Microeconomics Level 2

1
Microeconomics Level 2  Module 3

• Sandeep Kapur

2
Welfare Economics  Efficiency and Equity

• When do markets work well?
• Why markets do not work well?
• Implications for public policy

3
EQUITY

• How fair is the distribution of goods and
  services?
• A pure value judgement
• Horizontal equity equal treatment of equals
• Vertical equity different treatment of different
  people to reduce effects of inequality

4
Allocation a description of who gets what

• Starting from A B is better and C worse (people
  prefer more to less)
• Is D better than A?
• What about E or F relative to A?

5
Pareto Efficiency

• An allocation is Pareto efficient (given tastes,
  resources, technology) if it is impossible to
  find another allocation that makes someone better
  off and nobody worse off.
• Note that the ranking is incomplete, and
• there are infinitely many Pareto efficient
  allocations
•  
• ISSUE Does society end up at a Pareto efficient
  allocation?

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Competitive Equilibrium Pareto Efficiency

• Consider two industries, meals and films.
  Suppose both are competitive and in equilibrium.
  Meals cost Pm and films Pf each.
• Last meal eaten yields Pm extra utility to
  consumer last film watched yielded Pf
• Pm and Pf are also the marginal costs of
  production
• This suggests that there is no way to reallocate
  production to make consumers better off!

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An Example

• Suppose Pf 2Pm consumers need two meals to
  give up one film
• But producers need twice as much resources to
  'serve' a film instead of a meal
• So they could offer two meals for an extra film,
  but no profit (or loss) for the consumers
• PUNCH LINE Competitive equilibrium is Pareto
  efficient
• The Invisible Hand Theorem!

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AN IDEA

• Confine government intervention to redistribution
  
• Rely on markets to achieve efficiency
• But what if markets fail to be efficient?
• Market Failure any circumstance in which
  equilibrium in free, unregulated markets FAILS to
  achieve an efficient allocation

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Sources of Market Failure

• Tax distortions
• Externalities
• Public goods
• Imperfect information
• Imperfect competition
• We will look at these in turn

10
Group Work Efficiency and Equity

• Government intervention in the economy is
  pervasive. For each type of intervention listed
  below identify the possible rationale. Is it
  primarily
• (Pareto) efficiency considerations?
• a desire for greater equity?
• something else?

1. Income tax
2. Taxation of petrol
3. Windfall tax on utilities
4. Regulating electricity prices

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Group Work

1. Regulating discharge of sewage in the Thames
2. Legislation against insider trading
3. Banning the use of cocaine
4. Unemployment insurance
5. Making primary school compulsory
6. Maintaining an army
7. Running the NHS
8. Running the Post Office

Is there a trade-off between equity and
efficiency?
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MARKET FAILURE Taxation

• Suppose we have a tax only on films
• This tax wedge implies, for last film
• post-tax price exceeds producer's gain
• consumers value exceeds producer's
  value
• Implications for meals industry
• Marginal private cost of meals below their
  marginal soc cost
• Consequently, if only films are taxed,
• films are too expensive and meals too cheap
• we get too many meals relative to social optimum,
  and too few films
• IDEA a tax on meals too, to correct the
  imbalance

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THE SECOND BEST

• If there exists a price distortion, get rid of it
  to achieve the FIRST BEST (full efficiency)
• However, if you cannot get rid of the distortion
  in one market, it is NOT EFFICIENT to arrange for
  other markets to be undistorted
• rather it helps to spread the inevitable
  distortion more thinly, by DELIBERATELY
  introducing new distortions in other markets

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MARKET FAILURE Externalities

• EXTERNALITY
• an individual's production or consumption affects
  others' utility or productivity
• the effect is direct (and not through the market
  or prices)
•  

Beneficial consumption externality
house-painting Adverse consumption externality
smoking Beneficial production externality
Channel Tunnel Adverse production externality
pollution
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Why Externalities Matter

• THE ESSENTIAL PROBLEM
• Market mechanism aligns private costs and
  benefits
• Externalities imply divergence between social and
  private costs (or social and private benefit)
• If divergences exist, should not expect socially
  efficient allocations

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Adverse Production Externality

