• Life support

• Natural resources for the production of Goods and Services

• Amenity

• Waste assimilation

• Flows of goods and services link the economy and environment: economy operates within the environment

• Simple model of an economy: producers, consumers, capital

• Normative vs. Positive economics

• Economy = management and organisation of society

• Capital = ingredients for the production of goods and services

• Environment = our surroundings, which affect our ability to live on earth, though particularly the biological and physical resources and processes that are ‘natural’ i.e. not man-made

• Different types of economy, e.g. competitive market, barter, exchange, planned etc.

Environmental problems

Dimensions:

• Intergenerational e.g. hazardous nuclear waste
• Interspecies e.g. biodiversity loss and habitat destruction
• International e.g. transboundary acid rain

Uncertainty:

• Risky e.g. climate change
• Potentially irreversible e.g. climate change

Sustainability

• Associated with issues of exhaustibility and substitutability e.g. energy resources

Property Rights:

• Public goods vs. bads e.g. vehicle exhaust pollution
• Tragedy of the Commons e.g. open access fisheries

Rationality and Decision-making

• Rationality = individuals act rationally to maximise their profit/utility/rents, may have varying effects on society/other agents

• Definitions of best/better differ between agents/across society

• Economic agents = basic decision-making units within an economy.

• Bounded rationality = foregoing the task of collecting and assessing all the information because its costs will not result in a worthwhile improvement in the decision-making process.

• Identify actions

• Assess likely outcomes of actions

• Rank outcomes in order of preference

• Select top of the list

• Complete = all options can be compared

• Transitive = preferences are coherent and have logical hierarchy

à AKA The Axioms

Analytical techniques:

• Indifference curve analysis

• Marginal analysis

• Game theory analysis

Utility

• Utility function, u (· ) = a cardinal value attributed to a particular bundle of goods and services. The absolute value doesn’t matter, just the relative weight of preferences compared against each other. 
• Diminishing marginal utility = as someone has more and more of something, the added utility of each successive unit is less and less.
• Indifference curves = the set of combinations of goods that provide the same overall level of utility, such that the individual is indifferent regarding which combination results. Higher indifference curve = higher utility. Represent utility function/preferences

Consumer decisions

• Marginal Rate of Substitution = the rate at which a consumer will substitute a commodity for another while still maintaining the same overall level of utility, i.e. the value of a good in terms of another, at the margin

• Budget constraints place limitations on how many goods and services are available = all bundles of goods available at a given price

• Better and best can be well defined for individual agents, but that may not be what is best for society.

• Better to have a bundle that falls above the indifference curve, but below the budget constraint (all options in this area are improvements and more an individual to a higher indifference curve)

• Best to have the highest indifference curve compatible with the budget constraint:

[image]

Game Theory

• Game theory: individuals’ choices are shaped by those of others.

• Decisions are represented in a matrix, with a row player and a column player, with each cell representing a combination of decisions

• Convention: row player first in each cell

• Not possible to simultaneously get the maximum utility for both players because there is no strictly dominating strategy. Both players would be better off acting together rather than alone, i.e. they maximise utility by choosing the same option, rather than different ones

• The action taken depends on the relative bargaining power of the participants

• Negative consumption externality = when the consumption decisions of one agent impose costs on others who did not have a choice and whose interests were not taken into account (public bads).

• Similarly, firms make decisions that are based on those of their competitors, e.g. whether or not to advertise – it is always better for both/all firms to do the same than for one to do it and the other(s) not (as above)

• Negative production externality = when production decisions impose costs on other parties (e.g. reduce consumers’ utility/firms’ profits) who did not have a choice and whose preferences were not considered.

Producer Decisions

• what to produce

• which inputs (FOP) to use

• how much output to produce

• a desire to maximise profit

• desire to increase market share

• desire to maximise growth rate

• maximise share price

• social goals

• Market selection = like natural selection. Firms that do not maximise their profits will go bust

[image]

[image]

• Firms use FOP (inputs) in production process, and have to pay for their use. There are fixed costs incurred, e.g. interest repayments and variable costs, which depend on the level of output

[image]

• Rational firms will choose to produce a good or service that returns the most profit
• Investors and entrepreneurs want to make money back on an investment, e.g. by buying shares in a company to provide the start up capital.
• Normal returns on investment = prevailing rate of return on investments in the economy, aka the minimum payment required to ensure an investment

b) FOP to use

• Firms look to minimise production costs so as to maximise profit

• Production function q (· ) = inputs required to produce

• Can also be illustrated with isoquants, which are the combination of inputs that keep production constant – i.e. like a utility function for a firm.

