Chap 4 – Theory Welfare economics - incentives

1. Chap 4 – Theory Welfare economics - incentives .

2. Economic efficiency • Judging alternative policies • criteria • Economic efficiency: • maximum social economic benefit • minimum social cost • . • Markets: perfectly competitive • Perfect Information • Many buyers/sellers • Homogeneous product • Divisibility • No transaction costs, externalities • Optimal allocation, max welfare • Optimal income distribution • social welfare function • income redistribution • gains/losses due to intervention • need a criterion to judge alternatives

3. Methods to evaluate welfare • Pareto Principle - Compensation principle • Economic Surplus • Efficiency of Income Transfers • Contestable market theory • Economics and Information • Transaction cost theory • The economics of regulation • Pareto (1848-1923) • Economist - training in science, mathematics and engineering, • taught at the University of Lausanne

4. Pareto Principle • Criterion to rank alternatives - new policy • . • Does the policy lead to a better situation than before? • Is society better off or indifferent? • Pareto Improvement: • at least one person better off • no one worse off • Pareto Optimum: • No one better off without making one worse off • Marginal rate of substitution in production is equal to the marginal rate of substitution in consumption • Competitive equilibrium • Market prices link production to consumption • Problem: • many potential Pareto optima • distribution of benefits of new policy • transfers: achieve alternative optima • how to decide? • no Pareto answer

5. The Pareto Principle Grain MRS - Consumption MPL\MPG=PL\PG G* MRS - Production MPG \MPL =PL\PG PL\PG Livestock L*

6. Kaldor-Hicks Compensation PrincipleKaldor, and Hicks - 1939 Economic Journal Comparison of a new policy to the status quo • Policy option is preferred to the status quo if there are efficiency gains • Policy change => gainers and losers • gainers could compensate losers • all better off = welfare improvement • Does not require the actual payment of compensation - compensation is hypothetical • Examples: • Removal of the Crow benefit • Compensation for the elimination of supply management

7. Harberger's Postulates (JEL-1971) 1 - Empirically tractable (measurable) 2 - Economic Surplus - measure of gain/losses - costs/benefits - Dupuit (1844) - concept of economic suplus Three Postulates: At a competitive equilibrium: 1) demand price=value to consumer (WTP) 2) supply price= willingness to supply (MC) Given a policy intervention: 3) evaluate costs and benefits without prejudice to any individual or group > income transfer > Equality: Marginal value of a dollar • any deviation from competitive equilibrium • Government intervention or externality • economic welfare loss: Harberger triangle

8. Consumer-Producer Surplus • measure the impact of policy changes • Consumer & producer welfare • Consumer –> value of consuming Q* - cost • Producer –> revenue – cost of production • No externalities • Competitive equilibrium = max surplus Income Transfer Programs • Deficiency payments (Secretary Brannan – 1949) • Production Quota (W. Cochrane, JPE 1959)

9. Price Competitive Equilibrium Supply - MC CS P* PS Demand - WTP Q* Quantity Consumer Surplus (CS) - Marshallian Demand Producer Surplus (PS)

10. Price Market Distortion Supply CS P* PS Demand Q* Quantity Harberger Triangle - Deadweight loss (surplus)

11. Deficiency Payment Government support price Ps above the competitive price P* Consumer pays Pc < P* Government pays the price difference Result: Output increases Consumers benefit (lower price) Producers benefit (higher price) Government expenditure Deadweight loss to society > consumers > producers > government/taxpayers

12. Price Deficiency Payment Supply Ps P* Pc Demand Q* Quantity Harberger Triangle - Deadweight loss (society)

13. Production Quota Supply restricted by quota (enforced) milk, poultry, eggs Result: Lower output Higher supply price Higher consumer price No government payments Transfer from consumer to producer Deadweight loss to society Which is Better? Neither satisfy Pareto or compensation criteria Efficiency of income transfer Deadweight loss per dollar transferred Size of the deadweight loss

14. Price Production Quota Supply PQ P* Demand Q* QQ Quantity Harberger Triangle - Deadweight loss (society)

15. Quota vs Deficiency Payment • Assume: • Same price change • No cost to acquire quota • Which is more efficient ? • Quantities are different • higher for deficiency payments • agri-business happy • Deadweight Loss  = absolute demand elasticity  = supply elasticity  >   Quota more costly

16. Technological Change Does technological change benefit Consumers? Producers? Depends on the way technology affects supply (MC) • Horizontal supply shift > Pareto superior – both benefit > Lower prices – more output > Increased consumer and producer surplus • Rotation of the supply function > fails the Pareto criterion > compensation is possible > net gain in surplus – welfare improvement

17. Price Horizontal Supply Shift S1 S2 P* a b c Q* Quantity Consumer Surplus – increases (a + b) Producer Surplus - increases (c > a)

