Markets, Gov Intervention and Efficiency

Question 1

Pareto Efficiency

Answer 1

Resource allocations that have the property that no one can be made better off without someone being made worse off. Otherwise, Pareto efficiency gains can be made through reallocation.

Question 2

Perfect competition

Answer 2

The market has many firms which are price takers, market sets prices at the equilibrium level where price = marginal cost of production = marginal benefits and demand is perfectly elastic.

Question 3

Imperfect competition

Answer 3

In perfect competition, there are many buyers and sellers, each having an insignificant share of the market and none are strong enough to control or exploit the market. Firms are price-takers which face a horizontal demand curve.

Firm’s demand is the market’s demand so they are price makers and faces a downward-sloping demand. Thus, MR is always lower than the price it charges on that and all the previous units because to sell more units, prices must decrease. To maximise profits, firms set the price where MC = MR. This is because if MC > MR, firms earn losses and will reduce outputs to increase profits. If MR > MC, firms can still produce more and earn more revenue, so they will increase output. Since the price is much higher than the original equilibrium price where demand intersects MC, the output is less than the socially optimal output, there is a welfare loss leading to Pareto inefficiency.

Deadweight loss occurs because consumers who are willing to pay for the good at a price higher than the cost of producing the good are not able to access the good (consumer surplus decreases).

Question 4

Why is Pareto Efficiency only achieved under perfect competition?

Answer 4

Pareto efficient = perfect competition where price = marginal cost

This entails stringent conditions (e.g. exchange, production, product mix efficiency…) and are only met if firm are price takers

Question 5

Explain how efficient allocation is achieved in a free market.

Answer 5

The free market economy allocates resources according to the market forces of demand and supply. Assuming perfect competition and the absence of sources of market failure, the equilibrium quantity where supply equals demand represents the allocatively efficient level of output. This is because the DD curve, which represents consumers’ valuation of the good (maximum prices they are willing and able to pay at any quantity) reflects consumers’ additional utility (MPB) derived from purchasing the last unit of the good. In the pursuit of self-interest, utility-maximising consumers will only consumer an additional unit of the good if the MPB from consumption exceeds the price that they have to pay. Hence they will consume up the point where MPB from consumption equals price at Q0 where consumer surplus is maximised.

On the other hand, the SS curve which reflects producers’ marginal cost of producing the additional unit of corn shows the additional opportunity cost to producers in terms of the resources used* in producing that last unit of the good and the minimum price accepted by producers. In the pursuit of self-interest, profit-maximising producers will produce an additional unit of the good as long as MPC is less than the price they receive from selling the good. Hence they will produce up to the point where MPC equals to price at Q0 and producer surplus is maximised. Hence, allocative efficiency is achieved when the sum of consumers surplus and producer surplus is maximised.

Question 6

First theorem of welfare economics

Answer 6

Competitive markets achieve Pareto efficiency.

Question 7

Second theorem of welfare economics

Answer 7

If the market results a Pareto efficient allocation of resources that is undesirable due to high disparities, the government may intervene to redistribute where we end up achieving Pareto efficiency but with a more equitable distribution.

Question 8

What is required for Pareto Efficiency to be achieved?

Answer 8

Exchange efficiency
Production efficiency
Production mix efficiency

Question 9

Define what is required for Exchange Efficiency to be achieved?

Answer 9

Given the set of goods available in the economy, goods are distributed so nobody can be better of without making somebody worse off.

Condition: All individuals have the same marginal rate of substitution – amount of one commodity that an individual is willing to give up in exchange for a unit of another commodity – between any pair of commodities. Thus, there are no trades or exchanges that would make both parties better off

This is achieved in a competitive market because consumers face the same prices in a competitive economy, they set their marginal rate of substitution equal to the same price ratio, achieving exchange efficiency.

Question 10

Define what is required for Production Efficiency to be achieved?

Answer 10

Given the set of resources, the economy cannot increase the production of one good without reducing the output of some other goods, economy must be operating along its production possibility curve.

Condition: The marginal rate of technical substitution between any two inputs must be the same for all firms.

In a competitive economy, all firms face the same prices, so all firms using labour and land will set their marginal rate of technical substitution equal to the same price ratio.

