Markets, Efficiency And The Public Interest
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Markets, Efficiency and the Public Interest
Markets, Efficiency and the Public Interest
Efficiency under Perfect Competition
EFFICIENCY UNDER PERFECT COMPETITION • Defining social efficiency – Pareto improvements – Pareto optimality
• Private efficiency – ‘rational’ economic behaviour – equating marginal benefits and marginal costs
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC
Maximum total surplus under perfect competition £
MC
Pe
D = MU O
Qe
Q
Maximum total surplus under perfect competition £
MC
A Pe
B D = MU
C O
Qe
Q
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC – assumption of no externalities
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC – assumption of no externalities – social efficiency in goods markets: MSB = MSC
Maximum total surplus under perfect competition £
MC
A Pe
B D = MU
C O
Qe
Q
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC – assumption of no externalities – social efficiency in goods markets: MSB = MSC – social efficiency in factor markets: MSBf = MSCf
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC – assumption of no externalities – social efficiency in goods markets: MSB = MSC – social efficiency in factor markets: MSBf = MSCf
• Interdependence, efficiency and the invisible hand
The interdependence of goods and factor markets
FIRMS (suppliers of goods and services, demanders of factor services) HOUSEHOLDS (demanders of goods and services, suppliers of factor services)
The interdependence of goods and factor markets £
P
D1 = MU1 = MSBG1
O
Q
£
(1) Consumer demand
The interdependence of goods and factor markets (2) Producer supply
£ Goods P
S = MC = MSCG
D1 = MU1 = MSBG1
O
Q Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (2) Producer supply
£ Goods P
S
P1 D1 O
Q1
Q
Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
(2) Producer supply
£ Goods
P
P
S
P1 D1 = MRPF1 = MSBF1 O
Q
D1 O
Q1
Q
Goods
£
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
(2) Producer supply
£
Factor services P
S = MDUF = MSCF
Goods P
S
P1 D1 = MRPF1 = MSBF1 O
Q Factor services
(4) Factor supply
£
D1 O
Q1
Q
Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
(2) Producer supply
£
Factor services P
Goods P
S
PF1
S
P1 D1
O
QF 1
Q Factor services
(4) Factor supply
£
D1 O
Q1
Q
Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
(2) Producer supply
£
Factor services P
Goods P
S
S
P2 P1
PF1
D2 = MU2 = MSBG2
D1 O
QF 1
Q Factor services
(4) Factor supply
£
D1 Q1 Q2
O
Q
Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
£
Factor services P
Goods P
S
PF2 PF1
D2 = MRPF2 D1
O
QF 1 QF 2
Q
Factor services (4) Factor supply
(2) Producer supply
£
S
P2 P1
D2 = MU2 = MSBG2
= MSBF2
D1 Q1 Q2
O
Q
Goods
£
(1) Consumer demand
Markets, Efficiency and the Public Interest
Social Efficiency: Intermediate Analysis
SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS • Private efficiency in goods markets – in consumption: MUX / MUY (MRS) = PX / PY – in production: MCX / MCY (MRT) = PX / PY
• Social efficiency in goods markets – between consumers: MRSa = MRSb ... = MRSn – between producers: MRTg = MRTh ... = MRTn – in exchange (assuming no externalities): social MRS = social MRT
SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS
• Social efficiency in factor markets • The achievement of general equilibrium
Social efficiency under perfect competition
Good Y
Production possibility curve
Slope = MRT O Good X
Social efficiency under perfect competition
Good Y
Social indifference curves
Slope = MRS I3 I2
Slope = MRT
I1
O Good X
Social efficiency under perfect competition Market price ratio
Good Y
MRS = PX / PY = MRT
s Slope = MRS I3
Slope = PX / PY
I2
Slope = MRT
I1
O Good X
Markets, Efficiency and the Public Interest
The Case for Government Intervention
CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC
External costs in production
Costs and benefits
MC = S
P
D
O
Q1 Quantity
External costs in production
Costs and benefits
MSC
P
MC = S
D External cost
O
Q2 Social optimum
Quantity
Q1
CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC – External benefits of production MSC < MC
External benefits in production
Costs and benefits
MC = S
P
O
D
Q1 Quantity
External benefits in production
Costs and benefits
MC = S MSC
External benefit P
O
D
Q1 Quantity
Q2
Social optimum
External costs and benefits in production
D
P External cost
O
Q2
Q1
Quantity
(a ) External costs
MC = S MSC Costs and benefits (£)
