ECON 310 Chapter 2 Notes

Economic Efficiency and Markets: How the Invisible Hand Works

 

... and by directing industry in such a manner as its produce may be of the greatest value, he intends only his own gain and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention.  Nor is it always the worse for society that it was not part of it.  By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it.

Adam Smith, The Wealth of Nations, 1766

 

CHAPTER SUMMARY

Adam Smith’s argument is very simple.  People acting in their own best interests tend to promote the social interest.  By allocating the resources under their control in fashion that maximizes their well being, they maximize society’s well being.  Policy based on the establishment of free markets influenced global decision-making for much of the 1980’s and 1990’s from the US to Europe, Latin America and Asia.  However, by the end of the 1990’s there was a rise in anti-globalization protests against free markets.

The key to understanding the problem is understanding what kind of costs and benefits are generated by the good or activity in question.  This chapter examines how a market works in a simple case and then extends this to the more complex problem of the environment. 

In the market for blue jeans, the marginal costs of blue jeans can be represented by a positively sloped supply curve, while consumers willingness-to-pay for an additional pair of blue jeans is represented by a negatively sloped demand curve.  The negative relationship between willingness-to-pay and quantity demanded reflects the diminished marginal utility associated with additional units of a good or service.

It is possible to examine this market initially by making two assumptions.  First, all costs associated with blue jeans are incorporated into the supply function and that all benefits associated with blue jeans are incorporated into demand.  The implication of these assumptions is that the market equilibrium not only equates quantity demanded and quantity supplied and but also marginal benefits and marginal costs.  A basic microeconomic principle states that when marginal benefits (MB) equals marginal costs (MC) total net benefits are maximized.

The demand curve can be considered a marginal value function that is based on an individual’s willingness-to-pay for an additional unit.  A market demand curve is the sum of these individual demand curves and reflects individual choices based on satisfaction and income constraints.  As a result, the market demand curve reflects private benefits.

The supply curve reflects production costs and can also be viewed as private, in the sense that these costs are borne by suppliers.

The optimal use of a resource is where net benefits are maximized.  In the market the net benefits are private net benefits.  In order to maximize social net benefits, private marginal benefits must equal social marginal benefits and private marginal costs must equal social marginal costs.  Figure 2.2 illustrates the concept of equating marginal private cost and marginal private benefit.  Does this maximization of private net benefits imply the maximization of net social benefits?  It depends.  If all private values are equal to social values then yes.  However, if there is a disparity between private values and social values, then the answer is no.  It is the divergence between private and social benefits and costs which results in the inability of the market to always allocate resources efficiently.  This inefficiency is referred to as market failure.

There are five categories of market failure that will be examined in this book.  They are imperfect competition, imperfect information, public goods, inappropriate government intervention, and externalities.  Imperfect competition is the term used for markets where individual actions of particular buyers or sellers have an effect on price.  In such markets the marginal revenue of firms differs from market price.  At equilibrium in the market marginal social cost (MSC) does not equal marginal social benefits (MSB).

Imperfect information means that some segment of the market, consumers, producers or both, do not know the true costs or benefits associated with a good or action.  The market can not equate marginal social benefit and marginal social cost because the willingness-to-pay does not reflect full value or full costs.  Hazardous work should imply a higher wage unless labor does not have full information about the hazards.  The cost of production is lower than it would be with full information.  Supply is greater and equilibrium does not equate MSB and MSC.

Public goods are distinguished from private goods by two principle characteristics.  These are nonrivalry and nonexcludability in consumption.  Nonrivalry means that one individual’s consumption of the public good does not diminish that amount of public good available for others to consume.  Nonexcludability means that if one person has the ability to consume the public good, then others can not be excluded.  An example of a pure public good is national defense.  Once available no one is excluded and one person’s “consumption” of national defense does not diminished other’s consumption.  There are very few examples of pure public goods.  Goods are usually categories by the degree to which nonrivalry and nonexcludability exist.

Government action in the economy can also lead to a divergence between private and social costs.  When the government intervenes in the economy not to correct a divergence between private and social costs but for some other purpose, this is referred to as inappropriate government intervention. 

Externalities are perhaps the most important class of market failures.  Externalities are unintended consequences or unintended side effects (beneficial or detrimental) associated with a market transaction.  The result of an unintended detrimental consequence is marginal private cost (MPC) is lower than marginal social cost (MSC).  It is also possible to have marginal private benefit (MPB) less than marginal social benefit (MSB).  In this case, because the market does not reflect the full benefits of action, too little is provided.