Question 11

Define what is required for Production Mix Efficiency to be achieved

Answer 11

the optimal combinations of goods should be produced given existing production technology and consumer tastes and preferences

Question 12

Reasons for the lack of competition under imperfect competition

Answer 12

Economies of Scale (EOS): When a firm produces more, the average cost of production declines, allowing a larger firm to gain a competitive advantage over a smaller firm.

Different types of firms: Monopolies, Oligopolies, Monopolistic competition

Natural monopoly: When the fixed cost is so high that a single large firm producing the entire output is more cost efficient than several firms producing parts of it. A market in which the market demand is only large enough to support one large firm operating at or near its minimum efficient scale of production (MES).

Imperfect information: Firms know that they will not lose all its customers even if it raises prices, it faces a downward-sloping demand curve and entails various types of pricing strategies to discourage competition. Non-pricing strategies include advertising and promotion, R&D

Question 13

Sources of market failure

Answer 13

1) Failure of competition/Market dominance
2) Public goods
3) Externalities
4) Incomplete markets
5) information Failures (Imperfect information and asymmetric information)
6) Unemployment, inflation, disequilibrium

Question 14

Explain why failure of competition is a source of market failure

Answer 14

Under perfective competition, a competitive firm takes the price of its output as given by the market and will choose the quantity supplied such that P = MC.

Under imperfect competition, a firm can differentiate their product and thus has a degree of market power which allows them to raise the price of its product without losing all its sales to rivals. In order to maximise profits, firms will produce where MC = MR. This is because when MC<MR, increasing an additional unit of output leads to higher profit so firms will increase output to increase profit. Conversely, when MC>MR, increasing an additional unit of output will incur a loss so firms will reduce output to increase profit.

Since the quantity at which the monopoly produces at at MC = MR is lower than P = MC, it is less than the socially optimal quantity. Since the good is now priced higher than MC, the value that consumers place on the benefits derived from the consumption of that last unit of a good is greater than the cost of using society’s resources to produce that unit. Society will be better off if more units of the good were produced. This leads to a deadweight loss.

Question 15

Explain how incomplete markets are a source of market failure

Answer 15

Incomplete markets occur when private markets fail to provide a good or service even though the COP is less than what individuals are willing to pay

1) Insurance markets:
(a) Undersupply of innovation in insurance policies
(b) Transaction costs incurred when running markets, enforcing contracts, uncertain whether innovation would pay off at all
(c) Information asymmetry in form of adverse selection and moral hazard

2) Complementary markets: When large-scale coordination is not possible between complementary markets to produce the required goods, government intervention is needed.
Ex) Public urban renewal programmes in less-developed countries that require extensive coordination among factories

Question 16

Adverse selection

Answer 16

Adverse selection arises because of the incentive of sellers or buyers to conceal information from the other party involved in the trade, resulting in either the buyer not being able to distinguish between products of different qualities, or the seller not being able to distinguish between consumers of different qualities. This results in low-quality products/High-risk buyers crowding out high-quality products/Low-risk buyers.

(i) Profit-seeking seller knows more about the attributes of the good sold than the buyer. As a result, the buyer runs the risk of being sold a good of low quality (car market and defects). Buyers, knowing the sellers’ tendency to conceal information, would likely offer a lower price for all the vehicles in the market because they cannot tell the good quality cars apart from the bad ones. This low price in turn discourages sellers of higher quality cars to offer their cars for sale in the market. The market ends up adversely selecting against the higher quality products in favour of the lower quality ones. In the long run, this could lead to a ‘missing market’ where the goods will not be provided in the free market, exacerbating the extent of market failure.

(ii) Buyers have more superior information about themselves than the sellers (e.g. Market for insurance) Self-interested, utility-maximising insurance buyers might not divulge accurate and sufficient information about their full-health conditions to insurance companies because any pre-existing health problems may result in higher insurance premiums that they need to pay. They are incentivised to conceal information about their health. Knowing this, insurance companies that are unable to adequately know and monitor the health conditions of those who seek insurance coverage will thus raise the average price of insurance premiums. This, in turn, would discourage healthy individuals to buy insurance because the premium is too high to justify the coverage. As a result, the insurance company would be left with an even-riskier (adverse) pool of insurance buyers because only people with more underlying health conditions would find the high premiums worth paying for. This leads to an under-representation of ‘good consumers’ and an over-representation of ‘bad consumers’. In the long run, this could even lead to a missing market where the goods will not be provided in the free market, exacerbating the extent of market failure.

