1. Efficiency and Equity
2008/22165

2. A rationing system to deal with the economic problem
Because economic resources are relatively scarce (resources are limited, wants are unlimited) a society can’t have everything they want. There must be a system that rations both resources and products.
The rationing system must answer the following questions:
What, and how much, to produce
How to produce
For whom to produce
Efficiency and Equity (c) Andrew Tibbitt 2008

3. Tests for a rationing system
The two basic tests for any rationing system are:
Is the system efficient?
Is it fair?
Efficiency and Equity (c) Andrew Tibbitt 2008

4. Efficiency and equity
Efficiency – is the economy getting the most of out its scarce resources (or are they being wasted)?
Technical efficiency – is production being done at lowest unit cost?
Allocative efficiency – are resources being used to make products that people want?
Equity – how fair is the distribution of products between different members of society?
Horizontal equity – no discrimination between people whose economic characteristics and performance are equal
Vertical equity – different treatment of different people in order to reduce the differences between people
Efficiency and Equity (c) Andrew Tibbitt 2008

5. Different rationing systems
The world’s dominant rationing system is the price mechanism.
Prices are determined in markets (as a result of the interplay of demand and supply).
Given the correct economic conditions, advocates of market economies believe they lead to the best allocation of resources and the highest level of net economic welfare.
Efficiency and Equity (c) Andrew Tibbitt 2008

6. Different rationing systems
But markets are not the only way to resolve
what and how much to produce,
how to produce, and
for whom to produce
How else can economic activity be co-ordinated?
How can the necessary economic choices be made and on what grounds?
Will the resulting pattern of production, distribution and consumption be efficient?
Will it be fair?
Efficiency and Equity (c) Andrew Tibbitt 2008

7. Some options Ballot (lanes in Melbourne Cup)
Central directives (in Cuba, North Korea)
Allocate to members (finals tickets, some wine vintages)
Rules and regulations (water restrictions by street number)
Queues – first come first served (public hospitals)
Priority allocation (AFL draft)
Merit – university selection
Efficiency and Equity (c) Andrew Tibbitt 2008

8. The world’s dominant rationing system.
It has already be said that the world’s dominant rationing system is the price mechanism.
The circular flow of income model illustrates some of the markets that operate in the economy.
Efficiency and Equity (c) Andrew Tibbitt 2008

9. Markets in the circular flow
Consumption = demand
Goods and services = supply
HOUSEHOLDS
PRODUCERS
Supply
Demand
Quantity
Price
Efficiency and Equity (c) Andrew Tibbitt 2008

10. Markets in the circular flow
Supply
Demand
Quantity
Price
HOUSEHOLDS
PRODUCERS
Resources (e.g. labour) = supply
Demand for resources = demand
Efficiency and Equity (c) Andrew Tibbitt 2008

11. The super-computer network
In a competitive free market economy the market for each product and economic resource is connected to the market for all other products and resources through an ultra-complex network of prices.
This network operates ‘invisibly’ as if driven by a giant free-market super-computer.
What is the operating system for this free-market super-computer?
Efficiency and Equity (c) Andrew Tibbitt 2008

12. Prices as a signalling mechanism
The free-market super computer operates through an ultra-complex network of prices. The prices provide a messaging or signalling service for producers and consumers in the economy.
Normally, a rise in price reflects an increase in relative scarcity. The higher price signals
Consumers to reassess their buying choices (are they still getting value for money – some will buy less)
Producers to reassess their production choices (could they increase profits by supplying more?)
Efficiency and Equity (c) Andrew Tibbitt 2008

13. Prices as a signalling mechanism
The system only works if consumers and producers
get the right message
make a rational choices when they act on the message
Prices send the right message given the right economic circumstances. The right circumstances create ‘a truthful world’ where the demand curve reflects value or benefit and the supply curve reflects costs.
Efficiency and Equity (c) Andrew Tibbitt 2008

14. The correct economic conditions
What are the correct economic conditions that allow markets to maximise welfare?
No information gaps / no asymmetrical information
No side-effects (externalities) / no effect on bystanders
No monopoly (or scarcity power)
Good motives and incentives
No free riders or non-exclusion products
Efficiency and Equity (c) Andrew Tibbitt 2008

15. Given the right conditions markets maximise welfare.
In these economic conditions:
Price = marginal social benefit
Price = marginal social cost
Consumers get what they want
Producers don’t waste resources
If these conditions do not exist the market becomes distorted (price does not reflect value and cost). Demand and supply curves are in the wrong place. Welfare is reduced. There is a deadweight loss.
Efficiency and Equity (c) Andrew Tibbitt 2008