Costs and benefits (£)
MSC MC = S
External benefit P
O
D
Q1
Q2
Quantity
(b) External benefits
CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC – External benefits of production MSC < MC – External costs of consumption MSB < MB
Costs and benefits
External costs in consumption
P
D
(MB) MU = D
O
Q1 Quantity
Costs and benefits
External costs in consumption
External cost
P
D
(MB) MU = D MSB O Social optimum
Q2
Q1 Quantity
CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC – External benefits of production MSC < MC – External costs of consumption MSB < MB – External benefits of consumption MSB > MB
Costs and benefits
External benefits in consumption
P
D
(MB) MU = D
O
Q1 Quantity
External benefits in consumption
Costs and benefits
External benefit
P
D MSB (MB) MU = D
O
Q1 Quantity
Q2
Social optimum
External cost P
P
Costs and benefits (£)
Costs and benefits (£)
External costs and benefits in consumption
External benefit
P
P MSB MB
MB MSB O
Q2
Q1 Car miles
(a ) External costs
O
Q1
Q2
Rail miles
(b) External benefits
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource
Fishing in open-access fishing grounds £
AC = MC
ARP O
Number of boats
MRP
Fishing in open-access fishing grounds £ Equilibrium: well beyond Thethe collective optimum optimum Beyond this point no for boat owners more fish can be caught
AC = MC
ARP O
B1
B2
B3
MRP
Number of boats
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons – current-day examples
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons – current-day examples
• Market power
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons – current-day examples
• Market power – lack of Pareto optimality
A monopolist producing less than the social optimum £ MC
P1
MC1
MR O
Monopoly output
Q1
AR Q
A monopolist producing less than the social optimum £ MC = MSC
P1 P2 = MSB = MSC
MC1
MR O
Monopoly output
Q1
Q2
AR = MSB Q Perfectly competitive output
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons – current-day examples
• Market power – lack of Pareto optimality – deadweight loss under monopoly
Deadweight loss under monopoly MC
£
(= S under perfect competition)
Consumer surplus
Ppc
a Producer surplus
AR = D O
Qpc Q (a) Industry equilibrium under perfect competition
Deadweight loss under monopoly MC
£
(= S under perfect competition)
Pm Ppc
O
Consumer surplus
Deadweight welfare loss
b a
Producer surplus
AR = D
MR Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
Deadweight loss under monopoly MC
£
(= S under perfect competition)
Perfect competition
Consumer surplus
Ppc
a Producer surplus
AR = D O
Qpc Q (a) Industry equilibrium under perfect competition
Deadweight loss under monopoly MC
£
(= S under perfect competition)
Monopoly
Pm Ppc
O
Consumer surplus
Deadweight welfare loss
b a
Producer surplus
AR = D
MR Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
CASE FOR GOVERNMENT INTERVENTION • Ignorance and uncertainty • Immobility of factors and time lags • Protecting people’s interests – dependants – merit goods
• Other objectives • Possible conflict between objectives • Limitations of economics in assisting policy making
Markets, Efficiency and the Public Interest
Forms of Government Intervention
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world
Using taxes to correct a market distortion (“first-best” world)
Costs and benefits
MC = S
P
D
O
Q1 Quantity
Using taxes to correct a market distortion (“first-best” world)
Costs and benefits
MSC
P
MC = S
D External cost
O
Q2 Social optimum
Quantity
Q1
Using taxes to correct a market distortion (“first-best” world)
Costs and benefits
MSC
MC = S
Optimum tax = MSC – MC
P
D
MC
O
Q2 Quantity
Q1
Using subsidies to correct a market distortion (“first-best” world)
Costs and benefits
MC = S
P
O
D
Q1 Quantity
Using subsidies to correct a market distortion (“first-best” world)
Costs and benefits
MC = S MSC
External benefit P
O
D
Q1 Quantity
Q2
Social optimum
Using subsidies to correct a market distortion (“first-best” world)
MC = S MSC
Costs and benefits
MC Optimum subsidy = MC – MSC P
O
D
Q1 Quantity
Q2
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world • second-best tax and subsidy policies
Using taxes to correct for externalities: firms with monopoly power £ MC
Monopoly price and output
P1
D = MSB MR O
Q1
Q
Using taxes to correct for externalities: firms with monopoly power £
MSC
P2 P1
MC
Optimum price and output
D = MSB MR O
Q2 Q1
Q
Using taxes to correct for externalities: firms with monopoly power £
MSC
MC + tax MC
P2 P1
Optimum tax on the monopoly