Question 17

Moral hazard

Answer 17

Situation in which economic agents take greater risks than they normally would after a transaction has taken place. This is because the costs that result from their riskier behaviours would not be solely borne by themselves. This occurs when the party with more superior information in a transaction has both the incentive and the ability to shift costs onto the other party.

In the market for insurance, after the insurance is sold, the insurance company lacks adequate information about whether and how the insured would change their behaviour when they are insured. Individuals who are insured would generally take less care to prevent losses than they would in the absence of insurance. The socially beneficial purpose of insurance is to permit people to share given risks and not to increase the aggregate size of risk. However, moral hazard results in individuals taking more risks than they otherwise would, increasing the social costs and hance misallocation of resources.

Question 18

Explain how information failures (views of opponents and proponents) are a source of market failure

Answer 18

Information failure occurs when there is imperfect information and asymmetric information. This prevents economic agents from consuming or producing at the levels they would otherwise choose if given perfect information.

Imperfect information (merit/demerit goods, persuasive advertising) and asymmetric information (adverse selection and moral hazard)

Opponents argue that it is costly for the government to enforce firms to comply with regulations by disclosing all information, the competitive market also incentivises firms to do so and it might be irrelevant as consumers might not pay attention to the information that the law requires to be disclosed

Proponents argue that information is critical to markets and it is a public good, giving information to one more individual does not reduce the amount others have the only cost is that of information transmission

Question 19

Explain how unemployment, inflation and disequilibrium is a source of market failure

Answer 19

High unemployment is usually regarded as the most dramatic and convincing evidence of market failure.

This may be caused by the immobility of factors of production such as geographical immobility which discourages labour from moving into areas facing shortages of labour, leading to unemployment. Together with occupational immobility ( barriers to moving FOP between sectors of the economy), this causes an under-utilisation of resources and inefficient input-combination, resulting in market failure.

Question 21

Interrelations of market failures

Answer 21

Market failures, or economic inefficiency in the absence of government intervention are not mutually exclusive.

Information asymmetry → incomplete/missing markets → externalities arise (third-parties do not bear the cost of their actions) → provision of public goods (most extreme form of externalities)

Question 22

Reasons for government intervention

Answer 22

1) Income distribution
- Pareto efficiency under competitive markets may lead to an unequal distribution of income and thus, resources.
- The government may engage in welfare activities like food stamps and Medicaid

2) Providing information
- Individuals may not act in their best interest
- Fully informed consumers may fail to recognise what is best for their own welfare such as in the case of smoking or wearing of seatbelts.

3) Provision of merit goods
- Goods that the gov compels individuals to consume

Question 23

Paternalistic view

Answer 23

The view that the government should intervene because it knows what is in the best interest of individuals better than they do themselves.

Distinct and more extreme form of intervention compared to externalities
include taxes VS. bans on cigarettes, drugs

However, it is often difficult to distinguish cases that merit a paternalistic role and those that do not such as in cases of children and social security. State may have basic responsibilities such as ensuring that children receive proper education and are protected from abuse. The paternalistic role of the government may also be imperative to prevent individuals from making poor decisions that will become a burden to society; compelling individuals to take precautionary measures such as saving for retirement or purchasing an earthquake insurance.

Question 24

Libertarianism

Answer 24

The view that government should not interfere with the choices of individuals

Question 25

Normative analysis of the role of the government

Answer 25

2 Must be shown that the actual political processes and bureaucratic structures of a democratic society are capable of correcting the market failure and achieving a pareto improvement

Two qualifications for the government to act:
#1 It must be shown that there is, at least in principle, pareto improvement

Imperfect information, transaction costs and potential consequences need to be considered when government intervenes

Just because gov intervention can achieve Pareto improvements, it does not presume that it is desirable.

The nature of the government may explain government failures.

Question 26

Positive analysis of the role of the government

Answer 26

There is significant difference between a program’s stated objective (to remedy some market failure) and its design
Sometimes government intervention is just done in the name of fixing market failure - this may just be a rhetoric
We have to look at how the programs are designed and implemented, rather than by looking at the stated objectives of the legislation.
These economists think we should focus on what are the practical consequences of particular government intervention and the nature of political process, rather than just the normative analysis