16. Markets increase trade and trade increases welfare
Consumers only buy things if the value of the product to them is equal or greater than their opportunity cost.
So, people that buy something in a market at the ruling price are getting a bonus – the value they receive is greater than the price they pay.
This bonus is called consumer surplus. It increases their welfare or satisfaction.
Price
Consumer surplus
Supply
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

17. Markets increase trade and trade increases welfare
Producers only supply things if the price they can get is equal or greater than the cost of production.
Efficient producers can supply for less than the clearance price.
When a sale is made they get a bonus – the money they receive is greater than their costs of production.
This bonus is called producer surplus. It increases their welfare or profit.
Price
Supply
Producer surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

18. Trade increases welfare
The sum of consumer and producer surplus indicates the total increase in welfare from this market.
So markets create trade and trade increases welfare.
Price
Consumer surplus
Supply
Producer surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

19. The world of truth This is only good if the world of truth exists
Competitive markets create a WORLD OF TRUTH.
The demand curve is a true indicator of the value of the product to consumers.
The supply curve is a true indicator of the cost of production for producers.
Price
Consumer surplus
Supply
Producer surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

20. The world of truth
Competitive markets are, therefore efficient because:
consumers get what they want
producers make the right things in the right quantities.
Price
Consumer surplus
Supply
Producer surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

21. Welfare is maximised at the clearance price.
People will opt out of trading if they are going to reduce their welfare. They will lose if cost is greater than benefit.
Trade increases consumer and producer welfare up to quantity Q1. If the aim is to maximise benefits and profits trade should rise to Q1.
Price
Supply
Cost greater than benefit – trade stops at Q1 P1
Demand Q1
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

22. The world of truth
If the market clearance price is not charged welfare falls.
If a price is set below the clearance price producers reduce supply (to Q2).
There is excess demand.
Producer surplus is low (the orange area).
The consumers who can get the product get a big bonus (the red area), but some potential buyers go without.
Price
Consumer surplus
Supply
Deadweight loss
Producer surplus
Demand
Quantity Q2
Efficiency and Equity (c) Andrew Tibbitt 2008

23. The world of truth
If the market clearance price is not charged welfare falls.
If a price is set above the clearance price consumers reduce demand.
There is excess supply.
Consumer surplus is low (the red area).
Producers who make a sale get a big bonus (the orange area), but some production is left unsold.
Price
Consumer surplus
Supply
Deadweight loss
Producer surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

24. Applying the concept to international trade
It is easy to show that overall welfare rises if trade between countries is increased.
Exporters can get higher prices for their products (we are more efficient than the overseas country) and sell more. Some supply is diverted from domestic sales so consumers lose out.
However, overall welfare increases .
Price
Consumer surplus
Domestic Supply
Overseas supply
RISE IN WELFARE
Producer surplus
Domestic Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

25. Applying the concept to international trade
It is easy to show that overall welfare rises if trade between countries is increased.
Consumers can buy goods at cheaper prices (we are less efficient than the overseas country). Our producers lose out as competition from imports increases.
However, overall welfare increases.
Price
Consumer surplus
Domestic Supply
RISE IN WELFARE
Overseas supply
Producer surplus
Domestic Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

26. Applying the concept to international trade
Taken together more exports and more imports lead to higher welfare.
There has been a redistribution effect though, some producers gain, some lose, consumers gain if they buy some products and lose if they buy others. Is this fair?
Price
Domestic Supply
RISE IN WELFARE
Overseas supply
Domestic Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

27. Market failure
Markets sometimes fail to produce efficient results because the necessary conditions do not exist.
They fail, for example when :
1. Externalities are not taken into account (and bystanders suffer collateral damage)
2. Producers have scarcity or monopoly power (and they dominate the market, raise prices and earn excessive profits
3. Key information is not known or shared evenly
4. Income distribution is unfair.
Efficiency and Equity (c) Andrew Tibbitt 2008

28. When there are externalities
Bystanders (third parties) can be affected by economic decisions made by others. These spin-off or side effects of an economic decision are called externalities.
Bystanders can be affected in a good or positive way (e.g. your neighbour has nice garden). These positive externalities create social benefits.
Bystanders can be harmed or affected in a negative way (e.g. people become sick from factory pollution). These negative externalities create social costs.
Efficiency and Equity (c) Andrew Tibbitt 2008

29. Ignoring externalities leads to inefficiency
S total
Air travel
Price
If market players do not take these negative externalities or social costs into account (do not include them in their demand and supply decisions) the market will not work efficiently.
Too much will be produced and consumers will pay too low a price.
S airlines
Social cost of 5% of climate change D
Quantity
Greenhouse Gases are emitted by planes. So do free markets create too many flights at too low a price?
Efficiency and Equity (c) Andrew Tibbitt 2008