Optimum tax
D = MSB MR
O
Q2 Q1
Q
Using taxes to correct for externalities: firms with monopoly power £
MSC
MC + tax MC
P2 P1
Continuing excess profits can be reduced by a further lump-sum tax Optimum tax
D = MSB MR
O
Q2 Q1
Q
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world • second-best tax and subsidy policies
– to correct for monopoly
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world • second-best tax and subsidy policies
– to correct for monopoly • use of lump-sum taxes plus subsidies
Using a lump-sum tax to reduce monopoly profits £ MC
P =AR
MR O
Q1
AR = MSB Q
Using a lump-sum tax to reduce monopoly profits £ MC
AC
P =AR
Profit (no tax) AC
MR O
Q1
AR = MSB Q
Using a lump-sum tax to reduce monopoly profits £
1. Acceptable profit 2. Lump sum tax necessary to achieve acceptable profit
MC
AC
+ lump-sum tax
AC
P1
1 AC + tax AC
2
MR O
Q1
AR = MSB Q
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world • second-best tax and subsidy policies
– to correct for monopoly • use of lump-sum taxes plus subsidies
– advantages and disadvantages of taxes and subsidies
£
Deadweight loss from an indirect tax Before-tax situation
S
P1
D O
Q1
Q
£
Deadweight loss from an indirect tax Before-tax situation
S
Consumer surplus P1
D O
Q1
Q
£
Deadweight loss from an indirect tax Before-tax situation
S
Consumer surplus P1
Producer surplus D O
Q1
Q
£
Deadweight loss from an indirect tax S + tax S
P2 P1 P2 − tax
D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax S + tax S 1
P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax S + tax S 1
P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax S + tax S 1
P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax Tax revenue for government
S + tax S
1 P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax S + tax Deadweight loss from tax
S
1 P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
FORMS OF GOVERNMENT INTERVENTION • Changes in property rights – the problem of limited property rights – extending property rights – the Coase theorem – limitations of this solution
• Legal controls – laws prohibiting behaviour that imposes external costs – laws to regulate monopoly power – laws to prevent firms from exploiting people’s ignorance
FORMS OF GOVERNMENT INTERVENTION • Regulatory bodies • Price controls – high minimum prices – low maximum prices
• Provision of information • The direct provision of goods and services – providing public goods – other goods – making rational decisions
• Public ownership
Markets, Efficiency and the Public Interest
Cost–Benefit Analysis
COST–BENEFIT ANALYSIS • The procedure • Identifying costs and benefits – costs • direct private monetary • external monetary • external non-monetary
– benefits • direct private monetary • private non-monetary
Private non-monetary benefits (consumer surplus) £
50p
D O
Q1
Q
Private non-monetary benefits (consumer surplus) £
Private non-monetary benefit
Consumer surplus 50p
D O
Q1
Q
COST–BENEFIT ANALYSIS • The procedure • Identifying costs and benefits – costs • direct private monetary • external monetary • external non-monetary
– benefits • direct private monetary • private non-monetary • external
COST–BENEFIT ANALYSIS • Measuring costs and benefits – direct private monetary costs and benefits – non-monetary private benefits – monetary externalities – non-monetary externalities
• Risk and uncertainty – sensitivity analysis
COST–BENEFIT ANALYSIS • Discounting – working out the NPV – choosing the discount rate
• The distribution of costs and benefits – the strict Pareto criterion – the Hicks–Kaldor criterion – taking specific account of redistributive consequences
Markets, Efficiency and the Public Interest
The Case for Laissez-Faire
THE CASE FOR LAISSEZ-FAIRE • The growth of libertarian thinking – the neo-Austrian school and its influence on radical-right thinking – libertarian policies of governments
• Drawbacks of government intervention – shortages and surpluses – poor information – bureaucracy and inefficiency – lack of market incentives – shifts in government policy – lack of freedom for the individual
THE CASE FOR LAISSEZ-FAIRE • Advantages of the free market – automatic adjustments – dynamic advantages of capitalism – high degree of competition even under monopoly/oligopoly
• Judging the arguments
Markets, Efficiency and the Public Interest
Efficiency under Perfect Competition
EFFICIENCY UNDER PERFECT COMPETITION • Defining social efficiency – Pareto improvements – Pareto optimality
