1.3 — Review of Economics & Efficiency

# 1.3 — Review of Economics & Efficiency
## ECON 315 • Economics of the Law • Spring 2021
### Ryan Safner Assistant Professor of Economics <a href="mailto:safner@hood.edu">safner@hood.edu</a> <a href="https://github.com/ryansafner/lawS21">ryansafner/lawS21</a> <a href="https://lawS21.classes.ryansafner.com"> lawS21.classes.ryansafner.com</a>

---

# Outline

### [Exchange, Markets, and Efficiency](#15)

### [Problem: Transaction Costs](#31)

### [Problem: Collective Action](#36)

### [Problem: Public Goods](#41)

### [Problem: Externalities](#46)

### [Problem: Market Power](#59)

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# The Two Major Models of Economics as a “Science”

## Optimization

- Agents have .hi[objectives] they value

- Agents face .hi[constraints]

- Make .hi[tradeoffs] to maximize objectives within constraints

## Equilibrium

- Agents .hi[compete] with others over **scarce** resources

- Agents .hi[adjust] behaviors based on prices

- .hi[Stable outcomes] when adjustments stop

]

---

# Modeling Individual Choice

- The .hi[consumer's utility maximization problem]:

1. **Choose:** .hi-purple[ < a consumption bundle >]

2. **In order to maximize:** .hi-green[< utility >]

3. **Subject to:** .hi-red[< income and market prices >]

]

---

# Modeling Firm's Choice

1. **Choose:** .hi-blue[ < output >]

2. **In order to maximize:** .hi-green[< profits >]

- 2nd Stage: .hi-purple[firm's cost minimization problem]:

1. **Choose:** .hi-blue[ < inputs >]

2. **In order to _minimize_:** .hi-green[< cost >]

3. **Subject to:** .hi-red[< producing the optimal output >]
]

]

---

# What Does "Efficiency" Mean?

- Regular sense of the word:

- Achieving a .hi-purple[specified goal] with as .hi-purple[few resources as possible]

- .hi-green[Examples]:
  - driving
  - carrying groceries
  - producing pencils
]

---

# Problem: What Goal for Society?

- We will ruminate more on this next class

- .hi-purple[Society, government, law, etc. has no single, universally agreed-upon goal]

- “Society” is not a choosing agent
]

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# Social Problems

- .hi[Problem 2]: Different people have different subjective valuations for uses of resources

]

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# The Origins of Exchange I

- .hi-purple[Resources are in the wrong place!]

- People have *better* uses of resources than they are currently being used!

]

.pull-right[
.center[
![:scale 100%](https://www.dropbox.com/s/2ld8qe9p0mjak0b/exchange.png?raw=1)
]
]

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# The Origins of Exchange II

- .hi-purple[We have the same stuff but different preferences]

]

![:scale 65%](https://www.dropbox.com/s/pj6s1y20c3qfyfc/boxlunch.jpg?raw=1)

]
]

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# The Origins of Exchange III

- .hi-purple[We have different stuff and different preferences]

]

![:scale 50%](https://www.dropbox.com/s/xvjphzlwechgip6/3oranges.jpg?raw=1)

]
]

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# Economic Efficiency: First Pass

.hi[Economic efficiency]: degree to which as many people as possible get as much as possible of what they want
  - degree of .hi-purple[preference satisfaction]

- How do we measure this?
  - Expanding budget set `$\implies$` satisfying more goals
  - Income is a main constraint `$\implies$` maximize incomes
  - GDP per capita: market value of what is produced `$\iff$` incomes
]

<img src="1.3-slides_files/figure-html/unnamed-chunk-1-1.png" width="504" style="display: block; margin: auto;" />
]

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# The Economic Point of View

- Preferences are .hi-purple[subjective]
  - .hi-purple[Egalitarianism]: Nobody's preferences are dismissed

- .hi-turquoise[Higher incomes + freedom of choice = greater preference satisfaction]

- Harder to directly evaluate outcomes, better to look at basic processes/mechanisms (especially exchange)
]

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# Exchange, Markets, and Efficiency

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# Social Problems that Markets Solve Well

- **Solution**: Prices in a functioning market accurately measure .hi[opportunity cost] of using resources in a particular way

- .hi-purple[The price of a resource is the amount someone else is willing to pay to acquire it from its current use/owner]
]

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# Perfectly Competitive Market

