Chap 4

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

5
The Pareto Principle
Grain
MRS - Consumption
MPL\MPGPL\PG
G
MRS - Production
MPG \MPL PL\PG
PL\PG
Livestock
L
6
Kaldor-Hicks Compensation Principle Kaldor, 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 gt 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

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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 pricevalue 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
• gt income transfer
• gt Equality Marginal value of a dollar

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Consumer-Producer Surplus

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

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Price
Competitive Equilibrium
Supply - MC
CS
P
PS
Demand - WTP
Q
Quantity
Consumer Surplus (CS) - Marshallian
Demand Producer Surplus (PS)
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Price
Market Distortion
Supply
CS
P
PS
Demand
Q
Quantity
Harberger Triangle - Deadweight loss (surplus)
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Deficiency Payment Government support price
Ps above the competitive price P Consumer pays
Pc lt P Government pays the price
difference Result Output increases Consumers
benefit (lower price) Producers benefit
(higher price) Government expenditure Deadweight
loss to society gt consumers gt producers gt
government/taxpayers
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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

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

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Technological Change

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

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Price
Horizontal Supply Shift
S1
S2
P
a
b
c
Q
Quantity
Consumer Surplus increases (a b) Producer
Surplus - increases (c gt a)
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Price
Rotation of Supply
S1
S2
P
a
b
c
Quantity
Consumer Surplus increases (a b) Producer
Surplus - decreases (a gt c)
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Price
Harberger Tax
Supply
PT
a
P
b
PS
Demand
Q
QT
Quantity
Deadweight loss (a b)
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4.3 Transfer Efficiency

• government policy gt income transfers
• result distortions in market solutions
• gt criterion to compare interventions
• gt 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)

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Surplus Transformation Curve Quota vs Deficiency
Payment
e competitive equilibrium n maximum consumer
surplus m maximum producer surplus
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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 gtMC
• Imperfect Competition loss of efficiency (DWL)

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

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Transaction Cost Economics

• Transaction Cost
• cost of making exchange
• friction
• search, negotiation, transfer, closure
• any cost gt 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

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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
• gt produce brokers large retailers
• gt IP contracts farmers and seed suppliers

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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 lt
Cost(Information, enforcement) 2)
Opportunism Costs when self-interested agents
take advantage of the situation e.g. post
contract new information
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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

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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 (PMC) ?
• 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