• Private efficiency – ‘rational’ economic behaviour – equating marginal benefits and marginal costs
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC
Maximum total surplus under perfect competition £
MC
Pe
D = MU O
Qe
Q
Maximum total surplus under perfect competition £
MC
A Pe
B D = MU
C O
Qe
Q
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC – assumption of no externalities
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC – assumption of no externalities – social efficiency in goods markets: MSB = MSC
Maximum total surplus under perfect competition £
MC
A Pe
B D = MU
C O
Qe
Q
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC – assumption of no externalities – social efficiency in goods markets: MSB = MSC – social efficiency in factor markets: MSBf = MSCf
EFFICIENCY UNDER PERFECT COMPETITION • Achieving social efficiency under perfect competition – efficiency in consumption: MU = P – efficiency in production: P = MC – assumption of no externalities – social efficiency in goods markets: MSB = MSC – social efficiency in factor markets: MSBf = MSCf
• Interdependence, efficiency and the invisible hand
The interdependence of goods and factor markets
FIRMS (suppliers of goods and services, demanders of factor services) HOUSEHOLDS (demanders of goods and services, suppliers of factor services)
The interdependence of goods and factor markets £
P
D1 = MU1 = MSBG1
O
Q
£
(1) Consumer demand
The interdependence of goods and factor markets (2) Producer supply
£ Goods P
S = MC = MSCG
D1 = MU1 = MSBG1
O
Q Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (2) Producer supply
£ Goods P
S
P1 D1 O
Q1
Q
Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
(2) Producer supply
£ Goods
P
P
S
P1 D1 = MRPF1 = MSBF1 O
Q
D1 O
Q1
Q
Goods
£
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
(2) Producer supply
£
Factor services P
S = MDUF = MSCF
Goods P
S
P1 D1 = MRPF1 = MSBF1 O
Q Factor services
(4) Factor supply
£
D1 O
Q1
Q
Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
(2) Producer supply
£
Factor services P
Goods P
S
PF1
S
P1 D1
O
QF 1
Q Factor services
(4) Factor supply
£
D1 O
Q1
Q
Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
(2) Producer supply
£
Factor services P
Goods P
S
S
P2 P1
PF1
D2 = MU2 = MSBG2
D1 O
QF 1
Q Factor services
(4) Factor supply
£
D1 Q1 Q2
O
Q
Goods
£
(1) Consumer demand
The interdependence of goods and factor markets (3) Factor demand
£
£
Factor services P
Goods P
S
PF2 PF1
D2 = MRPF2 D1
O
QF 1 QF 2
Q
Factor services (4) Factor supply
(2) Producer supply
£
S
P2 P1
D2 = MU2 = MSBG2
= MSBF2
D1 Q1 Q2
O
Q
Goods
£
(1) Consumer demand
Markets, Efficiency and the Public Interest
Social Efficiency: Intermediate Analysis
SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS • Private efficiency in goods markets – in consumption: MUX / MUY (MRS) = PX / PY – in production: MCX / MCY (MRT) = PX / PY
• Social efficiency in goods markets – between consumers: MRSa = MRSb ... = MRSn – between producers: MRTg = MRTh ... = MRTn – in exchange (assuming no externalities): social MRS = social MRT
SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS
• Social efficiency in factor markets • The achievement of general equilibrium
Social efficiency under perfect competition
Good Y
Production possibility curve
Slope = MRT O Good X
Social efficiency under perfect competition
Good Y
Social indifference curves
Slope = MRS I3 I2
Slope = MRT
I1
O Good X
Social efficiency under perfect competition Market price ratio
Good Y
MRS = PX / PY = MRT
s Slope = MRS I3
Slope = PX / PY
I2
Slope = MRT
I1
O Good X
Markets, Efficiency and the Public Interest
The Case for Government Intervention
CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC
External costs in production
Costs and benefits
MC = S
P
D
O
Q1 Quantity
External costs in production
Costs and benefits
MSC
P
MC = S
D External cost
O
Q2 Social optimum
Quantity
Q1
CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC – External benefits of production MSC < MC
External benefits in production
Costs and benefits
MC = S
P
O
D
Q1 Quantity
External benefits in production
Costs and benefits
MC = S MSC
External benefit P
O
D
Q1 Quantity
Q2
Social optimum
External costs and benefits in production
D
P External cost
O
Q2
Q1
Quantity
(a ) External costs
MC = S MSC Costs and benefits (£)
Costs and benefits (£)
MSC MC = S
External benefit P
O
D
Q1
Q2
Quantity
(b) External benefits
CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC – External benefits of production MSC < MC – External costs of consumption MSB < MB
