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1.3 — Review of Economics & Efficiency

ECON 315 • Economics of the Law • Spring 2021

Ryan Safner
Assistant Professor of Economics
safner@hood.edu
ryansafner/lawS21
lawS21.classes.ryansafner.com

Outline

Exchange, Markets, and Efficiency

Problem: Transaction Costs

Problem: Collective Action

Problem: Public Goods

Problem: Externalities

Problem: Market Power

The Two Major Models of Economics as a “Science”

Optimization

  • Agents have objectives they value

  • Agents face constraints

  • Make tradeoffs to maximize objectives within constraints

The Two Major Models of Economics as a “Science”

Optimization

  • Agents have objectives they value

  • Agents face constraints

  • Make tradeoffs to maximize objectives within constraints

Equilibrium

  • Agents compete with others over scarce resources

  • Agents adjust behaviors based on prices

  • Stable outcomes when adjustments stop

Modeling Individual Choice

  • The consumer's utility maximization problem:

  1. Choose: < a consumption bundle >

  2. In order to maximize: < utility >

  3. Subject to: < income and market prices >

Modeling Firm's Choice

  • 1st Stage: firm's profit maximization problem:

  1. Choose: < output >

  2. In order to maximize: < profits >

  • 2nd Stage: firm's cost minimization problem:

  1. Choose: < inputs >

  2. In order to minimize: < cost >

  3. Subject to: < producing the optimal output >

What Does "Efficiency" Mean?

  • Regular sense of the word:

  • Achieving a specified goal with as few resources as possible

  • Examples:

    • driving
    • carrying groceries
    • producing pencils

Problem: What Goal for Society?

  • We will ruminate more on this next class

  • Society, government, law, etc. has no single, universally agreed-upon goal

  • “Society” is not a choosing agent

Social Problems

  • Problem 1: Resources are scarce, and have multiple, rivalrous uses

  • Problem 2: Different people have different subjective valuations for uses of resources

The Origins of Exchange I

  • Why do we trade?

  • Resources are in the wrong place!

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

The Origins of Exchange II

  • Why are resources in the wrong place?

  • We have the same stuff but different preferences

The Origins of Exchange III

  • Why are resources in the wrong place?

  • We have different stuff and different preferences

Economic Efficiency: First Pass

Economic efficiency: degree to which as many people as possible get as much as possible of what they want

  • degree of preference satisfaction
  • How do we measure this?
    • Expanding budget set ⟹ satisfying more goals
    • Income is a main constraint ⟹ maximize incomes
    • GDP per capita: market value of what is produced ⟺ incomes

The Economic Point of View

  • Preferences are subjective

    • Egalitarianism: Nobody's preferences are dismissed

  • Higher incomes + freedom of choice = greater preference satisfaction

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

Exchange, Markets, and Efficiency

Social Problems that Markets Solve Well

  • Solution: Prices in a functioning market accurately measure opportunity cost of using resources in a particular way

  • The price of a resource is the amount someone else is willing to pay to acquire it from its current use/owner

Perfectly Competitive Market

  • In a competitive market in long run equilibrium:
    • Economic profit is driven to $0; resources (factors of production) optimally allocated
    • Allocatively efficient: p=MC(q), maximized CS + PS
    • Productively efficient: p=AC(q)min (otherwise firms would enter/exit)

Allocative Efficiency in Competitive Equilibrium I

  • Allocative efficiency: resources are allocated to highest-valued uses
    • Goods are produced up to the point where marginal benefit = marginal costs

Allocative Efficiency in Competitive Equilibrium II

  • Economic surplus = Consumer surplus + 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 PS and CS

  • The social value of resources is maximized by allocating them to their highest valued uses!

Markets and Pareto Efficiency

  • Suppose we start from some initial allocation (A)

Markets and Pareto Efficiency

  • Suppose we start from some initial allocation (A)

  • Pareto Improvement: at least one party is better off, and no party is worse off

    • D, E, F, G are improvements
    • B, C, H, I are not

Markets and Pareto Efficiency

  • Suppose we start from some initial allocation (A)

  • Pareto Improvement: at least one party is better off, and no party is worse off

    • D, E, F, G are improvements
    • B, C, H, I are not

  • Pareto optimal/efficient: no possible Pareto improvements

    • Set of Pareto efficient points often called the Pareto frontier†
    • Many possible efficient points!

†I’m simplifying...for full details, see class 1.8 appendix about applying consumer theory!

Markets and Pareto Efficiency

  • Voluntary exchange in markets is a Pareto improvement

  • In equilibrium, markets are Pareto efficient: there are no more possible Pareto improvements

    • all gains from trade exhausted, qS=qD, no pressure for change

  • Note Pareto efficiency contains a normative claim about 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!

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

Markets and Kaldor-Hicks Efficiency

  • 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

  • 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

Pareto vs. Kaldor-Hicks Efficiency

  • Example: “eminent domain”

  • 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.”

