Study Notes on Welfare Economics: Evaluating Market Efficiency and Market Failure

Welfare Economics: Evaluating Market Efficiency and Market Failure

Chapter Overview

• Topics Covered:
  1. Evaluating Public Policies
  2. Measuring Economic Surplus
  3. Market Efficiency
  4. Market Failure and Deadweight Loss
  5. Beyond Economic Efficiency

Positive vs. Normative Analysis

• Positive Analysis:
  • Describes what is happening, explains why, or predicts future outcomes.
  • It involves questions like:
    • "What is going to happen if we adopt this policy?"
    • It focuses on objective analysis that forecasts the effects of the policy.
• Normative Analysis:
  • Prescribes what should happen and involves value judgments.
  • Involves questions like:
    • "Which is the better outcome, and what policy should the government adopt?"
    • Answers vary according to individual values.
    • Example: "In your opinion, do the benefits of this policy outweigh the costs?"

Economic Efficiency

• Defined as an outcome yielding the largest possible economic surplus.
  • Economic Surplus:
    • Defined as the total benefits minus total costs flowing from a decision.
    • It measures how much a decision has improved one’s well-being.
  • Efficiency outcome holds the potential to maximize the economic pie, signifying that economic surplus increases overall.

Equity in Economic Terms

• Equity gauges fairness in distribution.
  • Efficient outcomes may not be equitable.
  • Example: Uber's operations might benefit drivers and passengers overall but harm taxi drivers, leading to dissatisfaction despite overall efficiency.
  • There is potential for compensation, although it is rare in practice.

Measuring Economic Surplus

• Consumer Surplus:
  • The economic surplus from purchasing.
  • Calculated as: \text{Consumer Surplus} = \text{Marginal Benefit} - \text{Price}
    • Example: If a consumer is willing to pay $40 for a sweater but buys it for $35, then:
      \text{Consumer Surplus} = 40 - 35 = 5
• Producer Surplus:
  • The economic surplus from selling.
  • Represented as: \text{Producer Surplus} = \text{Price} - \text{Marginal Cost}
    • Example: If a tutor is willing to accept $25 for an hour’s work and receives $35:
      \text{Producer Surplus} = 35 - 25 = 10
• Economic Surplus:
  • Total surplus derived from a transaction, combining consumer and producer surplus.
  • Given by:
    \text{Economic Surplus} = \text{Consumer Surplus} + \text{Producer Surplus}

Market Efficiency

• Involves the effectiveness of markets in allocating resources:
  1. Who makes what?
     • Efficient production means producing output at the lowest possible costs.
     • Real-world scenarios illustrate when production is or isn't efficient.
  2. Who gets what?
     • Efficient allocation requires goods to go to those who will gain the highest marginal benefit.
  3. How much is bought and sold?
     • The equilibrium quantity maximizes economic surplus, with production aligning marginal benefits and costs.

Market Failure

• Defined as a situation where market forces lead to inefficient outcomes.
• Sources of Market Failure:
  1. Market Power
  2. Externalities
  3. Information Problems
  4. Irrationality
  5. Government Regulations
• Deadweight Loss (DWL):
  • Describes how far economic surplus falls below the efficient outcome.
  • Calculated as:
    \text{DWL} = \text{Economic Surplus at Efficient Outcome} - \text{Actual Economic Surplus}
  • Contributions to DWL can arise from underproduction or overproduction.

Critiques of Economic Efficiency

• Economic efficiency focuses on maximizing surplus but does not consider distributional consequences.
  • It raises questions on fair allocation:
    • Who receives what, and the process of allocation.
  • Example (Kim Kardashian Problem): Just because an individual is able to pay more for goods doesn't always justify exclusive ownership over those resources.

Implications of Economic Policies

• Evaluating policies should consider both efficiency and equity to arrive at outcomes that promote overall welfare.
  • Examine the distributional impact along with the ends and means of policy-making.

Conclusion and Further Considerations

• Economic policies should strive for both efficiency and equity, paving the way toward fair distribution of economic benefits to promote societal welfare.