Topic 1.1: The Market System and Social Objectives (Equity & Market Failure)

Pareto Efficiency and Market Outcomes

• Pareto efficiency outcome is one where no individual can be made better off without making another worse off.

• Critical question: is Pareto optimality the sole criterion for evaluating market outcomes?

• Distribution as a dimension of equity can also be a critical policy goal:

  • Vertical equity: Refers to the distribution of income, goods, and services among individuals with varying capabilities and needs.

  • Horizontal equity: Ensures equal access to services and opportunities regardless of differences in demographic factors.

Amartya Sen and Critique of Pareto Efficiency

• Amartya Sen (1933 - ) is a prominent professor of economics and philosophy at Harvard University and won the Nobel Prize in 1998 for developing an ethical framework to examine poverty and welfare.

• Sen criticizes Pareto efficiency in his book "Collective Choice and Social Welfare" (1970) with the assertion:

Critique Points

• Disregard for Distribution: Pareto efficiency ignores income and resource distribution, leading to potential inequality.

• Value of Choices: While 'freedom to trade' and 'choices' may benefit individuals, it overlooks their actual ability to transform resources into effective human activities.

• Definition of Utility: Utility becomes a restricted notion of well-being, solely based on the amount of goods (X and Y) possessed, hence ignoring the individual's situation and the transformation of those resources into capabilities. For example, individuals suffering from medical issues or lacking educational resources cannot convert resources effectively into capabilities.

  • Reference: Sen (1980), "Equality of what?"

Capability Approach

• Sen introduces the Capability Approach, which emphasizes:

  • Individuals’ genuine quality of life and the actual achievable capabilities based on their circumstances.

  • Functionings: Defined as the various things a person manages to do or what they can be.

  • Capability: The genuine freedom to choose between different life paths, which is influenced by factors such as:

  • Access to education.

  • Availability of healthcare.

  • Food security.

  • Shelter and transportation.

  • Example: A bicycle is considered a commodity; cycling is its functioning. However, an individual's capability to cycle may be limited by their health status.

John Rawls and the Veil of Ignorance

• John Rawls (1921 - 2002): Proposed a thought experiment regarding distribution in society under a "veil of ignorance," where individuals forget their own socioeconomic status, including income, wealth, education, and health.

• The aim is to determine what distribution principles society would choose to maximize the welfare of the least well-off (the "maximin principle").

  • This is discussed in his work "Theory of Social Justice" (1971).

Rawlsian Welfare Function

• The formulation presented is: $W = ext{max}(U<em>P, U</em>R)$

  • Where $UP$ is the utility of the poor individual, and $UR$ is the utility of the rich individual.

• Described as a ‘maximin function’, where welfare improvements for the least advantaged group is prioritized.

• Edgeworth Box Example: Demonstrates how if individual B receives all benefits, it represents a Pareto improvement but contradicts Rawls’s principles; an improved welfare extends more towards equality.

Libertarian Objections to Rawls

• Libertarians argue that individuals are entitled to property and wealth obtained through:

  • Personal earnings.

  • Inherited wealth.

• They oppose redistributive policies, advocating for a minimal state that protects property rights and enforces contracts, sometimes referred to as the "night-watchman state." They see taxation as "theft."

  • This school of thought is articulated by Robert Nozick (1938 - 2002) in "Anarchy, State and Utopia" (1974).

Market Failures

• Market failures arise when actual market operations deviate from the first-best economy assumptions. Key implications for efficiency include:

  • Public Goods: Non-excludable and non-rival benefits leading to under-provision issues.

  • Interdependent Utility Functions: Changes in one individual's utility can affect another's.

  • Imperfect Information: Results in suboptimal consumer choices and production decisions.

Public Goods

• Characteristics include:

  • Non-excludable: individuals cannot be effectively excluded from use.

  • Non-rival: one person's use does not diminish availability to others.

• Consequence: marginal cost of an additional user ($MCU$) is zero, resulting in sub-optimal provision.

• Free-rider Problem: Leads to a lack of incentive for individuals to contribute, resulting in inadequate public goods.

  • Potential solutions include taxpayer-funded services, like street lighting.

Under-provision of Public Goods

• Social optimum (Q*) contrasts with market provision, leading to higher prices above zero that signify sub-optimal consumption.

• Example: If the marginal cost (MC) at quantity Q1 exceeds marginal utility at a price greater than MCU, results in inefficiencies.

Free-riding and Non-provision

• Consider a scenario where:

  • Total cost of public goods = £10.

  • Benefit to each individual = £8.

• Decision-making among individuals A and B leads to a Nash equilibrium of (0, 0), resulting in no members contributing and hence no provision.