Costs and benefits
External costs in consumption
P
D
(MB) MU = D
O
Q1 Quantity
Costs and benefits
External costs in consumption
External cost
P
D
(MB) MU = D MSB O Social optimum
Q2
Q1 Quantity
CASE FOR GOVERNMENT INTERVENTION • Externalities – External costs of production MSC > MC – External benefits of production MSC < MC – External costs of consumption MSB < MB – External benefits of consumption MSB > MB
Costs and benefits
External benefits in consumption
P
D
(MB) MU = D
O
Q1 Quantity
External benefits in consumption
Costs and benefits
External benefit
P
D MSB (MB) MU = D
O
Q1 Quantity
Q2
Social optimum
External cost P
P
Costs and benefits (£)
Costs and benefits (£)
External costs and benefits in consumption
External benefit
P
P MSB MB
MB MSB O
Q2
Q1 Car miles
(a ) External costs
O
Q1
Q2
Rail miles
(b) External benefits
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource
Fishing in open-access fishing grounds £
AC = MC
ARP O
Number of boats
MRP
Fishing in open-access fishing grounds £ Equilibrium: well beyond Thethe collective optimum optimum Beyond this point no for boat owners more fish can be caught
AC = MC
ARP O
B1
B2
B3
MRP
Number of boats
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons – current-day examples
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons – current-day examples
• Market power
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons – current-day examples
• Market power – lack of Pareto optimality
A monopolist producing less than the social optimum £ MC
P1
MC1
MR O
Monopoly output
Q1
AR Q
A monopolist producing less than the social optimum £ MC = MSC
P1 P2 = MSB = MSC
MC1
MR O
Monopoly output
Q1
Q2
AR = MSB Q Perfectly competitive output
CASE FOR GOVERNMENT INTERVENTION • Public goods – Non-rivalry – Non-excludability: free-rider problem
• Common resources – equilibrium use of a common resource – the tragedy of the commons – current-day examples
• Market power – lack of Pareto optimality – deadweight loss under monopoly
Deadweight loss under monopoly MC
£
(= S under perfect competition)
Consumer surplus
Ppc
a Producer surplus
AR = D O
Qpc Q (a) Industry equilibrium under perfect competition
Deadweight loss under monopoly MC
£
(= S under perfect competition)
Pm Ppc
O
Consumer surplus
Deadweight welfare loss
b a
Producer surplus
AR = D
MR Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
Deadweight loss under monopoly MC
£
(= S under perfect competition)
Perfect competition
Consumer surplus
Ppc
a Producer surplus
AR = D O
Qpc Q (a) Industry equilibrium under perfect competition
Deadweight loss under monopoly MC
£
(= S under perfect competition)
Monopoly
Pm Ppc
O
Consumer surplus
Deadweight welfare loss
b a
Producer surplus
AR = D
MR Qpc
Qpc
(b) Industry equilibrium under monopoly
Q
CASE FOR GOVERNMENT INTERVENTION • Ignorance and uncertainty • Immobility of factors and time lags • Protecting people’s interests – dependants – merit goods
• Other objectives • Possible conflict between objectives • Limitations of economics in assisting policy making
Markets, Efficiency and the Public Interest
Forms of Government Intervention
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world
Using taxes to correct a market distortion (“first-best” world)
Costs and benefits
MC = S
P
D
O
Q1 Quantity
Using taxes to correct a market distortion (“first-best” world)
Costs and benefits
MSC
P
MC = S
D External cost
O
Q2 Social optimum
Quantity
Q1
Using taxes to correct a market distortion (“first-best” world)
Costs and benefits
MSC
MC = S
Optimum tax = MSC – MC
P
D
MC
O
Q2 Quantity
Q1
Using subsidies to correct a market distortion (“first-best” world)
Costs and benefits
MC = S
P
O
D
Q1 Quantity
Using subsidies to correct a market distortion (“first-best” world)
Costs and benefits
MC = S MSC
External benefit P
O
D
Q1 Quantity
Q2
Social optimum
Using subsidies to correct a market distortion (“first-best” world)
MC = S MSC
Costs and benefits
MC Optimum subsidy = MC – MSC P
O
D
Q1 Quantity
Q2
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world • second-best tax and subsidy policies
Using taxes to correct for externalities: firms with monopoly power £ MC
Monopoly price and output
P1
D = MSB MR O
Q1
Q
Using taxes to correct for externalities: firms with monopoly power £
MSC
P2 P1
MC
Optimum price and output
D = MSB MR O
Q2 Q1
Q
Using taxes to correct for externalities: firms with monopoly power £
MSC
MC + tax MC
P2 P1
Optimum tax on the monopoly
Optimum tax
