Econ 357 4. Economic Efficiency How much pollution is the right amount? How do we achieve this pollution target?

Outline 4.1 What is efficiency? 4.2 Efficiency and competitive markets 4.3 Measuring changes in social surplus

4.1 What is efficiency? Pareto frontier: all allocations of resources such that there are no allocations that are Pareto preferred. An allocation is efficient or Pareto optimal if it lies on the Pareto frontier. For a two person economy the Pareto frontier or UPC can be drawn as follows:

Andys utility

Jos utility

4.2 Efficiency and Competitive Markets Important result in economics: Competitive markets are efficient. (The assumptions of a competitive market are given in Section 4.2.5.) 4.2.1 Efficiency in exchange: goods Inefficiencies in exchange exist if resources can be moved around amongst individuals without making anyone worse off, while making someone better off.

Ec 357 4. Economic Efficiency

We can show that in a simple two person barter economy, free exchange between the two individuals will result in an efficient allocation of resources. Draw Anns and Bobs indifference curves for wine and cheese. Define the Marginal rate of substitution of wine for cheese (MRS).

Combine these two indifference curve diagrams into an Edgeworth box. Assume in the initial endowment (point Q) Ann has all the cheese and Bob has all the wine. Demonstrate what will happen if Ann and Bob exchange wine for cheese. Can you reach a point of Pareto efficiency?

What is the condition that determines Pareto efficiency in terms of the MRSs of Ann and Bob?

Now suppose there are prices established for the two commodities. Denote: C0 = original endowment of cheese W0 = original endowment of wine PC = price of cheese PW = price of wine What is the budget constraint for any level of C and W consumed?

Ec 357 4. Economic Efficiency

Sketch the Edgeworth box with the budget constraint included. With prices the condition for efficiency in exchange is:

Example of possible inefficiency in exchange: restriction on transport of wastes beyond provincial boundaries. 4.2.2 Efficiency in exchange: bads Sketch Annes indifference curves for wine and garbage

Draw an Edgeworth box showing wine and garbage exchange in a barter economy.

Now suppose there are prices for wine and garbage. The price of garbage is negative. Why?

Ec 357 4. Economic Efficiency

Draw the budget constraint on your Edgeworth box.

4.2.3 Efficiency in production We want to produce the maximum amount given the resources we have available. With a fixed amount of labour to produce wine and cheese. How much of each can we produce? Illustrate with a production possibilities curve (PPC).

The slope of the PPC is called: It depicts:

Efficiency in production requires that:

Denote the price of wine as pW and the price of cheese as pC. Profits from production are:

Ec 357 4. Economic Efficiency

Sketch the profit function on the PPC where profits are at a maximum.

Efficiency in production holds if: - the economy produces a combination of goods that is on the PPC - the MRT = the price ratio of the two goods - if there are multiple producers of wine and cheese the MRT between wine and cheese must be the same for all producers Repeat the forgoing analysis for efficiency in the production of one good and one bad (garbage).

Ec 357 4. Economic Efficiency

For efficiency the MRT between pollution and a good should be the same for all firms. This is called the equimarginal principle.

Example of inefficiency in production: Laws require a firm to install a scrubber to reduce SO2 emissions, when it would be cheaper to switch to low sulphur coal. Efficiency in production and exchange: MRTwc=MRSWC = PW/PC

4.2.4 Theorems of Welfare Economics First Theorem of Welfare Economics: In a competitive economy, a market equilibrium is Pareto optimal. Second Theorem of Welfare Economics: In a competitive economy, any Pareto optimum can be achieved by market forces, provided the resources of the economy are appropriately distributed before the market is allowed to operate. Second theorem implies that the issues of distribution and efficiency can be separated. Let prices reflect scarcity of resources. Use lump sum transfers of wealth to adjust for distributional goals.

4.2.5 Conditions of a competitive market (i) Complete property rights: A well defined, transferable, and secure set of property rights must exist for all goods and bads in the economy so that these commodities can be freely exchanged. All the benefits or costs must accrue to the agent holding the property right for the good or bad. Atomistic participants: Producers and consumers are small relative to the market and thus cannot influence prices. Instead, they maximize profits or utility, taking prices as given. Complete information: full knowledge about current and future prices. No transaction costs: It must be costless to attach prices to goods traded.

(ii)

(iii) (iv)

Ec 357 4. Economic Efficiency

4.3 Measuring changes in social surplus 4.3.1 Consumer surplus We can derive a consumers demand function from underlying preferences (as represented by indifference curves) and a budget constraint. We are usually interested with the reverse problem how to derive utility from observed demand behaviour. In particular we will be interested in finding the change in welfare or utility that results from some environmental policy. Demand curve can be viewed as the willingness to pay for a particular good.

Demand for wine for Amy (draw demand curve)

Area under the demand curve is the total benefit from consuming that good Demand curve can be thought of as a marginal benefit curve. The marginal benefit declines as consumption of the good increases because:

Consumer surplus:

Total demand for a good (the aggregate demand curve) is found by:

What is the value judgement implicit in moving from an individuals demand curve to an aggregate demand curve?

Ec 357 4. Economic Efficiency

4.3.2

Producer surplus

Costs of producing a particular good: consider the firms marginal cost of production the cost of increasing output by one unit.

Marginal Cost of Production

30 $/unit 20 10 0 1 2 3 4 quantity

Total cost of producing 4 units is:

$/unit
Typical u-shape MC curve shown as a continuous curve.

quantity

Costs are measured as opportunity costs defined as:

Ec 357 4. Economic Efficiency

Profit maximizing condition: provided variable costs are covered, expand production to the point where:

The supply curve of a firm is just the marginal cost curve above average variable cost.
Supply of good A
6 5 4 3 2 1 0 0 5 10 15 20 25 quantity marginal cost price

The total variable cost of production is the area under the marginal cost curve. In the long run all costs are variable so that the area under the supply curve represents total cost. If P=$3, then Q=15 units and total cost is: Producer surplus:

Market supply is the horizontal sum of individual firm supply curves.

Ec 357 4. Economic Efficiency

price

4.3.3

Total net social benefits and social surplus

Price S=SMC a b c Quantity D = SMB

Total Social Benefits (TSB ) =

Total Social Costs (TSC) =

Total Net Social Benefits (TNSB) = TSB -TSC

Consumer Surplus =

Producer Surplus =

In this simple case (no taxes, no externalities) net social benefits can be measured by CS +PS.

Show that NSB is maximized when price = social marginal cost. This implies the market equilibrium is Pareto optimal.

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4.3.4

Benefit-Cost Analysis

When considering various policy alternatives we are looking for the one which gives us the largest social surplus. Example of evaluating two policies to control quantity of garbage. Analyze the change in social surplus through limiting garbage disposal to q1, through a quantity restriction and through a tax per bag disposed. (Note that we are ignoring any potential environmental benefits of reduced garbage.)

Price of garbage disposal

Private MC of Garbage service

Demand for garbage service

Bags of garbage disposed Q1

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Secondary Markets in Cost Benefit Analysis: Suppose you are doing a cost benefit analysis of a regulation limiting SO2 emissions from power plants. You look at the benefits of pollution control due to reduced air pollution versus the costs of pollution abatement. You expect there will be an increase in demand for low sulphur coal as well as for scrubbers. What do you include when you add up the total benefits and costs of this policy?

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