• A Pareto improvement can occur through coordination and contracts.

Altruism and Utility Functions

• The traditional model excludes altruistic behavior, hence considering interdependent utility functions:

  • Let:

  • R = rich individual,

  • P = poor individual,

  • U = utility,

  • Y = income.

  • Utility functions are represented as:

  • $U<em>P = U</em>P(Y_P)$

  • $U<em>R = U</em>R(Y<em>R, Y</em>P)$

  • Recognizes that the utility of R increases with both their income and that of P (both partial derivatives are greater than 0).

Implications of Altruism

• The redistribution from R (rich) to P (poor) remains rational if the following holds true:

  • $ext{(Change in utility from P)} - ext{(Loss in utility from R)} ext{ is greater than or equal to 0.}$

• Diminishing marginal utility prevents R from giving up all income, as it shows a marginal benefit in keeping their resources.

Extent of Altruism and Free-riding Behavior

• The overall extent of altruism is impacted by marginal effects described in previous equations, with potential for free-riding behaviors:

  • Donation by one significant contributor (e.g., £1 from Bill Gates) may be treated as a substitute for contributions from others, leading to a suboptimal level of altruism.

  • The aggregate altruism is given by:

  • $G = ext{Sum of } g_i ext{ from individuals 1 to } n$.

Influencers of Altruism

• Prominent figures involved in philanthropic behaviors include:

  • Bill Gates and the Bill & Melinda Gates Foundation.

  • Warren Buffet and the Chan Zuckerberg Initiative (CZI) led by Mark Zuckerberg.

Motivators for Altruism

• Factors potentially enhancing altruistic behaviors include:

  • Warm Glow Effect: The pleasure derived from giving adds utility.

  • Reputation: Altruistic actions can enhance social standing.

  • Human Capital: Volunteerism can reflect positively on character.

  • Social Pressure: In smaller communities, individuals may feel obligated to contribute.

• If these motivations are weak, taxation may become a necessary solution.

Example of Free-riding in Altruism

• Discussion on 'Patriotic Millionaires UK' emphasizes the necessity for the super-rich to contribute to alleviating societal inequalities.

  • They warned about potential civil unrest if wealth disparities are not addressed.

  • Campaigning for increased taxes on the wealthy, citing a $22 billion potential revenue per year from a 2% wealth tax.

Imperfect Information

• Key issue in various markets where quality of service may only be recognized after consumption:

  • Consumers may overestimate or underestimate returns from investing in higher education or healthcare.

• Complex information can pose challenges for consumers, such as over-testing in healthcare due to misdiagnosis incentives.

Consumer Ignorance in Health and Education

• Important concepts include:

  • Marginal Private Valuation (MPV) and Marginal Price Cost (MPC):

  • D2 signifies over-valuation leading to over-consumption.

  • D1 indicates under-valuation resulting in under-consumption.

Solutions for Market Information Gaps

• Recommendations include:

  • Regulation of professional qualifications and licensing (e.g., GMC in the UK).

  • Structuring school curricula (e.g., National Curriculum in England).

  • Third-party incentives for information dissemination (e.g., university rankings).

Government Failure in Ensuring Efficient Outcomes

• Government Capture: Private interest groups may steer outcomes that preserve their profits, leading to market inefficiencies.

  • Example: Promises to politicians for lucrative jobs post-political career (e.g., Nick Clegg's transition to Facebook leader).

  • Advantages in financial resources for corporate lobbying compared to consumer advocacy.

Median Voter Theorem

• Developed by Anthony Downs (1930 – 2021), implying that political parties aim for policies that resonate with the median voter.

  • Reflects the distribution of voting behaviors and beliefs, identified as a form of product differentiation according to Harold Hotelling (1929).

Distribution of Voting Behavior

• Visualization of the distribution of voting behavior, with L (Left-wing), R (Right-wing) voters, and M representing the median voter.

Summary of Key Concepts

• The first-best economy assumes efficient outcomes under specific premises.

• Policy makers may prioritize equity, indicating that efficiency alone may not suffice for societal well-being.

• Market failures that inhibit achieving socially efficient and equitable outcomes include:

  • Existence of public goods,

  • Interdependent utility functions,

  • Imperfect information,

  • Monopolistic behaviors that create price disparities,

  • Positive externalities leading to reduced consumption compared to social optimum.

References

• Sen, A. (1980), Equality of what?, McMurrin, S. (ed.).: The Tanner Lectures on Human Values, Vol. 1. Cambridge University Press.

• Downs, A. (1957), An Economic Theory of Democracy, Harper.

• Hotelling, H. (1929), Stability in competition, Economic Journal, vol. 39, pp. 41–57.