• For social optimum, want social marginal cost
  social marginal benefit
• At the free market equilibrium E, output Q is
  higher than social optimum Q, which results in
  dead-weight burden EFG
• SOLUTION 1 (Pigou). Corrective taxation

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Property Rights

• Solution 2 (Coase)
• Assign property rights and let people trade these
  rights in pseudo-market
• Initial assignment affects distribution but gets
  an efficient outcome
• This solution does not work if there are high
  transactions costs or free riding

Efficient quantity is Q
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MARKET FAILURE Public Goods

• Consumed in the same quantity by everybody
• Examples defence, safe streets
• Characteristics
• Non-rival consumption my consumption does not
  diminish what is available for you
• Non-excludability impossible or too costly to
  prevent people from consuming it

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Why free markets cant get public goods right

• Possible solutions
• The problem of free-riding
• Note that government needs to ensure right
  quantity, but not need to produce it itself

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MARKET FAILURE Missing Markets

• Imperfections in information. Often there is
  asymmetry of information between buyers and
  sellers
• This causes problems, especially in insurance
  markets
• Adverse selection and Moral hazard
• Insurance markets also vulnerable to other
  problems
• All this may result in missing or incomplete
  markets

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MARKET FAILURE Monopoly

• With market power, price exceeds marginal cost
  (so social marginal benefit exceeds social
  marginal cost), leading to Pareto inefficiency.
  Importantly, restriction of output is costly
• Other inefficiencies resources wasted in
  securing monopoly power (lobbying or
  rent-seeking), and maintaining it (excessive
  capacity, etc)
• Equity political power of large companies

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MONOPOLY other issues

• Natural monopoliesVery severe economies of scale
  so socially desirable to have one producer rather
  than duplicate fixed costs. (First-best
  solution set price marginal cost, but this
  causes losses)
• Any benefits of monopoly?
• economies of scale
• dynamic efficiency higher RD
• better coordination of decisions

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MONOPOLY Solutions

• Solution 1. Nationalize and finance losses
  through taxes (politically not very feasible)
• Solution 2. Break monopoly (anti-trust
  legislation in US)
• Problem lose benefits as well, no good for
  natural monopolies
• Solution 3. Regulate. Prevent abuse of monopoly
  power through price and non-price controls (UK
  approach)
• Solution 4. Nurture competition. Encourage new
  entrants, (but will they enter and will it only
  lead to cream skimming?)
• In general, difficulties with the remedies
  themselves

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Regulation

• Is regulation really necessary?
• Not if monopoly power is restrained by
• foreign competition
• potential domestic competition contestability
• Inter-modal competition Eurostar vs airlines
• Types of price regulation
• Marginal cost pricing
• Average cost pricing
• Two-part tariffs fixed sum for access plus
  marginal cost

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Group Work Pollution

• Your are the National River Regulator, tackling
  the problem of a chemical company that is
  polluting the river Thames
• If everything could be quantified and valued,
  show in a diagram how a pollution tax can induce
  the chemical firm to behave in a socially
  efficient manner.
• Instead of the tax you offer the firm a pollution
  quota (specifying the maximum pollution it can
  discharge in any year). Show the size of the
  quota in the diagram. What difference does it
  make to the efficient quantity of pollution?
• Now suppose information is harder to come by. As
  the regulator, you are not entirely certain about
  the firm's cost curve. Does this affect your
  choice between tax and a quota?
• Lastly, suppose there are two chemical firms
  discharging into the river. Is it better to
• set a pollution tax (same rate per unit polluted
  for both firms)
• set each a quota?
• auction pollution quotas?

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INDUSTRIAL POLICY

• Central idea market failure calls for an active
  role for the government
• Research Development
• RD accounts for 2-3 of GDP in Western Europe,
  US and Japan
• PROBLEM Inventions are a public good. Without
  intervention, too few inventions will emerge

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Three solutions for the RD problem

• Patents confer time-bound legal monopoly on the
  inventor
• Optimal patent duration
• too short not enough incentive to invent
• too long long-lived monopoly power
• Procurement use of government research labs.
  E.g. defence
• Patronage subsidies to universities

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Other things that governments can do

• Assist diffusion of new technologies
• Coordinate selection of industrial standards
• Lock-in the economics of QWERTY
• VHS or Betamax
• The coordination role of government
• New lessons in economic geography
• Location externalities

