1. Microeconomics Level 2 Module 3
Sandeep Kapur

2. Welfare Economics Efficiency and Equity
When do markets work well?
Why markets do not work well?
Implications for public policy

3. EQUITY
How fair is the distribution of goods and services?
A pure value judgement
Horizontal equity: equal treatment of equals
Vertical equity: different treatment of different people to reduce effects of inequality

4. Allocation: a description of who gets what
Starting from A: B is better and C worse (people prefer more to less)
Is D better than A?
What about E or F relative to A?

5. Pareto Efficiency
An allocation is Pareto efficient (given tastes, resources, & technology) if it is impossible to find another allocation that makes someone better off and nobody worse off.
Note that the ranking is incomplete, and
there are infinitely many Pareto efficient allocations
ISSUE: Does society end up at a Pareto efficient allocation?

6. 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 make consumers better off!

7. 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 profit (or loss) for the consumers
PUNCH LINE: Competitive equilibrium is Pareto efficient
The Invisible Hand Theorem!

8. AN IDEA Confine government intervention to redistribution
Rely on markets to achieve efficiency
But what if markets fail to be efficient?
Market Failure : any circumstance in which equilibrium in free, unregulated markets FAILS to achieve an efficient allocation

9. Sources of Market Failure
Tax distortions
Externalities
Public goods
Imperfect information
Imperfect competition
We will look at these in turn

10. 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
(Pareto) efficiency considerations?
a desire for greater equity?
something else?
Income tax
Taxation of petrol
Windfall tax on utilities
Regulating electricity prices

11. …Group Work Regulating discharge of sewage in the Thames
Legislation against insider trading
Banning the use of cocaine
Unemployment insurance
Making primary school compulsory
Maintaining an army
Running the NHS
Running the Post Office
Is there a trade-off between equity and efficiency?

12. MARKET FAILURE: Taxation
Suppose we have a tax only on films
This tax wedge implies, for last film
post-tax price exceeds producer's gain
consumers’ value exceeds producer's value
Implications for meals industry
Marginal private cost of meals below their marginal soc cost
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

13. 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 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

14. MARKET FAILURE: Externalities
EXTERNALITY
an individual's production or consumption affects others' utility or productivity
the effect is direct (and not through the market or prices)
Beneficial consumption externality: house-painting
Adverse consumption externality: smoking
Beneficial production externality: Channel Tunnel
Adverse production externality: pollution

15. 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

16. 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*, which results in dead-weight burden EFG
SOLUTION 1 (Pigou). Corrective taxation

17. 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
Efficient quantity is Q*

18. MARKET FAILURE: Public Goods
Consumed in the same quantity by everybody
Examples: defence, safe streets
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

19. 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 not need to produce it itself

20. MARKET FAILURE: Missing Markets
Imperfections in information. Often there is asymmetry of information between buyers and sellers
This causes problems, especially in insurance markets
Adverse selection and Moral hazard
Insurance markets also vulnerable to other problems
All this may result in ‘missing’ or ‘incomplete’ markets

21. MARKET FAILURE: Monopoly
With market power, price exceeds marginal cost (so social marginal benefit exceeds social marginal cost), leading to Pareto inefficiency. Importantly, restriction of output is costly
Other inefficiencies: resources wasted in securing monopoly power (lobbying or ‘rent-seeking’), and maintaining it (excessive capacity, etc)
Equity : political power of large companies

22. MONOPOLY: other issues
Natural monopolies Very severe economies of scale so socially desirable to have one producer rather than duplicate fixed costs. (First-best solution: set price = marginal cost, but this causes losses)
Any benefits of monopoly?
economies of scale
dynamic efficiency: higher R&D
better coordination of decisions

23. MONOPOLY: Solutions
Solution 1. Nationalize and finance losses through taxes (politically not very feasible)
Solution 2. Break monopoly (anti-trust legislation in US)
Problem: lose benefits as well, no good for natural monopolies
Solution 3. Regulate. Prevent abuse of monopoly power through price and non-price controls (UK approach)
Solution 4. Nurture competition. Encourage new entrants, (but will they enter and will it only lead to cream skimming?)
In general, difficulties with the remedies themselves

24. Regulation Is regulation really necessary?
Not if monopoly power is restrained by
foreign competition
potential domestic competition : ‘contestability’
Inter-modal competition: Eurostar vs airlines
Types of price regulation
Marginal cost pricing
Average cost pricing
Two-part tariffs: fixed sum for access plus marginal cost

25. Group Work: Pollution
Your are the National River Regulator, tackling the problem of a chemical company that is polluting the river Thames
If everything could be quantified and valued, show in a diagram how a pollution tax can induce the chemical firm to behave in a socially efficient manner.
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?
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 a quota?
Lastly, suppose there are two chemical firms discharging into the river. Is it better to
set a pollution tax (same rate per unit polluted for both firms)
set each a quota?
auction pollution quotas?