• Marginal product = extra output a firm can produce with one extra unit of input at the margin

• MRTS = rate at which a firm can substitute one FOP for another to maintain the same level of production, i.e. the value of one input in terms of another = Ratio of MPs = slope of the isoquant

• Similarly, isocost lines join all combinations of inputs that cost the same amount, i.e. the value of a FOP in terms of another = budget constraint for a firm

• Similarly to consumers, the area between the isocost and isoquant lines represents a better combination of inputs. At the best combination (least cost) the MRTS must be equal to the ratio of factor prices, i.e. [image]

c) How much output to produce

• Marginal analysis used, i.e. decide whether to produce one more unit until answer is ‘no’.

• Marginal Cost = cost to a firm of increasing production by one unit

• Diminishing marginal production; each successive unit of input is less productive than the last.

• Increasing marginal costs means that the costs of producing each successive unit of output increases à Marginal cost curve

• Marginal revenue of production = revenue a firm expects to receive from each additional unit of production (should be equal to the price)

• MC = price (= MR)

• Equi-marginal conditions: where 2 marginal quantities are equated (e.g. marginal costs and revenues)

• Human capital/labour: productive input from humans

• Man-made capital: manmade goods used to make others, e.g. machines, roads etc.

• Natural Capital: NR of planet not created by people

• Enterprise: entrepreneurial start-up capital etc.

• assumed to have owners that claim the benefits of its use and can demand rents for their use – owners of FOP will act rationally to maximise their rents (rent-seeking)

• Normal returns = prevailing rate of payment to the owner of a FOP for its use

• Demand for FOP = derived because they are valuable because of what they can be used to produce, not because they are valuable in and of themselves.

• Transfer earnings = amount a FOP could earn in the next best employment, thus the minimum that must be paid to an owner to prevent it moving to that alternative employment

• When FOP receives payments > transfer earnings = economic rent. Only receives this when demand is high, e.g. premier league footballers/Hollywood actors or supply is limited, e.g. limited edition/collectibles

• Economic rent = payment over and above what it would receive in its next best employment

Social decision-making

• Society is endowed with an initial allocation of resources, i.e. capital/FOP/productive assets

• Pool resources finite, therefore how we allocate those resources impacts how much utility each individual in society can derive.

• Allocation of resources = how scarce resources of society are employed, the flows of goods and services that are produced in that employment and how those goods and services are distributed across society.

Welfare Economics

• Study of social choice

• Subjective statements about how resources should be distributed across society for the ‘best’ outcome

• Assumption: useful to make inter-comparisons of utility between individuals

• Requires subjective statements, e.g. about how we weight peoples’ utility/preferences

• Utilitarianism

• Rawlsianism

• Efficiency is important, but distribution is too

   

• All humans = members society

• Only humans members of society

• Social policy should take into account the welfare of all members of society

• Individual welfare is expressed through individual preferences

• Future welfare should be given less weight than that of the present (positive rate of time preference, i.e. discounting)

• Social policy should seek efficiency i.e. Pareto improving, or more weakly, potentially Pareto improving

à individualistic

à libertarian

à humanist

• Potential Pareto efficiency as ‘best’
• No conviction in principles – no prescription that re-distribution should happen, only that it should be possible
• Ignores important questions of distribution of welfare across society

BUT:

• Redistribution = political not economic. Would have to make inter-personal comparisons of welfare/utility, which are better dealt with by political process

(depends on if you think comparisons are meaningful or not)

SWFs

• Pareto and H-K say what’s better but not best.

• SWF = e.g. Jeremy Bentham: “greatest good for the greatest number of people” = best

[image]

• SWF is:

  • Non-decreasing in its arguments, i.e. welfare can only increase if one individual’s welfare increases

  • Arguments are individual utilities of members of society, i.e. welfare depends on utilities of these members

Utilitarian SWF

• Bentham and John Stuart Mill

• [image]

• Sum of all utilities - implies that we can compare utility across individuals: money can be used(e.g. WTA/WTP)

• Better = net benefits> net costs à can stipulate what is ‘best’

• Can also use indifference curves to say what is best; the indifference curve that just touches the utility possibilities frontier offers the highest level of social welfare

Pros of utilitarianism:

• Simple ethical system. Good vs. Bad
• Egalitarian: all members are equal

Cons of utilitarianism:

• Resources are diverted to those that make the most efficient use out of them, e.g. the fit and young
• Can justify very immoral activities, as long as it is beneficial to society as a whole, e.g. torture, slavery, animal testing
• Does not prescribe equality in its outcomes, i.e. ignores the distribution of resources
• Assumes we can compare across individuals

Maximin SWF

• Rawlsian justice – alternative to utilitarianism

• Basic principles would be agreed upon by any individuals once they’d passed through a ‘veil of ignorance’ and returned to the ‘original position’:

• Liberty principle: everyone should have the right to the maximum liberty that is compatible with similar liberty of others (i.e. everyone should get the most liberty rights possible)