18. Price Rotation of Supply S1 S2 P* a b c Quantity Consumer Surplus – increases (a + b) Producer Surplus - decreases (a > c)

19. Price Harberger Tax Supply PT a P* b PS Demand Q* QT Quantity Deadweight loss = (a + b)

20. 4.3 Transfer Efficiency government policy –> income transfers result: distortions in market solutions > criterion to compare interventions > minimize the economic costs Wallace (JFE, 1962) and Gardner (AJAE, 1983) • What is the most efficient way of transferring income to farmers? • transfer with a lower DWL is preferred • Compare quota with deficiency payment • COST (DWL) • Elasticity of supply and demand • Extent of intervention • Social cost of raising tax revenue • Surplus Transformation curve (STC)

21. Slope = -1 m e n CS Surplus Transformation Curve Quota vs Deficiency Payment e – competitive equilibrium n – maximum consumer surplus m – maximum producer surplus

22. Contestable Markets Policy analysis uses the basis of competitive markets Intervention = F( market structure, market failure ) • Competitiveness  Contestable market • Free entry and exit • Technology – cost of production • Economic Profits  Firms will enter or exit • Price = Marginal Cost = Average Cost • Barriers of entry • Advertising costs – licence fees • Regulations (Quota) • Outcome: P >MC • Imperfect Competition – loss of efficiency (DWL) • Monopoly, Duopoly, Oligopoly • Intervention (policy to improve effeciency) • E.g. Monopoly changing to Duopoly

23. Deadweight loss to Monopoly Price Supply - MC MR Pm P* Demand Q* Qm Quantity Duopoly – MR rotates right - smaller Deadweight loss (society)

24. Economics of Information Incomplete information - asymmetry • Some agents have more than others • Affects market equilibrium • Motive for policies and programs • Cost of information • search costs (transaction cost) Moral Hazard – Adverse Selection • Government involvement in insurance markets • Principal-agent problem • Insurance contracts => farmer incentives • Moral Hazard: - e.g. crop insurance • Farmer maximizes utility (farm profits) • Insurance contract – changes objective function • Now includes expected returns from contract • Agent can affect risk - outcome • Premiums increase • Adverse selection: • Principal can not distinguish between good/bad risks • Premiums discourage good risks from insuring • Market mail fail – government subsidy

25. Transaction Cost Economics Transaction Cost • cost of making exchange • friction • search, negotiation, transfer, closure • any cost => inefficiency (competitive ideal) • Examples: • Search – locate buyers/sellers/product • Standards, labels, testing, guarantees (GMO) • Speculation – liquidity – thin markets • Transaction costs and policy making • design, implement, deliver, monitor • define the target beneficiaries • search for the target beneficiaries • delivery - transfer cost • monitor & enforcement costs • evaluation – audit - prosecute

26. Transaction Costs & InstitutionsWilliamson (1985) and Coase (1937) • transaction costs • makes market inefficient • can prevent markets from existing • institutional arrangements for making exchanges Institution: rules/norms  behaviour • Organizations (government, church, market) • formal (marriage) – informal (handshake) • Institutional choice - minimize costs of exchange Transaction costs and the firm (Coase) - internalize exchange and reduce costs - vs exchanges in markets Vertical integration/coordination in agriculture > produce brokers – large retailers > IP contracts – farmers and seed suppliers

27. Human Differences in Costs Nature of transaction (physical) Factors affecting transaction costs (Williamson,1983, 1985) A) Human Factors 1) Bounded Rationality – context of decisions Limited information ex ante  ex post costs  Existence of contracts Full & costless information: contracts not needed Contract design <= Cost(Information, enforcement) 2) Opportunism Costs when self-interested agents take advantage of the situation e.g. post contract – new information

28. B) Nature of transaction • The nature of a transaction may affect the costs to one of the parties e.g. investment specific to the transaction  Asset specificity  limited alternative uses  low salvage value (sunk cost)  potential opportunistic behaviour • Agriculture: asset specificity • Potential for opportunism • “hold up problem” • underinvestment • Potential welfare loss • rationale: government intervention • Marketing boards – negotiated prices • Grades and standards • Economic inefficiency – motive for intervention • Externalities, market power • Transaction costs (bounded rationality, opportunism, asset specificity)

29. 4.7 Theory of Regulation • Stigler: regulation related to rent-seeking behaviour • Limits market power / improve market failures • Intervention is imperfect • Regulators are subject to capture by the regulated • Regulators need accurate information to establish the appropriate policies • e.g. • what is the right price (P=MC) ? • Information on industry cost structure • State of scientific knowledge • Difficult to obtain sufficient information • Asymmetry between the regulator and the industry • Government depends on industry for information, and is subject to lobbying - regulatory capture • Examples: • Supply management - COP formula • Labeling regulations