Part AIII continued Microeconomic Theory Review continued 91509

Part A-III (continued) Microeconomic Theory Review (continued) 9/15/09 Intro_D 1

Some fundamental economic concepts Positive Concepts n Maximization n Equilibrium n Predicting behaviour and outcomes Normative Concepts § Welfare Economics § Efficiency 9/15/09 Intro_D 2

Maximization Individual economic agents maximize something (objective) § Consumers maximize utility § Firms maximize profits § Politicians maximize votes § Clergy maximize souls saved 9/15/09 Intro_D 3

This maximization is subject to some constraint(s) - otherwise there is no economic problem, no scarcity n Income/budget constraint n Technology/resources n Campaign spending limits n etc. 9/15/09 Intro_D 4

Given all of the options available to them (that is, subject to whatever constraints they face), agents will maximize They will choose the ‘best’ alternative - the available option that best suits their individual preferences - their self-interest 9/15/09 Intro_D 5

To Summarize n n n Objective Constraint Maximize Examples § Utility maximization by households § Profit maximization by firms 9/15/09 Intro_D 6

Example: Maximization subject to a constraint Education Bill’s choice Unattainable Ed* Constraint Bill’s options Entertainment En* 9/15/09 Intro_D 7

Example: Controlling Bill’s behaviour by adding a new constraint Education Bill’s new choice Ed** Unattainable Bill’s new options New Constraint Entertainment En** 9/15/09 Intro_D 8

Example: Controlling Bill’s behaviour a different constraint Education Bill’s new choice Ed*** New Constraint Bill’s new options Unattainable Entertainment En*** 9/15/09 Intro_D 9

Equilibrium Economist believe that competing forces (competing interests) generally yield some form of equilibrium state This equilibrium state will exist until some external factor causes one of the competing forces to change 9/15/09 Intro_D 10

For example, in a given market: - the desires of buyers and sellers - equilibrium, price and quantity - change in taste, technology, legal rules, etc. If you disturb an economic system in some material way, then eventually a new stable outcome will arise 9/15/09 Intro_D 11

Predicting behaviour and outcomes If - all economic agents maximize (or minimize) some objective - subject to some constraint - if opposing economic forces generally yield an equilibrium Then economic theory should be able to predict the relevant outcomes. 9/15/09 Intro_D 12

Example: Changing Bill’s Constraint the entire market Market for Entertainment Price of entertainment Supply of entertainment Pe Demand for entertainment Qe 9/15/09 Intro_D Quantity of entertainment 13

Example: Close 50% of the bars in Downtown Windsor Market for Entertainment New supply of entertainment Price of entertainment Pe* Supply of entertainment Pe Demand for entertainment Qe* Qe 9/15/09 Intro_D Quantity of entertainment 14

You be the Policy Maker n n n Can you think of other policies that might affect Bill’s choice of education/entertainment? What might some of the secondary (perhaps unintended) consequences of these policies be? Which groups in society might gain and which groups might lose as a result of these policies? 9/15/09 Intro_D 15

Welfare Economics Some basic building blocks of economics as a normative science Welfare economics is the study of the welfare of society as a whole Welfare economics is largely normative in nature, requiring inter-personal comparisons or implicit assumptions concerning the wellbeing of individuals 9/15/09 Intro_D 16

The central objective of an economic system is the satisfaction of human wants Goods and services are supplied through production and exchange. An efficient economic system is one that satisfies the wants of its members to the greatest extent possible given its resources and technology. The above is just a definition not a statement that efficiency is desirable 9/15/09 Intro_D 17

Some Efficiency Concepts (1) Pareto Efficiency: A situation is said to be Pareto Efficient (or a Pareto Optimum) if no change is possible that would make some individual better off without causing someone else to be worse off A change in the state of the world which makes someone better off without making someone else worse off is said to be a Pareto Improvement 9/15/09 Intro_D 18

Why are most Neoclassical Economists so fixated with markets? One reason: In an unregulated system of markets with no market failures, Pareto Efficiency would be achieved automatically BUT there are some problems! - market failures - distributional issues 9/15/09 Intro_D 19

Market failures – a deficiency of the pure market system Individuals make private maximizing decisions in markets BUT the conditions for a Pareto Optimum will not exist if: Monopoly (monopsony) private MB not equal to private MC Externalities social MB > private MB external benefits social MC > private MC external costs Public goods non-rivalrous consumption and nonexcludability Severe informational asymmetries buyers and sellers have very different amounts of information 9/15/09 Intro_D 20

Distributional issues – deficiency of the Pareto concept Pareto Efficiency is an ‘almost’ a value free concept Why almost value free? Because it accepts the existing distribution of well-being across individual members of society as the correct one. The notion of Pareto Efficiency does not allow re-distribution of wellbeing If a Pareto Improvement is imposed, then the winners are required to compensate the losers (no one can be made worse off) 9/15/09 Intro_D 21

Basic problem with Pareto Efficiency concept Whatever the current distribution of well-being (income, consumption, etc. ) we cannot do anything that causes someone’s share to decrease Note: It is not that Pareto got it wrong. It is just that this is the point at which economics as a positive science reaches the end of the road. Pareto got it right. He developed a value free answer to the question “given the current distribution of resources, what conditions are necessary to ensure that the economic system generates the maximum amount of well being? ” Pareto efficiency does not provide practical guidance for policymakers – it generally ties their hands 9/15/09 Intro_D 22

