Summary Economics of Regulation Retake
Week 1: Efficiency
Market failure
- Competitive market is pareto efficient.
- Market failure is necessary (but not sufficient!) economic justification for state
intervention.
- Market failure:
1. Market power: price-setters, charge high price that exceeds marginal opportunity
costs of production. Therefore, consumers demand less of the product than is
efficient. It brings X-efficiency (= excessive production costs)
2. Externality: losses or benefits on third parties
3. Public goods (non-rivalrous & non-excludable). Dikes, national defense.
4. Imperfect information: asymmetric information causes two other problems:
a. Adverse selection: one party can’t distinguish between 2 or more actions which
have different risks/costs, and therefore makes a choice based on average value
of these.
b. Moral hazard: risky behavior increases due to prospect of insurance.
Non-market failure
- Market failure approach based on assumption that regulatory intervention is costless.
- But regulation is also costly and generates distortions and inefficiencies. à Coase.
- Economists exaggerate extent of market failure and ignore costs that government
intervention brings with them. Markets can sometimes fix themselves.
- Inefficiency of regulation often due to mismatch between regulatory objective and
regulatory instrument.
- 4 categories of costs:
1. Rule-making costs: costs of designing and implementing legal standards
2. Enforcement costs: costs of enforcing the standards
3. Compliance costs: costs that are imposed on regulated industry
4. Harm costs: social costs imposed by regulatory offences
Welfare
- Welfare = everything that humans value (consumption, leisure time, environmental
quality)
- First welfare theorem = in absence of market failures, competitive equilibrium is pareto-
efficient. However, conditions for competitive market don’t hold in real life. And pareto-
efficiency doesn’t say anything about fairness or redistribution.
- Economics = decision making under scarcity; making best use of resources
Equilibrium
- Nash equilibrium = each player chooses their best option given the expected option of
the other.
- Market clearing price = equilibrium price where there is no excess demand/supply.
- Competitive equilibrium = all buyers & sellers are price-takers, and the quantity
supplied is equal to the quantity demanded.
1
,Summary Economics of Regulation Retake
Competitive market
- Used as bench mark. It’s ideal market because:
1. Property rights well defined and secure
2. Consumers and suppliers are price takers
3. Perfect information
4. No entry/exit barriers
- If these assumptions hold, equilibrium price reflets social
marginal costs of producing.
- Competitive market is efficient because it reflects the social marginal costs of
producing
Ø Qs = social marginal costs
Ø CS & PS = good proxy for welfare and competitive market maximizes this surplus
without any government intervention.
- Deadweight loss = loss of total surplus relative to pareto-efficient allocation (equilibrium
situation)
Efficiency
- Three kinds of efficiency:
1. Exchange efficiency
2. Allocative efficiency
3. Production efficiency
Exchange efficiency
- Edgeworth box = how given quantities of 2 products are divided between 2 individuals.
- Exchange efficiency = only looks at preferences
- Indifference curve = all combinations of apples + bread that give the same utility.
- Equilibrium 0 not efficient outcome because there are opportunities for trade à can see
from slopes because slopes are not the same.
- Equilibrium 1 is pareto improvement à Bruno stays on same curve, so level of utility is
still the same. Angela better off because on higher indifference curve à traded some
apples for bread
Ø Slopes (MRS) for both now the same and therefore pareto-efficiency in equilibrium
1.
2
, Summary Economics of Regulation Retake
Production efficiency
- Production efficiency = looks at production function
- Production function = amount of output that can be produced by amount/combination
of input.
- Marginal product = extra amount of output if input increased by one unit.
- Diminishing returns = use of additional unit results in smaller increase in output.
- Time (scarce resource) used to produce bread. Input increases à output increases à
decreases
- Opportunity costs = input in A could have been used in
production B. Best alternative use of resource.
Ø To get more free time, forgo opportunity of getting
higher grade).
- Production possibilities frontier/feasibility frontier = how
much of every product can be produced if all inputs most
efficiently used. Inside the frontier is not efficient, on is
efficient and out is unfeasible.
- MRT = giving up output product 2 for little but more of
output of product 1
- Production must be on the frontier to be efficient
- But which point to choose on the frontier? à therefore we need preferences =
allocative efficiency
Allocative efficiency
- Aggregate indifference curve tells us which combination of output to produce.
- Best point: MRS = MRT.
Pareto
- Two kinds of efficiency
1. Pareto efficiency = welfare of an individual can’t be improved without making
someone else worse off à very strict definition, therefore Hicks.
n Pareto efficiency flows from 3 assumptions: price-taking, complete contract, no
effect on others
2. Pareto improvement = change that makes at least one individual better off, without
reducing welfare of others.
- Pareto criterion based on 2 value judgements:
1. Individual is best judge of his/her own welfare
2. Welfare of society depend on welfare of individuals that comprise it.
- Since most policies have winners and losers, pareto not really applicable to real life.
