Download Chapter 5: Efficiency and the Role of Government

Chapter 5: Efficiency and
the Role of Government
“According to the system of natural liberty, the sovereign has only three duties
to attend to ... first, the duty of protecting the society from the violence and
invasion of other independent societies; secondly, the duty of protecting, so
far as possible, every member of the society from the injustice or oppression of
every other member of it, or the duty of establishing an exact administration of
justice, and thirdly, the duty of erecting and maintaining certain public works
and certain public institutions, which it can never be for the interest of any
individual, or small number of individuals, to erect and maintain”
Adam Smith
The Minimum Role of Government
(Laissez Faire)
 According to Adam Smith, the fundamental roles of government include
 national defense,
 an impartial system of laws,
 a set of public works and institutions which can’t be maintained by
individuals, such as roads
Government in Perfect
Competition
Any change from a Pareto optimal situation is likely to
produce a loss of efficiency, including the actions of government.
Efficiency Concepts in an Economy
with Government
 Definition: Government Surplus (GS) = the net benefits of the market to
government = government tax revenue- government spending.
 Concept: The net benefits in a market with government include
government surplus as well as others.
 Net Benefits = Consumer Surplus + Producer Surplus + Government Surplus
+ External Surplus
 Taxes are positive gains for government, and government spending is a
loss for government.
A Tax on Producers Cuts Supply
by Increasing Cost
After a constant per-unit tax is imposed,
• Consumer Surplus Falls to A.
• Producer Surplus Falls to H + I.
• Government Surplus (tax revenue) rises
from nothing to B + D.
• Net Gains Fall because C and E are lost.
Table 5-1: The Efficiency Effects of a Constant Per-Unit Tax
Market
Condition
No Tax
With Tax
Difference
Consumer
Surplus
A+B+C
Producer
Surplus
D+E+H+I
Government
Surplus
None
A
-B -C
H+I
-D-E
B+D
B+D
Net Gain
A+B+C+D+E
+H+I
A+H+I+B+D
-C-E
Deadweight
Loss
None
C+E
C+E
A tax on Consumers has
very similar effects
• A tax on consumers creates two demand curves.
• The original curve gives the maximum willingness
to pay.
• The new demand subtracts the amount of tax
from willingness to pay, giving the new relation
between price and quantity.
• Quantity falls, just as with a producer tax
• Price falls, but consumers pay tax separately
• Consumer Surplus falls to A
• Producer Surplus Falls to H
• Govt. Surplus is B+D.
• Net gains fall by C and E
• C and E are the deadweight loss
Producer vs. Consumer tax
 If the demand and supply curves are the same, producer and consumer
taxes have the same effect on the market. Consumers pay more
(including any tax), producers keep less revenue for each unit sold,
quantity falls, and a deadweight loss occurs.
The Effects of a
Fixed per-unit Subsidy
 A subsidy is the opposite of a tax in several ways
 1) Government loses money and will have a negative government surplus.
 2) Consumers and Producers are both likely to gain from a subsidy
compared to the competitive market.
 3) If applied to a perfectly competitive market, subsidies encourage
overproduction rather than underproduction.
 4) Subsidies are likely to be politically popular among those groups who
receive them, unlike taxes.
The Effects of a Fixed per-unit
Production Subsidy
• Because producers receive revenue from
the government and also from consumers,
consumers will pay less than producers
receive in revenue.
• Consumer Surplus grows due to the lower
price and higher quantity.
• Producer Surplus grows because of the
higher revenue per unit they receive and
the higher quantity.
• Government Surplus is negative because it is
subsidizing the private sector.
• Area I is the deadweight loss because
it is the only part of the government subsidy that
doesn’t benefit producers or consumers
The Effects of a
Fixed per-unit Subsidy
Table 5-2: The Efficiency Effects of a Constant Per-Unit Subsidy
Market
Condition
No Subsidy
Subsidy
Difference
Consumer
Surplus
A+B
A+B+C+D+E
C+D+E
Producer
Surplus
C+F
B+H+C+F
B+G
Government Net Gain
Surplus
None
A+B+C+F
-B-H-I-C-D-E A+B+C+F-I
-B-H-I-C-D-E -I
Deadweight
Loss
None
I
I
The Effects of a Quota (a limit on
quantity bought and sold)
A quota has effects similar
to a monopoly
• Higher price
• Lower quantity
• Price is greater than the
marginal cost of production.