.pull-left[
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.smallest[
- In a .hi[competitive market] in .hi[long run equilibrium]:
  - .hi-purple[Economic profit] is driven to $0; resources (factors of production) optimally allocated
  - .hi-purple[Allocatively efficient]: `$p=MC(q)$`, maximized .blue[CS] `$+$` .red[PS]
  - .hi-purple[Productively efficient]: `$p=AC(q)_{min}$` (otherwise firms would enter/exit)
]

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# Allocative Efficiency in Competitive Equilibrium I

]

- .hi[Allocative efficiency]: resources are allocated to highest-valued uses
  - Goods are produced up to the point where .blue[marginal benefit] `$=$` .red[marginal costs]
]

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# Allocative Efficiency in Competitive Equilibrium II

]

- **Economic surplus** = .blue[Consumer surplus] + .red[Producer surplus]

- Maximized in competitive equilibrium

- Resources flow away from those who value them the lowest (min WTA) to those that value them the highest (max WTP)
  - creating .red[PS] and .blue[CS]

- .hi-purple[The social value of resources is **maximized** by allocating them to their highest valued uses!]

]

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# Markets and Pareto Efficiency

]
]

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<img src="1.3-slides_files/figure-html/unnamed-chunk-6-1.png" width="504" style="display: block; margin: auto;" />

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# Markets and Pareto Efficiency

- .hi[Pareto Improvement]: at least one party is better off, and no party is worse off
  - .green[D, E, F, G] are improvements
  - .red[B, C, H, I] are not

]
]

.pull-right[
<img src="1.3-slides_files/figure-html/unnamed-chunk-7-1.png" width="504" style="display: block; margin: auto;" />
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# Markets and Pareto Efficiency

- .hi[Pareto Improvement]: at least one party is better off, and no party is worse off
  - .green[D, E, F, G] are improvements
  - .red[B, C, H, I] are not

- .hi[Pareto optimal/efficient]: no possible Pareto improvements
 - Set of Pareto efficient points often called the .hi-green[Pareto frontier].magenta[†]
 - Many possible efficient points!

]

.tiny[.magenta[†]I’m simplifying...for full details, see [class 1.8 appendix](https://microf20.classes.ryansafner.com/files/CT_Application_2_Exchange.pdf) about applying consumer theory!]

]

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# Markets and Pareto Efficiency

- *In equilibrium*, markets are .hi[Pareto efficient]: there are no more possible Pareto improvements
  - all gains from trade exhausted, `$q_S=q_D$`, no pressure for change

- Note Pareto efficiency contains a normative claim about .hi-purple[equity]
  - It might be possible to improve the *total* welfare of *society*
  - But if this comes *at the expense of even 1 individual*, it’s not a Pareto improvement!
]
]
.pull-right[

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# Markets and Pareto Efficiency

- Pareto efficiency is conceptual gold standard: allow all welfare-improving exchanges so long as nobody gets harmed

- In practice: Pareto efficiency is a *first best* solution
  - only takes one holdout to disapprove to violate Pareto efficiency

]

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# Markets and Kaldor-Hicks Efficiency

.pull-left[
.smallest[
- .hi[Kaldor-Hicks Improvement]: an action improves efficiency its generates more social gains than losses
    - those made better off could in principle compensate those made worse off

- .hi[Kaldor-Hicks efficiency]: no potential Kaldor-Hicks improvements exist

- Keeps intuitive appeal of Pareto but more practical
    - Every Pareto improvement is a KH-improvement (but not the other way around!)
    
- Consider policies where winners' maximum WTP `$>$` losers' minimum WTA

- Policies should **maximize social value of resources**
]
]

![](https://www.dropbox.com/s/krmhqn3ryhk9l03/compensate.jpg?raw=1)

]
]

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# Pareto vs. Kaldor-Hicks Efficiency

- The “takings clause” of the 5th Amendment to the U.S. Constitution:

> “No person shall...be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.”

- What is a “public use”? What is “just compensation”?

