Efficiency and Equity

A rationing system to deal with the

economic problem
Because economic resources are relatively scarce
(resources are limited, wants are unlimited) a society
can’t have everything they want. There must be a
system that rations both resources and products.

The rationing system must answer the following

questions:

1. What, and how much, to produce

2. How to produce
3. For whom to produce

Slide 2
Tests for a rationing system

The two basic tests for any rationing system are:

 Is the system efficient?

 Does it enhance welfare?
 Is it fair?

Slide 3
Efficiency and equity
1. Efficiency – is the economy getting the most of out its
scarce resources (or are they being wasted)?
1. Technical efficiency – is production being done at
lowest unit cost?
2. Allocative efficiency – are resources being used to
make products that people want?
2. Equity – how fair is the distribution of products between
different members of society?
1. Horizontal equity – no discrimination between
people whose economic characteristics and
performance are equal
2. Vertical equity – different treatment of different
people in order to reduce the differences between
people
Slide 4
Different rationing systems

The world’s dominant rationing system is the price

mechanism.

Prices are determined in markets (as a result of the

interplay of demand and supply).

Given the correct economic conditions, advocates of

market economies believe they lead to the best
allocation of resources and the highest level of net
economic welfare.

Slide 5
Different rationing systems

But markets are not the only way to resolve

 what and how much to produce,
 how to produce, and
 for whom to produce

How else can economic activity be co-ordinated?

How can the necessary economic choices be made
and on what grounds?
Will the resulting pattern of production, distribution
and consumption be efficient?
Will it be fair?
Slide 6
The world’s dominant rationing
system.

It has already be said that the world’s dominant

rationing system is the price mechanism.

The circular flow of income model illustrates some

of the markets that operate in the economy.

Slide 7
Markets in the circular flow
Consumption =
demand

Goods and
services
= supply
HOUSEHOLDS PRODUCERS

Price
Supply

Demand

Quantity
Slide 8
Markets in the circular flow
Price
Supply

Demand

Quantity
HOUSEHOLDS PRODUCERS

Resources (e.g. labour)

= supply

Demand for resources =

demand

Slide 9
The super-computer network

In a competitive free market economy the market for

each product and economic resource is connected to
the market for all other products and resources
through an ultra-complex network of prices.

This network operates ‘invisibly’ as if driven by a giant

free-market super-computer.

What is the operating system for this free-market

super-computer?

Slide 10
Prices as a signalling mechanism

The free-market super computer operates through an

ultra-complex network of prices. The prices provide
a messaging or signalling service for producers and
consumers in the economy.

Normally, a rise in price reflects an increase in relative

scarcity. The higher price signals
– Consumers to reassess their buying choices (are
they still getting value for money – some will buy
less)
– Producers to reassess their production choices
(could they increase profits by supplying more?)

Slide 11
Prices as a signalling mechanism

The system only works if consumers and producers

– get the right message
– make a rational choices when they act on the
message

Prices send the right message given the right economic

circumstances. The right circumstances create ‘a
truthful world’ where the demand curve reflects value
or benefit and the supply curve reflects costs.

Slide 12
The correct economic conditions

What are the correct economic conditions that allow

markets to maximise welfare?

1. No information gaps / no asymmetrical

information
2. No side-effects (externalities) / no effect on
bystanders
3. No monopoly (or scarcity power)
4. Good motives and incentives
5. No free riders or non-exclusion products

Slide 13
Given the right conditions markets
maximise welfare.
In these economic conditions:

Price = marginal social benefit

Price = marginal social cost

Consumers get what they want

Producers don’t waste resources

If these conditions do not exist the market becomes

distorted (price does not reflect value and cost).
Demand and supply curves are in the wrong place.
Welfare is reduced. There is a deadweight loss.