26. INDUSTRIAL POLICY
Central idea: market failure calls for an active role for the government
Research & Development
R&D accounts for 2-3% of GDP in Western Europe, US and Japan
PROBLEM: Inventions are a public good. Without intervention, too few inventions will emerge

27. Three solutions for the R&D problem
Patents: confer time-bound legal monopoly on the inventor
Optimal patent duration
too short: not enough incentive to invent
too long: long-lived monopoly power
Procurement: use of government research labs. E.g. defence
Patronage subsidies to universities

28. Other things that governments can do
Assist diffusion of new technologies
Coordinate selection of industrial standards
Lock-in: the economics of QWERTY
VHS or Betamax
The coordination role of government
New lessons in economic geography
Location externalities

29. Other things that governments can do
Sunrise industries
Imperfection in markets for loans to new firms
Deficient incentives to acquire skills
Sunset industries
managing the transition: prevent survival of an inefficiently large number of firms
Other reasons for intervention
pool risks across many projects
spread risks thinly across population
However, the possibility of government failure

30. Taxation and Public Spending

31. Taxation Variety of taxes Direct taxes: income tax, corporation tax
Indirect taxes: on expenditure, VAT
Effect on choice
Lump sum tax (eg poll tax) do not distort choice; variable taxes do
Progressivity of taxes
Proportional: average tax rate constant
Progressive: average tax rate rises with income
Regressive: average tax rate falls with income

32. Taxation Principles of fair taxation
Ability to pay: take more from the rich
Benefits principle: beneficiaries of public provision to pay more
Desirable Characteristics of Tax System
Efficiency
Equity
Administrative simplicity
Cost of ensuring compliance
Responsiveness to changed economic circumstances

33. 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)
Relative to original equilibrium, gross price goes up but less than tax (i.e., net price goes down)
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

34. Principles of Optimal Taxation
EFFICIENCY
use lump-sum taxes wherever sensible
choose tax rates to minimise distortion
Ramsey principle: tax rate higher if supply or demand is inelastic
taxes could even help correct distortions, externalities: ‘sin’ taxes on cigarettes, alcohol
EQUITY
Vertical equity suggests progressive tax system
but this may conflict with efficiency
and we must assess progressiveness carefully: incidence of taxes, benefits, direct provision

35. 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
The big three - social security, health, education - account for 3/5 of spending
Public goods: law and order, defence

36. Health care

37. 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?: cars, housing etc.
The issues
Is a private market for health care efficient?
Is it equitable?
Is public production and allocation more efficient? More equitable?

38. 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
Efficiency
macro: what fraction of GDP on health
micro: how to allocate resources within system
Equity:
but of what?

39. WHY INTERVENE IN HEALTH-CARE?
Would a private health care market be efficient?
Is competition perfect? Monopoly power of medical associations and drug companies
Imperfections due to asymmetric information and insurance: some missing markets
Externalities
In addition to efficiency issues,
equity issues
ethical issues

40. Asymmetric 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
high cost of errors
patients' inability to weigh product against alternatives
In sum: this is hardly rational consumer choice
Solution: provision of information and regulation but both are costly
Public provision?

41. 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/chronic problems
    Can intervene to reduce these problems, but causes other problems.
Social insurance?

42. Other reasons for intervention
Externalities and scale economies
communicable diseases
economies of scale
Other reasons for public intervention
Equity arguments
Moral and ethical arguments
babies, organs should not be sold

43. How to intervene? Target: to maximise equity and efficiency
macro: how much should we spend on health? rising cost of health care, ageing population, more sophisticated (and expensive) treatments
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? eg health maintenance organisations

44. Health care in the UK: case notes
THE PATIENT: NHS
Department of Health
Regional Health Authorities oversee District Health Authorities
Family Health Services: GPs, dentists, etc.
Hospital Trusts, with financial and managerial autonomy can borrow, hire and fire

45. THE CASE HISTORY Universal and virtually free access Publicly financed
Good health outcome
Cheap: expenditure 6-7% of GDP,
But rising (up by 70% in real terms , bulges in birth rate in post-war period, ageing population & new, costly treatments)
A crisis of confidence: queues, alleged inefficiencies

46. DIAGNOSIS?
Inefficient or underfunded?
If inefficient, why?
lack of incentives
absence of choice for patients
skills shortages?
If underfunded,
more public money
private resources

47. TREATMENT 1989 White Paper: create an ‘internal market’
invisible hand rather than central control
separation of funding from provision: purchaser can buy from competing providers
GP fundholders: manage budgets to minimise own cost
Hospital Trusts, with greater managerial control and financial autonomy
More recently, Foundation Trusts

48. PROGNOSIS Did the internal market work?
Were objectives genuine, or just a response to fiscal crisis?
Market structure: choice or monopoly?
Dual structure: rich vs the poor? Implications for life expectancy?
Speed of reform: intergenerational equity?
What reforms would you propose?

49. THE FUTURE?
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?
Is there growing privatisation of the NHS?
What will Foundation Trusts achieve?

