Equity and Efficiency revision.pptx

Equity and efficiency revision

1. Equity and Efficiency

2. The concept of equity Equity is essentially fairness. What is fairness in regards to economics? Fairness in economics is about how societies production (or income) is divided up amongst the population. There are two types of equity: Horizontal equity states that those with the same ability to earn should pay the same tax rates. Vertical equity states that those who earn more should pay higher tax rates.

3. The relationship between equity and efficiency Equity and efficiency are very different concepts, a simple way to understand this is: Efficiency is concerned with increasing the economic pie. Equity is concerned with dividing up the economic pie into equal slices. The two can be achieved in conjunction with each other when there is government intervention, however without such intervention it is virtually impossible to achieve the two together and there then has to be a trade off. In the case that equity is chosen there is a deadweight loss.

4. Market Efficiency Consumer surplus and producer surplus are the basic tools that economists use to study the welfare of buyers and sellers in a market. The economic well-being of a society is measured as the sum of consumer surplus and producer surplus - total surplus . Market efficiency is attained when the allocation of resources maximises total surplus.

5. Economic well-being and total surplus or Total Surplus = Total Benefits _ Total Costs Total Surplus = Consumer Surplus Producer Surplus +

6. Price Equilibrium price Quantity Equilibrium quantity Supply Demand Producer Surplus Consumer Surplus TS = MAX only at EQUIL ! Total Surplus

7. Market Inefficiency Deadweight Loss The decrease in total surplus that results from an inefficient allocation of resources

8. Sources of Inefficiency Price & quantity restrictions Taxes & subsidies Monopoly – market power Externalities These lead to either underproduction or overproduction.

9. Price Quantity Qe Supply Demand Under & Overproduction Deadweight loss underproduction overproduction

10. Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 10 Price Ceiling If the market clearance price is not charged welfare falls. If a price is set below the clearance price producers reduce supply (to Q2). There is excess demand. Producer surplus is low (the orange area). The consumers who can get the product get a big bonus (the red area), but some potential buyers go without. Price Quantity Supply Demand Consumer surplus Producer surplus Q2 Deadweight loss

11. Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 11 Price Floor If the market clearance price is not charged welfare falls. If a price is set above the clearance price consumers reduce demand. There is excess supply. Consumer surplus is low (the red area). Producers who make a sale get a big bonus (the orange area), but some production is left unsold. Price Quantity Supply Demand Consumer surplus Producer surplus Deadweight loss

12. Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 12 Market failure Markets sometimes fail to produce efficient results because the necessary conditions do not exist. They fail, for example when : 1. Externalities are not taken into account (and bystanders suffer collateral damage) 2. Producers have scarcity or monopoly power (and they dominate the market, raise prices and earn excessive profits 3. Key information is not known or shared evenly 4. Income distribution is unfair.

13. Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 13 When there are externalities Bystanders (third parties) can be affected by economic decisions made by others. These spin-off or side effects of an economic decision are called externalities . Bystanders can be affected in a good or positive way (e.g. your neighbour has nice garden). These positive externalities create social benefits. Bystanders can be harmed or affected in a negative way (e.g. people become sick from factory pollution). These negative externalities create social costs.

14. Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 14 Ignoring externalities leads to inefficiency If market players do not take these negative externalities or social costs into account (do not include them in their demand and supply decisions) the market will not work efficiently. Too much will be produced and consumers will pay too low a price. D S airlines Air travel Price Quantity S total Greenhouse Gases are emitted by planes. So do free markets create too many flights at too low a price? Social cost of 5% of climate change

15. Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 15 Scarcity or monopoly power If one of the players in a market has power over the other then the market outcome becomes distorted and the result can be inefficient. If a producer has monopoly power in a sense they have scarcity power . Monopoly power comes from a lack of competition. Producers can deliberately minimise competition (e.g. by branding, innovation, take overs ). Producers with monopoly power can restrict supply or push up prices. The price no longer reflects the costs of production .

16. Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 16 Monopolists restrict supply and push up prices. Monopolists have the power to control supply in the market. This can lead to prices that are higher than those set in competitive markets. The result is inefficiency. Price Quantity Supply (competitive) Demand New Supply (monopoly) Deadweight loss Consumer surplus Producer surplus

17. Market Efficiency The concepts of consumer and producer surplus can be used to analyse a wide range of policy issues: How do taxes affect market efficiency? How do price controls affect market efficiency? How do quantity restrictions affect market efficiency? Who wins and who loses when a country opens itself to international trade? How do externalities, such as pollution, affect the efficiency of market outcomes?

18. Efficiency and Equity (c) Andrew Tibbitt 2008 Slide 18 In a similar way, if market players do not take positive externalities or social benefits into account (do not include them in their demand and supply decisions) the market will not work efficiently. Too little will be supplied and consumers will pay too high a price. D S total Public transport Price Quantity S private Free market public transport could be too expensive if it forces people to use their cars and cause congestion Social benefit of less congestion Ignoring externalities leads to inefficiency

19. Review Maria decides that she would pay as much as $3000 for a new laptop computer. She buys the computer and realises a consumer surplus of $700. How much did Maria pay for her computer? A. $700 B. $2300 C. $3000 D. $3700

20. Review Mr Smith values watching Legally Blonde for the fourth time at $20. He finds a cinema showing Legally Blond e for $5. Mr Smith’s willingness to pay is ___ and his consumer surplus is ___ A. $5; $15 B. $5; $20 C. $20; $5 D. $20; $15

21. Review Tariffs raise prices, increase domestic production and lower domestic consumption. They cause consumer surplus to ____, producer surplus to ____, and total surplus to ____ decrease, decrease, decrease increase, decrease, increase decrease. increase, decrease increase, increase, increase