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Other things that governments can do

• Sunrise industries
• Imperfection in markets for loans to new firms
• Deficient incentives to acquire skills
• Sunset industries
• managing the transition prevent survival of an
  inefficiently large number of firms
• Other reasons for intervention
• pool risks across many projects
• spread risks thinly across population
• However, the possibility of government failure

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Taxation and Public Spending
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Taxation

• Variety of taxes
• Direct taxes income tax, corporation tax
• Indirect taxes on expenditure, VAT
• Effect on choice
• Lump sum tax (eg poll tax) do not distort choice
  variable taxes do
• Progressivity of taxes
• Proportional average tax rate constant
• Progressive average tax rate rises with income
• Regressive average tax rate falls with income

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Taxation

• Principles of fair taxation
• Ability to pay take more from the rich
• Benefits principle beneficiaries of public
  provision to pay more
• Desirable Characteristics of Tax System
• Efficiency
• Equity
• Administrative simplicity
• Cost of ensuring compliance
• Responsiveness to changed economic circumstances

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Tax incidence who really bears the tax
Tax incidence diagrams either (as here) at
consumer prices (supply curve shifts) or at
producer prices (demand curve shifts)

• Relative to original equilibrium, gross price
  goes up but less than tax (i.e., net price goes
  down)
• Regardless of who the tax is levied on, its
  INCIDENCE depends on elasticity of supply and
  demand
• Inelastic supply/demand means bear the tax
• Elastic supply/demand escape the burden

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Principles of Optimal Taxation

• EFFICIENCY
• use lump-sum taxes wherever sensible
• choose tax rates to minimise distortion
• Ramsey principle tax rate higher if supply or
  demand is inelastic
• taxes could even help correct distortions,
  externalities sin taxes on cigarettes, alcohol
• EQUITY
• Vertical equity suggests progressive tax system
• but this may conflict with efficiency
• and we must assess progressiveness carefully
  incidence of taxes, benefits, direct provision

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Public Spending
Government expenditure around 40 of GDP Social
insurance contributory benefits such as
unemployment, sickness, pensions benefits Equity
non-contributory benefits, such as income
support, housing benefit, family support Merit
goods what society believes all should have
(externalities or paternalism) benefits-in kind,
education, health The big three - social
security, health, education - account for 3/5 of
spending Public goods law and order, defence
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Health care
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Health Care A merit good?

• Sources of muddled thinking
• an emotional issue
• is health a basic right? (but so is food)
• is health care a commodity like any other? cars,
  housing etc.
• The issues
• Is a private market for health care efficient?
• Is it equitable?
• Is public production and allocation more
  efficient? More equitable?

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Health Care

• The product
• Health care is only an input. Output -- improved
  health outcomes -- also depends on diet,
  environment, lifestyle
• Does health care reduce suffering? prolong life?
  improve life?
• And how valuable is improved health? Impact on
  output, earnings, income? Impact on happiness
• Efficiency
• macro what fraction of GDP on health
• micro how to allocate resources within system
• Equity
• but of what?

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WHY INTERVENE IN HEALTH-CARE?

• Would a private health care market be efficient?
• Is competition perfect? Monopoly power of
  medical associations and drug companies
• Imperfections due to asymmetric information and
  insurance some missing markets
• Externalities
• In addition to efficiency issues,
• equity issues
• ethical issues

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Asymmetric information

• Do people know if they are ill? What treatment do
  they need? What is available?
• Here seller (doctor) knows more than buyer
• technical complexity of information
• high cost of errors
• patients' inability to weigh product against
  alternatives
• In sum this is hardly rational consumer choice
• Solution provision of information and
  regulation but both are costly
• Public provision?

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Problems with Health Insurance

• Pattern of demand small probability of major
  expenditure Usually buy insurance in such
  situations
• but insurance markets suffer from many problems
• adverse selection attract especially sick
• moral hazard tendency to over-treat
• correlated risk are hard to insure epidemics
• missing markets for congenital/chronic problems
•     Can intervene to reduce these problems, but
  causes other problems.
• Social insurance?

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Other reasons for intervention

• Externalities and scale economies
• communicable diseases
• economies of scale
• Other reasons for public intervention
• Equity arguments
• Moral and ethical arguments
• babies, organs should not be sold

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How to intervene?