50. Group Work: Education
1 Identify the salient characteristics of education as a commodity. Do you consider it a ‘merit good’?
2 Do you expect private markets for education to be efficient? Identify reasons for any market failures.
3 Do you expect private markets for education to be equitable?
4 Should the government intervene? How? Does intervention create any problems?
5 ‘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.

51. The Welfare State

52. Moral hazard in insurance markets
If your bike is fully insured against theft, you have no incentive to be careful (to lock it)
if you lose the bike, insurance company bears the loss
increased carelessness increases risk of loss: this is called moral hazard
A solution
Insurance company forces you to bear some cost, to maintain some incentive to be careful: coinsurance Eg: excess payments, no-claim discounts etc.
What is the optimal risk-sharing arrangement?

53. Principal-agent theory
Imagine that
an agent's effort affects probability of success for principal’s project
that effort is unobservable or hard to measure
If so,
the principal needs to provide incentives (carrot or stick) to induce effort
without incentives, individuals will just slack-off
Once again, the issue of optimal risk sharing.
Lesson: incentives matter

54. Is the government less efficient?
Remember
public sector losses: sometimes intentional
cost structures differ: Post office vs private couriers
Evidence
private sector firms 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

55. Why is the government 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 no high financial rewards, but not much punishment either
Why not use better incentive schemes in the public sector?
In part, because measuring success is harder due multiplicity of of objectives and poor information
2. Institutional aspects: what DO bureaucrats do?

56. 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 governments to rent-seeking behaviour
Weigh existing inefficiencies against risk of government failure
Incentives are important: prospect of high reward may be ESSENTIAL to spur people into action

57. Supply-side economics
Central idea
Force government OUT of market place, to unleash private sector dynamism.
Use microeconomic incentives to increase productivity
Intellectual origins
disenchantment with Keynesian, ‘demand-side’ thinking
tax fatigue of the 1970s
anti-government

58. 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)
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, privatisation), allowing private sector to expand
Reform labour market, curb the Trade Unions. Encourage profit-sharing schemes to incentivise workers. Flexible markets encourage growth
Vocational training, etc.

59. 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 troubles US government found it easier to reduce public investment but not current expenditure (wages of civil servants, etc). 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

60. In sum Implications for efficiency
Claims about likely efficiency gains were exaggerated
‘there is nothing wrong with supply-side economics that division by 10 cannot cure.’ (Charles Schultze)
not much support even from arch-priests of right-wing economics, but right idea at the right time
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)

61. THE WELFARE STATE Designed for both equity and efficiency Equity
reduce poverty (insurance)
more equal distribution of wealth
not just altruism, also desire for social cohesion
Efficiency
provide insurance against risks that private market do not cover well (unemployment, illness)
provide social services to correct for market failures in areas of health, education, housing, pensions, training

62. LESSONS OF HISTORY Economic sense vs electoral politics
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

63. LESSONS OF HISTORY
Thatcher's contribution: linking payments to inflation not earnings
Efficiency: What matters is the size of market failures against the size of possible government failures. Otherwise the welfare state just translates market failure into government failure.
Equity?

64. Cost-Benefit Analysis

65. 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

66. THE PROCESS Justify action and set objectives
Appraise the options including the ‘do minimum’ and so-called politically infeasible ones
Identify and value costs and benefits of each option
Adjustments
non-market impacts
risk and optimism
distributional impacts
relative price movements
tax implications
Develop and implement solutions
Evaluation

67. FORMS OF APPRAISAL Financial Appraisal (Social) Cost-benefit analysis
Compare revenue with costs, as a 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 analysis
If benefits are hard to quantify, compare the costs of achieving some target level of benefits
Example
Is is profitable for a firm to build the Channel Tunnel Rail Link?
Should it be built when we include the larger benefits and costs to society?

68. SOME TECHNICALITIES TIME PREFERENCE OPPORTUNITY COST OF CAPITAL
People prefer £1 today to £1 tomorrow
demand a premium to postpone consumption
OPPORTUNITY COST OF CAPITAL
cost in terms of opportunities foregone
rate r at which you borrow
DISCOUNTING AND NET PRESENT VALUE
What discount rate should we use?
INFLATION erodes future values
either all values real or all values nominal

69. 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 Rule
ONE OPTION: Invest if NPV is positive
MANY OPTIONS: Invest in project with highest NPV
All this is easier said than done

70. 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

71. 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)

72. Some caveats
‘Additionality’ Need not make allowances for broader effects, such as tax flowbacks, 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.

73. 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

74. The Effect of the chosen discount rate
Consider stream of positive returns: NPV falls as we use a higher discount rate
Choice of too high a discount rate will reject good projects
Choice of too low a discount rate will accept bad ones

75. 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.

76. 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

77. 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: how costs and benefits affect different groups
Tax impact, relative price movements

78. Green Accounting: A Case Study

79. Further reading
Begg, Fisher and Dornbush, Economics, 7th edition, PART 3
Nicholas Barr, The Economics of the Welfare State, third edition, Oxford University Press, 1998
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

80. Sandeep Kapur Birkbeck College London
Microeconomics Level 2
Sandeep Kapur
Birkbeck College London