Microeconomics Level 2

 Module 3

Sandeep Kapur

Welfare Economics  Equity and Efficiency

EQUITY

How fair is the distribution of goods and services?

Of course, fairness is a value judgement

In principle, we can distinguish between• Horizontal equity: equal treatment of equals• Vertical equity: different treatment of different

people to reduce effects of inequality

Equity of Allocations

Starting from A, a move to E or F reflects a decrease in equity

Goods for Paul

Goods for Gordon

A

E

F .

Allocation: a description of who gets what

Efficiency of allocations

Relative to initial point A• B is better for all (and C is worse) • D is better for one, and no worse for other

B & D are said to be Pareto improvements on A

Goods for Paul

Goods for Gordon

A

B

C. E

F

D

.

Pareto Efficiency

An allocation is Pareto efficient (given tastes, resources and technology) if it is impossible to find another allocation that makes someone better off and nobody worse off.

• There can be more than one Pareto efficient allocation, and

• even inequitable allocations may be Pareto efficient

Are Markets Pareto Efficient?

Key Questions

• Do free markets always lead to Pareto efficient allocations?

• If not, why not?• What are the implications for policy?

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 generate a Pareto improvement

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 net gain for consumers or producers

• PUNCH LINE: Competitive equilibrium is Pareto efficient (The Invisible Hand Theorem!)

AN IDEA

If markets are efficient• confine government intervention to

redistribution, and • rely on markets to achieve efficiency

However markets may not always be efficient • Market Failure : a circumstance in which

equilibrium in free markets fails to achieve an efficient allocation

Sources of Market Failure

• Tax distortions

• Externalities

• Public goods

• Imperfect information

• Imperfect competition

We will look at each of these in turn

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

a. (Pareto) efficiency considerations?b. a desire for greater equity?c. something else?

1. Income tax2. Taxation of petrol3. Windfall tax on utilities4. Regulating electricity prices

…Group Work

5. Regulating discharge of sewage in the Thames

6. Legislation against insider trading

7. Banning the use of cocaine

8. Unemployment insurance

9. Making primary school compulsory

10. Maintaining an army

11. Running the NHS

12. Running the Post Office

Is there a trade-off between equity and efficiency?

MARKET FAILURE: Taxation

Suppose we have a tax only on films

This tax wedge implies, for last film seenpost-tax price exceeds producer's gain consumers’ value exceeds producer's value

Implications for meals industry

Marginal private cost of meals is below their marginal social cost

Taxes distort

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

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 always 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

MARKET FAILURE: Externalities

EXTERNALITY• A circumstance in which an individual's

production or consumption affects others' utility or productivity

• the effect is direct (and not through the market or prices)

Externalities: examples

• Adverse consumption externality: smoking• Beneficial consumption externality:

painting the exterior of your house• Beneficial production externality: bees and

orchards• Adverse production externality: pollution

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

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*: this results in dead-weight loss EFG

SOLUTION 1 (Pigou). Corrective taxation

Quantity

Demand

MPC

MSC

E

FG

QQ*

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

Quantity

MC (for you)

QQ*

MB (to me)

Efficient quantity is Q*

MARKET FAILURE: Public Goods

‘Consumed in same quantity by everyone’Examples: defence, safe streets, TV signal

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

Why free markets can’t get public goods right

• Possible solutions• The problem of free-

riding• Note that government

needs to ensure right quantity, but does not need to produce it itself

QuantityQ*

D1

D2

MSB

MARKET FAILURE: Imperfect information

• In reality, information in markets is less than perfect (e.g. we often need to search)

• Often there is asymmetry of information between buyers and sellers

• Resulting in the problems of adverse selection and moral hazard

• This may result in ‘incomplete markets’ or even ‘missing markets’

• Solutions: mitigate informational problems or provide goods directly

Moral hazard

If you are fully insured against losses, you have little incentive to be careful

• insurance company bears the loss, not you • increased carelessness increases risk of loss:

this is moral hazard

The usual solutionInsurance company forces you to bear some risk (excess payments or coinsurance) to maintain incentives to be careful

Here you can buy only partial insurance. In some cases, no market at all

MARKET FAILURE: Imperfect Competition

The essential problem• With market power, price exceeds marginal

cost,• so social marginal benefit exceeds social

marginal cost, • leading to Pareto inefficiency • Importantly, it is the restriction of output that

is costly • First-best solution

align price = marginal costs

MONOPOLY: benefits

• Dynamic efficiency: more R&D? • Better coordination of decisions• Economies of scale:

With ‘natural monopolies’, economies of scale so strong that it is cheaper to have one producer rather than duplicate fixed costs.

