Notes for Chapter 4
ECON 2390
Objectives

To define






Economic efficiency
Explanation of how markets work
Fairness and social efficiency
Social costs
External costs and benefits
Refine the concept of public goods
2
Economic Efficiency



Efficiency is measured in a market context.
A market is a social mechanism whereby humans
can exchange goods and services
Common markets





Labour
Services (accounting, education…
Goods (housing, cars…)
Others (?)
All markets have two key elements


Demand (relation between quantity of outputs and
marginal willingness to pay)
Supply (relation between quantity of output and marginal
willingness to produce)
3
Efficient allocation


TP
MW
Price
A
C
M
Equilibrium occurs
when MWTP = MC
At this position,
consumer surplus plus
producer surplus is
greatest
B
P1

Q1
Demand = supply.
Quantity
4
Efficiency and equilibrium



At the equilibrium position in the demand supply
relation, there is no incentive fro anyone to change
prices or quantities.
Changes on the consumer side include:

Wealth

Income

Population.
Changes on the producer side include:


Technology that reduces costs
Shortages in key supplies (oil) that raise costs and shift
supply.
5
The Norm of Perfect Competition
If:
Each buyer and seller is small – no monopoly (single seller) or
monopsony (single buyer).

A market has Many buyers and sellers.

Perfect information exists (all buyers and sellers have the same, full
knowledge of market opportunities and any change is known by all
instantaneously).

The costs of becoming a buyer or seller are negligible.
Then:

Prices will reflect only the cost of production and no “extra” profit will
be earned.

No seller will earn more or less than any other seller.

The economic rationale for intervention to adjust the
distribution of benefits (goods and services) that
would exist in a competitive equilibrium.
6
Changes in social surplus
Consumer surplus is the difference between the
personal assessment of value and price.
 Producer surplus is difference between the price and
the willingness to sell price.
 Social surplus is the sum of consumer and producer
surplus.
Implications of perfect competition
1. Prices reflect the full cost of production.
2. No profit is earned, no rent is earned.
3. Prices adjust instantaneously to any shock.

7
Small problem – perfect competition
never exists
But then neither do perfect children, perfect spouses, etc.
That does not prevent us from imaging an ideal against
which to compare the existing state, and under some
conditions to effect a policy change
This seems like an ideal world, except:


no incentive to innovate, explore or do anything new.
technical and social change do not occur.
Imperfection impels change
8
Main deviations from perfect competition

Public goods – goods and services where the value
cannot be entirely appropriated by the
seller/producer



Pure public good – production means that anyone can
share without having to pay (radio broadcasts)
Mixed public good – production involves benefits/harms
that are exist, but the purchaser still retains much of the
benefit, the producer does not bear all of the costs..
Market failure – private costs/benefits diverge from
public costs/benefits.
9
Two important deviations from perfect
competition

Monopoly/monopsony (single seller or buyer)



Sellers use trademarks, predatory pricing and coercive
tactics to extract extra income from consumers/taxpayers.
Natural monopoly conferred by technical features that allow
the incumbent supplier to enjoy falling costs (increased
profits) arising from expansion, thereby preventing entrants.
Externalities (pollution)


Consumers and producers (more often) create by-products
that affect the welfare of those who are not direct parties to
transactions.
This means that the cost to the consumer (private cost)
does not include all costs since some are borne by those
who may not consume the product directly.
10
Why does government exist?
Three main rationales for public sector action:



1.
2.
3.
Market failure (consumer ignorance of mortgages, pollution)
Externalities (public goods and bads)
Distributional unfairness (poverty)
Market failure typically evokes a regulatory response (e.g.,
consumer education, fair lending laws, securities regulation).
Public goods encourage government to supplement private sector
provision of a good or services (e.g., subsidization of crop insurance,
subsidization of vaccines, public education).
Distributional fairness can result in regulatory, direct provision of a
service, or direct cash transfer

Laws regarding usury, anti-discrimination legislation
Public housing

National child benefit, progressive tax, GST rebate for lower income

households
11
Government provided goods and services
Pure Public
Goods
Public
Goods
Market Failure
Defence, public health, external trade,
education, transportation infrastructure
Risk
management
Subsidies to basic research, northern
geo-science mapping
Information
failures
Moral hazard, asymmetric information,
time myopia..
External effects
Pollution control, subsidies to education,
compulsory vaccination...
Decreasing Cost
Regulation (price, profits, revenues..),
nationalization
Market
Manipulation
Prosecution, fines, incarceration ...
Monopoly
Merit
Goods
Definition of government initiatives


Social marketing to promote a goal (articulation of goal or intent;
guidance on preferred behaviour)
Expenditures on goods and services

Direct resource commitments on goods (public housing, vaccination)

Direct resource commitments on services (consumer information,
training)

Tax expenditures (tax deductions and credits awarded to citizens and
businesses to behave, spend, invest, etc.)



Grants/contributions/contracts to third parties to perform services
Legislation is a general framework for how citizens conduct themselves
(smoking bans, criminal code) and requires political assent.
Regulation modifies elements of legislation (changes to the speed limit)
and can be completed by administrative fiat.
13
Information Failure

Moral hazard




Market participants alter their behaviour in response to the divergence
of public and private costs
Taxes/subsidies cause market participants to purchase/sell less/more
than would have occurred with prices equal to the marginal cost
Asymmetry of information

Sellers are typically more informed than buyers

Prisoners paradox - information lack produces sub-optimal outcomes
Uncertainty about other players reactions causes poor decisions

Nash equilibrium exists when I account for your probable reaction to my
choices. Equilibrium exists when we have all adjusted and readjusted
to each others choices/decisions.
14
Government provided goods and services
Public
Goods
Merit
Goods
Quality of Life
Support for arts ,recreational sports, community
centres, ethno cultural support...
Nationalism
Support for elite arts and sports,...
Redistribution
Progressive income tax, National
Child Benefit, GST rebate...
Safety Net
Social assistance, employment
insurance, farm safety nets,
workers’ compensation...
Equity, Fairness
Demand (MWTP) for public goods

Recall that consumption of a private good is internal
between the consumer and producer.



Buying and eating a hamburger is internal to the cook/seller
and the eater/buyer,
We get to a total demand (MWTP) by adding horizontally.
Consumption of a public good involves some
externality.


Clean air is a public good, since it involves non-rivalry (my
consumption does not reduce your consumption) and nonexclusion (I cannot limit or exclude you).
We get to total demand by adding vertically.
16