• Target to maximise equity and efficiency
• macro how much should we spend on health? rising
  cost of health care, ageing population, more
  sophisticated (and expensive) treatments
• efficiency who should PRODUCE health care?
  private, public, or mixed production?
• equity how should we PAY for it?
• tax (payments based on ability or need?)
• tax private (help for the poor?)
• private insurance (compulsory?)
• Should production and finance be handled
  together? eg health maintenance organisations

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Health care in the UK case notes

• THE PATIENT NHS
• Department of Health
• Regional Health Authorities oversee District
  Health Authorities
• Family Health Services GPs, dentists, etc.
• Hospital Trusts, with financial and managerial
  autonomy can borrow, hire and fire

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THE CASE HISTORY

• Universal and virtually free access
• Publicly financed
• Good health outcome
• Cheap expenditure 6-7 of GDP,
• But rising (up by 70 in real terms 1979-96,
  bulges in birth rate in post-war period, ageing
  population new, costly treatments)
• A crisis of confidence queues, alleged
  inefficiencies

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DIAGNOSIS?

• Inefficient or underfunded?
• If inefficient, why?
• lack of incentives
• absence of choice for patients
• skills shortages?
• If underfunded,
• more public money
• private resources

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TREATMENT

• 1989 White Paper create an internal market
• invisible hand rather than central control
• separation of funding from provision purchaser
  can buy from competing providers
• GP fundholders manage budgets to minimise own
  cost
• Hospital Trusts, with greater managerial control
  and financial autonomy
• More recently, Foundation Trusts

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PROGNOSIS

• Did the internal market work?
• Were objectives genuine, or just a response to
  fiscal crisis?
• Market structure choice or monopoly?
• Dual structure rich vs the poor? Implications
  for life expectancy?
• Speed of reform intergenerational equity?
• What reforms would you propose?

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THE FUTURE?

• Private health care currently cheap (residual use
  only, complicated treatment done by NHS, high
  number of young in privately insured, low cost of
  medical services in the UK), but will this last?
• Is there growing privatisation of the NHS?
• What will Foundation Trusts achieve?

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Group Work Education

• 1 Identify the salient characteristics of
  education as a commodity. Do you consider it a
  merit good?
• 2 Do you expect private markets for education to
  be efficient? Identify reasons for any market
  failures.
• 3 Do you expect private markets for education to
  be equitable?
• 4 Should the government intervene? How? Does
  intervention create any problems?
• 5 If a university degree has any worth,
  individuals will be prepared to pay for it. This
  makes a case for more private finance in higher
  education. Comment.

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The Welfare State
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Moral hazard in insurance markets

• If your bike is fully insured against theft, you
  have no incentive to be careful (to lock it)
• if you lose the bike, insurance company bears the
  loss
• increased carelessness increases risk of loss
  this is called moral hazard
• A solution
• Insurance company forces you to bear some cost,
  to maintain some incentive to be careful
  coinsurance Eg excess payments, no-claim
  discounts etc.
• What is the optimal risk-sharing arrangement?

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Principal-agent theory

• Imagine that
• an agent's effort affects probability of success
  for principals project
• that effort is unobservable or hard to measure
• If so,
• the principal needs to provide incentives (carrot
  or stick) to induce effort
• without incentives, individuals will just
  slack-off
• Once again, the issue of optimal risk sharing.
• Lesson incentives matter

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Is the government less efficient?

• Remember
• public sector losses sometimes intentional
• cost structures differ Post office vs private
  couriers
• Evidence
• private sector firms more efficient PROVIDED they
  operate in markets with strong competition key
  issue not ownership but severity of competition
  (or competition policy). E.g., many UK utilities
  improved in RUN-UP to privatisation, while they
  were still in public hands
• But this is not to deny that there have been
  serious inefficiencies

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Why is the government less efficient?

• 1. The incentives problem
• At the organisational level no fear of
  bankruptcy, no competition
• At the individual level not enough carrot
  (relatively fixed salary) or stick (relative
  security of tenure)
• In sum, incentive structures are relatively flat
  no high financial rewards, but not much
  punishment either
• Why not use better incentive schemes in the
  public sector?
• In part, because measuring success is harder due
  multiplicity of of objectives and poor
  information
• 2. Institutional aspects what DO bureaucrats do?