The definition for externalities which will be used in this text is one developed by Baumol and Oats (1988).  An externality is present whenever some individual’s (say A’s) utility function or production relationships include real (that is nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A’s welfare.  The keywords in this definition are unintended, real (non-monetary), production and utility relationships.

Many externalities have public good characteristics.  These are called non-depletable externalities and are characterized by the public good property of nonrivalry in consumption.  The pollution of drinking water is an example where one person’s consumption doesn’t reduce the amount available to others.

One reason for the disparity between social benefits and costs has to do with the definition of property rights.  For example, o one has property rights to clean air, unless environmental legislation specifically defines these property rights.  A special class of externality that is generated by a lack of property rights (or an inability to enforce property rights) is the open-access externality.  An open-access externality exists when property rights are insufficient to prevent general use of a resource and when this uncontrolled use leads to destruction or damage of the resource.  For example, if access is not controlled to a fishery, then anybody who wants to can purse the fish, diminishing the availability of future fish and increasing the cost of harvesting fish. 

Even if property rights exist, a lack of ability to enforce them might lead to destruction of the resource. 

Many critics of the market system criticize it on distributional grounds rather than for efficiency reasons.  There is nothing inherently superior I how the market distributes costs and benefits across society.  The “best” distribution depends on what view of equity and fairness is held by society.

The second half of this chapter focuses on the dynamic efficiency of a market system.  Focusing on one time period (static analysis) will be sufficient as long as optimizing decisions are independent across time periods.  However, if the optimizing decisions of one period depend on the optimizing decisions of past or future periods, then a dynamic analysis must be employed.  An important and often cited example of dynamic optimization is the investment decision. 

Since decisions today can influence the quality of the environment and the stock of a resource far into the future, one would expect dynamic considerations to be important in the study of environmental and resource economics.  An example of the importance of intertemporal decisions is the choice of how much oil to take out of the ground.  In a single time period, the optimal quantity of oil to take out of the ground would be found by comparing private marginal cost and private marginal benefits, which in the absence of market failure, results in social marginal cost equal to social marginal benefit.

When multiple time periods are considered, the optimal amount of oil to bring out of the ground in one time period must be made by including the cost of not having the oil available in the future.  This opportunity cost is sometimes known as user cost or rent.  The oil producer has two choices for future income, to sell all his oil and invest the money or hold the oil and invest it in the future. The oil producer will make a choice that will maximize the sum of the present values of the earning potentially received in each period. 

The price of oil, at any particular time t, can be represented by

 

Pt = MUCt + MECt

 

Where Pt is the price of oil in time t, MUC is the marginal user cost and MEC refers to the marginal extraction cost.  The most important thing to be noted about this equation is that one can predict changes in the price of oil by predicting changes in the marginal extraction cost and the marginal user cost.  When Iraqi forces invaded Kuwait in August of 1990 and it looked as if Iraq might also gain control of the Saudi oil fields, the opportunity cost of using a barrel of oil rose (MUC).  This was reflected in a 50 percent increase in the price per barrel of oil.  When the coalition forces lead by the United States began their air attacks this lowered people’s perceptions of the MUC of using a barrel of oil and the price of oil fell almost as dramatically as it had risen.

            Two other important observations can be made with respect to marginal user cost.  First the existence of marginal user cost implies that price will be different from marginal extraction cost.  Second, in order for an owner of oil to be indifferent as to the period in which he or she sells the oil, the present value of the marginal user cost of oil must be the same in all periods.

            A final point is that market failures can also have a dynamic dimension.  For example, the decision of how much to pollute has intertemporal dimensions when pollutants accumulate in the environment without breaking down.  These are referred to as persistent pollutants, chronic pollutants, or stock pollutants.

            An additional example of the dynamic dimension of environmental policy involves changes in land use.  Many land use changes result in the inability to revert land to a prior use.  For example, overgrazing by livestock in the Sahel region of Africa has destroyed grassland and allowed the Sahara desert to move south.

            Appendix 2.A reviews the techniques of discounting and present value.  Appendix 2.B reviews the concepts of dynamic efficiency.