Welfare Economics

  • The 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

Welfare Economics

  • The 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 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

Welfare Economics

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

Welfare Economics

  • Markets are great when:
    1. They are Competitive: many buyers and many sellers
    2. They each equilibrium (prices are free to adjust): absence of transactions costs or policies preventing prices from adjusting to meet supply and demand
    3. There are no externalities† are present: costs and benefits are fully internalized by the parties to transactions
  • If any of these conditions are not met, we have market failure
    • May be a role for governments, other institutions, or entrepreneurs to fix

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

Problem: Transaction Costs

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 unrealized gains from trade that exist in disequilibrium (shaded)

    • Buyers & sellers both can be made better off if they can adjust the price

Dis-equilibrated Markets

  • If market prices are prevented from adjusting, shortage/surplus becomes permanent

  • Lost CS and/or PS: Deadweight loss (DWL)

    • inefficiency created by (permanent) diseq.

  • Various government policies can prevent markets from equilibrating & create DWL:

    • Price regulations (price ceiling like rent control, price floor like minimum wage)
    • Taxes, subsidies, tariffs, quotas†
    • These should have been covered in Principles

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

Transaction Costs and Exchange I

  • Transaction costs:
    • Search costs: cost of finding trading partners
    • Bargaining costs: cost of reaching an agreement
    • Enforcement costs: trust between parties, cost of upholding agreement, dealing with unforeseen contingencies, punishing defection, using police and courts

Transaction Costs and Exchange II

  • With high transaction costs, resources cannot be traded

  • Resources cannot be switched to higher-valued uses

  • If others value goods higher than their current owners, resources are inefficiently allocated!

Problem: Collective Action

Generalizing: Collective Action Problems

  • 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

Collective Action Problem: Examples I

Collective Action Problem: Examples II

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

Problem: Public Goods

A Classic Economic Problem

  • Public Good: a good that is non-rival and non-excludable

  • Rivalry: one use of a resource removes it from other uses

  • Excludability: ability or right to prevent others from using it (ownership)

The Free Rider Problem

  • 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...

  • Free riding: individuals consume the good without paying for it

Examples?

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

Problem: Externalities

Supply and Demand: Social Costs & Benefits

  • Demand: marginal social benefit (MSB)

    • value to consumers of consuming output

  • Supply: marginal social cost (MSC)

    • opportunity cost of pulling resources out of other uses

  • Equilibrium: MSB=MSC

    • using resources efficiently, no better alternative uses

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

Externality

  • 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

Externality

  • The real problem is that it is external to the price system!

  • 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 internalize those effects!

Pigouvian Solutions

A.C. Pigou

1877-1959

  • 1920, The Economics of Welfare

  • Principle of "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

  • Problem with externality is that there is a missing price!

Negative Externality

Marginal Private Cost to producer is less than Marginal Social Cost to society

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

Negative Externality

Marginal Private Cost to producer is less than 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

Negative Externality

Marginal Private Cost to producer is less than 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

Negative Externality: Pigouvian Solution

A.C. Pigou

1877-1959

  • Policy solutions to externalities should focus on the missing price

    • Narrowly tailor policy to create or modify price

  • "Pigouvian" tax or subsidy

Negative Externality: Pigouvian Solution

  • Set a specific tax t=MSC−MPC

  • Eliminates the DWL

  • Internalizes the externality into the price system

  • Producers (and consumers) now consider the true cost to society

    • MPC (with tax) =MSC

Another Classic Economic Problem

  • Tragedy of the commons: multiple people have unrestricted access to the same rivalrous resource

  • Rivalry: one use of a resource removes it from other uses

Hardin, Garett, 1968, "The Tragedy of the Commons," Science 162(3859):1243-1248

Another Classic Economic Problem

  • Cannot exclude others

  • No responsibility over outcome

  • Incentive to overexploit and deplete resource (before others do)

  • A negative externality on others

Problem: Market Power

Perfectly Competitive Market

  • In a competitive market in long run equilibrium:
    • Economic profit is driven to $0; resources (factors of production) optimally allocated
    • Allocatively efficient: p=MC(q), maximized CS + PS
    • Productively efficient: p=AC(q)min (otherwise firms would enter/exit)

Market Power

  • Consider a market with some simplified cost assumptions:

    • No fixed costs, constant variable costs
    • implies MC(q)=AC(q)

  • If this was a competitive market, firms would set pc=MC(q) and (collectively), industry would produce qc

    • Consumer surplus maximized

Market Power

  • A monopolist faces the entire market demand and sets (qm,pm):

    • Sets MR(q) = MC(q) at qm
    • Raises price to maximum consumers are WTP (Demand): pm

  • Restricts output and raises price, compared to competitive market

  • Earns monopoly profits (p>AC)

  • Loss of consumer surplus

Market Power

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

Outline

Exchange, Markets, and Efficiency

Problem: Transaction Costs

Problem: Collective Action

Problem: Public Goods

Problem: Externalities

Problem: Market Power

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