Hicks-Kaldor
3
Week 1: Efficiency
Market failure
- Competitive market is pareto efficient.
- Market failure is necessary (but not sufficient!) economic justification for state
intervention.
- Market failure:
1. Market power: price-setters, charge high price that exceeds marginal opportunity
costs of production. Therefore, consumers demand less of the product than is
efficient. It brings X-efficiency (= excessive production costs)
2. Externality: losses or benefits on third parties
3. Public goods (non-rivalrous & non-excludable). Dikes, national defense.
4. Imperfect information: asymmetric information causes two other problems:
a. Adverse selection: one party can’t distinguish between 2 or more actions which
have different risks/costs, and therefore makes a choice based on average value
of these.
b. Moral hazard: risky behavior increases due to prospect of insurance.
Non-market failure
- Market failure approach based on assumption that regulatory intervention is costless.
- But regulation is also costly and generates distortions and inefficiencies. à Coase.
- Economists exaggerate extent of market failure and ignore costs that government
intervention brings with them. Markets can sometimes fix themselves.
- Inefficiency of regulation often due to mismatch between regulatory objective and
regulatory instrument.
- 4 categories of costs:
1. Rule-making costs: costs of designing and implementing legal standards
2. Enforcement costs: costs of enforcing the standards
3. Compliance costs: costs that are imposed on regulated industry
4. Harm costs: social costs imposed by regulatory offences
Welfare
- Welfare = everything that humans value (consumption, leisure time, environmental
quality)
- First welfare theorem = in absence of market failures, competitive equilibrium is pareto-
efficient. However, conditions for competitive market don’t hold in real life. And pareto-
efficiency doesn’t say anything about fairness or redistribution.
- Economics = decision making under scarcity; making best use of resources
Equilibrium
- Nash equilibrium = each player chooses their best option given the expected option of
the other.
- Market clearing price = equilibrium price where there is no excess demand/supply.
- Competitive equilibrium = all buyers & sellers are price-takers, and the quantity
supplied is equal to the quantity demanded.
1
,Summary Economics of Regulation Retake
Competitive market
- Used as bench mark. It’s ideal market because:
1. Property rights well defined and secure
2. Consumers and suppliers are price takers
3. Perfect information
4. No entry/exit barriers
- If these assumptions hold, equilibrium price reflets social
marginal costs of producing.
- Competitive market is efficient because it reflects the social marginal costs of
producing
Ø Qs = social marginal costs
Ø CS & PS = good proxy for welfare and competitive market maximizes this surplus
without any government intervention.
- Deadweight loss = loss of total surplus relative to pareto-efficient allocation (equilibrium
situation)
Efficiency
- Three kinds of efficiency:
1. Exchange efficiency
2. Allocative efficiency
3. Production efficiency
Exchange efficiency
- Edgeworth box = how given quantities of 2 products are divided between 2 individuals.
- Exchange efficiency = only looks at preferences
- Indifference curve = all combinations of apples + bread that give the same utility.
- Equilibrium 0 not efficient outcome because there are opportunities for trade à can see
from slopes because slopes are not the same.
- Equilibrium 1 is pareto improvement à Bruno stays on same curve, so level of utility is
still the same. Angela better off because on higher indifference curve à traded some
apples for bread
Ø Slopes (MRS) for both now the same and therefore pareto-efficiency in equilibrium
1.
2
, Summary Economics of Regulation Retake
Production efficiency
- Production efficiency = looks at production function
- Production function = amount of output that can be produced by amount/combination
of input.
- Marginal product = extra amount of output if input increased by one unit.
- Diminishing returns = use of additional unit results in smaller increase in output.
- Time (scarce resource) used to produce bread. Input increases à output increases à
decreases
- Opportunity costs = input in A could have been used in
production B. Best alternative use of resource.
Ø To get more free time, forgo opportunity of getting
higher grade).
- Production possibilities frontier/feasibility frontier = how
much of every product can be produced if all inputs most
efficiently used. Inside the frontier is not efficient, on is
efficient and out is unfeasible.
- MRT = giving up output product 2 for little but more of
output of product 1
- Production must be on the frontier to be efficient
- But which point to choose on the frontier? à therefore we need preferences =
allocative efficiency
Allocative efficiency
- Aggregate indifference curve tells us which combination of output to produce.
- Best point: MRS = MRT.
Pareto
- Two kinds of efficiency
1. Pareto efficiency = welfare of an individual can’t be improved without making
someone else worse off à very strict definition, therefore Hicks.
n Pareto efficiency flows from 3 assumptions: price-taking, complete contract, no
effect on others
2. Pareto improvement = change that makes at least one individual better off, without
reducing welfare of others.
- Pareto criterion based on 2 value judgements:
1. Individual is best judge of his/her own welfare
2. Welfare of society depend on welfare of individuals that comprise it.
- Since most policies have winners and losers, pareto not really applicable to real life.
Hicks-Kaldor
3
