Chapter 7 - Economic Efficiency and Equity PDF
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University of Alberta
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Summary
This chapter discusses economic efficiency, focusing on concepts like positive and normative analysis, consumer and producer surplus. It also touches upon the idea of voluntary exchange, highlighting the economic benefits it brings to both sides of a transaction.
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Positive - Normative Analysis Positive analysis— describes what is going to happen “What is going to happen if we enact this policy?” ○ ○ Purely objective, describing and forecasting the effects of the policy Normative analysis— evaluates...
Positive - Normative Analysis Positive analysis— describes what is going to happen “What is going to happen if we enact this policy?” ○ ○ Purely objective, describing and forecasting the effects of the policy Normative analysis— evaluates what should happen “ Which is the better outcome, and what policy should the government adopt?” ○ ○ It requires making a judgement. It's what you think should happen, its based on your values and judgement Efficiency and Equity E conomic efficiency— more economic surplus, the betterthe outcome. If its efficient, it yields the biggest surplus Efficient outcome— largest possible economic surplus E conomic efficiency won’t make everyone happy, because most policies will help some but not others. Economic efficiency evaluates if the efficient outcome is greater than the decline in those who were harmed ○ U ber operates and generates economic surplus, but this harms taxi drivers. Overall, the surplus from uber outweighs the impacts it has on taxi drivers Efficient outcomes have the possibility to make everyone better off. An argument is that when economic surplus rises, that can be used to compensate those that were harmed. However, this is extremely rare is a possibility, not a reality. Equity — assessing whether a policy will yield a fair distribution of economic benefits Consumer surplus C onsumer surplus— the economic surplus you gain frombuying something. You gain this when you pay less than what you would've been willing to pay for that item. C ○ alculated by marginal benefit minus the price ○ Area below the demand curve and above the price (B-D, A-P) (1/2)Base [highest marginal price - actual price] x Height [intersection of price and demand] Y ou earn consumer surplus up until your last purchase. Even if you don’t earn surplus on the last item, all of the items before will provide you with it. Producer surplus P roducer surplus— gain economic surplus from sellingsomething. You gain this when you sell an item for more than the marginal cost C ○ alculated by price minus marginal cost ○ Area above supply, below price (A-S, B-P) (1/2)Base [Price - lowest marginal cost] x Height [intersection of price and supply] You earn producer surplus on all but your last sale. Voluntary Exchange & Gains from Trade V oluntary exchange create both consumer and producer surplus, meaning they both gain from the trade ○ B uying and selling goods isn't a win-lose situation. Trade is actually a win-win scenario since both the buyer and seller are gaining from the transaction when done right. ○ Its better to think of them as working in cooperation instead Voluntary exchange— buyers and sellers exchange moneyfor goods only if they both want to ○ Y ou’d only buy a product if the marginal benefit is greater than the cost, and sellers will only produce if the price is higher than the marginal cost ○ This doesn't mean the surplus needs to be equal, it just means that both parties are benefitting from it either way E conomic surplus is the marginal benefit minus the marginal cost ○ If you buy something and gain $90 of benefit, and it only costed $40 to make, it generates a $50 surplus ○ Area between the demand and supply curve on the lefthand side of the graph Consumer surplus + producer surplus = total economic surplus Assessing Market Efficiency One — who makes what? E fficient production — production of a given level of output for the lowest cost. This requires allocating production so each item is produced for the lowest cost ○ minimizes cost and allows for the most generation of outputs for the lowest price to all suppliers If one company produces 8 goods for $4 and another makes 10 for $8, it wouldn't make sense to alter their production because those 18 items would cost more to produce then $12 if it was split another way ○ No company has a desire to purposefully share production with another. Instead, they are all driven by their own self-interest to maximize their own profits and this often allows for the natural creation of an efficient market ○ Perfectly competitive markets ensure efficient production so every item is produced for the lowest price Two — who gets what? E fficient allocation— when good are allocated tocreate the largest economic surplus from them, which requires goods to go to the person with the highest marginal benefit from it ○ If you and someone else have different demand curves, economic benefit would not create the largest marginal benefit for either if its allocated in a way where you get more/less than your demand curves peak marginal benefit ○ Any other allocation would lead to a reduce in total economic surplus ○ A competitive market will will naturally allocate resources to those with the highest economic benefit from it as they are all perusing their own person self-interest, Three — how much gets bought and sold Efficient quantity — the quantity that produces the largest economic surplus possible ○ R ational rule for markets tells producer to continue producing items until the marginal benefit is equal to the marginal cost, which is where they maximize their economic surplus ○ The equilibrium between supply and demand is where economic surplus is maximized ○ Efficient quantity comes as a result of a perfectly competitive market Organizing and economy and choosing who makes how much and where it goes is difficult. When individuals are naturally driven by their own self-interest in maximizing their economic surplus from a transaction, the economy naturally comes together into equilibrium in a perfectly competitive market Market failure & deadweight loss Market Failure— occurs when the forces of supply and demand lead to an inefficient outcome Market Failure Failure one — market power undermines