Slide 14
 Markets increase trade and trade
increases welfare
Consumers only buy things if
the value of the product to
them is equal or greater than
Price
their opportunity cost.
Consumer Supply
surplus So, people that buy something
in a market at the ruling price
are getting a bonus – the value
they receive is greater than the
price they pay.
Demand
This bonus is called consumer
Quantity
surplus. It increases their
welfare or satisfaction.

Slide 15
 Markets increase trade and trade
increases welfare
Producers only supply things if
the price they can get is equal or
greater than the cost of
Price production.
Supply

Efficient producers can supply

for less than the clearance price.
When a sale is made they get a
Producer
surplus
bonus – the money they receive
Demand
is greater than their costs of
Quantity
production.
This bonus is called producer
surplus. It increases their
welfare or profit. Slide 16
 Trade increases welfare

The sum of consumer and

producer surplus indicates the
Price
Consumer Supply
total increase in welfare from
surplus this market.
So markets create trade and
trade increases welfare.
Producer
surplus

Demand

Quantity

Slide 17
 The world of truth

This is only good if the

world of truth exists
Price
Consumer Supply Competitive markets
surplus
create a WORLD OF TRUTH.
The demand curve is a true
indicator of the value of
Producer the product to consumers.
surplus
The supply curve is a true
Demand
indicator of the cost of
Quantity
production for producers.

Slide 18
 The world of truth

Price
Competitive markets are,
Consumer Supply therefore efficient because:
surplus
 consumers get what
they want
 producers make the
Producer
surplus
right things in the right
Demand
quantities.
Quantity

Slide 19
 Welfare is maximised at the clearance
price.

People will opt out of

trading if they are going to
Price
Supply
reduce their welfare. They
Cost greater
will lose if cost is greater
than benefit than benefit.
P1
– trade
stops at Q1 Trade increases consumer
Demand and producer welfare up to
quantity Q1. If the aim is to
Q1 Quantity
maximise benefits and
profits trade should rise to
Q1.

Slide 20
 The world of truth
If the market clearance price
is not charged welfare falls.
Price
Consumer Supply
If a price is set below the
surplus clearance price producers
reduce supply (to Q2).
Deadweight
loss
There is excess demand.
Producer surplus is low (the
orange area).
Producer The consumers who can get
surplus
Demand the product get a big bonus
Quantity (the red area), but some
Q2
potential buyers go without.

Slide 21
 The world of truth
If the market clearance price
is not charged welfare falls.
If a price is set above the
Price
Consumer Supply clearance price consumers
surplus
reduce demand.
There is excess supply.
Deadweight
loss Consumer surplus is low
(the red area).
Producer
surplus
Producers who make a sale
get a big bonus (the orange
Demand
area), but some production
Quantity
is left unsold.

Slide 22
Applying the concept to international
trade
It is easy to show that overall
Price
welfare rises if trade between Consumer
surplus
countries is increased.
Domestic
Supply
Exporters can get higher
Overseas
prices for their products (we supply
are more efficient than the RISE IN
overseas country) and sell WELFARE

more. Some supply is

diverted from domestic sales Producer
so consumers lose out. surplus Domestic
Demand

Quantity
However, overall welfare
increases .

Slide 23
Applying the concept to international
trade
It is easy to show that overall
Price
welfare rises if trade between Consumer
surplus
countries is increased.
Domestic
Supply
Consumers can buy goods at
cheaper prices (we are less
efficient than the overseas RISE IN
country). Our producers lose WELFARE

out as competition from Overseas

supply
imports increases. Producer
surplus Domestic
Demand
However, overall welfare
Quantity
increases.

Slide 24
Applying the concept to international
trade
Taken together more Price
exports and more imports
lead to higher welfare.
Domestic
Supply

There has been a

redistribution effect RISE IN
WELFARE
though, some producers
Overseas
gain, some lose, supply

consumers gain if they Domestic

buy some products and Demand

lose if they buy others. Is Quantity

this fair?
Slide 25
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.

Slide 26
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.