D = MSB MR
O
Q2 Q1
Q
Using taxes to correct for externalities: firms with monopoly power £
MSC
MC + tax MC
P2 P1
Continuing excess profits can be reduced by a further lump-sum tax Optimum tax
D = MSB MR
O
Q2 Q1
Q
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world • second-best tax and subsidy policies
– to correct for monopoly
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world • second-best tax and subsidy policies
– to correct for monopoly • use of lump-sum taxes plus subsidies
Using a lump-sum tax to reduce monopoly profits £ MC
P =AR
MR O
Q1
AR = MSB Q
Using a lump-sum tax to reduce monopoly profits £ MC
AC
P =AR
Profit (no tax) AC
MR O
Q1
AR = MSB Q
Using a lump-sum tax to reduce monopoly profits £
1. Acceptable profit 2. Lump sum tax necessary to achieve acceptable profit
MC
AC
+ lump-sum tax
AC
P1
1 AC + tax AC
2
MR O
Q1
AR = MSB Q
FORMS OF GOVERNMENT INTERVENTION • The problem of the second best – the first-best world – the second-best solution to market distortions
• Taxes and subsidies – to correct externalities • the first-best world • second-best tax and subsidy policies
– to correct for monopoly • use of lump-sum taxes plus subsidies
– advantages and disadvantages of taxes and subsidies
£
Deadweight loss from an indirect tax Before-tax situation
S
P1
D O
Q1
Q
£
Deadweight loss from an indirect tax Before-tax situation
S
Consumer surplus P1
D O
Q1
Q
£
Deadweight loss from an indirect tax Before-tax situation
S
Consumer surplus P1
Producer surplus D O
Q1
Q
£
Deadweight loss from an indirect tax S + tax S
P2 P1 P2 − tax
D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax S + tax S 1
P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax S + tax S 1
P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax S + tax S 1
P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax Tax revenue for government
S + tax S
1 P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
£
Deadweight loss from an indirect tax S + tax Deadweight loss from tax
S
1 P2
2
P1
3 5
4
P2 − tax
6 D O
Q2
Q1
Q
FORMS OF GOVERNMENT INTERVENTION • Changes in property rights – the problem of limited property rights – extending property rights – the Coase theorem – limitations of this solution
• Legal controls – laws prohibiting behaviour that imposes external costs – laws to regulate monopoly power – laws to prevent firms from exploiting people’s ignorance
FORMS OF GOVERNMENT INTERVENTION • Regulatory bodies • Price controls – high minimum prices – low maximum prices
• Provision of information • The direct provision of goods and services – providing public goods – other goods – making rational decisions
• Public ownership
Markets, Efficiency and the Public Interest
Cost–Benefit Analysis
COST–BENEFIT ANALYSIS • The procedure • Identifying costs and benefits – costs • direct private monetary • external monetary • external non-monetary
– benefits • direct private monetary • private non-monetary
Private non-monetary benefits (consumer surplus) £
50p
D O
Q1
Q
Private non-monetary benefits (consumer surplus) £
Private non-monetary benefit
Consumer surplus 50p
D O
Q1
Q
COST–BENEFIT ANALYSIS • The procedure • Identifying costs and benefits – costs • direct private monetary • external monetary • external non-monetary
– benefits • direct private monetary • private non-monetary • external
COST–BENEFIT ANALYSIS • Measuring costs and benefits – direct private monetary costs and benefits – non-monetary private benefits – monetary externalities – non-monetary externalities
• Risk and uncertainty – sensitivity analysis
COST–BENEFIT ANALYSIS • Discounting – working out the NPV – choosing the discount rate
• The distribution of costs and benefits – the strict Pareto criterion – the Hicks–Kaldor criterion – taking specific account of redistributive consequences
Markets, Efficiency and the Public Interest
The Case for Laissez-Faire
THE CASE FOR LAISSEZ-FAIRE • The growth of libertarian thinking – the neo-Austrian school and its influence on radical-right thinking – libertarian policies of governments
• Drawbacks of government intervention – shortages and surpluses – poor information – bureaucracy and inefficiency – lack of market incentives – shifts in government policy – lack of freedom for the individual
THE CASE FOR LAISSEZ-FAIRE • Advantages of the free market – automatic adjustments – dynamic advantages of capitalism – high degree of competition even under monopoly/oligopoly
• Judging the arguments
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