competitive pressures M arket power occurs when markets don’t meet the perfectly competitive ideal of many sellers selling an identical item. Most markets are dominated by only a handful of companies. Sellers exploit limited competition by charging higher prices, leading consumers to buying a smaller quantity. This results in an underproduction since they’re not producing at their efficient quantity Failure two — externalities create side effects E xternalities arise whenever the choices that buyers and sellers make have side effects on others ○ Many utilities generate electricity from burning coal, which contribues to pollution that effects you and others, even if you don’t buy or sell coal When suppliers don’t take account of the side effects produced, they’ll produce more coal than whats in societies interest. Generally, producers will supply a higher quantity than efficient with side effects Externalities aren’t always negative. ○ Making the choice to get the COVID-19 vaccine is a decision you make, which has the side effect of protecting you and others from the infection of the virus Failure three — information problems undermine trust P rivate information occurs when you’re worried that the people you’re doing business with know something that you don’t ○ If the sellers knows more about the car than you do, you may question why they’re selling it for such a low price ○ This leads to people to buy or sell less than the efficient qauntity Failure four — irrationality leads to bad decisions Irrationality occurs when people make decisions that aren’t in their best interests. ○ If buyers and sellers aren’t using the rational rule, they will not consider their marginal benefits/costs and thus not meet efficient allocation/production Failure five — government forces impede on market forces taxes or quotas impede on the market being able to reach its market efficiency. Sometimes these are done to fix some of the aforementioned failures, but they often create their own distortions that drive the market away from its efficiency. Deadweight loss D eadweight loss — the difference between the highest economic surplus and the actual level of surplus ○ C alculated by economic surplus at efficient quantity minus the actual economic surplus ○ Economic surplus and deadweight loss focus on marginal benefits and costs ○ It can happen when there is an underproduction preventing them from reaching their efficient quantity, but it can also happen when too much is produced in the market Deadweight loss looks like in graphs like an arrowhead that points towards the market efficiency ○ W hen tip is pointed right, when its a result of underproduction. It its pointing left, its a result of overproduction Q uantites matter more than price in terms of DWL ○ T his happens because it measures the loss as a result of the quantity being produced being more/less than equilibrium. ○ After this is had been determined does price matter as it redistributes the economic surplus Market Failure vs Government Failure In reality, market failure is extremely common. This creates room for the argument of government intervention as they well-designed market failures can correct market failures and lead to a more efficient outcome Government failure limits the extent to which we should rely on government intervention G overnment failure — when government policies lead to worser outcomes. This often arises when politicians and bureaucrats don’t make choices that are in the publics interest ○ P oliticians are often motivated by policies that will get them reelected, rather that improving efficiency or equality. They’ll choose whats popular for voters and those they receive donations from T his happens in non-democratic countries too, as those with dictatorships or monarchies do not have to worry about reelection. This causes them to be able to pass policies that enrich themselves but no one else ○ Likewise, bureaucrats face incentives that drive them to do things that are not in the publics interest. If agencies want to expand their empires, they will wind up created a bloated bureaucracy that fails to provide efficient services. Or some are too friendly with those they regulate and they begin to act in the interests of those instead of the broader public. Some simply, poorly paid bureaucrat don’t have an incentive to work or make the best decisions. M arket failure is inevitable, but so is government failure ○ T he question of whether our society would be better of with greater emphesis on market forces versus a powerful government comes down to if the losses cause by market failure exceed the losses due to government failure Beyond Economic Efficiency Critiques of economic efficiency B efore deciding to evaluate an economic policy on efficiency grounds, make sure you reference the following critiques: ritique One — distribution matters, and its also important to account for C equity E conomic efficiency focuses on economic surplus, regardless of who it goes to but some people believe distribution of the benefit also matters Most economists look beyond efficiency and consider distributional consequences, and assess whether that outcome seems fair and equitable ○ Distributional consequences — who gets what ritique Two — willingness to pay reflects ability to pay, not just marginal C benefits H ow much you’re willing to pay often reflects your ability to pay and not just your marginal benefits If someone has a higher income and can thus have a higher willingness to pay for an item, that doesn’t mean their marginal benefit will be as significant as someone will a lower income and willingness Critique Three — the means matter, not just the ends Economic efficiency is about the outcome, but people often care about the process too. ○ If you make an item, do you deserve a higher portion of that item? If everyone can make an item, then why should it be shared if you make it? Were the portions democratic or dictatorial? Or maybe you believe some people some people shouldn't get some of that item People often don’t judge the the desirability of an outcome because the process matters too. Y our normative analysis may involve economic efficiency, but you might also to emphasize ethical considerations too R eal world debates do not reflect strictly evaluate efficient qauntity or deadweight loss, but also distributional and equity consequences and broader notions of fairness. Few arguments are won by focusing on economic surplus.