• Difference principle: equalities should be minimised/arranged so they are to everyone’s advantage, and so that opportunities are equally available to all (because humans are risk averse)(i.e. inequality is only acceptable if everyone is better off)

• This supports egalitarianism in society
• Indifference curves L shaped along 45 degree slope[image]
• Society should therefore choose options that increase the utility of the worst off in society

Cons:

• Any policy that moves society away from a situation of equality is wrong

• Assumes humans are risk averse

• Need to assess who is worst off – requires inter-personal comparisons

• Outcomes depend on original position

Pros:

• Pro-poor
• Egalitarian
• Aims for a more equal distribution across society, which is morally just

New Welfare economics

• Cannot compare utility across individuals; utility of individuals in known only to them

• Pareto Criterion = ‘objective’ description of what is ‘best’

• Society has limited resources, thus there is a utility possibility frontier = the maximum level of utility that can be enjoyed by an individual, while holding constant the utility of everyone else in society, and given the technical constraints of society

• Efficiency is paramount, while distribution = politics

• If you can’t compare across individuals, then everyone must agree to a decision… which isn’t going to happen

• False dichotomy between efficiency and equity – don’t necessarily have to be mutually exclusive

Pareto

• Pareto improvement = a change in the allocation of resources such that no one is left worse off, and at least one person is left better off.

• Pareto efficiency when there are no further options that could make someone better off without making anyone else worse off

• Relies on unanimous consent – this is rare in real life and someone will probably always lose out, therefore it is biased towards the status quo because all outcomes are equally bad

• Pareto efficiency doesn’t incorporate questions of distribution. All outcomes are equally good, regardless of their equity

Hicks-Kaldor

• Hicks-Kaldor compensation criterion = possible way of overcoming Pareto’s shortcomings (weaker

• Hicks-Kaldor requires only that something be a potential Pareto improvement, i.e. there is the possibility of redistributing the wealth after the change in resource allocation so that the losers are compensated and everyone will be better off.

• To assess whether something is a potential Pareto improvement, can turn things into money terms, i.e. WTP for benefits and WTA compensation for losses

• If [image] then Hicks-Kaldor would be met

• Solves the unanimity problem of Pareto, and forms the basis of CBA

• BUT only requires redistribution to be possible: not prescriptive

Society

• Who is a member of society? Often defined as within nation states
• Key elements of definition:

• Association of people

• Recognise and adhere to certain rules/code of conduct

• Co-operation for mutual advantage

• Ethical consideration of who is included, e.g. in SWF – rights

Consideration for other nations: international

Rawlsian

• ‘equal rights for nations’ similar to liberty principle – Rawls didn’t see much application of his ideas to international issues

• Rawls: “people in other nations shouldn’t be considered”

• Beitz notes that there are considerable interactions between nation states, and that along the lines of his (wider) definition of society, the international veil of ignorance would yield an international difference principle, which would oblige nations to redistribute wellbeing to the “globally least advantaged person” (or nation)

Consideration for other nations: international

Communitarian

• View human communal relations as having inherent and independent value: trust, mutual understanding, reciprocity

• Community has value, and is not just a means to an end

• Primary responsibility therefore is to fellow members of one’s community

• welfare of members of other communities (including nations) should not be included in social decision-making

Consideration for other nations: international

Utilitarian

• Individual pleasure/pain (= utility) is the only thing that matters, so communities/states etc. can’t be included in moral judgement

• Political arrangements and borders are only justifiable as long as they contribute to net human happiness – individual utility weighted equally

• States have a duty to protect their citizens’ interests, but still have a duty to others in the world

• All people bound to maximise their utility, which means no priority is given to anyone else, regardless of their common religion, nationality, membership of community etc. (brutally individualist)

Consideration for other nations: international

Welfare economics

• no ethical perspective: the utility of those who are affected by a choice should be included in the decision

• Decision pays no heed to morally arbitrary political boundaries

• Assumes society is pre-defined, and usually doesn’t engage in deciding who is within it: side-steps the issue

• If individuals within a society care about the welfare of those outside of it, however, that should be taken into account because it affects the utility of those considered.

Consideration for non-humans: interspecies

Humanist

• Concerned primarily with human welfare

Consideration for non-humans: interspecies

Humanist: Kantian

• Humans are special because they are capable of rational choice and reasoning: ethics and morality can be determined with reasoning

• ‘Respect for persons’ principle:

• humanity should be treated “…as an end, and never as a means only”

• “Only” is important – people use each other all the time, but as long as it is not disrespectful or abusive, or showing that you have no value for them apart form their immediate value it is ok.

• Duty to not mistreat animals arises indirectly – cruelty to animals often leads to cruelty to people

Consideration for non-humans: interspecies

Humanist: Contractarian

• Rawls = contractarian

• Members of society decide on a set of rules and make a contract – this will be mutually advantageous, and based on reciprocity

• Everyone is better off by abiding by the contract, and worse-off by breaking it

• Contractarianism is motivated by self-interest, unlike Kantian ethics.