Slide 27
Ignoring externalities leads to inefficiency
Air travel S total
If market players do not Price
take these negative S
externalities or social airlines
costs into account (do
not include them in
their demand and
supply decisions) the
market will not work
efficiently.
D
Too much will be
produced and Quantity
consumers will pay too Greenhouse Gases are emitted by planes.
low a price. So do free markets create too many flights
at too low a price?
Slide 28
Ignoring externalities leads to inefficiency
Public transport S
In a similar way, if market Price private
players do not take S total
positive externalities or
social benefits into
account (do not include
them in their demand and
supply decisions) the
market will not work
efficiently.
D
Too little will be supplied
and consumers will pay Quantity
too high a price. Free market public transport could be
too expensive if it forces people to
use their cars and cause congestion
Slide 29
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.

Slide 30
 Monopolists restrict supply and push up
prices.

New Supply Monopolists have the

Consumer (monopoly)
Price surplus power to control supply
Supply
(competitive)
in the market. This can
lead to prices that are
Deadweight higher than those set in
loss competitive markets.
The result is inefficiency.
Producer
surplus
Demand

Quantity

Slide 31
Information gaps

Competitive free markets only produce efficient

outcomes if
 Demand curves reflect the true level of consumer
value or marginal benefit
 Supply curves reflect true costs of production
(the opportunity of using the resource inputs)

If producers don’t know the cost of production (like

insurance companies) and consumers don’t know the
value of the product they are buying (like health care
and second hand cars) then the market can’t operate
efficiently.
Slide 32
Other problems for the market economy

Income distribution
Demand curves reflect effective demand.
Effective demand exists if a need or want can be
backed up by the ability to pay for it.
If income distribution is unfair (lacks equity) the
pattern of effective demand will be unfair.

Slide 33
Other problems for the market economy

Public and collective goods

Products
– that are non-rival products (one person using the
good doesn’t prevent another for using it as well)
– where the exclusion principle does not operate
(the supplier or owner can’t prevent non-payers or
free-riders from using the product)
– where individual demand is unrealistic (such as
national defence)

will not be efficiently produced in a free market

economy.

Slide 34
 Modified market economies
As a result of market failure, nearly all economies are not
pure free market economies but mixed economies.
Government’s modify markets or override the market
altogether by influencing:
 the allocation of resources (e.g. through taxes, subsidies,
or directives) – allocative role
 business behaviour (e.g. through regulations and
legislation) – regulatory role
 the distribution of household incomes (e.g. through
taxation and welfare) – redistribution role
 the overall level of aggregate demand (e.g. through fiscal
and monetary policy) – demand management role
Slide 35
Government modifications

Policy measures to fix up or prevent market failure

include:

1. Taxing bad behaviour, taxing high income earners

2. Subsidising good behaviour, paying welfare to low
income earners.
3. Regulating or legislating against bad behaviour
4. Regulating or legislating good behaviour
5. Establishing markets to trade ‘permits to behave
badly’

Slide 36
Government failure
In some situations government intervention does prevent or
fix up market failure. But overall central planning does not
provide a more efficient and fairer rationing system.
Government run economies suffer from:

1. Bureaucratic and cumbersome allocation processes

2. Moral hazard
3. Rent seeking behaviour (corruption)
4. Lack of incentive – bottomless pots, feather bedding,
no competition
5. Lack of consumer freedom or sovereignty

The trick is to intervene only when necessary.

Slide 37
 Taxing a competitive market reduces
net economic welfare.
Supply with Taxing a
tax
competitive market
Price reduces welfare.
Supply
without tax

REDUCTION IN NET
WELFARE =
DEADWEIGHT LOSS

Demand

Quantity

Slide 38
A difference of emphasis

When to intervene and modify a market is a matter of

judgement for governments. Economists can use the
concepts of consumer surplus, producer surplus and net
economic welfare to inform the policy debate.

LEFT RIGHT
Responsibilities Rights
Entitlements Choice
Equity Efficiency
Market failure Incentives
Government intervention Government failure
Slide 39