Here, imposing the first-best solution (i.e., price = marginal cost) results in losses

MONOPOLY: Solutions

Solution 1. Nationalize and finance losses through taxes politically not very feasible

Solution 2. Break monopoly e.g. anti-trust legislation in US

However, no good for natural monopolies

MONOPOLY: Solutions

Solution 3. Regulate Prevent abuse of monopoly power through price and non-price controls (UK approach)Practical issues: when is regulation necessary? What form?

Solution 4. Nurture competition Encourage new entrants, (but will they enter and will it only lead to cream skimming?)

In general, difficulties with the mix of remedies

Group Work: Pollution control

You are the National Rivers Regulator, tackling the problem of a chemical firm that is polluting the Thames

a. If everything could be quantified and valued, show in a diagram how a pollution tax can induce the firm to behave in a socially efficient manner.

b. 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?

c. 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 quotas?

d. Lastly, suppose there are two chemical firms discharging into the river, one cleaner than the other. Is it better to

• set a pollution tax? (same rate per unit polluted for both?) • set each a quota? • auction pollution quotas?

INDUSTRIAL POLICY

Central idea: market failure calls for an active role for the government

Based on the idea that intervention can• Correct failures in markets for knowledge• Assist in the diffusion of new technologies• Correct for excessive risk aversion• Circumvent coordination failures, etc.

However, the possibility of government failure

Research & Development

PROBLEM: Inventions are a public good, so that unregulated markets may not produce enough

• R&D activity equals 2-3% of GDP in OECD

THREE SOLUTIONS1. Patents: confer time-bound legal monopoly on

the inventor2. Procurement: use government research labs

e.g. defence3. Patronage: provide subsidies to universities

New technologies and standards

Problem: uncertainty about new technologies and standards may cause

• lock-in in to poor standards (QWERTY?)• delays in adoption (VHS and Betamax)

Solution: guide technological choices?

Risk

Problem: Markets may display excessive risk aversion

Collectively, society can pool risks across projects & spread risks across population

Solution: underwrite private sector losses? venture capital?

Coordination of economic activity

• Location externalities and new lessons in economic geography

• Sunrise industries: correct deficient incentives to acquire skills and imperfection in markets for loans to new firms

• Sunset industries: managing the transition: prevent survival of an inefficiently large number of firms

Government Failure

• However, we must beware of the possibility of government failure.

• For instance, the possibility that governments may face the same informational constraints as markets.

• If so, government intervention may just replace market failure with government failure

Taxation and

Public Spending

Taxation

Variety of taxes

• Direct taxes: income tax, corporation tax• Indirect taxes: on expenditure, VAT

Desirable Characteristics of Tax System

• Equity• Efficiency• Administrative simplicity• Cost of ensuring compliance• Responsiveness to changing economic

circumstances

Progressivity of taxation

• Proportional: average tax rate constant • Progressive: average tax rate rises with

income• Regressive: average tax rate falls with

income

We must assess progressiveness carefully: incidence of taxes, benefits, direct provision of goods

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)

Price

Quantity

Supply Curve (with tax)

Supply Curve (net of tax)

Demand

Relative to original equilibrium, gross price goes up but less than tax (i.e., net price goes down)

Tax incidence: who really bears the tax

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

Principles of Optimal Taxation

EFFICIENCYaim to minimise harmful effects on choice

• use lump-sum taxes wherever sensible • if choosing variable taxes, choose tax rates to

minimise distortionRamsey principle: tax rate higher if supply or demand is inelastic

• of course, taxes often help correct other distortions: pollution taxes, and ‘sin’ taxes on cigarettes, alcohol

Principles of Optimal Taxation

EQUITY: Two principles

‘Ability to pay’: take more from the rich

‘Benefits principle’: beneficiaries of public provision to pay more

Vertical equity suggests progressive tax system but this may conflict with efficiency

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

• Public goods: law and order, defence

Public Spending

The big three

• Social security

• Health

• Education

account for 3/5 of all public spending.