• You don’t steal not because it is wrong in itself, but because by doing so you imply that people can steal generally, which is worse for everyone

• Key elements:

• Rational choice

• Mutuality

• Reciprocity

• Those who are capable of these features are given rights and responsibilities – those that meet these criteria have primary moral standing

• E.g. Children and animals don’t have primary moral standing because they cannot understand and act upon the terms of the agreement – only matters when their suffering affects the utility of those with primary moral standing (e.g. pet owners/parents)

Consideration for non-humans: interspecies

Humanist: Utilitarian

• Unlike Kantian and contractarian ethics, utilitarianism doesn’t really care about rights

• Instead it assesses actions by how much aggregate wellbeing they create. Overall happiness > overall suffering = right

• Some rights that interfere with the maximisation of overall wellbeing are considered undesirable (e.g. protection of indigenous rights to land, preventing extraction of NR to make goods that people demand...?)

• Rights and responsibilities can only be afforded to humans, so only humans should be included in the social calculus

• The extent to which non-human things are included, depends on the extent to which the welfare of those things affects the welfare of humans

Consideration for non-humans: interspecies

Naturalist:

• Non-human entities possess moral rights too

• Humanist ethics are too exclusive

Consideration for non-humans: interspecies

Naturalist: Kantian

• ‘respect for persons’ can be broadened to ‘respect for others’ (Watson, 1979), where others = those capable of reciprocity (e.g. Gallup mirror test), including some animals

Consideration for non-humans: interspecies

Naturalist: Contractarian

• Can take metaphor of contract too literally - as long as it involves adhering to rules of behaviour that lead to mutual gain, it is contractarian

• Three characteristics must be present to be party to a contract:

  • Potency: must be able to do things that affect the wellbeing of other members of the contract

  • Vulnerability: must be capable of having their wellbeing affected by other members

  • Responsiveness: must be capable of modifying behaviour to conform with rules of the contract

• Any entity with these characteristics = potential party

• Some animals can adapt their behaviour to avoid conflict with humans, e.g. wolves

Consideration for non-humans: interspecies

Naturalist:Utilitarian

• Non-human entities should be included in assessing overall level wellbeing e.g. Singer (egalitarianism)

• Utilitarianism: commitment to maximise surplus of happiness over suffering. Entities themselves don’t matter, but the happiness/suffering they endure does (so only sentient species matter?)

• Bias towards humans = anthropocentrism = speciesism

• Should weight equality because any ‘ism’ goes against principles of equal consideration in utilitarianism

• Some animals are more equal than others – can we attach different weights to welfare of different animals?

Consideration for non-humans: interspecies

Naturalist:ecological

• Kantian, contractarian and Utilitarian ethics confer moral value to some mammalian species. Where do you draw the line?

• Prejudiced and intellectually dishonest to restrict moral standing to entities that fulfil certain criteria: should be expanded to include all living things (e.g. Goodpaster) à Deep ecology – nature has intrinsic value

• Leopold: “a thing is right when it tends to preserve the integrity, stability and beauty of the biotic community”

• Deep Ecology: actions that significantly disturb ecosystems are morally wrong… i.e. more human activity.

• Critique: value is determined by trade-offs. Value is a human construct therefore intrinsic value is hard to swallow

Consideration for non-humans: interspecies

Welfare economics

•  Humanist and utilitarian
• Decisions should be judged based on their effect on human welfare, revealed by peoples’ preferences
• BUT cannot compare individuals’ utility
• Therefore Pareto improving or potentially Pareto improving situations are preferable
• Non-humans (a/biotic) given consideration only to the extent to which their welfare affects that of humans
• Nature has instrumental value

Consideration for future generations: intergenerational

Identity Problem

• Parfit: regardless of policy adopted, we are not harming actual people because they would not exist unless we took the actions we did in the present (past)

• e.g. child of teen mother; from child’s perspective, it is always better to have lived and suffered than to not have lived at all. That particular child was the product of those specific circumstances

• ‘What if’ changes in the way people conduct their lives, or decisions made, change the outcome of the future, and change the actual people that will be born in the future.

• Thus actual people are no worse off because of our actions because they wouldn’t have existed unless we made the decisions we did then.

• No obligation to consider future generations

Consideration for future generations: intergenerational

Utilitarianism

• Maximise social welfare

• Lower weight on future utility because remoteness and uncertainty.