Situations often arise in which a given individual/group can be made better off (much better off? or a `deserving? ’ individual/group) but in the process some other individual/group will be made worse off (not much worse off? or a `less deserving? ’ individual/group) But there is no general mechanism through which the gainers can compensate the losers - this ‘winner to loser’ transfer is often (almost always? ) impossible Is there a better scientific (positive) approach to this problem? No, not yet anyway. It is just an admission that positive science has it limits – values play a role and this fact takes us beyond positive science. Remember TECHNOCRATS 9/15/09 Intro_D 23

Question: What is TECHNOCRACY? Check Google As an economist would you believe that a society organized on the basis of Technocracy as opposed to, say, Democracy, Tribalism or Monarchy would make sense? 9/15/09 Intro_D 24

So, why can’t the winners compensate the losers? Transaction costs Many small winners and/or losers. Why don’t we just trade for the right to build a road through your neighborhood? Accurate reporting of gains and losses Why doesn’t the government just pay everyone what they lose and tax everyone what they gain? 9/15/09 Intro_D 25

Under the Pareto criteria only the really easy (obvious? ) improvements in efficiency can be done - the obviously wasteful corrections. Why? Because as a strictly ‘positive science’ economics is not allowed to decide who is, and who is not, ‘deserving’, or the extent to which someone’s gain outweighs someone else’s loss. Is this a failing of economics? NO, ‘who deserves what’ is just too important for any science to deal with. It is beyond the edge of purely positive science. 9/15/09 Intro_D 26

EXAMPLES (consider these problems and possible solutions – are there losers? ): - 9/15/09 the monopoly power of a large corporation the pollution caused by cars or factories the inefficiencies caused by tariffs banning smoking in public places banning drunk drivers traffic congestion on Huron Line hungry children foreign aid Intro_D 27

Some Additional Efficiency Concepts (2) Potential Pareto improvements or Kaldor-Hicks efficiency Governments, courts and all of us must make interpersonal comparisons of economic well-being in order to actually deal with problems that arise. So what to do? Are there rules that might be applied to guide ‘normative’ decisions in a public context? 9/15/09 Intro_D 28

Potential Pareto improvement - a change that results in the gainers gaining more than the losers lose. Kaldor-Hicks improvement - results if the gainers gain enough so that they ‘could’ compensate the losers. These two criteria are the same. This is the basis for costbenefit analysis The gains must outweigh the losses, but the losers need not actually be compensated. (Why? Because of transaction costs and reporting problems. ) 9/15/09 Intro_D 29

The potential Pareto improvement or Kaldor- Hicks criteria would imply that we - we first determine the potential winners and potential losers - determine how much the winners will win and how much the losers will lose - select the policy choice that maximizes the difference between the gains and losses. 9/15/09 Intro_D 30

EXAMPLES: - the introduction of Free Trade - de-regulation (of anything) - pollution control - drunk driving laws - eliminating border traffic congestion - banning smoking in public places Does it always happen this way? Are decisions ‘value free’? Does each individual count the same? Should they? 9/15/09 Intro_D 31

What about distribution? Distribution involves decisions concerning which individuals or groups should get more and which individuals or groups should get less. Almost all public policy affects the distribution of well-being. But sometimes the main purpose of a policy is to re -distribute well-being across individuals in society. 9/15/09 Intro_D 32

There really is no ‘positive’ economic theory setting out the optimal distribution of societal well-being. Recall, ‘who deserves what’ is too important (difficult) a question for science. However, if given a socially desirable change in distribution of well-being, as proposed by policy makers for example, economics can help assess the extent to which a given change in the law will achieve the stated distributional goal. 9/15/09 Intro_D 33

Most efficient re-distribution mechanism? Tax-Transfer system (CASH) – least distorting Economists tend to argue that the ‘law’ should focus on ‘efficiency’ – make the pie as big as is possible THEN Re-distribute well-being through the tax-transfer system 9/15/09 Intro_D 34

BUT What if concepts such as ‘dignity’, ‘status’ or ‘role’ matter? OR even fairness, justice? There are limits to what we will trade for MONEY! Daddy or mommy has no job! Our family is on public assistance! Re-distributing purchasing power (CASH) might not do the trick. 9/15/09 Intro_D 35

Conclusion on distribution: the law is a tool for helping to make society more ‘efficient’ and this is what we will focus on (as Economists) BUT The Law is also a tool for re-distribution of wellbeing. Which comes first? Historically and currently the law is generally viewed primarily as a tool of ‘justice’ – distribution! 9/15/09 Intro_D 36

HOWEVER In many legal cases distributional issues are not the major public concern. (Ford sues a major tire producer over quality of their product. ) So much of the time when Judges deal with issues (particularly) in Property, Contract and Tort law, public issues of distributional impacts do not dominate. BUT distribution consideration are always important to the plaintiff and defendant but this is private stuff. 9/15/09 Intro_D 37

At times it appears that common law has developed as if judges had employed theorems of welfare economics to guide their decision making (‘the greatest good for the greatest number’ or some other efficiency rule) Two views: Economics should help construct laws that are ‘efficient’ Economics should help make the law a tool for ‘social justice’ – redistribution. 9/15/09 Intro_D 38

A ‘middle road’ Positive economic analysis can be applied to normative issues, as can the more normative economic concepts of welfare economics For example: In discussing appropriate criminal law procedures we might take the perspective of either potential victims or potential perpetrators. We might also consider the view of society as a whole (this is what welfare economics generally attempts to do). But we will not decide who should actually gain or lose. We can state the distribution problem but not actually answer it. 9/15/09 Intro_D 39