In the Name of God. Sharif University of Technology. Graduate School of Management and Economics

Size: px
Start display at page:

Download "In the Name of God. Sharif University of Technology. Graduate School of Management and Economics"

Transcription

1 In the Name of God Sharif University of Technology Graduate School of Management and Economics Microeconomics (for MBA students) ( st term) - Group 2 Dr. S. Farshad Fatemi Welfare Economics

2 Welfare Economics: The branch of economics dealing with normative issues. Its purpose is not to describe how the economy works; but to assess how well it works. Welfare economics discusses both Allocative Efficiency Fairness of distribution Microeconomics (for MBA students) Dr. F. Fatemi Page 228

3 Equity Horizontal equity: the identical treatment of identical people Vertical equity: the different treatment of different people in order to reduce the consequences of their innate differences Pareto efficiency An allocation is Pareto-efficient for a given set of consumer tastes, resources and technology, if it is impossible to move to another allocation which would make some people better off and nobody worse off. For example it is Pareto-efficient if the train company price discriminate by offering student discounts to fill in their otherwise empty seats. Microeconomics (for MBA students) Dr. F. Fatemi Page 229

4 Perfect competition and Pareto efficiency If every market in the economy is a perfectly competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient. As expressed in Adam Smith s notion of the Invisible Hand. At any output such as Q * 1, the last film must yield consumers P * 1 extra utility. The supply curve for the competitive film industry (SS) is the marginal cost of films. Away from P * 1, Q * 1, there is a divergence between the marginal cost and the marginal benefit derived by consumers; so a move to that position makes society better off. Microeconomics (for MBA students) Dr. F. Fatemi Page 230

5 Distortions A distortion exists whenever society s marginal cost of producing a good does not equal society s marginal benefit from consuming that good. Some such distortions may be inevitable and it may be more efficient to spread such distortion over a wide range of markets, rather than concentrating it in one market this results from the theory of the secondbest Microeconomics (for MBA students) Dr. F. Fatemi Page 231

6 Market failure Market failure occurs when equilibrium in free unregulated markets will fail to achieve an efficient allocation. Imperfect competition Social priorities (e.g. equity) Externalities Other missing markets (future goods, risk, information). Microeconomics (for MBA students) Dr. F. Fatemi Page 232

7 Externalities An externality arises whenever an individual s production or consumption decision directly affects the production or consumption of others other than through market prices e.g. a chemical firm discharges waste into a lake & ruins the fishing for fishers a smoker smokes in a room & creates discomfort for the others a resident in a street who spends money on a nice front garden & neighbours also enjoy it somebody who vaccinates himself against a potentially epidemic disease & reduces the risk of epidemic for the others as well a farmer whose cattle create greenhouse gases & increases the possible risk of global warming Microeconomics (for MBA students) Dr. F. Fatemi Page 233

8 Marginal benefit versus marginal cost The demand curve reflects the marginal benefits. The supply curve reflects the marginal cost of producing each loaf. For each loaf of bread up to Q1, the marginal benefits exceed the marginal cost. The shaded area shows the maximum welfare that can be gained from the production of bread. When the market is at equilibrium (when supply equals demand), all those benefits will be realized. Microeconomics (for MBA students) Dr. F. Fatemi Page 234

9 Production Externality / External Costs / Negative Exernality Ignoring the external costs associated with the manufacture of paper products, firms will base their production and pricing decisions on S 1 (Marginal Private Costs). If they consider external costs, such as the cost of pollution, they will operate on S 2 (Marginal Social Cost), producing Q 1. The shaded area abc shows the amount by which the marginal cost of production of Q 2 Q 1 units exceeds the marginal benefits to consumers and the inefficiency of the private market. Microeconomics (for MBA students) Dr. F. Fatemi Page 235

10 Consumption Externality / External Benefits / Positive Exernality Ignoring the external benefits of getting flu shots, consumers will base their purchases on D 1 (Marginal Private Benefit) instead of D 2 (Social Private Benefit). Fewer shots will be purchased than could be justified economically. Because the marginal benefit of each shot between Q 1 and Q 2 exceeds its marginal cost of production. External benefits are not being realized. The shaded area abc indicates market inefficiency. Microeconomics (for MBA students) Dr. F. Fatemi Page 236

11 The Limits on Government Intervention Sometimes the distortion resulting from externality effect is negligible. Then little can be gained by government intervention. Government Action itself generates an external cost which should be considered whenever government decides to intervene in a market. Over the long-run some of the externalities might internalize which government action may delay or destroy this process. Microeconomics (for MBA students) Dr. F. Fatemi Page 237

12 Methods of Reducing Externalities (how government should intervene?) Persuasion / Providing Information Advertisements to urge people not to litter or to risk forest fires / Not to drink and drive / To cultivate the land so as to minimize erosion / To conserve water and gas / publishing studies showing the external costs of smoking. (Such efforts are limited in their effect) Assignment of Property Rights Assignment of land rights to cattle owner in order to eliminate overgrazing Government Production Nationalization of schools, public health services, national and state parks, transportation systems (it might reduce the competition and therefore reduce efficiency) Microeconomics (for MBA students) Dr. F. Fatemi Page 238

13 Taxes and Subsidies Taxing the polluting industries (1. find alternative technologies to pollute less 2. reducing the number of units consumed) / Tax credits for the installation of pollution controls Quotas and Standards Imposing quotas and/or standards on all producers. Standards / Minimum Quality Forcing the firms to consider some features in their production (ABS in cars) Microeconomics (for MBA students) Dr. F. Fatemi Page 239

14 Market for Pollution Rights Microeconomics (for MBA students) Dr. F. Fatemi Page 240

15 Reducing pollution is costly adds to the costs of production, increasing product prices and reducing the quantities of products demanded. Therefore firms have a demand for the right to avoid pollution abatement costs. The lower the price of such rights, the greater the quantity of rights that firms will demand. If the government fixes the supply of pollution rights at ten and sells those ten rights to the highest bidder, the price of the rights will settle at the intersection of the supply and demand curves here, about $1,500. Microeconomics (for MBA students) Dr. F. Fatemi Page 241

16 Other Missing Markets Time and risk under free market uncertainty in the future markets may result underinvestment. Microeconomics (for MBA students) Dr. F. Fatemi Page 242