• E.g. stone age man didn’t preserve flint reserves for arrow heads or future generations

[image]

• Utility in the future not given same weight as present, therefore:

[image]

Where δ=weight given to each successive generation (t+n)

• δ gets continually smaller as time goes on until so small as indistinguishable from 0 - discounting

• controversy arises over how to weight each generation in SWF

• Parfit repugnant conclusion: nothing would ever be done for people in the present because the social welfare of ALL the people to come in successive generations would outweigh the welfare of the present generation

• To counter this, could try to maximise utility per head/minimise total suffering (other side of the coin)

Consideration for future generations: intergenerational

Rawlsian

• Just savings principle

• Parties to the original position don’t know which generation they will be born into, so will adopt a just savings principle

• Each generation can use up capital and increase their own consumption and promote their well-being, or can sacrifice consumption by adding to the productive assets (resources) of society

• As long as generations leave to future generations what they would feel entitled to demand from their predecessors, activities can be justified.

• Moral obligation to consider future generations

• Each generation should hand on a better situation than it inherited

Consideration for future generations: intergenerational

Welfare Economics

• No general rule about future generations

• Usually included in some form of discounting

• Discounting because:

• Without discount = slaves to future generations, foregoing consumption now to benefit those who will come after because the number of people that will come after >>> present

• Uncertainty over future existence of humanity: each generation less likely to exist than the last

• Future generations are likely to be wealthier than present, therefore can afford to be weighted lower

• Producers produce with FOP, create G + S, which consumers consume

• Social planners may like to maximise efficiency (Pareto) - would have to decide where to allocate resources used in production as well as the resources available to consumers = centrally planned economy

• Hard to define ‘beneficial’ and also requires that the social planner knows what is best/has complete information

Exchange economy

• Initial allocation of resources can be changed via mutually advantageous exchange

• Consumers will obviously want to engage in exchange that either allows them to move to a higher indifference curve, or to stay on the same one

• There are possibilities for exchange wherever the MRS of different individuals for a particular good are not the same, i.e. one values something more/less in terms of something else

• Individuals will engage in exchange that is Pareto improving until there are no more beneficial exchanges to be made, and the economy is efficient/optimum/equilibrium. At this point, all individuals will value goods the same, that is their MRS are = i.e. [image]

= equi-marginal condition i.e. where a marginal measured (MRS) is equalised across all agents

• Actual allocation of resources will depend on:

• Relative bargaining power of agents

• Initial endowments

• Anywhere within lens shaped area between indifference curves of individuals in Edgeworth box = Pareto improving

• Contract curve = line drawn through all Pareto efficient allocations, = utility possibilities frontier (when plotted in utility space), when production is fixed

• Any combination of resources within the Edgeworth box is a possible combination/distribution within the utility possibilities frontier

Market economies

Perfectly competitive market

• no individuals or firms have enough influence to affect the price mechanism of the market for their own gain

• Interaction between buyers and sellers determines the price: law of one price (prices tend to equalise at equilibrium due to demand and supply)

Market economies:

Value

• Consumption efficiency = [image]

• MRS describes marginal valuation of a good, i.e. how much it is valued in terms of another

• Money is used as a medium of exchange. Money facilitates transactions by creating common currency

• Instead of using MRS therefore, we can use MWTP and MWTA

• Market = forum for exchange

• MWTP = MRS in terms of money =  Customer’s value of a good = MAX a consumer would pay to have another unit of some good

   

  [image]

   

Market economies

Consumer demand

• Diminishing marginal utility, therefore MWTP falls with each successive unit consumed. MWTP curve therefore traces out how much an individual values each successive unit of a good

• Consuming a good provides welfare equal to the difference between how much individual is willing to pay, and how much they actually paid = consumer surplus

• Consumer surplus = monetary measure of welfare derived from purchasing goods in the market

• Therefore MWTP curve = marginal benefit curve = demand for goods at different prices à individual demand curve

• Rational consumers will therefore seek to maximise their utility and consume up until the point where their MWTP = P

• Generally, more wealthy people are prepared to pay more for a good, because they have more money to spend

• Horizontally sum individual demand curves into aggregate demand curve = total demand for good at different prices across whole economy

• Area below curve, above price = aggregate consumer surplus

• price < equilibrium price, demand increases (excess demand) and firms adjust their prices accordingly and  vice versa

Market economies

Allocation of goods

• Equilibrium when supply=demand, market settles at this price and market clears:

[image]

• Individuals purchase good up until their MWTP = market clearing price= P

• Goods are allocated to those that value them most à efficiency

 [image]

• MRS = ratio MWTP for 2 goods = P

• Demand curve approach and indifference curve approach show the same thing, but demand curve approach gives monetary value of consumer surplus i.e. utility

Market economies

Producers

• MWTA = firm’s MRS: rate at which they will trade off one good for another (or the MIN amount of compensation they are prepared to accept for its loss) = individual supply curve

• Diminishing marginal utility therefore MWTA increases

• Individuals will sell things up until the MWTA = P, at which point they would make no further gain from an exchange

• Producer surplus = monetary measure of the amount of utility a producer makes from selling goods in the market – area below the price and above the supply curve

