Markets, Efficiency and

the Public Interest

Markets, Efficiency and the Public Interest

Efficiency under
Perfect Competition
EFFICIENCY UNDER PERFECT COMPETITION

• Defining social efficiency

– Pareto improvements

– Pareto optimality

• Private efficiency
– ‘rational’ economic behaviour

– equating marginal benefits and marginal

costs
EFFICIENCY UNDER PERFECT COMPETITION

• Achieving social efficiency under perfect

competition
– efficiency in consumption: MU = P
– efficiency in production: P = MC
Maximum total surplus under perfect competition
£

MC

Pe

D = MU

O
Qe Q
Maximum total surplus under perfect competition
£

MC

Pe
B

D = MU
C
O
Qe Q
EFFICIENCY UNDER PERFECT COMPETITION

• Achieving social efficiency under perfect

competition
– efficiency in consumption: MU = P
– efficiency in production: P = MC
– assumption of no externalities
EFFICIENCY UNDER PERFECT COMPETITION

• Achieving social efficiency under perfect

competition
– efficiency in consumption: MU = P
– efficiency in production: P = MC
– assumption of no externalities
– social efficiency in goods markets:
MSB = MSC
Maximum total surplus under perfect competition
£

MC

Pe
B

D = MU
C
O
Qe Q
EFFICIENCY UNDER PERFECT COMPETITION

• Achieving social efficiency under perfect

competition
– efficiency in consumption: MU = P
– efficiency in production: P = MC
– assumption of no externalities
– social efficiency in goods markets:
MSB = MSC
– social efficiency in factor markets:
MSBf = MSCf
EFFICIENCY UNDER PERFECT COMPETITION

• Achieving social efficiency under perfect

competition
– efficiency in consumption: MU = P
– efficiency in production: P = MC
– assumption of no externalities
– social efficiency in goods markets:
MSB = MSC
– social efficiency in factor markets:
MSBf = MSCf
• Interdependence, efficiency and the
invisible hand
The interdependence of goods and factor markets

FIRMS
(suppliers of goods and services,
demanders of factor services)
HOUSEHOLDS
(demanders of goods and services,
suppliers of factor services)
The interdependence of goods and factor markets

D1 = MU1
= MSBG1
O Q

£ (1) Consumer
demand
The interdependence of goods and factor markets
(2) Producer
supply
£

Goods

P
S = MC
= MSCG

D1 = MU1
= MSBG1
O Q

Goods

£ (1) Consumer
demand
The interdependence of goods and factor markets
(2) Producer
supply
£

Goods

P
S

P1

D1
O Q1 Q

Goods

£ (1) Consumer
demand
 The interdependence of goods and factor markets
(3) Factor (2) Producer
demand £ supply
£

Goods

P P
S

P1

D1 = MRPF1 = MSBF1 D1
O Q O Q1 Q

Goods

£ £ (1) Consumer
demand
 The interdependence of goods and factor markets
(3) Factor (2) Producer
demand £ supply
£

Factor Goods
services
P P
S = MDUF S
= MSCF

P1

D1 = MRPF1 = MSBF1 D1
O Q O Q1 Q

Factor
services Goods

(4) Factor £ £ (1) Consumer

supply demand
 The interdependence of goods and factor markets
(3) Factor (2) Producer
demand £ supply
£

Factor Goods
services
P P
S S

PF1 P1

D1 D1
O QF 1 Q O Q1 Q

Factor
services Goods

(4) Factor £ £ (1) Consumer

supply demand
 The interdependence of goods and factor markets
(3) Factor (2) Producer
demand £ supply
£

Factor Goods
services
P P
S S

P2
PF1 P1 D2 = MU2
= MSBG2

D1 D1
O QF 1 Q O Q1 Q2 Q

Factor
services Goods

(4) Factor £ £ (1) Consumer

supply demand
 The interdependence of goods and factor markets
(3) Factor (2) Producer
demand £ supply
£

Factor Goods
services
P P
S S
PF2
P2
PF1 P1 D2 = MU2
D2 = MRPF2 = MSBG2
= MSBF2
D1 D1
O QF 1 QF 2 Q O Q1 Q2 Q

Factor
services Goods

(4) Factor £ £ (1) Consumer

supply demand
Markets, Efficiency and the Public Interest

Social Efficiency:
Intermediate Analysis
SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS

• Private efficiency in goods markets

– in consumption:
MUX / MUY (MRS) = PX / PY
– in production:
MCX / MCY (MRT) = PX / PY
• Social efficiency in goods markets
– between consumers:
MRSa = MRSb ... = MRSn
– between producers:
MRTg = MRTh ... = MRTn
– in exchange (assuming no externalities):
social MRS = social MRT
SOCIAL EFFICIENCY: INTERMEDIATE ANALYSIS