- [*Kelo v. City of New London*](https://en.wikipedia.org/wiki/Kelo_v._City_of_New_London), 545 U.S. 469 (2005
]
]
.pull-right[

]
]

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# Welfare Economics
.smallest[
- The .hi[1st Fundamental Welfare Theorem]: markets in competitive equilibrium maximize allocative efficiency of resources and are Pareto efficient
  - initial endowments does not affect efficiency but does affect final distribution

]

- The .hi[2nd Fundamental Welfare Theorem]: any desired Pareto efficient distribution can be achieved with a lump-sum tax & transfer scheme, and then allowing markets to work freely
  - allows a targetted (re)-distribution to be achieved without sacrificing efficiency

]

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# Welfare Economics

.smallest[
- **Markets are great when:**
 1. They are .hi-purple[Competitive]: many buyers and many sellers
 2. They each .hi-purple[equilibrium] (.hi-purple[prices are free to adjust]): absence of transactions costs or policies *preventing prices from adjusting* to meet supply and demand
 3. .hi-purple[There are no externalities].magenta[†] are present: costs and benefits are fully internalized by the parties to transactions 
]

.smallest[
- If any of these conditions are not met, we have .hi[market failure]
  - May be a role for governments, other institutions, or entrepreneurs to fix
]

.footnote[.magenta[†] Or public goods, or asymmetric information. But in essence, I am treating these as special cases of more common externalities.]

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# Problem: Transaction Costs

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# Dis-equilibrated Markets

- To *reach* equilibrium, market prices need to be able to adjust
  - Shortage: price needs to rise
  - Surplus: price needs to fall

- There are .b[*unrealized* gains from trade] that exist in disequilibrium (shaded)
  - Buyers & sellers both can be made better off if they can adjust the price

]

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# Dis-equilibrated Markets

.pull-left[
.smallest[
- If market prices are *prevented* from adjusting, shortage/surplus becomes *permanent*

- Lost .blue[CS] and/or .red[PS]: .b[Deadweight loss (DWL)]
  - **inefficiency** created by (permanent) diseq.

- Various government policies can prevent markets from equilibrating & create DWL:
 - .hi-purple[Price regulations] (price ceiling like rent control, price floor like minimum wage)
 - .hi-purple[Taxes, subsidies, tariffs, quotas].magenta[†]
 - These should have been covered in Principles
]

.tiny[.magenta[†] Some may be necessary (taxes fund government), but create market inefficiencies.]
]

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<img src="1.3-slides_files/figure-html/unnamed-chunk-10-1.png" width="504" style="display: block; margin: auto;" />
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# Transaction Costs and Exchange I

.pull-left[
- .hi[Transaction costs]:
  - .hi-purple[Search costs]: cost of finding trading partners
  - .hi-purple[Bargaining costs]: cost of reaching an agreement
  - .hi-purple[Enforcement costs]: **trust** between parties, cost of upholding agreement, dealing with unforeseen contingencies, punishing defection, using police and courts 
]

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# Transaction Costs and Exchange II

- Resources *cannot* be switched to higher-valued uses

- If others value goods higher than their current owners, resources are *inefficiently* allocated!
]

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# Problem: Collective Action

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# Generalizing: Collective Action Problems

- .hi[Collective action problem]: situation where an individual's interest and a group's interest may conflict

- Benefits (or costs) of outcome are **nonrival** and flow to *all members* of the group

- Decisions & costs need to be incurred by individuals

- **Individual preferences** need to aggregate into a **single decision/outcome**
]

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# Collective Action Problem: Examples I

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# Collective Action Problem: Examples II

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# Collective Action Costs I

- Groups may share a **common interest**

- But **composed of individuals with their own preferences**
  - Individuals bear the personal cost of contributing
  - Individuals gain a small share of the benefits of group action

- Additionally, **cost of bargaining** to get a group to agree on decision
]

]

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# Problem: Public Goods

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# A Classic Economic Problem

- .hi[Public Good]: a good that is .hi-purple[non-rival] and .hi-purple[non-excludable]

- .hi-purple[Rivalry]: one use of a resource removes it from other uses

- .hi-purple[Excludability]: ability or right to prevent others from using it (ownership)

]

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# The Free Rider Problem

.pull-left[
- Individual bears a **private cost to contribute**, but only gets a **small fraction of the (dispersed) benefit** of a good

- If individuals can gain **access** to the good (nonexcludable) **without paying**, may lead to...

- .hi[Free riding]: individuals consume the good without paying for it
]

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# Examples?

.pull-right[
.center[
![:scale 100%](https://www.dropbox.com/s/i4e5a16dy4qzhdq/jetfighter.png?raw=1)
]
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# Market Failure from Public Goods

- No incentive for people to contribute and pay for the good

- If enough people obtain the benefits without incurring the costs...