• Sum horizontally to create aggregate supply curve

• Where demand meets supply = equilibrium price = market clearing price[image]

Market economies:

Market equilibrium

• Aggregate demand curve = value of goods to buyers

• Aggregate supply = value of goods to sellers

[image]

• Market forces tend to direct the market towards equilibrium:Interaction between buyers/sellers causes market clearing/equilibrium price to arise

• MRS for all buyers and sellers in the market is the same, and is the same as the price of a good in the market = Equi-marginal condition = efficient allocation of resources

• Social planners should not intervene in the working of the market to achieve distributive equity, rather they should change the initial allocation of resources or use redistribution after the market has achieved efficiency, e.g. taxation

Production in Market Economies

• Goods are allocated by the price mechanism to those who value them highest (max WTP) from those who value them lowest (min WTA), for the most efficient distribution of resources

• Firms = economic units dedicated to a specific production task

• Min WTA for products of a profit-maximising firms’ production = amount it costs to make

• Profit maximisation = cost minimisation

• For firms, MWTA = MC curve

• As production increases, MC increases because each successive unit of FOP employed is less and less productive – Diminishing Marginal Product

• Firms will keep producing as long as the costs of production < P

i.e. [image]

• Profits = producer surplus (although leaves out fixed costs)
• Because firms will always produce until MC = P, MC curve also = supply curve
• Different firms have different MC/Supply curves because they have different technical/organisational/location factors

Production in Market Economies

Interference

Price mechanism ensures:

• production is directed towards those firms that can manufacture goods more cheaply and efficiently à production efficiency

• consumption is directed to those that value goods most à consumption efficiency

• production is organised so that the set of goods produced is most highly valued by consumers à product-mix efficiency

• Interfering in the market mechanism makes problems because it creates artificial demand or supply. If the price is lowered, demand increases, but it is not profitable for firms to make quite so many, therefore supply decreases.
• Deadweight loss = lost potential surplus when a market fails to allocate resources efficiently, e.g. when governments or companies intervene
• This creates a black market, in which people are prepared to pay more than the equilibrium price for a good (up to their MWTP).

Production in Market Economies

FOP

• Basic resources of society

• Assumed to have owners, who have rights:

  • To claim benefits

  • To chose how to use FOP

  • To exchange/rent/sell

• Firms pay for the use of FOP with wages

• Problem arises when environmental goods have no owners, and thus there is no price paid for their use

• The wealth individuals have is derived from their ownership of FOP, which firms pay them to use

• Society allocates its resources/FOP to the most useful and productive uses via price mechanism

   

Production in Market Economies

Supply

• Owners of FOP have MWTA in return for their use

• Not consumption goods (no utility out of them) so seek to maximise rents

• Min WTA for use of FOP is the amount paid if in the next best employment, i.e. transfer earnings

• More skilled jobs are in shorter supply, so can command higher wages – hence the transfer earnings are high

• To attract the amount of workers you require, a firm would have to offer a figure very close to the transfer earnings of the individuals with the skill levels it requires

• Factor supply curve = total quantity of FOP supplied at different levels of payment, constructed from the ordered set of transfer earnings = payments could get in next best employment = market-clearing prices in next best employments = value of output if FOP switched to alternative employment

• Even highly skilled and sought-after individuals, like pop stars or footballers, might have very low transfer earnings because their next-best employment might be minimum wage-slavery. They therefore earn very high rents.

• If curve goes vertical, indicates that there are never more than a very few individuals capable of doing that job

Production in Market Economies

Demand

• Derived demand because FOPs not valuable in themselves, rather because the things they produce have value.

• Diminishing marginal product in product function (q)

• q() doesn’t always have to pass through 0 if having none of a particular FOP means production can still happen, albeit limitedly (e.g. scooters – pizzas can still be delivered on foot)

• Firms are WTP the owner of each FOP up to the amount that FOP makes for the firm, i.e. the MP multiplied by the price in the market

[image]

• MWTP falls to 0 as successively more of a FOP is employed – diminishing marginal product
• MWTP curve = FOP demand curve = the amount of a FOP a firm will employ at different prices (derived demand so = value of products that can be made by those FOP)

Production in Market Economies

Demand (2)

• Firms employ FOP up until MWTP = cost employing it, i.e. [image]

  (labour)

  [image]

  (other FOP)

• Price mechanism ensures that FOP are engaged in most productive employment

• Aggregate demand curve = value derived from employing each unit of FOP from most to least valuable

• Aggregate supply curve = value for individuals placing labour into process, i.e. transfer earnings

• Wages settle where FOP supply = demand (equilibrium)[image]

• Total shaded area = total output

• Light/medium combined square = costs (wages/rents)

• Dark shaded area = profit (producer surplus)

• Costs = transfer earnings (what they could get elsewhere) + economic rents (what they get here)

• The sliver (medium shaded) above transfer earnings (below wage) = economic rent

Production in Market Economies

Efficiency

• Firms employ FOPs until value of output created by employing one more unit = market clearing price (so if one more unit were employed = factor clearing price

• Market clearing price = value of output gained by dedicating one more unit of FOP to that productive activity

• Factor supply = transfer earnings = market price in alternative employment = value of output in alternative employment

• Value a FOP can generate for society in that employment = factor demand curve.