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Lessons for policy makers

• Market failure does not make an automatic case
  for intervention
• Sometimes government intervention makes matters
  worse. Informational problems affect both public
  and private sectors.
• regulation often has perverse effects
• vulnerability of governments to rent-seeking
  behaviour
• Weigh existing inefficiencies against risk of
  government failure
• Incentives are important prospect of high reward
  may be ESSENTIAL to spur people into action

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Supply-side economics

• Central idea
• Force government OUT of market place, to unleash
  private sector dynamism.
• Use microeconomic incentives to increase
  productivity
• Intellectual origins
• disenchantment with Keynesian, demand-side
  thinking
• tax fatigue of the 1970s
• anti-government

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Supply-side economics suggestions

• Cut marginal tax rates to provide incentive for
  hard work). Cut the dole, to increase labour
  participation. If output goes up, so might tax
  revenue (Laffer)
• Cut taxes on savings, dividends, to reduce
  distortions
• Cut business tax, allow more depreciation to
  induce new investment
• Rein in the state, cut govt spending (cut real
  interest rates, privatisation), allowing private
  sector to expand
• Reform labour market, curb the Trade Unions.
  Encourage profit-sharing schemes to incentivise
  workers. Flexible markets encourage growth
• Vocational training, etc.

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Evaluation of Supply-side economics

• did well on the inflation front
• tax cuts may not induce more workSubstitution
  effect (work more because work is rewarded more),
  vs income effect (work less as you can get goods
  you want with fewer hours of work) Evidence
  inconclusive
• likewise, cutting taxes on interest raises the
  return on saving, but may not induce people to
  save more
• budgetary troublesUS government found it easier
  to reduce public investment but not current
  expenditure (wages of civil servants, etc).
  Laffer was off the mark
• aggregate investment did not expand much, once
  you correct for the business cycle
• incentive effects of some US tax cuts were
  perverse

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In sum

• Implications for efficiency
• Claims about likely efficiency gains were
  exaggerated
• there is nothing wrong with supply-side
  economics that division by 10 cannot cure.
  (Charles Schultze)
• not much support even from arch-priests of
  right-wing economics, but right idea at the right
  time
• Implications for equity
• Given that they aim to increase incentive to work
  and invest, supply-side policies -- if successful
  -- will inevitably widen the gap between those
  who succeed and those that fail.
• Did alter income distribution (tax cuts were
  deeper for the rich public spending on poor fell)
  

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THE WELFARE STATE

• Designed for both equity and efficiency
• Equity
• reduce poverty (insurance)
• more equal distribution of wealth
• not just altruism, also desire for social
  cohesion
• Efficiency
• provide insurance against risks that private
  market do not cover well (unemployment, illness)
• provide social services to correct for market
  failures in areas of health, education, housing,
  pensions, training

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LESSONS OF HISTORY

• Economic sense vs electoral politics
• welfare state disconnects relationship between
  effort and reward
• but habits die hard habit-restrained lags
  between welfare provision and deterioration of
  incentives
• overshooting of welfare provision, leading to
  potential fiscal crises

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LESSONS OF HISTORY

• Thatcher's contribution linking payments to
  inflation not earnings
• Efficiency What matters is the size of market
  failures against the size of possible government
  failures. Otherwise the welfare state just
  translates market failure into government
  failure.
• Equity?

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Cost-Benefit Analysis
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COST-BENEFIT ANALYSIS

• Analysis of costs and benefits useful for
• Capital projects
• Policy and programme development
• Use or disposal of existing assets
• Environmental standards, health and safety
• Procurement decisions

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THE PROCESS

• Justify action and set objectives
• Appraise the options including the do minimum
  and so-called politically infeasible ones
• Identify and value costs and benefits of each
  option
• Adjustments
• non-market impacts
• risk and optimism
• distributional impacts
• relative price movements
• tax implications
• Develop and implement solutions
• Evaluation

67
FORMS OF APPRAISAL

• Financial Appraisal
• Compare revenue with costs, as a private firm
  does
• (Social) Cost-benefit analysis
• Quantify costs and benefits of each option,
  including costs and benefits that the market does
  not value
• Cost-effectiveness analysis
• If benefits are hard to quantify, compare the
  costs of achieving some target level of benefits
• Example
• Is is profitable for a firm to build the Channel
  Tunnel Rail Link?
• Should it be built when we include the larger
  benefits and costs to society?