30. Ignoring externalities leads to inefficiency
S private
Public transport
Price
In a similar way, if market players do not take positive externalities or social benefits into account (do not include them in their demand and supply decisions) the market will not work efficiently.
Too little will be supplied and consumers will pay too high a price.
S total
Social benefit of less congestion D
Quantity
Free market public transport could be too expensive if it forces people to use their cars and cause congestion
Efficiency and Equity (c) Andrew Tibbitt 2008

31. Scarcity or monopoly power
If one of the players in a market has power over the other then the market outcome becomes distorted and the result can be inefficient. If a producer has monopoly power in a sense they have scarcity power.
Monopoly power comes from a lack of competition.
Producers can deliberately minimise competition (e.g. by branding, innovation, take overs). Producers with monopoly power can restrict supply or push up prices. The price no longer reflects the costs of production.
Efficiency and Equity (c) Andrew Tibbitt 2008

32. Monopolists restrict supply and push up prices.
Monopolists have the power to control supply in the market. This can lead to prices that are higher than those set in competitive markets.
The result is inefficiency.
New Supply
(monopoly)
Consumer surplus
Price
Supply
(competitive)
Deadweight loss
Producer surplus
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

33. Information gaps
Competitive free markets only produce efficient outcomes if
Demand curves reflect the true level of consumer value or marginal benefit
Supply curves reflect true costs of production (the opportunity of using the resource inputs)
If producers don’t know the cost of production (like insurance companies) and consumers don’t know the value of the product they are buying (like health care and second hand cars) then the market can’t operate efficiently.
Efficiency and Equity (c) Andrew Tibbitt 2008

34. Other problems for the market economy
Income distribution
Demand curves reflect effective demand.
Effective demand exists if a need or want can be backed up by the ability to pay for it.
If income distribution is unfair (lacks equity) the pattern of effective demand will be unfair.
Efficiency and Equity (c) Andrew Tibbitt 2008

35. Other problems for the market economy
Public and collective goods
Products
that are non-rival products (one person using the good doesn’t prevent another for using it as well)
where the exclusion principle does not operate (the supplier or owner can’t prevent non-payers or free-riders from using the product)
where individual demand is unrealistic (such as national defence)
will not be efficiently produced in a free market economy.
Efficiency and Equity (c) Andrew Tibbitt 2008

36. Modified market economies
As a result of market failure, nearly all economies are not pure free market economies but mixed economies.
Government’s modify markets or override the market altogether by influencing:
the allocation of resources (e.g. through taxes, subsidies, or directives) – allocative role
business behaviour (e.g. through regulations and legislation) – regulatory role
the distribution of household incomes (e.g. through taxation and welfare) – redistribution role
the overall level of aggregate demand (e.g. through fiscal and monetary policy) – demand management role
Efficiency and Equity (c) Andrew Tibbitt 2008

37. Government modifications
Policy measures to fix up or prevent market failure include:
Taxing bad behaviour, taxing high income earners
Subsidising good behaviour, paying welfare to low income earners.
Regulating or legislating against bad behaviour
Regulating or legislating good behaviour
Establishing markets to trade ‘permits to behave badly’
Efficiency and Equity (c) Andrew Tibbitt 2008

38. Government failure
In some situations government intervention does prevent or fix up market failure. But overall central planning does not provide a more efficient and fairer rationing system. Government run economies suffer from:
Bureaucratic and cumbersome allocation processes
Moral hazard
Rent seeking behaviour (corruption)
Lack of incentive – bottomless pots, feather bedding, no competition
Lack of consumer freedom or sovereignty
The trick is to intervene only when necessary.
Efficiency and Equity (c) Andrew Tibbitt 2008

39. Taxing a competitive market reduces net economic welfare.
Taxing a competitive market reduces welfare.
Supply with tax
Price
Supply without tax
REDUCTION IN NET WELFARE = DEADWEIGHT LOSS
Demand
Quantity
Efficiency and Equity (c) Andrew Tibbitt 2008

40. A difference of emphasis
When to intervene and modify a market is a matter of judgement for governments. Economists can use the concepts of consumer surplus, producer surplus and net economic welfare to inform the policy debate.
LEFT
Responsibilities
Entitlements
Equity
Market failure
Government intervention
RIGHT
Rights
Choice
Efficiency
Incentives
Government failure
Efficiency and Equity (c) Andrew Tibbitt 2008