Welfare Economics: Efficiency and Fairness

Welfare Economics

• Study of how the allocation of resources affects economic well-being
• Evaluates the ability of competitive markets to allocate resources efficiently and fairly

Efficiency

• Refers to the way resources are allocated
• Allocative efficiency: quantities of goods and services produced are those that people value most highly
• Resources are allocated efficiently when we cannot produce more of one thing without giving up something else that people value more highly
• Can be measured using marginal benefit and marginal cost

Demand and Marginal Benefit

• Marginal benefit: the maximum price that people are willing to pay for an additional unit of a good or service
• Demand curve: shows the maximum price willingly paid for a given quantity
• Alternative interpretation: shows the maximum price that people are willing to pay for a selected quantity

Consumer Surplus

• The difference between what buyers are willing to pay for a good and what they actually pay
• Measures the benefit to buyers of participating in a market
• Can be calculated as the total benefit minus the amount paid
• Graphically, it is the area above the actual price line and below the demand curve

Cost, Price, and Producer Surplus

• Sellers distinguish between cost and price
• Cost: what a seller must give up to produce the good
• Price: what a seller receives when the good is sold
• Marginal cost: the cost of producing one more unit of a good or service
• Supply curve: shows the minimum price that producers must receive to supply a given quantity
• Producer surplus: the amount a seller is paid minus the cost of production
• Measures the benefit to sellers of participating in a market

Calculating Producer Surplus

• Producer surplus is the difference between price and marginal cost
• Can be calculated as the total revenue minus the total cost
• Graphically, it is the area below the price line and above the supply curve

Efficient Allocation

• Allocative efficient allocation: the highest valued allocation
• Occurs when marginal benefit equals marginal cost
• Resources are used more efficiently when MB > MC
• Resources are used less efficiently when MC > MB### Market Efficiency and Failure
• Efficient Allocation of Resources: Resources are allocated efficiently when the marginal benefit (MB) equals the marginal cost (MC).
• Consumer and Producer Surplus: Consumer surplus is the benefit that buyers receive from participating in a market, while producer surplus is the benefit that sellers receive.
• Total Surplus: The sum of consumer surplus and producer surplus, which represents the economic well-being of society.
• Competitive Equilibrium: The market equilibrium is allocatively efficient, and the forces of supply and demand allocate resources efficiently.

Market Failure

• Deadweight Loss: The decrease in total surplus that results from an inefficient underproduction or overproduction.
• Sources of Market Failure:
  • Price and Quantity Regulations: Regulations can lead to underproduction or overproduction.
  • Taxes and Subsidies: Taxes decrease quantity produced, while subsidies increase quantity produced.
  • Externalities: Positive or negative effects on third parties not involved in a transaction.
  • Public Goods and Common Resources: Non-excludable and non-rival goods, and common resources that are available to anyone.
  • Monopoly: A single firm that can influence the market price, leading to underproduction.
  • High Transaction Costs: Costs associated with exchanging goods and services.

Self-Interest and Social Interest

• Allocative Efficiency of Market Equilibrium: The equilibrium outcome is efficient, and the social interest is served.
• The Invisible Hand: Adam Smith's concept that competitive markets send resources to their highest-valued uses.

The Free Market versus Government Intervention

• Laissez Faire: The notion that government should not interfere with the market.
• Government Intervention: The planner would need to know every seller's cost and every buyer's willingness to pay for every good in the economy, which is impossible.

Are Markets Fair?

• Efficiency vs. Equity: Efficiency concerns the size of the economic pie, while equity concerns the fairness of the distribution of the pie.
• Fairness Approaches:
  • It's Not Fair if the Rules Aren't Fair: Fairness requires equal opportunity and voluntary trade.
  • It's Not Fair if the Result Isn't Fair: Fairness requires a fair distribution of the economic pie.

The Big Trade-off

• Trade-off between Efficiency and Fairness: The cost of making income transfers to achieve fairness is a decrease in efficiency.
• Inefficiency Sources:
  • Taxation: Reduces the quantity of labor and capital, leading to a smaller economic pie.
  • Discourages Work and Saving: Taxation discourages work and saving, reducing the quantity of labor and capital.### The Big Trade-off
• Income redistribution reduces the size of the economic pie, creating a trade-off between the size of the economic pie and equality in its distribution.
• The greater the scale of income redistribution through income taxes, the greater the inefficiency, resulting in a smaller economic pie.

Inefficiency of Income Redistribution

• A Rand taken from a rich person does not end up as a full Rand in the hands of a poor person due to administrative costs.
• Administrative costs include the costs of accountants, auditors, and lawyers, which use skilled labor and capital resources that could have produced other goods and services.

Consequences of Income Redistribution

• Transferring a Rand from a rich person to a poor person may not result in a full Rand for the poor person, and may even make them worse off.
• Highly taxed entrepreneurs may decide to work less hard and shut down businesses, resulting in low-income workers being fired or seeking lower-paid work.

Compromise and Alternative Solutions

• Most people and economists sympathize with the fair rules view, but consider it too extreme, and see a role for taxes and government income support schemes to transfer income from the rich to the poor.
• John Rawls proposes making the poorest person as well off as possible by taxing the rich and transferring the remaining income to the poor, after accounting for administrative costs.

Rawls' Solution

• The goal is to make the poorest person's share of the economic pie as large as possible, which may not be an equal share, but the largest possible share.
• A bigger share of a smaller pie can be less than a smaller share of a bigger pie, so the goal is to find the optimal balance.