In the Name of God
Sharif University of Technology
Graduate School of Management and Economics
Microeconomics (for MBA students)
44111 (1393-94 1st term) - Group 2
Dr. S. Farshad Fatemi
Welfare Economics
Welfare Economics:
• The branch of economics dealing with normative issues.
• Its purpose is not to describe how the economy works;
• but to assess how well it works.
Welfare economics discusses both
• Allocative Efficiency
• Fairness of distribution
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 228
Equity
Horizontal equity: the identical treatment of identical people
Vertical equity: the different treatment of different people in order to
reduce the consequences of their innate differences
Pareto efficiency
An allocation is Pareto-efficient for a given set of consumer tastes,
resources and technology, if it is impossible to move to another allocation
which would make some people better off and nobody worse off.
For example it is Pareto-efficient if the train company price discriminate by
offering student discounts to fill in their otherwise empty seats.
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 229
Perfect competition and Pareto efficiency
If every market in the economy is a perfectly competitive free market,
the resulting equilibrium throughout the economy will be Pareto-efficient.
As expressed in Adam Smith’s notion of the Invisible Hand.
 At any output such as Q1*, the last film
must yield consumers P1* extra utility.
 The supply curve for the competitive
film industry (SS) is the marginal cost of
films.
 Away from P1*, Q1*, there is a
divergence between the marginal cost
and the marginal benefit derived by
consumers; so a move to that position
makes society better off.
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 230
Distortions
A distortion exists whenever society’s marginal cost of producing a
good does not equal society’s marginal benefit from consuming that good.
Some such distortions may be inevitable and it may be more efficient
to spread such distortion over a wide range of markets, rather than
concentrating it in one market this results from the theory of the secondbest
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 231
Market failure
Market failure occurs when equilibrium in free unregulated markets will fail
to achieve an efficient allocation.
• Imperfect competition
• Social priorities (e.g. equity)
• Externalities
• Other missing markets (future goods, risk, information).
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 232
Externalities
An externality arises whenever an individual’s production or consumption
decision directly affects the production or consumption of others other
than through market prices
e.g. a chemical firm discharges waste into a lake & ruins the fishing for fishers
a smoker smokes in a room & creates discomfort for the others
a resident in a street who spends money on a nice front garden &
neighbours also enjoy it
somebody who vaccinates himself against a potentially epidemic disease
& reduces the risk of epidemic for the others as well
a farmer whose cattle create greenhouse gases & increases the possible
risk of global warming
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 233
Marginal benefit versus marginal cost
The demand curve reflects the
marginal benefits.
The supply curve reflects the marginal
cost of producing each loaf.
For each loaf of bread up to Q1, the
marginal benefits exceed the
marginal cost.
The shaded area shows the maximum
welfare that can be gained from the
production of bread.
When the market is at equilibrium (when supply equals demand), all those
benefits will be realized.
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 234
Production Externality / External Costs / Negative Exernality
Ignoring the external costs associated
with the manufacture of paper
products, firms will base their
production and pricing decisions on
S1 (Marginal Private Costs).
If they consider external costs, such as
the cost of pollution, they will
operate on S2 (Marginal Social Cost),
producing Q1.
The shaded area abc shows the
amount by which the marginal cost
of production of Q2 – Q1 units exceeds the marginal benefits to consumers
and the inefficiency of the private market.
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 235
Consumption Externality / External Benefits / Positive Exernality
Ignoring the external benefits of getting flu shots, consumers will base their
purchases on D1 (Marginal Private Benefit) instead of D2 (Social Private
Benefit).
Fewer shots will be purchased than
could be justified economically.
Because the marginal benefit of each
shot between Q1 and Q2 exceeds
its marginal cost of production.
External benefits are not being
realized.
The shaded area abc indicates market
inefficiency.
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 236
The Limits on Government Intervention
Sometimes the distortion resulting from externality effect is negligible. Then
little can be gained by government intervention.
Government Action itself generates an external cost which should be
considered whenever government decides to intervene in a market.
Over the long-run some of the externalities might internalize which
government action may delay or destroy this process.
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 237
Methods of Reducing Externalities (how government should intervene?)
Persuasion / Providing Information
Advertisements to urge people not to litter or to risk forest fires / Not to
drink and drive / To cultivate the land so as to minimize erosion / To
conserve water and gas / publishing studies showing the external costs of
smoking. (Such efforts are limited in their effect)
Assignment of Property Rights
Assignment of land rights to cattle owner in order to eliminate overgrazing
Government Production
Nationalization of schools, public health services, national and state parks,
transportation systems (it might reduce the competition and therefore
reduce efficiency)
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 238
Taxes and Subsidies
Taxing the polluting industries (1. find alternative technologies to pollute less
2. reducing the number of units consumed) / Tax credits for the installation
of pollution controls
Quotas and Standards
Imposing quotas and/or standards on all producers.
Standards / Minimum Quality
Forcing the firms to consider some features in their production (ABS in cars)
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 239
Market for Pollution Rights
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 240
Reducing pollution is costly adds to the costs of production, increasing
product prices and reducing the
quantities of products demanded.
Therefore firms have a demand for the
right to avoid pollution abatement
costs.
The lower the price of such rights,
the greater the quantity of rights that
firms will demand.
If the government fixes the supply of
pollution rights at ten and sells those
ten rights to the highest bidder, the
price of the rights will settle at the intersection of the supply and demand
curves – here, about $1,500.
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 241
Other Missing Markets
Time and risk
under free market uncertainty in the future markets may result underinvestment.
Microeconomics (for MBA students)
Dr. F. Fatemi
Graduate School of Management and Economics – Sharif University of Technology
Page 242