• A deadweight loss due to
underproduction.
Table 5-3: Effects of a Quota
Market
Condition
No Quota
Quota
Difference
Consumer
Surplus
A+B+C
A
-(B+C)
Producer
Surplus
D+E
B+D
B-E
Government
Net Gain
Surplus
None
A+B+C+D+E
None
A+B+D
None
-(C + E)
Deadweight
Loss
None
C+E
C+E
The Effects of Price Floors and Ceilings
• If effective, price floors and
ceilings produce disequilibria
(production shortages
or surpluses).
• Either buyers or sellers
definitely lose.
• Both policies produce
an under-production
deadweight loss of C+E.
Table 5-4: Price Floors and Ceilings
Market
Condition
Consumer
Surplus
Producer
Surplus
Government
Surplus
Net Gain
Deadweight
Loss
Competition
A+B+C
D+E+F
None
None
Price Ceiling
Price Floor
A+B+D
A
F
B+D
None
None
A+B+C+D+
E+F
A+B+D+F
A+B+D
C+E
C+E
Agricultural Policy:
Alternative Strategies
 Is there any market failure you can think of that would justify the
subsidization of agriculture on efficiency grounds?
 There have been several types of policies for subsidizing agriculture in
different nations.
Agricultural Policy:
Price Floor Policies
• A policy that includes buying
surplus grain is much less efficient
than paying farmers not to grow
because the cost of growing the
grain is wasted.
Table 5-5: Alternative Price Floor Policies
Policy
Competitive
Market
Price Floor:
Govt. buys the
surplus
Price Floor: Pay
farmers not to
grow beyond Q
Consumer
Surplus
A+B+C
Producer
Surplus
G+F
Governme
nt Surplus
None
A
B+C+D
+G+F
-(C+D+E
B+C+D+G
+F+E+I
-(C+D+E
A
Net Gains
A+B+C
+G+F
A+B+G-E-I
Deadweight
Loss
None
C+F+E+I
+F+I)
+F+I)
A+B+G
C+F
Quotas and Subsidies
 Quotas and Subsidies have been applied to agricultural markets. Their
general effects are expected to be the same as those in our models.
 Quotas will raise the price and lower the quantity, but will not involve any
payments to farmers for excess grain
 Subsidies will increase production, lower consumer prices, raise producer
surplus, and cost the government money.
Summarizing Alternative
Agricultural Programs
Table 5-6: The Efficiency Effects of Alternate Agriculture Programs
Policy
Competition
Price Floor + Govt.
Buys Surplus
Price Floor + Govt.
pays not to grow
Quota
Subsidy
Consumer
Surplus
A+B+C
Producer
Surplus
G+F+J
Government
Surplus
None
B+C+D+
G+F+J
B+C+D+
G+F+J+
E+I+L
-C-D-EF-I-L
-C-D-EF-I-L
A
B+G+J
A+B+C+G
+F+H+I
B+C+D+
G+F+J
A
A
Net Gain
A+B+C+
G+F+J
A+B+G+J
-E-I-L
Deadweight
Loss
None
C+F+
E+I+L
A+B+G+J
C+F
None
A+B+G+J
C+F
-B-C-D-E
-F-G-H-I
A+B+C+
G+F+J-E
E
Government and
Imperfect Markets
Can two “wrongs” make a right?
Taxing Negative Externalities
• An optimal Pigou tax can eliminate overproduction and
reduce the negative externality.
• Both consumers and producers lose, however.
Table 5-7 (from Figure 5-9): A Tax on a Polluting Market
Private Equilibrium
With Tax
CS
ABCD
A
PS
EFGKLM
KLM
External S.
