1.1.1
Reasons Why Markets Fail to Achieve Efficiency
• The efficiency of outcomes in markets required one important assumption:
that they are competitive
— In a competitive market, no individual producer (or consumer) has an
effect on the equilibrium price
— In a monopolized market, however, the monopolist sets the price (and
quantity follows from the demand curve)
— Instead of taking the price as given and selling a quantity such that
P = M C (Q), the monopolist maximizes profits by selecting instead
P = M R (Q), where MR (Q) is marginal revenue (Figure 1.7)
• When considering to sell an extra unity, the monopolist takes into account
the fact that, for that extra unit to be bought, the price must decline
— In turn, this reduces the price of all preceding units and, consequently,
the profit per unit (even before considering whether or not the marginal
cost of the last unit exceeded that of previous ones)
— As a consequence, the monopolist selects a higher price and lower
quantity than under competitive conditions
• This leads to an efficiency loss: consumers would be willing to buy more
units of output at a lower price
— The price would still exceed the marginal cost of production
— Yet, the associated profits for the monopolist would be lower and thus
he does not want that outcome
• Thus, one area where governmental intervention can be justified is the
control of competitive conditions
— Typically, the monitoring of whether or not some agents (usually producers) undertake noncompetitive practices (such as collusion with
other producers, for example) is performed by an antitrust agency
• Monopolies have another downside as well: monopolists can compromise
economic freedom
— A sole buyer (or a sole seller) may refuse to buy (or sell)
— Anonymity in a competitive market ensures economic freedom to buy
or sell
• Monopolistic or other noncompetitive practices are instances where governmental action might be necessary
— However, out focus is on situations where competitive markets still fail
to achieve efficiency
• Next, we list some reasons why competitive markets mail fail to be efficient:
— Public goods — These are goods that provide benefits to a group of
people simultaneously
Unlike hamburgers (only one person benefits from eating it), these
goods are simultaneously beneficial to a group of people (e.g. national
defense)
When people cannot be excluded from the benefits of public goods,
there is an incentive in not paying for them as well
This generally leads to inefficient provision of public goods; they are
thus a source of market failure
— Asymmetric information
So far, we have not considered asymmetries of information
Information is asymmetric when market participants have information
about themselves that others cannot know (for example regarding the
quality of a car on sale in the used car market)
In the context of social justice, asymmetric information will arise in
insurance markets
People facing income uncertainty (all of us!) would want insurance
against future negative income shocks
When future income depends on personal effort — unobservable to others — insurance companies do not wish to sell insurance against negative
income shocks:
Insurers are unable to determine if the people were lazy or truly had
bad luck
Asymmetries of information may cause the insurance market for personal income not to exist, leaving a role for governments to fulfil
• There are other reasons why efficiency may fail, but we will not be concerned with them:
— Externalities — the actions of one individual/firm affect the costs or
benefits of others
Examples include smoking and pollution
— Natural monopoly — a situation where competing suppliers would wastefully duplicate fixed costs
It would be inefficient to have more than one producer
The Prima Facie Case for the Market
• We will consider in detail instances where competitive markets fail to
achieve efficiency and why governmental intervention might be required
— However, our starting point (first impression, prima facie) is the efficiency of the markets
— In other words, markets will be assumed efficient unless shown otherwise
1.1.2
Information and Spontaneous Order
• Absent reasons for market failure, we have shown that competitive markets
are efficient
— We have not shown that market decisions are the only means of achieving efficiency
— An alternative to a market is a governmental agency that replaces
decentralized decisions with centralized ones
— Could such an agency replicate the efficiency of the market? A case
based on information suggests that this is not the case
• Markets aggregate information
— The aggregated information is expressed in demand and supply functions which determine the market price
— The market price P results from the interaction of buyers and sellers
• With market prices determined and observable, people only need to know
their M Bs as buyers and MCs as sellers in order to make an efficient
decision
• For the government to replicate the market outcomes, it would have to
know the MB and MC of each market participant!
— Further, the information that is sought — marginal benefits and marginal
costs — may not be revealed without the market operating
• Although governmental agencies are at an informational disadvantage compared to markets, politicians might still prefer the centralized environment
— Through centralization, they retain control over market outcomes
— They may get credit for providing benefits to constituencies or political
supporters
• Ideology might be another source of preferences for centralized market
outcomes
— An ideology associated with the “left” in economics and politics proposes that centralized decisions avoid the “anarchy of markets”
— The ideology associates markets with anarchy because of the decentralized and uncoordinated actions of buyers and sellers
— The view that markets are anarchic is in direct contradiction with Adam
Smith’s invisible hand whereby markets achieve efficiency through the
economic freedom to make voluntary personal decisions
• A simple example of spontaneous order achieved by the market is a farmer’s
market
— Farmers arrive with produce to sell everyday
— They made supply decisions beforehand without anyone telling them
what to grow
— Buyers also arrive independently at the market to buy produce
— At the end of the day, farmers leave to return again the following day
with new produce
— Buyers likewise return to buy again
— And no one needed anyone else to tell them what to do!
