Welfare Economics and the Role of the State: Perfect Markets and Market Failures, Study notes of Forestry

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Welfare Economics & the Role of the State 1 • Concepts related to perfect markets – Consumer surplus, producer surplus, and societal welfare • Markets function well & generate efficient social outcomes only if we have – 1) Perfect competition – 2) Perfect information and foresight – 3) No externalities – 4) Well defined and enforceable property rights Markets and Welfare Economics 2 Market Failures • Definition: Cases where the invisible hand may not lead to the best of all possible outcomes • The invisible hand is a concept introduced by Adam Smith (The Wealth of Nations) which states that in a competitive market, self interest also leads to maximum social benefits. • Examples of market failures: • Imperfect competition • Risk and uncertainty • Externalities • Common Pool Resources • Public Goods 5 Government Intervention • Government intervention is needed to address market failures. • Even if markets function well, they do not ensure distributional equity. • Government intervention, through public policies, is needed. 6 Imperfect Competition • Natural monopoly = Monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could 2 or more firms. • Monopolies arise because of barriers to entry • Monopolies provide less output with fewer inputs than equivalent set of competitive firms. • Marginal Cost = the increase in total cost that arises from an extra unit of production. (Change in total costs / change in quantity produced) • Average Total Cost = Total cost divided by the quantity produced. • Marginal Revenue = Change in total revenue from an additional unit sold 7 Imperfect Competition • With Regulation, the government sets the price. But which price? To maximize total surplus, usually set price at marginal cost. • Problems with price = MC: • MC < AC (characteristic of a natural monopoly). Thus, firm would lose money and fold. • Some solutions (imperfect): • subsidize the monopoly (but requires taxes) • Set the price equal to or higher than AC, but created deadweight in total surplus. • No incentives to reduce costs 10 Risk and Uncertainty • The invisible hand assumes: • Perfect competition • Perfect information • No barriers to reallocation of resources • Risk and uncertainty represent a lack of perfect information • Producers and consumers need information to allocate resources efficiently • How does lack of, asymmetric, information affect resource allocation? • How does the lack of perfect foresight influence resource allocation? 11 Risk and Uncertainty • Risks and uncertainties are unavoidable: some economic decisions will be wrong. •The government has a role to play • Disaster events are unpredictable but events are not independent • Moral hazard • Adverse selection 12 Game Theory • John Forbes Nash • Our game: • Black = 2pts for you, 0 for the other • Red = 0pts for you, 3 for the other 15 Prisoners’ Dilemma Confesses (No cooperation with partner) Refuses to Confess (Cooperation with partner) Confesses (No cooperation with partner) Refuses to Confess (Cooperation with partner) Prisoner A Prisoner B 0 10 0 1 110 5 5 • Dominant Strategy = best strategy for a player regardless of strategy chosen by other players. • Dominant outcome: when both dominant strategies coincide. • Is it pareto optimal? 16 Back to CPR • Two underlying factors problematic in the management of Common Pool Resources: • Open access • Lack of self regulation • Inability to cooperate. • Prisoners’ dilemma shows how rational individual seeking their self interest cause collective harm. • How do we get around open access & prisoners’ dilemma? 17 Public Goods • Jointness or Non rivalry • Good in question can be consumed by more than one at a level that is the same for all • Good in question can be supplied only as an indivisible lump • Difficult to determine the socially optimal price and quantity • Non-excludability • Suppliers have no ability to exclude people from consumption of the good • Undermines the ability of markets to regulate supply and demand for public goods • Creates incentive to hide individual preference to enjoy free- rider problem 20 Public Goods • Examples • Solutions? • The free rider problem 21 Income Distribution • Highly concentrated distribution undermines democratic process • Distributive justice principles • First, justice requires that everyone be guaranteed some minimum entitlement that allows to satisfy basic survival needs • Second, if everyone possesses at least this minimum, it could be considered that fairness is violated if wealth is distributed in a highly unequal manner • Practical problems of distributive justice principles • Minimum entitlement varies from society to society • “Relative deprivation” • Poverty is a relative rather than an absolute 22 0 25 50 75 100 0 20 40 60 80 100 Pe rc en t of in co m e Percent of population Gini Coefficient • Lorenz curve data and graph • Gini calculation • Gini = A/(A+B) • Perfect equality: A= 0, Gini = 0 • Total inequality: B=0, Gini = 1 • Gini ex. from the world • lowest: Denmark (.24) • highest: Namibia (.74) • Most of Europe: .25 - .33 • US: .41 • Bosnia (.26); Ethiopia (.3); Pakistan (.31) • Limitations of Gini Pe rfe ct eq ua lity A B Percent of population Percent of income Lowest 20% 4.8% Second 20% 10.5% Third 20% 16.0% Fourth 20% 23.5% Highest 20% 45.2% 25 Compensation • Policies violate Pareto optimality • Compensation principle can be used to justify policies • Should actual compensation be paid to losers? • Kaldor argues that a policy change satisfies Pareto criterion if it produces enough benefits to compensate the losers while still leaving the winners better off, even if no compensation is actually made 26