Efficiency and Equity2008/22165

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:

What, and how much, to produce How to produce For whom to produce

Tests for a rationing systemThe two basic tests for any rationing system are:

Is the system efficient?Is it fair?

Efficiency and equityEfficiency is the economy getting the most of out its scarce resources (or are they being wasted)?Technical efficiency is production being done at lowest unit cost?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?Horizontal equity no discrimination between people whose economic characteristics and performance are equalVertical equity different treatment of different people in order to reduce the differences between people

Different rationing systemsThe 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.

Different rationing systemsBut 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 optionsBallot (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 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.

Markets in the circular flowHOUSEHOLDSPRODUCERSGoods and services = supplyConsumption = demand

Markets in the circular flowHOUSEHOLDSPRODUCERSResources (e.g. labour) = supplyDemand for resources = demand

The super-computer networkIn 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 mechanismThe 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 mechanismThe system only works if consumers and producers get the right messagemake 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 conditionsWhat are the correct economic conditions that allow markets to maximise welfare?

No information gaps / no asymmetrical informationNo side-effects (externalities) / no effect on bystandersNo monopoly (or scarcity power)Good motives and incentivesNo free riders or non-exclusion products

Given the right conditions markets maximise welfare.In these economic conditions:

Price = marginal social benefitPrice = marginal social cost

Consumers get what they wantProducers 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.

Markets increase trade and trade increases welfareConsumers 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.PriceQuantitySupplyDemandConsumer surplus

Markets increase trade and trade increases welfareProducers 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.PriceQuantitySupplyDemandProducer surplus

Trade increases welfareThe sum of consumer and producer surplus indicates the total increase in welfare from this market. So markets create trade and trade increases welfare.PriceQuantitySupplyDemandConsumer surplusProducer surplus

The world of truthThis is only good if the world of truth existsCompetitive 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. PriceQuantitySupplyDemandConsumer surplusProducer surplus

The world of truthCompetitive markets are, therefore efficient because:consumers get what they wantproducers make the right things in the right quantities. PriceQuantitySupplyDemandConsumer surplusProducer surplus

Welfare is maximised at the clearance price.SupplyDemandQuantityPricePeople 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. P1Cost greater than benefit trade stops at Q1Q1

The world of truthIf 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. PriceQuantitySupplyDemandConsumer surplusProducer surplusQ2Deadweight loss

The world of truthIf 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. PriceQuantitySupplyDemandConsumer surplusProducer surplusDeadweight loss

Applying the concept to international tradeIt 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 .PriceQuantityDomestic SupplyDomestic DemandConsumer surplusProducer surplusOverseas supplyRISE IN WELFARE

Applying the concept to international tradeIt 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.PriceQuantityDomestic SupplyDomestic DemandConsumer surplusProducer surplusOverseas supplyRISE IN WELFARE

Applying the concept to international tradeTaken 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? PriceQuantityDomestic SupplyDomestic DemandOverseas supplyRISE IN WELFARE

Market failureMarkets 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 profits3.Key information is not known or shared evenly4. Income distribution is unfair.

When there are externalitiesBystanders (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 inefficiencyIf 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.DS airlinesAir travelPriceQuantityS totalGreenhouse Gases are emitted by planes. So do free markets create too many flights at too low a price?Social cost of 5% of climate change

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.DS totalPublic transportPriceQuantityS privateFree market public transport could be too expensive if it forces people to use their cars and cause congestionSocial benefit of less congestionIgnoring externalities leads to inefficiency

Scarcity or monopoly powerIf 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. PriceQuantitySupply(competitive)DemandNew Supply(monopoly)Deadweight lossConsumer surplusProducer surplus

Information gapsCompetitive free markets only produce efficient outcomes if Demand curves reflect the true level of consumer value or marginal benefitSupply 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.

Other problems for the market economyIncome distributionDemand 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 economyPublic and collective goodsProductsthat 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 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.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

Government modificationsPolicy measures to fix up or prevent market failure include:

Taxing bad behaviour, taxing high income earnersSubsidising good behaviour, paying welfare to low income earners.Regulating or legislating against bad behaviourRegulating or legislating good behaviourEstablishing markets to trade permits to behave badly

Government failureIn 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:

Bureaucratic and cumbersome allocation processesMoral hazardRent seeking behaviour (corruption)Lack of incentive bottomless pots, feather bedding, no competitionLack 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.

PriceQuantitySupply with taxSupply without taxDemandREDUCTION IN NET WELFARE = DEADWEIGHT LOSS

A difference of emphasis

LEFTResponsibilitiesEntitlementsEquityMarket failureGovernment intervention

RIGHTRightsChoiceEfficiencyIncentivesGovernment failureWhen 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.