 

 

KEY CONCEPTS AND DEFINITIONS

 

Marginal costs - measures the costs of production; ex., labor, materials, energy associated with the production of an additional unit of a good or service.  In a perfectly competitive market, MC = supply curve for the firm.

 

Marginal benefit - measures the value of benefit associated with the consumption of an additional unit of a good or service.  Within a perfectly competitive market, this is represented by the demand curve which reflects marginal willingness to pay.

 

Market Failure - the inability of the market to allocate resources efficiently, that is to the point where the marginal social benefits equal marginal social costs.

 

Imperfect Competition - the term used for markets where the individual actions of particular buyers or sellers have an effect on market price.  Marginal revenue is not equal to price.

 

Imperfect Information - some segment of the market, consumers or producers or both, do not know the true cots or benefits associated with the good or activity.

 

Public Goods - goods that are distinguished by two primary characteristics: nonrivalry and nonexclusivity.  One person's consumption of a pure public good does not diminish the quantity available for another consumer.  Nor is it possible, with a pure public good, to prevent consumption by one consumer when it has been made available.

 

Nonrivalry - one person's consumption of a good does not diminish the quantity available for another consumer.

 

Nonexclusivity - once good has been made available for one consumer, it is not possible to exclude other person's from consumption.

 

Inappropriate Government Intervention - refers to government intervention in the market that does not correct for a divergence between private and social costs and benefits but creates a divergence.

 

Externalities - unintended consequences or unintended side-effects (either beneficial or detrimental) associated with market transactions.

 

Baumol and Oates Externality - "An externality is present whenever some individual's (say A's) utility or production relationships includes real (that is nonmonetary) variables, whose values are chosen by others (person's, corporations, governments) without particular attention to the effects on A's welfare."

 

Pecuniary externality - unintended price change in a market.  Pecuniary externalities are not "real" externalities. 

 

Real (technological) externality - implies a change in the production or utility function of a third party.  Real externality shifts the production frontier and results in a net change in welfare for society as a whole.

 

Nondepletable externalities - are characterized by the public good property of nonrivalry in consumption.  An example is pollution of drinking water, where one person's consumption does not reduce the amount of polluted water available for others.

 

Open-access externality - generated by the inability to enforce property rights.  The property rights are insufficient to prevent general use.  Leads to uncontrolled destruction of the resource.

 

Static efficiency conditions - marginal social benefits (time 1) are equal to marginal social costs (time 1).  The optimal allocation of goods,services, resources within one time period are not dependent upon the decisions made in any other time period.

 

Dynamic efficiency conditions - optimal allocation of resources will be dependent upon the net benefits through time.  Intertemporal considerations require the comparison the present value of net benefits. Net benefits equals marginal benefit minus marginal cost.  A dynamic efficiency conditions would equate the present value of net benefits across all time periods.

 

Present value of net benefits - net benefits adjusted for the decreased value of future dollars.  Net benefits received in the future are adjusted by a discount rate which reflects the opportunity cost of allocating dollars today in return for future benefits.

 

Marginal user cost - in an intertemporal model, the owners of a resource incorporate the additional opportunity cost associated with not having the resource in the future.  This is referred to as a user cost or rent. 

MC = MUC + MEC.

 

Marginal extraction cost - reflects the addition to costs of extracting an additional unit of the resource.  MC = MUC + MEC.

 

 

Chapter 2 Short-answer questions

 

1.                  How is the “invisible hand” an efficient allocator of resources?

·        Efficient allocation of resources is defined as resources being used in their highest and best use.  Individuals seeking to maximize their satisfaction or individual firms seeking to maximize their own profit will lead to an efficient allocation of resources.

 

2.         Adam Smith argued that "people acting in their own self-interest tend to promote the social interest".  According to Adam Smith, why would self-interest lead to social benefit?

·        Individuals seeking to maximize their own satisfaction or individual firms seeking to maximize their own profit will lead to an efficient allocation of resources.  Equilibrium price and quantity within a market will be achievement of both these goals and an efficient allocation of resources.

 

3.         Within a market, since demand is assumed to reflect private benefits and supply reflects private costs, equilibrium reflects maximizing net private benefits.  When does this equilibrium also reflect maximizing social benefits?  When does it not reflect maximizing social benefits?

·        Equilibrium will maximize social benefits when the market has perfect competition, full information, no public goods, no inappropriate government action, and no external costs or benefits.