• Social efficiency in factor markets

• The achievement of general equilibrium
 Social efficiency under perfect competition

Production
possibility curve
Good Y

Slope = MRT
O

Good X
 Social efficiency under perfect competition

Social
indifference curves
Good Y

Slope = MRS

I3
I2
Slope = MRT I1
O

Good X
 Social efficiency under perfect competition

Market price
ratio

MRS = PX / PY = MRT
Good Y

s
Slope = MRS

I3
Slope = PX / PY
I2
Slope = MRT I1
O

Good X
Markets, Efficiency and the Public Interest

The Case for

Government Intervention
CASE FOR GOVERNMENT INTERVENTION

• Externalities
– External costs of production
MSC > MC
 External costs in production
MC = S
Costs and benefits

P D

O Q1

Quantity
 External costs in production
MSC
MC = S
Costs and benefits

P D
External cost

O Q2 Q1
Social optimum
Quantity
CASE FOR GOVERNMENT INTERVENTION

• Externalities
– External costs of production
MSC > MC
– External benefits of production
MSC < MC
 External benefits in production
MC = S
Costs and benefits

P D

O Q1
Quantity
 External benefits in production
MC = S MSC
Costs and benefits

External benefit

P D

O Q1 Q2
Social optimum
Quantity
 External costs and benefits in production

MSC MC = S MC = S MSC

Costs and benefits (£)

Costs and benefits (£)

External benefit

P D P D
External cost

O Q2 Q1 O Q1 Q2
Quantity Quantity

(a ) External costs (b) External benefits

CASE FOR GOVERNMENT INTERVENTION

• Externalities
– External costs of production
MSC > MC
– External benefits of production
MSC < MC
– External costs of consumption
MSB < MB
Costs and benefits External costs in consumption

P D

(MB)
MU = D

O Q1
Quantity
 External costs in consumption

External cost
Costs and benefits

P D

(MB)
MU = D
MSB

O Q2 Q1
Social optimum
Quantity
CASE FOR GOVERNMENT INTERVENTION

• Externalities
– External costs of production
MSC > MC
– External benefits of production
MSC < MC
– External costs of consumption
MSB < MB
– External benefits of consumption
MSB > MB
Costs and benefits External benefits in consumption

P D

(MB)
MU = D

O Q1
Quantity
 External benefits in consumption

External benefit
Costs and benefits

P D
MSB

(MB)
MU = D

O Q1 Q2
Social optimum
Quantity
 External costs and benefits in consumption

Costs and benefits (£)

Costs and benefits (£)

External benefit

External cost
P P P P
MSB

MB MB
MSB

O Q2 Q1 O Q1 Q2

Car miles Rail miles

(a ) External costs (b) External benefits

CASE FOR GOVERNMENT INTERVENTION

• Public goods
– Non-rivalry
– Non-excludability: free-rider problem
• Common resources
– equilibrium use of a common resource
 Fishing in open-access fishing grounds
£

AC = MC

ARP

O Number of boats
MRP
 Fishing in open-access fishing grounds
£

Equilibrium: well beyond

Thethe
collective
optimum optimum
Beyond this point no
for boat owners
more fish can be caught

AC = MC

ARP

O B1 B2 B3 Number of boats
MRP
CASE FOR GOVERNMENT INTERVENTION

• Public goods
– Non-rivalry
– Non-excludability: free-rider problem
• Common resources
– equilibrium use of a common resource
– the tragedy of the commons
CASE FOR GOVERNMENT INTERVENTION

• Public goods
– Non-rivalry
– Non-excludability: free-rider problem
• Common resources
– equilibrium use of a common resource
– the tragedy of the commons
– current-day examples
CASE FOR GOVERNMENT INTERVENTION

• Public goods
– Non-rivalry
– Non-excludability: free-rider problem
• Common resources
– equilibrium use of a common resource
– the tragedy of the commons
– current-day examples
• Market power
CASE FOR GOVERNMENT INTERVENTION

• Public goods
– Non-rivalry
– Non-excludability: free-rider problem
• Common resources
– equilibrium use of a common resource
– the tragedy of the commons
– current-day examples
• Market power
– lack of Pareto optimality
A monopolist producing less than the social optimum
£
MC

P1

MC1
AR
MR
O Q1 Q
Monopoly output
 A monopolist producing less than the social optimum
£
MC = MSC