- **Not profitable** for private market actors to supply it

]

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# Problem: Externalities

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# Supply and Demand: Social Costs & Benefits

]

- .hi-blue[Demand: marginal social benefit (MSB)]
  - value to consumers of consuming output

- .hi-pink[Supply: marginal social cost (MSC)]
  - opportunity cost of pulling resources out of other uses

- **Equilibrium**: `$MSB=MSC$`
  - using resources efficiently, no *better* alternative uses
]

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# Supply and Demand: Social Costs & Benefits

]

- **Price system** mitigates costs and benefits of people's actions

- People using scarce resources must **account for consequences**:
  - Pay to pull scarce resources out of other uses in society
  - Compensated for producing something valuable for others

]

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# Externality

- .hi[Externality]: an action that incurs a cost or a benefit not compensated via prices

- Often interpretted as an action that affects (benefits or harms) a third party not privy to the action

]

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# Externality

- People base decisions off of their preferences and opportunity costs of resources for society (captured in prices)

- Prices properly negotiate the opportunity costs and provide information to people

- But without price, decisions do not .hi-purple[internalize] those effects! 
]

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# Pigouvian Solutions

A.C. Pigou

1877-1959
]
]

- 1920, *The Economics of Welfare*

- Principle of .hi["payment in accordance with product"]

- People should pay average externality of their actions
  - Markets make you do this automatically
  - If markets fail, policy can force the market to work again

- .hi-purple[Problem with externality is that there is a missing price!]
]

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# Negative Externality

]

.hi-pink[Marginal _Private_ Cost] to producer
is less than
.hi-red[Marginal _Social_ Cost] to society

**Market Equilibrium (B)** too much `$q$` at too low `$p$` compared to **Social Optimum (A)**
]

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# Negative Externality

]

.hi-pink[Marginal _Private_ Cost] to producer
is less than
.hi-red[Marginal _Social_ Cost] to society

**Market Equilibrium (B)** too much `$q$` at too low `$p$` compared to **Social Optimum (A)**

- Overproduction due to external cost

]

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# Negative Externality

]

.hi-pink[Marginal _Private_ Cost] to producer
is less than
.hi-red[Marginal _Social_ Cost] to society

**Market Equilibrium (B)** too much `$q$` at too low `$p$` compared to **Social Optimum (A)**

- Overproduction due to external cost

- A **deadweight loss** from overproduction
]

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# Negative Externality: Pigouvian Solution

A.C. Pigou

1877-1959
]
]

- Policy solutions to externalities should .hi-purple[focus on the missing price]
  - Narrowly tailor policy to create or modify price

- "Pigouvian" tax or subsidy
]

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# Negative Externality: Pigouvian Solution

]

- Set a specific tax 
`$$t = MSC-MPC$$`

- Eliminates the DWL

- .hi-purple[Internalizes the externality] into the price system

- Producers (and consumers) now consider the true cost to society
  - `$MPC$` (with tax) `$=MSC$`
]

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# Another Classic Economic Problem

- .hi[Tragedy of the commons]: multiple people have unrestricted access to the same .hi-purple[rivalrous] resource

- .hi-purple[Rivalry]: one use of a resource removes it from other uses

]

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# Another Classic Economic Problem

.pull-left[
.center[
![:scale 100%](https://www.dropbox.com/s/qgnqwqr86wi1nlz/pollutedriver.png?raw=1)
]
]

- Cannot exclude others

- No responsibility over outcome

- Incentive to **overexploit** and **deplete** resource (before others do)

- A negative externality on others
]

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# Problem: Market Power

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# Perfectly Competitive Market

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# Market Power

]

- Consider a market with some simplified cost assumptions:
  - No fixed costs, constant variable costs
  - implies `$\color{red}{MC(q)=AC(q)}$`

- If this was a *competitive* market, firms would set `$p_c=MC(q)$` and (collectively), industry would produce `$q_c$`
  - .blue[Consumer surplus] maximized
]

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# Market Power

]

- A **monopolist** faces the *entire* market demand and sets `$(q_m,p_m)$`:
  - Sets .purple[`\$MR(q)\$`] `$=$` .red[`\$MC(q)\$`] at `$q_m$`
  - Raises price to .blue[maximum consumers are WTP (Demand)]: `$p_m$`

- .hi-purple[Restricts output and raises price], compared to competitive market

- Earns .hi-green[monopoly profits (`\$p>AC\$`)]

- Loss of .hi-blue[consumer surplus]

]

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# Market Power

]

- **Deadweight loss** of surplus destroyed from lost gains from trade
  - Consumers willing to buy more than `$q_m$`, if the monopolist would lower prices!
  - Monopolist *would* benefit by accepting lower prices to sell more, but this would yield *less* than maximum profits

]