Slide 1Economic Efficiency and the Role of GovernmentThe Meaning of EfficiencyPareto ImprovementsSide Payments and Pareto ImprovementsMarkets and Economic EfficiencyReinterpreting the Demand CurveFigure 1: The Marginal Benefit From Guitar LessonsReinterpreting the Supply CurveFigure 2: The Marginal Costs of Guitar LessonsThe Efficient Quantity of a GoodFigure 3: Efficiency In The Market For Guitar LessonsPerfect Competition and EfficiencySlide 14Consumer SurplusFigure 4(a): Consumer Surplus in a Small and Large Market for Guitar LessonsFigure 4(b): Consumer Surplus in a Small and Large Market for Guitar LessonsProducer SurplusFigure 5(a): Producer Surplus From Selling Guitar LessonsFigure 5(b): Producer Surplus From Selling Guitar LessonsTotal Net Benefits in a MarketFigure 6: Total Net Benefits in a Competitive Market for Guitar LessonsPerfect Competition and Efficiency: The Total Benefits ViewA Price CeilingFigure 7(a): Why Price Ceilings and Price Floors Are InefficientFigure 7(b): Why Price Ceilings and Price Floors Are InefficientCalculating the Welfare LossA Price FloorThe Efficiency Role of GovernmentThe Institutional Infrastructure of a Market EconomyFigure 8: Government Infrastructure and Output per WorkerThe Legal System: Criminal LawProperty LawContract LawSlide 35Tort LawAntitrust LawRegulationLaw and Regulation in PerspectiveSlide 40Market FailuresMonopoly and Monopoly PowerFigure 9: The Welfare Loss from MonopolyAnti-trust Law as a RemedyThe Special Case of Natural MonopolyFigure 10: Regulating A Natural MonopolyRegulation of Natural MonopolySlide 48Slide 49Slide 50ExternalitiesThe Private Solution to a Negative ExternalityThe Coase TheoremSlide 54The Free Rider ProblemMarket Externalities and Government SolutionsFigure 11: A Tax on Producers to Correct a Negative ExternalityTaxing a Negative ExternalityRegulation and Tradable PermitsDealing with a Positive ExternalityFigure 12: A Subsidy for Consumers to Correct a Positive ExternalityPublic GoodsFigure 13: Pure Private, Pure Public and Mixed GoodsMixed GoodsExcludable But Nonrivalrous GoodsNonexcludable But Rivalrous GoodsSlide 67Using the Theory: Traffic as a Market FailureSlide 69Lecture by: Jacinto F. FabiosaFall 2005Economic Efficiency and the Role of Government2Economic Efficiency and the Role of Government•Virtually every disagreement about the economy ultimately leads to government–Some disagreements start there as well•All these disagreements tend to obscure a remarkable degree of agreement about the economy, and government’s role in it–Vast majority of goods and services that you buy in stores, over the internet, or obtain in other ways •Are provided by private firms—and almost everyone agrees that’s how it should be•Widespread agreement that certain goods and services should be provided by government–Such as general police protection, the court system, and national defense•Much of this agreement is based on ideas about economic efficiency3The Meaning of Efficiency•What, exactly, does efficiency mean?–Economic efficiency is achieved when there is no way to rearrange the production or allocation of goods in a way that makes one person better off without making anybody else worse off•A limited concept in that–An efficient economy is not necessarily a fair economy•Why do economists put so much stress on efficiency, rather than fairness?–Issues of fairness must be resolved politically•Economics can make a major contribution to our material well being by–Helping us understand the preconditions for economic efficiency, –Teaching us how we can bring about those preconditions4Pareto Improvements•A trade in which both parties are made better off, and no one is harmed•Named after Italian economist, Vilfredo Pareto (1848-1923)–First systematically explored the issue of economic efficiency•Helps us arrive at a formal definition of economic efficiency–Achieved when every possible Pareto improvement is exploited•Alternatively, we can look at the economy as a whole–If we discover remaining Pareto improvements that are not occurring then we would deem the economy economically inefficient•Perfectly competitive markets tend to be economically efficient, and –Well-functioning market economics tend to lie close to the economically efficient end of the spectrum5Side Payments and Pareto Improvements•There are more complicated situations in which a Pareto improvement will come about–Only if one side makes a special kind of payment to the other—called a side payment–Situations in which action will benefit one group and harm another•If an action creates more total benefits for gainers than total harm to losers–Than a side payment exists which—if transferred from gainers to losers—would make the action a Pareto improvement•Important implication for economic efficiency–If there is an action that benefits some more than it harms others, and if an appropriate side payment can be easily arranged•Than not taking the action is a waste of an opportunity to make everyone better off•When a side payment cannot be made—or for any reason is not made—then even of action might create greater gain than harm, it might not be considered fair6Markets and Economic Efficiency•In a market system, firms and consumers are largely free to produce and consume as they wish, without anyone orchestrating the process from above–Can we expect such unsupervised trading to be economically efficient?•Yes—as long as trading takes place in perfectly competitive markets–To demonstrate this, we’ll return to the tools we’ve used to analyze competitive markets•Demand and supply curves•But we’ll look at them in a slightly different way7Reinterpreting the Demand Curve•Figure 1 shows a market demand curve for guitar lessons–Quantity demanded per week at each price•Also indicates who would be taking each lesson•Standard way of thinking about a market demand curve•But we can also view the curve in a different way–Maximum price someone would be willing to pay for each unit of good–Tells us how much that unit is worth to the person who buys it•Each guitar lesson in the market has a different value–In part, this is because consumers differ in their incomes and tastes•But also—for each individual—value of additional lessons declines as more lessons are taken–Height of market demand curve at any quantity shows us value—to someone—of last unit
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