Week 1 Slides

First fundamental Theorem of Welfare Economics

The competitive equilibrium where supply equals demand, maximises social efficiency

Market Failure

A problem that causes the market economy to deliver an outcome that does not maximise efficiency

Second Fundamental Theorem of Welfare Economics

Society can attain any efficient outcome by suitably redistributing resources among individuals and then allowing them to freely trade

Social Welfare

The level of well-being in society

Redistribution

The shifitng of resources from some groups in society to others

Equity-efficiency trade-off

The choice society must make between the total size of the economic pie and its distribution among individuals

Government intervention: Direct Effect

The effects of government interventions that would be predicetd if individuals did not change their behaviour in response to their interventions

Government Interventions: Indirect effects

The effects of government intervention that arise only because individuals change their behaviour in response to the interventions.

Political Economy

The theory of how the political process produces decisions that affect individuals and the economy

Externality

Arise whenever the actions of one party make another worse or better off, yet the first party neither bears the costs nor receives the benefits of doing so.

Market failure

A problem that causes the market economy to deliver an outcome that does not maximise efficiency

Negative Production Externality

When a firm’s production reduces the well-being of others who are not compensated by the firm

Negative consumption Externality

When an individual’s consumption reduces the well-being of others who are not compensated by the individual

Private Marginal Cost

The direct cost to producers of producing an additional unit of a good

Social Marginal Cost

The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others

Private Marginal Benefit

The direct benefit to consumers of consuming an additional unit of a good by the consumer

Social Marginal Benefit

The private marginal benefit to consumers minus any costs associated with the consumption of the good that are imposed on others

Efficiency requires that:

Social Marginal Costs = Social Marginal Benefits

Markets Set:

Private Marginal Costs = Private Marginal Benefits

Hence, the market is efficient when

PMC = SMC and PMB = SMB

Positive Production Externality

When a firm’s production increases the well-being of others but the firm is not compensated by those others

Positive Consumption Externality

When an individual’s consumption increases the well-being of others, but the individual is not compensated by those others

Solution to externalities

Internalise the externalities

Internalising the externality

When either private negotiatons or government action lead the party to fully reflect the external costs or beenfits of that party’s actions

Coase Theorem

If property rights are clearly assigned and the transaction costs are low (or zero), then private bargaining between parties will lead to an efficient allocation of resources - regardless of who initially holds the rights.

Issues with Coase: Assignment problem

• Assigning the blame for the given externality

• Assigning the monetary damage to the externality

Issues with Coase: Holdout Problem

• Shared ownership of property rights, gives each owner power over all the others

• Each person has veto power and may withhold motions to demand large payments

Issues with Coase: Free Rider Problem

• When an investment has a personal cost but a common benefit, individuals will underinvest

• Individuals may not want to pay enough to reduce the externality

Issues with Coase: Transaction costs + Negotiating problems

• Hard to negotiate when there are large numbers of individual on different sides of the negotiation

• Sides must somehow be aggregated for negotiation

Hence Coase Conditions must be:

• Well-defined, enforceable, property rights over the external effect

• Low transaction costs, few agents, minimal free-riding/asymmetric information

• No wealth effects that change efficient outcome (or are negligible)

Public-sector Remedies for Externalities

1. Corrective taxation to discourage use

2. Subsidies to encourage use

3. Regulation to direct change use

Taxation & subsidies

• Change the private marginal cost or private marginal benefit without affecting the social marginal cost or benefit.

• Hence they interlise externalities

Quantity Regulation: Command-and-control

• Each firm must reduce by the same amount

• Inefficient if firms have different marginal costs

Quantity Regulation: Cap-and-trade

• Government chooses overall level of pollution and issues permits to firms giving them the right to pollute

• Firms can trade permits - High MC will buy, low MC will sell.