LESSON 1 (Refer to TUT101 for assessment guidelines) Benchmark model of resource allocation: positive and normative approaches INTRODUCTION Public economics should be the concern of all South Africans, rich or poor because it will influence everyone's economic position in one way or another. Rich people may be more concerned with the rates of personal income tax, company tax and capital gains tax and what they will get in return for their taxes, while poor people, on the other hand, maybe far more interested in the increases in grants (e.g. social pensions and child support) or expenditure on health, housing and education. Public economics focuses on the government's role in a market economy (refer to chapter 1 in the textbook, Calitz, Siebrits and Steenekamp or CSS). Will governmentʼs involvement in the economy promote efficiency, equity and economic growth? To be able to analyse the government's actions we need economic tools to determine whether such actions will promote efficiency and equity. In this lesson, the focus falls on the benchmark model, which is a very valuable tool to determine whether the actions of the government will promote efficiency or inefficiency. In life, we tend to look at matters in relative terms. We know someone is tall because someone else is short, and person A is rich relative to person B who is poor – we are making comparisons. In economics, we also think in relative terms, for example, when prices are studied. We know that the price of diamonds is high because in comparison the price of doughnuts is low. This relationship is often expressed as a ratio Pdiamonds/Pdoughnuts. When we compare things and view matters in relative terms, we are benchmarking. You will recall from your first-year Economics that we aim to study the economic problem (scarcity and unlimited wants) and to find solutions to this problem. Several possible economic systems attempt to solve this problem. The second chapter of the textbook mainly explains and illustrates how the perfectly competitive market system solves the economic problem in a (Pareto) efficient manner. The perfectly competitive market (or neoclassical general equilibrium model) with its very restrictive assumptions is our benchmark economic system (or model). Make sure that you understand this well because we are going to use this tool repeatedly in subsequent chapters to determine whether government intervention promotes allocative efficiency or not. After you have studied this lesson (and the prescribed sections in chapter 2 in CSS), you will have a better understanding of how to use a neoclassical general equilibrium model as a benchmark to evaluate the role of government in the economy. You should, therefore, be able to: • • • • • • • Open Rubric explain the basic assumptions of the benchmark model explain the benchmark model and allocative efficiency define a Pareto optimal allocation of resources define X-efficiency and its relationship with economic growth provide an overview of market failure distinguish between broad approaches to rectify market failures distinguish between direct and indirect government intervention • explain government failure CONTENTS 1.1 Assumptions of the benchmark model When we study public economics, a logical beginning is to consider the role of government in the economy. Surely, if we cannot identify a role for government there should be no need to study public economics! A highly theoretical economic model is used as a starting point, namely the “benchmark model”, which shows how a perfectly competitive economic system will ensure allocative efficiency. If we can prove that this system cannot solve some of the economic issues without the help of government, we have set the scene for studying government from an economics perspective. If you recall the microeconomics you have studied at the second-year level, we now continue where you left off. To retrace our steps we begin with the assumptions of the perfectly competitive model (see box 2.1 of CSS). 1.2 The benchmark model and allocative efficiency In section 2.2 of CSS, it is shown that in a perfectly competitive economy allocative efficiency will occur if three conditions hold, namely equilibrium in production, equilibrium in consumption and simultaneous equilibrium for producers and consumers. Once you have studied section 2.2 you should be able to define Pareto optimality and discuss the conditions for allocative efficiency with the aid of equations [2.4], [2.5] and [2.6] as well as figure 2.4. Note that the condition for simultaneous equilibrium MRPTxy = MCx/MCy = Px/Py = MRSaxy = MRSbxy (equation [2.6] will reoccur in later chapters (eg when we discuss the efficiency of a tax). A good understanding of these conditions is, therefore, essential for grasping important issues in later chapters. First, consider Condition 1. Condition 1 refers to efficiency in production and can be summarised as follows: • It is a situation where it is impossible to increase the production of one commodity without thereby decreasing the production of another commodity. Under perfect competition, each firm (or sector) will try to maximise output (reach the highest possible isoquant in figure 2.2) and minimise costs (reach the lowest possible isocost curve in figure 2.2). Equilibrium is only possible when firms face the same equilibrium factor prices (= (wage (w))/(implicit rental value of capital (r))). This occurs where the isoquants are tangent such as point f in figure 2.2. At this point labour and capital are used Pareto optimally – production of good X cannot be increased by reallocating labour or capital without reducing the production of good Y. There are many such points and when these points are linked a contact curve is obtained. The contract curve can be used to derive the familiar production possibility curve (PPC). The slope of the tangent to the PPC measures the marginal rate of product transformation (MRPT). The slope of PPC also measures the marginal cost of producing one good (X) relative to producing the other good (Y) and can be expressed as a ratio (MCx/MCy). Therefore, at all points on the PPC the following condition holds: MRPTxy = MCx/MCy Under perfect competition, good X is produced where the MCx = Px and good Y is produced where MCy = Py. Because the MRPT is equal to the marginal cost ratio it follows that MRPTxy = MCx/MCy = Px/Py (see equation [2.5] in CSS). Condition 2 refers to efficiency in consumption (or exchange) and can be summarised as follows: • It is a situation where it is impossible to increase the utility of one consumer without thereby reducing the utility of another consumer. Under perfect competition, consumers will maximise utility (reach the highest indifference curve in the figure below) subject to his/her preferences and budget constraint (or budget line in the figure below). Note: The figure below is simply a reproduction of the Edgeworth-Bowley box diagram drawn inside the