• Value FOP can generate for society in alternative employment = factor supply curve

• Therefore, market mechanism ensures that each unit that can create more value for society in this employment is used in this employment, and vice versa

   

• Market clearing price where supply = demand
• Indicates value of output gained from employing FOP in this employment AND cost of output foregone by not employing it in alternative employment

Factor Markets and MCs: full circle

outline

• Price for a FOP at the margin tells us about the value of goods NOT produced

• Prices of goods from product markets signal to factor markets how much value can be made from employing FOP in making different products, and hence determine factor prices

• Prices in factor markets signal the cost of using a FOP to make one good, and also of foregone production elsewhere in the economy

• Rational firms produce at least cost, so their costs per unit of FOP = costs per unit output = MCs = value consumers place on goods not produced

Factor Markets and MCs: full circle

more detail

• Rational firms MWTP = P (FOP)

[image](and same for good B)

• w/MP_L relates cost per unit output contributed by last person (unit of labour) to be employed

• r/MP_K relates cost per unit output contributed by last unit of FOP to be employed

• Substitute cost-effective FOP for less cost-effective until balance is achieved, producing at least cost.

• So:

[image]

• MC of production determined by prices they have to pay for inputs in product markets, therefore their supply curves (MC curves) in product markets arise from participation in factor markets

• Market prices of MCs of production = value of output foregone elsewhere in the economy by employing FOP in a certain way

• Therefore, although MCs = price they have to pay for employing one more of a factor to produce one more unit of a good, they also represent the value consumers place on goods not produced.

• Supply curve therefore = costs to firms of making a product, AND costs to consumers of losing out on products not made

• Consumption efficiency: price mechanism in product markets ensures consumers hold the same marginal value for all goods, so no Pareto improvements are possible

• Production efficiency: firms expand til MC = P, so couldn’t produce those goods at a cheaper cost

• Product-mix efficiency: product market supply curve = value of goods not produced, and product market demand curve = value of goods produced. Market therefore ensures production of goods where MWTP goods produced > MWTP goods that aren’t produced, so the set of goods produced is most highly valued by consumers

General equilibrium

• Consumers use their wealth to convey desire for goods via WTP in product markets, summed into aggregate demand curve showing value of goods.

• Interacts with aggregate supply to create equilibrium price

• Firms use this price information to determine how much they are WTP for units of FOP

• So product prices determine firms’ WTP for each FOP in factor market, summed to create aggregate demand curve for FOP

• Interacts with aggregate supply curve for FOP, which conveys value of products that are foregone.

• Factor market reaches equilibrium where supply = demand, indicating the value of the output created, and also of that foregone

• Factor prices determine firms’ costs of manufacturing, i.e. MCs, which when added together, represent the firms’ aggregate supply curve in the product market

General equilibrium

• Demand consumers + availability FOP determine input prices, which determine supply of product market

• Prices from demand = supply in product market determine demand for FOP in factor markets

• Prices FOP, determined by demand = supply in factor market, determine firms’ costs of production

• Firms’ costs of production determine supply in product markets

• Supply in product markets interacts with consumer demand to create price!

= General Equilibrium

• First fundamental theorem of welfare economics (Efficiency):

If all markets are perfectly competitive, the allocation of resources will be Pareto efficient

• Second fundamental theorem of welfare economics (Equity):

Any Pareto efficient allocation can be obtained via competitive market processes, as long as the initial endowment of resources can be redistributed

àno need for social planners except to determine initial allocation, and let markets take care of efficiency

Assumptions of markets:

• Property Rights: well-defined, transferable and secure. Benefits accrue to the owner of a good

• Complete information: all parties have access to the same information. Where asymmetric information arises, e.g. where there is uncertainty, allocation is not efficient

• Market Power: No single agent can influence the price of a good (e.g. monopoly/monopsoly)

• Transaction costs: no costs associated with carrying out exchanges which might otherwise discourage the exchange, e.g. bargaining costs, taxes, search and information costs etc.

