
• Monopoly is characterised by
– a single seller
– a unique product
– high barriers which make it difficult or impossible for
other firms to enter the market.

45
Comparing monopoly and perfect
competition
• Compared to perfect competition, the monopolist
– allocates resources inefficiently
– produces less output.

46
Resource misallocation
in monopoly
• Perfectly competitive firms produce more output (in total)
than the monopolistic firm.
• The monopolistic firm charges higher prices – in
monopoly, price exceeds marginal cost (this is known as
an economic profit).

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.

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 travel
Price
Quantity
S total
Greenhouse Gases are emitted by planes.
So do free markets create too many flights
at too low a 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.
D
S total
Public transport
Price
Quantity
S
private
Free market public transport could be
too expensive if it forces people to
use their cars and cause congestion
Ignoring externalities leads to inefficiency

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.

Other problems for the market economy
Public and collective goods
Products
– 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 behaviour
4. Regulating or legislating good behaviour
5. 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 processes
2. Moral hazard
3. Rent seeking behaviour (corruption)
4. Lack of incentive – bottomless pots, feather bedding, no
competition
5. 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.

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