1.2
Efficiency and Social Justice
• As a measure of efficiency, we used net social benefit W = B − C
— As an alternative, we could have used the notion of a Pareto efficient
outcome, after Vilfredo Pareto (1848-1923)
— Pareto efficiency in production occurs when a given quantity Q is provided using the least resources
— Pareto efficiency in consumption is achieved when an allocation of
goods or income across people cannot be changed to make someone
better off without making someone else worse off
— Pareto efficiency in the market occurs when an efficiently produced
quantity Q is also the quantity demanded by consumers
— Pareto efficiency thus means the absence of waste
• Decisions to buy and sell in competitive markets are generally Pareto efficient (instances of market failure will be discussed later in the course)
— We saw earlier that, if we redistributed outputs across producers (relative to the competitive outcome), we would be raising total cost
— This means that the vector of quantities q̄sd arising from the free choice
of producers manages to provide Q at the least possible cost
— It is thus a Pareto efficient outcome
— On the consumption side, consumers cannot be worse off from a voluntary decision to purchase goods
— They are necessarily doing the best for themselves and cannot be hurt
by the free choice to participate in the market
— Redistribution of wealth (and thus of the consumption bundle) would
hurt those who give income and benefit those who receive
— Again, the market outcome of free consumer choices is Pareto efficient
• Efficiency can also be defined in terms of change:
— Change is Pareto efficient if someone gains and no one loses
• Using the concept of change, we can also redefine the concept of Paretoefficient outcomes:
— An outcome is Pareto efficient when Pareto improving changes cannot
take place
— That is, it is not possible to make someone better off without making
someone else worse off
• While generally the decisions of private individuals to participate in the
market are Pareto efficient, the same need not be true of public decisions
— It could be that a given public decision still raises net social benefit,
∆W = ∆B − ∆C > 0, but does not benefit everybody
— For example, a road that benefits many people might go through someone’s house
— This measure — building the road — will not be Pareto efficient if the
owners of the house are worse off overall (they might benefit from the
road as well but not by enough to compensate for the loss of the house)
— If total benefit from building the road exceeds total cost (so that
∆W > 0), those who gain from the policy gain more than the losers
lose
— The gainers from the policy could compensate the losers and everyone
would be better off
— This would make the policy a Pareto improvement relative to the status
quo
• Any policy justified on efficiency grounds (it raises W = B − C) also
allows for the Pareto criterion to be satisfied through compensation of the
losers (How could you justify a policy that reduces W ?)
— In fact, the possibility of compensation follows from the definition of
efficiency:
— If a new policy (with associated ∆W = ∆B − ∆C) is efficient —
∆W > 0 — gainers can compensate losers and still win
• Though efficient change allows, in principle, for Pareto-improving change
as well — by compensation to the losers — a different question concerns
social justice:
— Does social justice require that actual compensation take place?
• Actual compensation might only be possible in principle and not in practice
— In the case of the road construction, it might be easy to identify those
who lose their homes
— But in many other cases, the identification of the losers and of the loss
to compensate for is very difficult or impossible
• For example, the introduction of new technologies — e.g. personal computer replacing typists — would have made it very difficult to identify gainers
and losers
— Additionally, it would have been needed to identify how much each
gainer gained and how much each loser lost
— It would have been necessary to create an administrative office to administer the compensation
— ...
• This example shows that the administrative and information costs of making compensation payments might be too high to make compensation feasible
— Somewhere down the list of losers, society might decide to draw a line
and stop compensation payments
— This might occur at the very beginning of the list, with no compensation given at all
• Note that compensation is not designed to ensure efficiency
— If the policy satisfies ∆W > 0, it will be efficient:
— The gains will outweigh the costs
— Compensation might be required in the cases that some people are net
losers from the policy while others are net gainers
— In such as case, compensation is motivated by the desire of social
justice
• If it is not possible to compensate the losers (it could be too costly), society
faces a trade-off between efficiency and social justice
— Compensation of the losers is socially just
• However, there is a cost in implementing compensation
— Efficiency is blocked when compensation is not feasible and this results
in the policy not being undertaken
— On the other hand, if the policy is not implemented due to the impossibility of compensation, the potential gainers also forego their gains
— We have a dilemma between efficiency and social justice
• A society that emphasizes efficiency might choose to adopt the general
rule that public policies are justified whenever ∆W > 0
— Such a society does not investigate how benefits B and costs are distributed among the population
— The principle might be that, over time, all will come to benefit even if
some initially lose
1.2.1
Are Competitive Markets Socially Just?
• We have seen that competitive and free markets deliver efficient outcomes
— Are these outcomes socially just?
• Social justice is more difficult to define than efficiency
— We will next consider several sides of social justice and examine whether
the outcomes of free and competitive markets are socially just in each
case
Social Justice as the Natural Right of Possession
• One definition of social justice says that “an outcome is socially just if the
natural right of possession is honored”
— According to English political economist John Stuart Mill (1806-73),
“The institution of property [...] consists in the recognition, in each
person, of a right to the exclusive disposal of what he or she have
produced by their own exertions, or received either by gift or by fair
agreement, without force or fraud, from those who produced it.”