We shall study these more carefully

Health care

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?

like cars, houses, etc.

Health Care: the issues

• Is a private market for health care efficient?• Is it equitable? • Is public production and allocation more

efficient? More equitable?

Efficiencymacro: what fraction of GDP on health micro: how to allocate resources within system

Equity: but of what?

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

Why intervene in health care

Would a private health care market be efficient?

1. Imperfections in competition2. Imperfections due to asymmetric information

and insurance3. Externalities and public goods aspects

In addition to efficiency issues

4. equity issues

5. ethical issues

Imperfect competition

Would a private health care market be perfectly competitive?

• monopoly power of medical associations• market power of drug companies

Possible solutions• Regulation• Countervailing power

(say, drug purchases by the NHS)

Imperfect 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• patients' inability to weigh alternatives• high cost of errors

In sum, this is hardly rational consumer choice Solutions: provision of information and

regulation but both are costly Public provision?

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 problems

Can intervene to reduce these problems, but causes other problems.

Social insurance?

Externalities and public good

Problem: Communicable diseases are a negative externality

A solution: to subsidise treatment

In general, the public good aspect of basic healthcare

Other reasons for intervention

• Equity arguments

• Moral and ethical argumentsbabies, organs should not be sold

How to intervene?

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? e.g. health maintenance organisations

Other questions

Macro-economic issue

How much should we spend on health? rising cost of health care

• ageing population• more sophisticated (and expensive) treatment

Health care in the UK: case notes

THE PATIENT: NHS• GPs provide primary care: guide and

gatekeeper• Since 2003, Foundation Trusts, with

financial and managerial autonomy run hospitals

• Primary Care Trusts purchase hospital care, community services

• Strategic Health Authorities to oversee Primary Care Trusts and NHS Trusts

• Department of Health

THE CASE HISTORY

• Universal and virtually free access• Publicly financed• Good health outcome• Cheap: expenditure is 7-8% of GDP, • But rising (up by 70% in real terms 1979-

96, due to bulges in birth rate in post-war period, ageing population & new, costly treatments)

• A recurrent crisis of confidence: queues, alleged inefficiencies

Health Spending, 2001

Spending per head, US$PPP

Spending, per cent of GDP

Australia 2350 8.9%

France 2561 9.5%

Japan 1984 7.6%

Germany 2808 10.7%

UK 1992 7.6%

USA 4887 13.9%

DIAGNOSIS?

Inefficient or under-funded?

If inefficient, why?• skills shortages?• bureaucratic inefficiency?• absence of choice for patients?

If under-funded,• more public money or private resources?

PREVIOUS TREATMENT

1989 White Paper called for an ‘internal market’

invisible hand rather than central control separation of funding from provision:

purchaser can buy from competing providers GP fund-holders to manage own budgets Hospital Trusts, with greater managerial

control and financial autonomyWere the objectives genuine, or just a

response to fiscal crisis?

SWITCHING PROTOCOL

• Prior to 1991, central planning• 1991-97: quasi markets• 1997-2003: move away from markets• 2003-: competition and choice

LONG-TERM CARE

• More public money or is privatisation inevitable?

• Will this create a dual structure, for rich and poor? Implications for life expectancy?

• 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?

Group Work: Education

1. Identify the salient characteristics of education as a commodity. Is it a ‘merit good’?

2. Do you expect private markets for education to be efficient? Identify reasons for any market failures.

3. Private markets for education are likely to be inequitable. Should we worry about this?

4. ‘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.

The Welfare State

Public versus Private Sector

When comparing public with private sector, it is important to remember that

• public sector losses were sometimes intentional

• cost structures differ: Post Office vs private couriers

Are governments less efficient than markets?