-(MFCDGH)
-CFM
Govt. S.
None
BCEF
Net Gains
ABEKL - H
ABEKL
An Extended Example:
A Pollution Tax with Numbers
 marginal private cost = 10 + Q
 marginal social cost = 10 + 1.5 Q
 demand
P = 100 – Q
Step 1: Find social equilibrium Price and Quantity
Step 2: Find the private marginal cost at the same quantity , and the difference
between the private and social MCs
An Extended Example:
A Pollution Tax with Numbers
 marginal private cost = 10 + Q
 marginal social cost = 10 + 1.5 Q
 demand
P = 100 – Q
Step 1: Find social equilibrium Price and Quantity
Qsocial = 36, P = 64 (from demand curve)
Step 2: Find the private marginal cost at the same quantity , and the difference
between the private and social MCs
MCprivate = 10 + 36 = $46
MCsocial = 10 + 1.5 (36) = $64
Difference = $18 = the marginal external cost at that quantity
The Policy: Impose a per-unit tax equal to the marginal
external cost at the social equilibrium
 Imposing an $18 tax per unit shifts the private MC upward by $18, to…
Private MC + tax = 28 + Q
The new private equilibrium with the tax will be 100 – Q = 28 + Q
The new quantity = 36, and the new price = 64
Calculating the Net Gains for all parties:
CS, PS, and GS
CS = ½ x 36 x ($100 – 64) = $648
GS (tax revenue) = $18 x 36 = $648
PS = ½ x 36 x ($46 - $10) = $648
External Surplus (ES) equals area C+F+M+I minus area I:
External Surplus = – [½ x 36 x (64-10) - ½ x36 x (46-10)] = - $324.
Total net gains = CS + PS + GS + ES = $648 + $648 + $648 - $324 = $1,620.
Compared to the Private Equilibrium:
 At the private equilibrium, Q = 45, P= 55
CS = 1,012.5 PS = 1,012.5 Ex. S. = -506.25 Net Gains = 1,518.75
 At the social equilibrium, Q = 36, P = 64
CS = 648 PS = 648 GS = 648, Ex. S. = - 324 Net Gains = 1620
 $101.25 of deadweight loss has been eliminated (area H in Figure 5-8)
 Negative externalities have been reduced
 Consumers and producers are worse off
Price Ceilings and Natural Monopoly
A “Natural Monopoly” has high
economies of scale, and therefore
has a falling average total cost
over much of its range.
If unregulated, it will produce too little
(recall that the social equilibrium would
Be where demand = Marginal cost)
and charge a high monopoly price.
A price Ceiling changes the relationship between
Price and Marginal Revenue for a Monopoly
Table 5-8: No Price Ceiling
PRICE
Quantity
Total
Revenue
Marginal
revenue
10
2
9
3
8 7
4 5
6
6
5
7
4
8
xxx
• If the Marginal Cost is Fixed at
$3, how much will be
produced in each table?
Table 5-9: Price Ceiling at $6
PRICE
6
6 6 6 6 5 4
Quantity 2
3 4 5 6 7 8
Total
Revenue
Marginal xxx
revenue
Different Price Cap Policies
 If the price cap is set where Demand = ATC,
the monopoly will produce Q1 and will make
zero economic profits (because price = ATC)
But some deadweight loss will remain.
 If the price cap is set where Demand = MC,
The monopoly will produce Q2 and reach an
Efficient outcome, but will have negative profits
because Price is less than ATC.
 States regulate utilities using versions of the average
cost approach.
Public Choice and
Government Failure
Public choice theory uses the concepts of self-interest and competition to
analyze the behavior of voters, politicians, interest groups, and bureaucrats.
Two Categories of Public Choice Theory
 The “Virginia School”: Self-interested voters, politicians, and interest groups
create multiple layers of problems that limit the ability of government to translate a
society’s preferences into effective policy.
 The “Chicago School”: Government policies tend to evolve into rational
responses to market imperfections and injustice
The limits of Social Welfare Functions
 The social welfare function defines society’s well-being as a function of the utility of
its individual citizens. SWF = f(U1,U2,…,UN), where U1 is the utility of individual 1,
etc.
