Efficiency and Equity

2008/22165

A rationing system to deal with the economic problem

Because economic resources are relatively scarce (resources are limited, wants are unlimited) a society cant 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

Efficiency and Equity (c) Andrew Tibbitt 2008

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Tests for a rationing system

The two basic tests for any rationing system are: Is the system efficient? Is it fair?

Efficiency and Equity (c) Andrew Tibbitt 2008

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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? 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
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2.

Efficiency and Equity (c) Andrew Tibbitt 2008

Different rationing systems

The worlds 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.

Efficiency and Equity (c) Andrew Tibbitt 2008

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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?
Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 6

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

Efficiency and Equity (c) Andrew Tibbitt 2008

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The worlds dominant rationing system.

It has already be said that the worlds dominant rationing system is the price mechanism. The circular flow of income model illustrates some of the markets that operate in the economy.

Efficiency and Equity (c) Andrew Tibbitt 2008

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Markets in the circular flow

Consumption = demand

Goods and services = supply

HOUSEHOLDS Price

PRODUCERS
Supply

Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 9

Markets in the circular flow

Price Supply

Demand Quantity HOUSEHOLDS PRODUCERS Resources (e.g. labour) = supply

Demand for resources = demand

Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 10

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 ultracomplex network of prices.

This network operates invisibly as if driven by a giant freemarket super-computer. What is the operating system for this free-market supercomputer?

Efficiency and Equity (c) Andrew Tibbitt 2008

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Prices as a signalling mechanism

The free-market super computer operates through an ultracomplex 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?)

Efficiency and Equity (c) Andrew Tibbitt 2008

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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.

Efficiency and Equity (c) Andrew Tibbitt 2008

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The correct economic conditions

What are the correct economic conditions that allow markets to maximise welfare? 1. 2. 3. 4. 5. No information gaps / no asymmetrical information No side-effects (externalities) / no effect on bystanders No monopoly (or scarcity power) Good motives and incentives No free riders or non-exclusion products

Efficiency and Equity (c) Andrew Tibbitt 2008

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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 dont 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.
Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 15

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.
Consumer surplus Supply

Price

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.
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Demand Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

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.
Price Supply

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.
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Producer surplus Demand Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

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.
Producer surplus Demand Quantity

Price Consumer surplus Supply

Efficiency and Equity (c) Andrew Tibbitt 2008

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The world of truth

This is only good if the world of truth exists
Price Consumer surplus Supply

Competitive markets create a WORLD OF TRUTH. The demand curve is a true indicator of the value of the product to consumers.

Producer surplus Demand Quantity

The supply curve is a true indicator of the cost of production for producers.
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Efficiency and Equity (c) Andrew Tibbitt 2008

The world of truth

Price Consumer surplus Supply

Competitive markets are, therefore efficient because: consumers get what they want

Producer surplus Demand Quantity

producers make the right things in the right quantities.

Efficiency and Equity (c) Andrew Tibbitt 2008

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Welfare is maximised at the clearance 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.

Price

Supply Cost greater than benefit trade stops at Q1 Demand Q1 Quantity

P1

Efficiency and Equity (c) Andrew Tibbitt 2008

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The world of truth

If the market clearance price is not charged welfare falls.
Price Consumer surplus Supply

Deadweight loss

Producer surplus

Demand Quantity

Q2

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.
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Efficiency and Equity (c) Andrew Tibbitt 2008

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 Consumer surplus Supply

Deadweight loss

Producer surplus Demand Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

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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
Consumer surplus Domestic Supply Overseas supply RISE IN WELFARE

Producer surplus

Domestic Demand Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 24

Applying the concept to international trade

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
Consumer surplus Domestic Supply

RISE IN WELFARE Overseas supply Producer surplus Domestic Demand Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

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Applying the concept to international trade

Taken together more exportsPrice 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?
Efficiency and Equity (c) Andrew Tibbitt 2008

Domestic Supply

RISE IN WELFARE Overseas supply Domestic Demand Quantity

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Market failure
Markets sometimes fail to produce efficient results because the necessary conditions do not exist.

They fail, for example when : 1. Externalities are not taken into account (and bystanders suffer collateral damage) 2. Producers have scarcity or monopoly power (and they dominate the market, raise prices and earn excessive profits 3. Key information is not known or shared evenly 4. Income distribution is unfair.
Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 27

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.

Efficiency and Equity (c) Andrew Tibbitt 2008

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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.
Price

Air travel

S total

S airlines

Quantity Greenhouse Gases are emitted by planes. So do free markets create too many flights at too low a price?
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Efficiency and Equity (c) Andrew Tibbitt 2008

Ignoring externalities leads to inefficiency

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.
Price

Public transport S

private

S total

Quantity Free market public transport could be too expensive if it forces people to use their cars and cause congestion
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Efficiency and Equity (c) Andrew Tibbitt 2008

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.

Efficiency and Equity (c) Andrew Tibbitt 2008

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Monopolists restrict supply and push up prices.

Consumer surplus New Supply (monopoly) Supply (competitive)

Price

Deadweight loss

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.

Producer surplus

Demand Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

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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 dont know the cost of production (like insurance companies) and consumers dont know the value of the product they are buying (like health care and second hand cars) then the market cant operate efficiently.

Efficiency and Equity (c) Andrew Tibbitt 2008

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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.

Efficiency and Equity (c) Andrew Tibbitt 2008

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Other problems for the market economy

Public and collective goods Products that are non-rival products (one person using the good doesnt prevent another for using it as well) where the exclusion principle does not operate (the supplier or owner cant prevent non-payers or freeriders from using the product) where individual demand is unrealistic (such as national defence) will not be efficiently produced in a free market economy.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 35

Modified market economies

As a result of market failure, nearly all economies are not pure free market economies but mixed economies.

Governments 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
Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 36

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

Efficiency and Equity (c) Andrew Tibbitt 2008

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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. 2. 3. 4. Bureaucratic and cumbersome allocation processes Moral hazard Rent seeking behaviour (corruption) Lack of incentive bottomless pots, feather bedding, no competition Lack of consumer freedom or sovereignty

5.

The trick is to intervene only when necessary.

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 38

Taxing a competitive market reduces net economic welfare.

Supply with tax Price Supply without tax

Taxing a competitive market reduces welfare.

REDUCTION IN NET WELFARE = DEADWEIGHT LOSS

Demand Quantity

Efficiency and Equity (c) Andrew Tibbitt 2008

Slide 39

A difference of emphasis
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. LEFT Responsibilities Entitlements Equity Market failure Government intervention
Efficiency and Equity (c) Andrew Tibbitt 2008

RIGHT Rights

Choice
Efficiency Incentives Government failure
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