• Rational Behaviour: self-interested, utility maximising consumers, and profit-maximising firms

• Rights to:

• Choice of use

• Benefits from use

• Exchange

• Can have property rights over physical or less tangible things, like ideas, NR, commodities etc.
• Fundamental to the functioning of markets – without them, there are no markets for things (GOOOOD)
• Libertarianism: only function of the government is to protect PR
• Markets will ensure resources are used well as long as PR are strong

Goods, Bads, Externalities

• Enforcing PR for some goods is (nearly) impossible
• Ability to enforce PR depends on excludability – simpler and cheaper to exclude = more secure rights of ownership
• Categorisation can change over time, e.g. as technology develops (e.g. monitoring – drones)

Private goods:

• Excludable: easy to assert ownership with legal protection afforded by social institutions, e.g. beer, cars, clothes etc. Markets can be easily established

• Rivalrous in consumption: once they have been used, they cannot be enjoyed by others

Public goods:

• Non-excludable: impossible to assert PR.The problem of free riders arises; people who benefit without contributing to its provision. Valuable public goods will therefore go unproduced if this problem cannot be solved

• Non-rivalrous in consumption: other people enjoying them doesn’t detract from your enjoyment of them, e.g. fireworks display

• Excludable: only certain people are permitted to use them, e.g. cinema

• non-rivalrous in consumption once the group which is permitted to enjoy them has been established (i.e. people have been excluded)

Common Goods

• non-excludable: impossible or prohibitively expensive to assert PR. Unprotected by legal institutions.

• Rivalrous in consumption: once they have been used up, others cannot use them too, e.g. open access fisheries, grazing land etc. (Hardin) By using them, one creates an externality

• Environmental goods are often public goods (positive externalities), e.g. clean air. These therefore tend to be under-produced if their level is determined by market forces, while public bads are overproduced.

• Disincentives against producing public bads (negative externalities) are not established without PR, because no-one has to pay for polluting, while they DO have to pay for not polluting (i.e. Public bads are free, while public goods are expensive à rational firms will always minimise costs, therefore create public bads instead)

• Firms that pollute claim de facto PR because they are choosing how to use the atmosphere, a public good.

• These PR are not well-defined, however, so others cannot claim compensation, or enjoy benefits of not polluting because a firm has decided to use the resource in a certain way.

• Pollution, e.g. cigarette smoking, vehicle exhausts, garden bonfires – cannot assert PR over small part of the atmosphere, therefore negative externalities are created

Pollution and Marginal Abatement Curve

• Consider clean air as a FOP in the production of a good; health

  • Firms can use clean air as repository for waste and therefore create pollution

  • Individuals use clean air when they breathe, contributing to good health

• Set of firms producing same (sort of) things = industry

• Quantity pollution = quantity clean air used up

• Firms create pollution as a by-product of the goods they produce. To prevent this would cost them money while polluting is free because there are no PR over things like the atmosphere

• Firms expand production until MC = P, therefore if pollution is a free FOP, they will increase production further than if they had to pay

• [image]: M = market outcome

• Costs of abatement increase as firms emit less, because it becomes harder to reduce pollution - the cheapest way of abating pollution is done first

• Costs of abatement measures are plotted on a Marginal Abatement Cost Curve (MAC) = costs of measures taken by a polluting firm to reduce each unit of pollution, ordered from most expensive to the least

• Can interpret the other way around: the max WTP for emitting one unit of pollution (cost of abatement measure) à MWTP for creating pollution/using up clean air

• When pollution is free, the firm will use all units of clean air for which its MWTP > 0.

• Can sum the total of all firms in an industry to find an aggregate curve = least cost pathway for abatement in industry

• Industry MAC = industry demand for clean air. Would change if pricing were introduced…

Pollution and Marginal External Costs Curve

• Individuals MWTP = transfer earnings = MEC = indicates cost to society of each successive unit of pollution created/clean air used up

• More individuals are impacted more significantly with each successive unit of pollution à sum of WTP for each unit of clean air, i.e. avoiding negative health outcomes

• External because not considered by polluters in deciding their levels of emissions

• Transfer earnings of clean air; each unit of clean air has an alternative use and this MEC curve indicates the value it would have in its next best employment, i.e. creating good health. If it had an owner, the maximum amount that would be paid for a unit would be given by the total WTP for that unit

Factor market for clean air

• When P_M = 0, the pollution level will be Q_M: is it efficient?

• Reducing pollution by one unit has a relatively small associated abatement cost, while the WTP of individuals in society for that abatement is lots higher, so the allocation of resources is not efficient.

• An efficient allocation of resources would arise when the use of clean air is directed towards uses where it is valued most

• The optimal level of pollution Q* (if PR were well-defined) is found when individuals are WTP the same amount that it costs to abate that pollution. Beyond that, the WTP of individuals would not cover the costs to firms of abatement.

• i.e. socially efficient level of pollution when[image]

• so eliminating all pollution is too much of a sacrifice (costs too much).

• Clean air possesses value therefore not just as a life-support system, but also as a repository for waste.

• Pollution is not the problem, it is the unassigned PR that cause problems – factor markets cannot convey to firms the value that society puts on its alternative uses (i.e. goods foregone, like good health and functioning ecosystems)