68
SOME TECHNICALITIES

• TIME PREFERENCE
• People prefer 1 today to 1 tomorrow
• demand a premium to postpone consumption
• OPPORTUNITY COST OF CAPITAL
• cost in terms of opportunities foregone
• rate r at which you borrow
• DISCOUNTING AND NET PRESENT VALUE
• What discount rate should we use?
• INFLATION erodes future values
• either all values real or all values nominal

69
Decision rule Net Present Value Criterion

• Forecast the cash flow generated by the project
  over its lifetime
• Assess opportunity cost of capital, and discount
  future cash flows
• Calculate the net present value (NPV) sum of
  discounted net flows
• Decision Rule
• ONE OPTION Invest if NPV is positive
• MANY OPTIONS Invest in project with highest NPV
• All this is easier said than done

70
SOCIAL COST-BENEFIT ANALYSIS

• While private sector cares about profits,
  government must consider a larger of benefits
  and costs
• The government uses the Net Present Value
  criterion but, to the extent social benefits and
  costs diverge from private benefits and costs,
  estimates of NPV could differ
• Social rate of time preference may differ from
  market rates of interest

71
VALUING NON-MARKET IMPACTS

• Evaluate non-market consequences
• externalities, including environmental ones
• consumers surplus
• saving of time, human life
• possibilities of catastrophic risk
• Often hard to value these. Can use
• Willingness to Pay (WTP)
• Willingness to Accept (WTA)
• Contingent Valuation Methods (CVM)

72
Some caveats

• Additionality Need not make allowances for
  broader effects, such as tax flowbacks, savings
  in benefit payments, etc. These may happen even
  if the proposed project is rejected and some
  other is accepted
• What prices should the government use?Best to
  use MARKET PRICES. The use of so-called shadow
  prices can be justified only if there is severe
  market failure.

73
What discount rate should the government use?

• Should it use the market rate at which private
  firms attract finance?
• In THEORY, the answer depends on aggregate impact
  of all public investment on private investment
  and consumption
• In PRACTICE, government uses a fixed rate of
  social time preference for consistency.
• was set at 6 pa in real terms
• now has been stripped down to 3.5
• Lower rates for long-term projects

74
The Effect of the chosen discount rate

• Consider stream of positive returns NPV falls as
  we use a higher discount rate

Choice of too high a discount rate will reject
good projects Choice of too low a discount rate
will accept bad ones
75
Risk and Uncertainty

• What if benefits or cost are uncertain?
• Private firms add some risk premium to the
  discount rate this lowers NPV, making acceptance
  of risky project less likely
• Should the government discount risk?In
  principle, if the government can spread risk very
  thinly across the population, answer is NO.
• In practice, risk evaluation and management is an
  important part.

76
Managing and Evaluating Risk

• IDENTIFY all risks
• Assess what can be transferred, at low cost, to
  the private sector
• Use of pilot projects to learn more about costs
  and benefits. Use flexible designs avoid the risk
  of being hostage to fortune.
• Eliminate optimism bias
• Monte Carlo analyses sensitivity analyses to
  look at NPV of project under alternative
  assumptions about the value of uncertain
  parameters

77
Other issues

• What if the project has irreversible consequence?
• Be cautious. Raise the threshold of acceptance
  for a project to compensate for the
  irreversibility.
• Distributional impact how costs and benefits
  affect different groups
• Tax impact, relative price movements

78
Green Accounting A Case Study
79
Further reading

• Begg, Fisher and Dornbush, Economics, 7th
  edition, PART 3
• Nicholas Barr, The Economics of the Welfare
  State, third edition, Oxford University Press,
  1998
• This is a good manual for many aspects of public
  finance and the welfare state. See especially
• chapter 3 social theory and the state
• chapter 4 state intervention
• chapter 12health and health-care
• chapter 13 housing

80
MicroeconomicsLevel 2

• Sandeep Kapur
• Birkbeck College London