 

4.         What are the five categories of market failure?

·        Imperfect competition

·        Imperfect information

·        Public goods

·        Inappropriate government intervention

·        Externalities

 

5.         Discuss the importance of real variables and unintended side effects in     Baumol and Oates definition of an externality.

·        Baumol and Oates argue that monetary changes are a reflection of market interaction.  Only real variables are part of the definition of an externality.  In addition, if the action that causes external harm or benefit is intentional, then the agent meant for the action to occur and it is not a “side effect” of the market.  Therefore, only non-monetary and unintentional side effects are defined as externalities.

 

6.         Compare the following goods in terms of rivalry and excludability:

            -Checkout lines at Walmart vs. ticket lines at Superbowl .

            -A Malibu sunset vs. a lunar eclipse

·        Limited space implies rivalry, more so with Superbowl because this event occurs only once a year.  It is possible to exclude individuals from Superbowl, less so from Walmart because of no entrance fee.

 

7.         For each of the following events, discuss whether this is an example of pecuniary or technological externality?

            -A crop failure in Brazil results in a substantial rise in the price of coffee.

·        Price change implies market change.

            -The rise in the price of coffee drives up the consumer price index.

·        Price change implies market change.

            -The rise in the CPI causes the Federal Reserve Chairman to raise short-term interests rates.

·        Price change which results in policy change is still market related.

            -The rise in short-term interest rates makes it cost prohibitive to invest in the new technology for reducing pollution levels in Jason's plant effluent.

·        Price change implies market change.

            -Jason dumps untreated effluent into near by stream.

·        This is a real externality.

 

8.         Define the following terms:

            -Imperfect information

·        One part of the market does not possess information of equal quality or content as some other portion of the market.  As a result, the decision about what to consumer or what to produce is not made from the same information foundation.

-Public Good

·        Good which is nonexcludable and nonrival in use.

-Inappropriate government action

·        Government action creates market failure.

-Externalities

·        Non-monetary and unintentional costs or benefits which result from the actions of demand and supply.

-Pecuniary Externality

·        A monetary unintentional cost or benefit.

-Open-access externality

·        It is not possible to exclude people from consumption.

-Marginal extraction cost

·        Portion of marginal cost associated with “harvest or mining” of the resource.

-Marginal user cost

·        Portion of marginal cost associated with not having the resource available for use in the future time periods.

-Intertemporal model of resource use   

·        Optimal use of resources through multiple time periods. Dynamic efficiency

·        Optimal use of resource through time.

 

9.         What is a nondepletable externality?

·        An externality that does not decline in quantity as additional individuals “consume” it.  For example, air pollution.

 

10.       In absence of market failure, the invisible hand is an efficient allocator of resources.  What can be said about the equity associated wit this allocation of resources?

·        Efficiency does not imply equity.

 

11.       Explain the rise in the price per barrel of oil when Iraq invaded Kuwait.   Use the concepts of MEC and MUC.

·        MEC did not change, but uncertainty about continued availability of Kuwait oil fields dramatically increased MUC.  As a result, MC rose and price rose.

 

12.       Assume that the demand for a particular food is fully coincident with the marginal social benefit function and can be described by MSB=MPB= 20 - 5q, where q refers to the quantity of the good.  Assume that the marginal private cost function can be described by MPC=q, and the marginal social costs are always double the marginal private cost.

 

            Graph the functions and algebraically determine the market level of output and the optimal level of output.

·        Market                   MPB=MPC

      20 – 5q = q

              20 = 6q

            3.33 = q

·        Optimal                  MSB=MSC

                                                20 – 5q = 2q

                                                       20 = 7q

                                                      2.86 = q

 

13.       Assume that the costs and benefits associated with a proposed government project are as follows:

 

                        Year                 Benefits                        Cost

 

                                                            ($ millions)

                         1                       200                            500

                         2                       500                            500

                         3                     1500                            500

                         4                       800                              20

 

            -If the discount rate is 5 percent, calculate the present value of the net benefits for this project (show your work).

·        Assume that in Year 1 the values are not discounted.  In Year 2, the calculation would be (500-500)/(1+.05).  In Year 3, the calculation would be (1500-500)/[(1+.05)2] and so on.

            -Not all of the benefits associated with this project are easily quantifiable

            in dollar terms.  What can be done to include these in your cost/benefit

            analysis?

·        It is important to note these benefits and discuss their potential importance.