P1

P2 = MSB
= MSC

MC1
AR = MSB
MR
O Q1 Q2 Q
Monopoly output Perfectly competitive output
CASE FOR GOVERNMENT INTERVENTION

• Public goods
– Non-rivalry
– Non-excludability: free-rider problem
• Common resources
– equilibrium use of a common resource
– the tragedy of the commons
– current-day examples
• Market power
– lack of Pareto optimality
– deadweight loss under monopoly
 Deadweight loss under monopoly
£ MC
(= S under perfect competition)

Consumer
surplus
a
Ppc
Producer
surplus

AR = D
O Qpc Q
(a) Industry equilibrium under perfect competition
 Deadweight loss under monopoly
£ MC
(= S under perfect competition)

Deadweight
Consumer welfare loss
surplus b
Pm

Ppc Producer a
surplus

MR AR = D
O Qpc Qpc Q
(b) Industry equilibrium under monopoly
 Deadweight loss under monopoly
£ MC
(= S under perfect competition)
Perfect
competition

Consumer
surplus
a
Ppc
Producer
surplus

AR = D
O Qpc Q
(a) Industry equilibrium under perfect competition
 Deadweight loss under monopoly
£ MC
(= S under perfect competition)
Monopoly

Deadweight
Consumer welfare loss
surplus b
Pm

Ppc Producer a
surplus

MR AR = D
O Qpc Qpc Q
(b) Industry equilibrium under monopoly
CASE FOR GOVERNMENT INTERVENTION

• Ignorance and uncertainty

• Immobility of factors and time lags
• Protecting people’s interests
– dependants
– merit goods
• Other objectives
• Possible conflict between objectives
• Limitations of economics in assisting
policy making
Markets, Efficiency and the Public Interest

Forms of Government
Intervention
FORMS OF GOVERNMENT INTERVENTION

• The problem of the second best

– the first-best world
– the second-best solution to market
distortions
• Taxes and subsidies
– to correct externalities
• the first-best world
Using taxes to correct a market distortion (“first-best” world)

MC = S
Costs and benefits

P D

O Q1

Quantity
Using taxes to correct a market distortion (“first-best” world)
MSC
MC = S
Costs and benefits

P D
External cost

O Q2 Q1
Social optimum
Quantity
Using taxes to correct a market distortion (“first-best” world)
MSC
MC = S

Optimum tax = MSC – MC

Costs and benefits

P D

MC

O Q2 Q1

Quantity
 Using subsidies to correct a market distortion (“first-best” world)
MC = S
Costs and benefits

P D

O Q1
Quantity
 Using subsidies to correct a market distortion (“first-best” world)
MC = S MSC
Costs and benefits

External benefit

P D

O Q1 Q2
Social optimum
Quantity
 Using subsidies to correct a market distortion (“first-best” world)
MC = S MSC

MC
Costs and benefits

Optimum subsidy
= MC – MSC

P D

O Q1 Q2
Quantity
FORMS OF GOVERNMENT INTERVENTION

• The problem of the second best

– the first-best world
– the second-best solution to market
distortions
• Taxes and subsidies
– to correct externalities
• the first-best world
• second-best tax and subsidy policies
 Using taxes to correct for externalities:
firms with monopoly power
£
MC

Monopoly price
P1 and output

D = MSB
MR
O Q1 Q
 Using taxes to correct for externalities:
firms with monopoly power
£
MSC
MC

P2 Optimum price
P1 and output

D = MSB
MR
O Q2 Q1 Q
 Using taxes to correct for externalities:
firms with monopoly power
£
MSC MC + tax MC

P2 Optimum tax
P1 on the monopoly

Optimum
tax
D = MSB
MR
O Q2 Q1 Q
 Using taxes to correct for externalities:
firms with monopoly power
£
MSC MC + tax MC

P2
P1
Continuing excess profits
can be reduced by a
further lump-sum tax

Optimum
tax
D = MSB
MR
O Q2 Q1 Q
FORMS OF GOVERNMENT INTERVENTION

• The problem of the second best

– the first-best world
– the second-best solution to market
distortions
• Taxes and subsidies
– to correct externalities
• the first-best world
• second-best tax and subsidy policies
– to correct for monopoly
FORMS OF GOVERNMENT INTERVENTION

• The problem of the second best

– the first-best world
– the second-best solution to market
distortions
• Taxes and subsidies
– to correct externalities
• the first-best world
• second-best tax and subsidy policies
– to correct for monopoly
• use of lump-sum taxes plus subsidies
Using a lump-sum tax to reduce monopoly profits
£
MC