— Based on the natural right of possession, it is socially just that individuals be rewarded according to the value of their personal productive
contributions
— This is what competitive markets do
• Competitive markets provide income to individuals in accordance with their
contribution to production
— To see this, consider the problem of a firm hiring labor L
— The firm chooses L in order to maximize profits π:
π = P Q (L) − wL,
where P is output price, w the wage rate, L the labor input and Q (L)
the firm’s output, which depends positively on L
— Optimal choice of labor satisfies:
P Q0 (L) = w
or the equality between the value of labor’s marginal product (or contribution to production) and the wage rate
— Thus, individual workers will receive as wage the value of their contribution to production
• Personal incomes earned in competitive markets are consistent with social
justice if we make the judgement that people should be rewarded according
to the value of their personal contributions to output
— If we make this judgement, then a competitive market is both efficient
and socially just
• Personal reward according to one’s contributions to production leaves incapacitated people with no income, however...
— Moreover, people may object to this reward criterion since innate ability
is random and a factor of luck at birth
— Further, luck also determines whether or not individuals received a lot
of support and encouragement to study from their families (and raise
their human capital)
— Some people may consequently regard the inequality arising from a
competitive market as unjust and view social justice as requiring equality
1.2.2
Social Justice as Equality
• Equality can be of two types:
1. Ex-ante equality — requires equal opportunities for everyone expressed
as equal chances for improvement later in life
2. Ex-post equality — requires that everyone end up equally
• Ex-ante equality requires that there be no privileged beginnings in life
— But how could that be? If privileges include having high intelligence,
patience to study, motivation, help from loving parents...
— Governments may seek to provide ex-ante equality through equal access
to education and health
— But children and their motivation to pursue education are already very
different at early ages (before kindergarten)
• The objective of sharing to attain ex-post equality appears very deeply
rooted in humans
— People shared food in early hunter-gatherer groups for failing to share
resulted in starvation and even death
• In general, ex-post equality is inconsistent with Pareto improvement, as in
the following example
— Three people each have incomes CHF 1000
— After the government spends CHF 600 on education with a tax of CHF
200 paid by each person, the incomes increase but unequally
— The new incomes are CHF 1400, 1600 and 2000, respectively
• In this example, ∆B = CHF 2000, ∆C = CHF 600, ∆B − ∆C =
CHF 1400 > 0
— The policy is efficient and even Pareto-improving: all are better off, no
one worse off
— Yet, the policy would have meant departing from the initial conditions
of ex-post equality
• In general, insisting on ex-post equality prevents Pareto-improving change
1.2.3
The Choice Between Efficiency and Equality
• The choices between Pareto efficiency and equality is illustrated by the
story of two travellers in the desert who have water enough for only one
of them to survive
• Sharing the water — in any way — results in an equal outcome which is also
the death of both travellers...
— If the person in charge of the water keeps it all, the outcome is Pareto
improving compared to any form of sharing: one person alive is better
than none
• This question is discussed in the Talmud, a central text of mainstream
Judaism, where two opinions are given
— A commentator named Ben-Petura proposed that the water be shared
because it is better that both should drink and die than that one should
witness the death of his fellow
— This is the notion of ex-post equality through sharing
— Another, R. Akiva, proposed that your life takes precedent over your
fellow’s life, and so, if the water can save only one, you are obliged to
save yourself
— This suggestion reflects Pareto efficiency
Efficiency and Ex-ante Equality
• A lottery could assign ownership of the water with equal probability to
both travellers and provide social justice in the form of ex-ante equality
— After the lottery’s draw, one person owns all the water and the outcome
is Pareto efficient
— The lottery presupposes that neither person owns the water
— If someone owned the water, the lottery would contradict the natural
right of possession
— A lottery is thus a socially just way of providing ex-ante equality only
if there is no pre-identified owner of the water
The Popular Bias Against Efficiency
• Judgements about whether an outcome is socially just require a definition
of social justice
— The choice of ex-post equality requires in turn the acceptance of the
efficiency losses that equality generally entails
• When confronted with the need to choose between the alternatives of efficiency and ex-post equality, people often reject allocation through markets
— For example, after a snowstorm, people were asked whether or not the
market price of snow shovels should rise to equate demand with the
limited supply
— Most people viewed the market allocation as unjust
• Evidence from experiments shows that economists tend to favor the market
and efficiency more than the public
— The public tends to favor fair allocations in the sense of ex-post equality
— Economists seem to believe that people who work hard to achieve
personal advancement should benefit from their efforts
— And, likewise, that if someone values something more than others, s/he
should be allowed to pay more and obtain what they value
• At any rate, the preference for ex-post equality might have been a decisive
survival trait in evolution (personal conjecture)
Efficiency, Equality and Social Justice
• As a summary of our conclusions regarding efficiency, equality and social
justice, we have that:
— When social justice is defined as ex-post equality, Pareto efficiency is
generally inconsistent with social justice
— However, efficiency and social justice are consistent objectives when
social justice is defined as ex-ante equality or as the natural right of
possession