PPC of figure 2.4 in CSS. Note the differences between this figure and figure 2.2. In the diagram below the consumption of good X and good Y by two individuals (a and b) are represented in the diagram, that is, consumer equilibrium. Utility functions (indifference curves) and budget lines are plotted inside the box diagram. In contrast, figure 2.2 represents the production by two suppliers combining capital and labour to produce two goods X and Y, that is, production equilibrium. Isoquants (or equal output curves) and equal-cost curves (isocost curves) are plotted inside the box diagram. Consumers face the same relative price ratio (Px/Py). If the price ratio differs between consumers they can increase utility through the exchange. For example, at point Z the price ratios differ and by exchanging/bargaining consumer (a) can reach a higher indifference curve Ua without reducing the utility of person (b) (who remains on indifference curve Ub3) until point F' is reached. Equilibrium occurs where the budget line (or price line vv') is tangent to the indifference curves at a point such as F'. At this point, consumption is Pareto efficient since one person (a) cannot be made better off through exchange (trade) without making the other person (b) worse off. Again there are many such points and by linking these points we obtain a contract curve for consumption. The slope of the budget (price) line at point F' is equal to the relative price ratio Px/Py and the slope of the tangent to the indifference curves at point F' is equal to the marginal rates of substitution, that is, MRSaxy = MRSbxy. Because the slope of the budget line and the slope of the tangent to the indifference curves are equal it implies that MRSaxy = Px/Py = MRSbxy (see equation [2.6] in CSS) 0b Good Y v Ub3 Z F' Ua3 Ua1 Ua2 v' 0a Good X Condition 3 requires that consumption and production equilibrium are achieved simultaneously to ensure efficiency in the output mix (or market efficiency). We can summarise market efficiency (or the top-level equilibrium) as follows: • • • • In a competitive market, producers will maximise profits where MRPTxy = MCx/MCy = Px/Py consumers will use their budgets so that MRSaxy = Px/Py = MRSbxy the equilibrium price Px/Py is the same for producers and consumers (i.e. the relative price ratio is the common denominator in both equilibrium conditions) and therefore MRPTxy = MCx/MCy = Px/Py = MRSaxy = MRSbxy (see equation [2.6] in CSS) Assume that the market produces the combination F on the PPC in figure 2.4. The indifference curves of the two consumers are drawn within the dimensions of the box – we insert the Edgeworth-Bowley box diagram above within the PPC and obtain figure 2.4 (reproduced below). If the top-level equilibrium condition is to be met, the slopes of vv' and tt' must be the same, that is, the lines must be parallel. If the lines are not parallel it means that the price ratios for consumption and production differ implying Pareto inefficiency. It would then be desirable to increase the output of one product and/or reduce that of the other until the two ratios are the same again. At a point such as B in the diagram below we notice that line kk' is not parallel to tt' or the MRSxy differs from the MRPTxy. By producing more of good X and less of good Y a Pareto efficient output mix can be obtained. M Good Y t Y2 F = 0b v k t' Ub3 Z B F' Ua3 k' Ua1 Ua2 N 0a v' X2 Good X ACTIVITY 1 State the equilibrium conditions for Pareto efficiency using mathematical equations. Outline the three conditions for a top-level general equilibrium with the aid of diagrams and explain why it represents a Pareto-optimal allocation of resources. Use a diagram to illustrate simultaneous equilibrium. How would the initial distribution of income impact on the equilibrium? For an explanation of this activity, see video clip 1, 2 and 3. 1.3 X-efficiency and economic growth X-inefficiency (or technical inefficiency) means that firms are not maximising profit or factors of production (labour and capital) are not maximising their welfare. A position inside the PPC such as R in figure 2.5 is indicative of X-inefficiency. Non-maximising behaviour is found under conditions of monopoly (see chapter 4) and may occur in some developing countries where lack of market information and organisational slack lead to economies not reaching their full potential (producing on the PPC). Economic growth (dynamic efficiency) can be illustrated as an outward shift of the PPC. Note the causes of economic growth in section 2.3 (CSS). 1.4 Market failure: An overview In section 2.4 you will find a summary of different market failures, which are discussed in much more detail in later chapters. These failures relate to the non-applicability of some of the assumptions of perfect competition noted in section 2.1 of the textbook. This implies that under certain circumstances the perfectly competitive economic system will not ensure allocative efficiency in the real world. Market failure allows for government intervention and, thus, a role for government in a market economy. 1.5 Enter the public sector: General approaches In this section and the next section, you will see that the role of government is viewed from two sides. The one approach is to consider the possible functions of government. Another approach is to consider the nature of government intervention (this is done in sec 2.6). Generally, a distinction is made between three functions: allocative, distributive and stabilisation. Make sure that you understand what each of these functions entails. Note, however, that the descriptions of these topics in this section are mere introductions to what follows in later chapters. This section nevertheless provides a concise summary of the government's possible role in the economy. 1.6 Direct versus indirect government intervention The second approach to the role of government is to look at government intervention. Two types of interventions can be distinguished: direct (e.g. producing goods and services) and indirect (e.g. regulations). Note that since it is difficult, if not impossible, to quantify the resource use of indirect interventions, the true size of government may be underestimated. 1.7 Concluding note on government failure The final section of this chapter ponders an important caveat. Although markets fail, the government in its attempts to correct the shortcomings of the market may also fail. This may imply that instead of promoting efficiency government may contribute to inefficiency. LOOKING BACK Now that you have worked through this lesson you must be able to explain which conditions must prevail for a perfectly competitive market to ensure an efficient allocation of resources. However, you also became aware that market failure, as well as a government failure, may occur. In the following lessons, you will learn how we use benchmark tools to analyse some of the budget proposals of the Minister of Finance.