Evidence

Private sector firms are 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

Agency theory and incentives

Imagine a project where• the agent's effort affects probability of success• effort is unobservable or hard to measure

If so,• the principal needs to provide incentives

(carrot or stick) to induce effort• without incentives, individuals may slack-off

Lesson: incentives matter

Why is the public sector 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

Why not use better incentive schemes in the public sector?

Mostly because measuring success is harder due multiplicity of objectives and poor information

2. Institutional aspects: what DO civil servants do?

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 civil servants to rent-seeking

behaviour

• Weigh existing inefficiencies against risk of government failure

Supply-side economics

Central idea

Force government OUT of market place, to unleash private sector dynamism.

Use microeconomic incentives to increase productivity

Origins• disenchantment with Keynesian, ‘demand-side’

thinking• tax fatigue of the 1970s

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 curve)

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), encourage privatisation Reform labour market (curb the Trade Unions)

Encourage profit-sharing schemes to incentivise workers. Vocational training, etc.

Evaluation of Supply-side economics

did well on the inflation front tax cuts may not induce more work

Substitution 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). 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

In sum

Implications for efficiency Claims about likely efficiency gains were exaggerated

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)

THE WELFARE STATE

Designed for both equity and efficiency

Equity reduce poverty (insurance) and create a more

equal distribution of wealth not just altruism, also desire for social cohesion

Efficiency provide insurance against risks that market do

not cover well (unemployment, illness) provide social services to correct for market

failures in health, education, housing, pensions

LESSONS OF HISTORY

Dynamics of welfare state provision 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

LESSONS OF HISTORY

Is the welfare state viable? Thatcher's contribution: linking payments to

inflation not earnings Should benefits be targeted or universal?

Cost-Benefit Analysis

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

THE PROCESS

Justify action and set objectives Appraise the options including the ‘do minimum’

and so-called politically infeasible onesIdentify costs and benefits of each option

Adjustmentsnon-market impactsrisk and optimismdistributional impacts

Develop and implement solutions Evaluation

FORMS OF APPRAISAL

Financial Appraisal Compare revenue with costs, as 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 analysisIf benefits are hard to quantify, compare the

costs of achieving some target level of benefits

SOME TECHNICALITIES

TIME PREFERENCEPeople prefer £1 today to £1 tomorrowdemand a premium to postpone consumption

OPPORTUNITY COST OF CAPITAL cost in terms of opportunities foregonerate r at which you borrow

DISCOUNTING AND NET PRESENT VALUE What discount rate should we use?

INFLATION erodes future valueseither all values real or all values nominal

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 RuleONE OPTION: Invest if NPV is positiveMANY OPTIONS: Invest in project with highest NPV

All this is easier said than done

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

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)

Some caveats

Macroeconomic effects• Need not make allowances for broader effects, such

as tax flow-backs, 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.

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 see how costs and benefits affect different

groups

The effect of the chosen discount rate

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

DISCOUNT RATE, r

NPV

R

Choice of too high a discount rate will reject good projects

Choice of too low a discount rate will accept bad ones

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

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.

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

Green Accounting: A Case Study

1985 1986 1987 1988 1989 1990

Children's health 223 600 547 502 453 414Adult blood pressure 1724 5897 5675 5447 5187 4966Other pollutants 0 222 222 224 226 230Maintenance 102 914 859 818 788 767Fuel economy 35 187 170 113 134 139Total benefits 2084 7821 7474 7105 6788 6517-Refining costs -96 -608 -558 -532 -504 -471Net Benefits 1988 7213 6916 6573 6284 6045

Costs and Monetized Benefits of of reducing lead from gasoline, 1983 dollars

Children's health: lead in blood is related to IQ-impairment.Lead causes hypertension and increased heart-attacks: a statistical life was valued at $1 mnLow lead levels reduce other pollutants, economies in fuel & maintenance

Further reading

Begg, Fisher and Dornbush, Economics, 7th edition, PART 3 John Kay, The Truth about Markets: their genius, their limits,

their follies, Allen Lane, 2003 Nicholas Barr, The Economics of the Welfare State, 4th edition,

Oxford University Press, 2004

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 12:health and health-care

chapter 13: housing

MicroeconomicsLevel 2

Sandeep Kapur