ERE4: Efficiency, optimality, market failure & public policy• Efficiency and optimality

– Static efficiency– Optimality– Dynamic efficiency and optimality– Market efficiency

• Market failure & public policy– Externalities– Public policy

Last week• Ethics

– Why is ethics so important?– Alternative views, including the

standard economic position• Time dimensions

– Discounting– Sustainability

Static Economic Efficiency• Efficiency = Pareto optimality =

For some initial distribution of endowments, an allocation is efficient if it is not possible to make one or more persons better off without making at least one person worse off

Static Efficiency: NotationTwo persons (A,B), two goods (X,Y),

two inputs (L,K) , ; ,A A A A B B B BU U X Y U U X Y

, ; ,X X Y YX X K L Y Y K L

:A

AX A

UUX

:YL Y

YMPL

Efficiency in Consumption

• Equal marginal utility ratios• If not, then the two consumers can

exchange commodities at the margin such that both gain

or A B

A BX XA BY Y

U U MRUS MRUSU U

.

.

a

BXa

b

AXa AXbAX

AYa

AYb

BXb

BYb

BYa

IB0

IB1

IB1

IB0

IA

IA

B0

A0

BX

BY

AY

T

S

Efficiency in Consumption (2)

Efficiency in Production

• Equal marginal production ratios• If not, it would be possible for

producers to exchange some K for some L so that the total production of both goods could be increased from the same total volume of inputs

or X YL L

X YX YK K

MP MP MRTS MRTSMP MP

.

.

a

LYa

b

LXa LXbLX

KXa

KXb

LYb

KYb

KYa

IY0

IY1

IY1

IY0

IX

IX

Y0

X0

LY

KY

KX

Efficiency in Production (2)

Efficiency in Product-Mix

• Marginal utility ratio equals marginal production cost ratio

• If not, inputs could be reallocated to make alternative output such that each consumer would be better off

or

A B Y YX X K LA B X XY Y K L

A BL K

U U MP MPU U MP MP

MRT MRT MRUS MRUS

a

Xa

b

XC

Yb

Ya

I

I

c

YM

0X

Y

Xb

XM

Yc

Efficiency in Product-Mix

Is the solution unique?

There are many efficient solutions, depending on the initial distribution

Social Welfare & Optimality

• Social welfare function

• Optimality

,A BW W U U

A

B

B BX YUA AX YU

W U UW U U

Intertemporal Efficiency and Optimality

• Three approaches– Individual with finite life span– Overlapping generations– Infinitely lived agent

• Condition 1: The real rate of return is equalised across all sectors and assets

• Condition 2: The consumption discount rate is equalised across all agents

• Condition 3: The real rate of return on investment is equal to the consumption discount rate

• To choose among the intertemporally efficient allocations requires a SWF

Markets are efficient, iff• Markets exist for all goods and services

– Property rights are fully assigned– All goods and services are private– No externalities exist

• All markets are perfectly competitive– Long run average costs are non-decreasing

• All agents have perfect information

Market efficiency (1)

• Ratio of marginal utilities equals price ratio

• In a competitive market, consumers face the same prices

• So, the market establishes efficiency of consumption

; or A A B BX X X X XA A B BY Y Y Y Y

U P U P PMRUSU P U P P

Market efficiency (2)

• Ratio of marginal production equals input price ratio

• In a competitive market, producers face identical input prices

• So, the market establishes efficiency of production

; or X X Y YL L L L LX X Y YK K K K K

MP P MP P PMRTSMP P MP P P

Market efficiency (3)

• Price equals ratio of input price and marginal productivity

• In a competitive market, producers supply at marginal cost

• So, the market establishes efficiency of product-mix

A BXL K

Y

PMRT MRT MRUS MRUSP

Resources and Markets• Many environmental resources are

not transacted at markets– Atmosphere, oceans, wilderness

• Many resources are public goods or open access

• Other resources are traded– Land, minerals, energy

• Markets are often far from perfect

Property Rights• Property is

– The right to use– The right to exclude– The right to destroy

• Property rights are often attenuated• Property rights can be

– Private– Common– Public– Absent (open access)

• Environmental resources are seldom privately owned

Environmental Services and Property Rights

• Different kind of environmental services• Renewable and non-renewable resources

– Open-access resources– Common-property resources

• Waste sink– From open access to a common-property

resource• Amenity services• Life-support services

Public Goods• Public goods are indivisible and, according

to some, non-excludable, in consumption• E.g., lighthouses, national defence,

biodiversity, and, provide that use is not excessive, atmosphere, ocean

Excludable Non-Excludable

Rivalrous Pure private good

Open-access resource

Non-rivalrous

Congestible resource

Pure public good

Public Goods and Economic Efficiency

• Product mix efficiency with private goods:

– Can consume different amounts of the goods• Product mix efficiency with public goods:

– Can value goods differently at the margin• Will not be satisfied in a market economy• Free-rider problem

A BMRUS MRUS MRT

A BMRUS MRUS MRT

Externalities• External effect is said to occur when the

production or consumption of one agent affects the utility of another agent in an unintended way, and when no compensation is made

• External effect = externality = external cost = external diseconomy

• External effect may be beneficial or adverse, consumption or production related

• If compensated, the externality is said to be internalised

Public policy• Government instruments to correct

market failure– Create property rights– Provide information– Command-and-control– Fiscal instruments

• Is the instrument appropriate to increase efficiency– Lack of information – More than one source of market failure