P =AR

AR = MSB
MR
O Q1 Q
Using a lump-sum tax to reduce monopoly profits
£
MC

P =AR AC
Profit
(no tax)
AC

AR = MSB
MR
O Q1 Q
 Using a lump-sum tax to reduce monopoly profits
£
1. Acceptable profit
2. Lump sum tax MC
necessary to achieve
acceptable profit

AC + lump-sum tax
P1 AC
1
AC + tax

2
AC

AR = MSB
MR
O Q1 Q
FORMS OF GOVERNMENT INTERVENTION

• The problem of the second best

– the first-best world
– the second-best solution to market
distortions
• Taxes and subsidies
– to correct externalities
• the first-best world
• second-best tax and subsidy policies
– to correct for monopoly
• use of lump-sum taxes plus subsidies
– advantages and disadvantages of taxes and
subsidies
 Deadweight loss from an indirect tax
£

Before-tax
situation S

P1

O Q1 Q
 Deadweight loss from an indirect tax
£

Before-tax
situation S

Consumer
surplus
P1

O Q1 Q
 Deadweight loss from an indirect tax
£

Before-tax
situation S

Consumer
surplus
P1

Producer
surplus
D

O Q1 Q
 Deadweight loss from an indirect tax
£
S + tax

P2

P1

P2 − tax

O Q2 Q1 Q
 Deadweight loss from an indirect tax
£
S + tax

1
P2
2 3
P1
4 5
P2 − tax

6
D

O Q2 Q1 Q
 Deadweight loss from an indirect tax
£
S + tax

1
P2
2 3
P1
4 5
P2 − tax

6
D

O Q2 Q1 Q
 Deadweight loss from an indirect tax
£
S + tax

1
P2
2 3
P1
4 5
P2 − tax

6
D

O Q2 Q1 Q
 Deadweight loss from an indirect tax
£
S + tax
Tax revenue
for government
S

1
P2
2 3
P1
4 5
P2 − tax

6
D

O Q2 Q1 Q
 Deadweight loss from an indirect tax
£
S + tax
Deadweight
loss from tax
S

1
P2
2 3
P1
4 5
P2 − tax

6
D

O Q2 Q1 Q
FORMS OF GOVERNMENT INTERVENTION

• Changes in property rights

– the problem of limited property rights
– extending property rights
– the Coase theorem
– limitations of this solution
• Legal controls
– laws prohibiting behaviour that imposes
external costs
– laws to regulate monopoly power
– laws to prevent firms from exploiting
people’s ignorance
FORMS OF GOVERNMENT INTERVENTION

• Regulatory bodies
• Price controls
– high minimum prices
– low maximum prices
• Provision of information
• The direct provision of goods and services
– providing public goods
– other goods
– making rational decisions
• Public ownership
Markets, Efficiency and the Public Interest

Cost–Benefit Analysis
 COST–BENEFIT ANALYSIS

• The procedure
• Identifying costs and benefits
– costs
• direct private monetary
• external monetary
• external non-monetary
– benefits
• direct private monetary
• private non-monetary
Private non-monetary benefits (consumer surplus)
£

50p

O Q1 Q
Private non-monetary benefits (consumer surplus)
£

Private non-monetary
Consumer benefit
surplus
50p

O Q1 Q
 COST–BENEFIT ANALYSIS

• The procedure
• Identifying costs and benefits
– costs
• direct private monetary
• external monetary
• external non-monetary
– benefits
• direct private monetary
• private non-monetary
• external
 COST–BENEFIT ANALYSIS

• Measuring costs and benefits

– direct private monetary costs and benefits

– non-monetary private benefits

– monetary externalities

– non-monetary externalities

• Risk and uncertainty

– sensitivity analysis
 COST–BENEFIT ANALYSIS

• Discounting
– working out the NPV
– choosing the discount rate

• The distribution of costs and benefits

– the strict Pareto criterion
– the Hicks–Kaldor criterion
– taking specific account of redistributive
consequences
Markets, Efficiency and the Public Interest

The Case for

Laissez-Faire
 THE CASE FOR LAISSEZ-FAIRE

• The growth of libertarian thinking

– the neo-Austrian school and its influence on
radical-right thinking
– libertarian policies of governments
• Drawbacks of government intervention
– shortages and surpluses
– poor information
– bureaucracy and inefficiency
– lack of market incentives
– shifts in government policy
– lack of freedom for the individual
 THE CASE FOR LAISSEZ-FAIRE

• Advantages of the free market

– automatic adjustments

– dynamic advantages of capitalism

– high degree of competition even under

monopoly/oligopoly

• Judging the arguments