 Different ethical theories have different weights for individual utilities
 Since utility is generally not measurable it can’t be directly added or
compared across individuals.
Voting and Elections
 Arrow’s Impossibility Theorem
 The Median Voter Model
 Interest Groups and “Rent Seeking”
Arrow’s Impossibility Theorem
An effective rule for collective decisions must meet the following criteria:
1. The rule leads to a decision regardless of the form of voters’ preferences.
2. The rule can provide a societal ranking for all possible outcomes.
3. The rule must be consistent with individual preferences.
4. The rule is transitive.
5. Society’s ranking of any two choices must be independent of other alternatives.
6. Dictatorship is not permitted.
Arrow’s Impossibility Theorem
 Arrow’s Impossibility Theorem: It is impossible for a collective decision
rule, including elections, to meet all six of these conditions.
 Arrow’s Paradox: The only collective choice mechanism that is always
transitive and allows for consistent preferences over all choices is
dictatorship
The Median Voter Model
 In a simple yes or no or two-party vote the outcome of the median voter model
reduces to majority rule.
 If voter preferences are not distributed in a normal distribution (with “single peaked
preferences”) the election result may not produce a policy favored by a majority.
Table 5-10: A Distribution of Spending Preferences
PROPOSAL
Number of
voters
50 %
SPENDING
INCREASE
20 %
SPENDING
INCREASE
NO
SPENDING
INCREASE
20 %
SPENDING
CUT
50 %
SPENDING
CUT
3,500
1,000
1,000
2,500
2,000
total = 10,000
 In Table 5-10 the median voter favors no spending increase, but 9/10 of all
voters favor a different policy.
Interest Groups and “Rent Seeking”
 Rent seeking takes place when an organization uses political donations,
public relations, or lobbying efforts to gather benefits from government.
 For a firm or industry, rent seeking activity is rational if the net benefits of
governmental activity outweigh the benefits of investment in productive
activity.
 Rent Seeking biases the political process and diverts funds from socially
productive uses.
 A political interest group that relies on membership may organize
through persuasion or offers of services, and then use member’s
contributions to pursue political activities.
Administration
 The administration and enforcement of laws and programs are the duties
of the government’s bureaucracy.
 The goals of administrators may not be consistent with the public interest.
 One model of bureaucracy hypothesizes that the goal of the bureaucrat is
to maximize her agency’s discretionary budget, which is the difference
between total revenue and the minimum cost of producing the agency’s
expected output.
 If oversight is lacking government services are likely to be too small in
scale and too expensive relative to the efficient ideal, much like the effects
of a monopoly
Regulatory Agencies and Capture Theory
 According to Capture Theory, businesses in regulated industries may be
able to control the setting of prices or enforcement of rules by rewarding
the regulator for actions favorable to the firms or by controlling information
about costs in a way that leads to favorable judgments.
 However, oversight by the public and the legislature provides a possible
controlling mechanism for interest group power over regulators.
Enforcement
 The role of financial punishment in law enforcement can be viewed
through a relatively simple concept known as the expected fine. The
expected fine equals the odds of being found guilty of a violation times the
fine if convicted. In symbols,
 EF = π•F; where EF is expected fine, π (the Greek letter pi) is the
probability of being convicted and F is the fine if convicted.
 If the fine or the odds of being convicted are very low, the expected fine
will also be low, and the incentive to follow the regulation or law will be
small.
An Enforcement Example
 Your Turn 5-5: Using the expected fine formula, if the average firm has a
.02 chance of being inspected by OSHA and faces a $400 average fine if
inspected, what is the average expected fine? (Hint: You probably have
more in your wallet).
Conclusion
 The main goal of this chapter is to review the economic rationale for the
role of government in an economy.
 When markets are inefficient a window of opportunity exists for improved
efficiency through public policy.
 Mathematically, this chapter provided further examples of the marketbased mathematical topics introduced in Chapters 2 and 4.