Microeconomics

Session 7 Microeconomics SESSION 7 - The Role of Organisations and Institutions In this subsection we are going to look in a bit more detail at the role of institutions and organisation in microeconomics. Institutions and organisations are important in microeconomics for while the market is the main way in which goods and services will be exchanged in the economy, this is not the only way in which transactions can occur. In this session we are going to discuss the concept of public goods and their externalities in more detail in addition to exploring the free rider problem. We will also be considering the nature of collective goods and the role of both state and non-state governance in microeconomics. We will be exploring the nature of market design. We will also be discussing the concept of Arrow’s Impossibility Theorem before we finally conclude this session by looking at the influence of policy upon the market and economy. 1 Microeconomics Here, we’re going to be exploring the role of institutions and organisations in microeconomics particularly in relation to governments, government policy, and public goods. Public Goods A public good can be defined as a good that can be consumed by more than one individual at a time. Examples of public goods could include a fireworks display, a local pool or national defence. This is the opposite of a private good which can only be consumed by a single individual. Examples of private goods could include a sandwich, a jacket, or a bicycle. One of the main key economic differences between public and private goods is that public goods are non-rivalrous while private goods are rivalrous. In reality when we are considering goods we should think of them existing on a continuum of non-rivalrous to rivalrous as most goods are not usually extreme in this way. If a good is completely non-rivalrous this would mean that we could keep adding consumers without any enjoyment of the good being taken any from others. An example of this type of good would be a country’s national defence in which another consumer can be added and enjoy the benefit of defence without anyone else being adversely affected. Goods can also be further defined as being excludable or nonexcludable. If a good is non-excludable it means that others cannot be excluded from enjoying goods. An example could be a fireworks display in which anyone who is close enough will be able to view the fireworks without needing to obtain permission or pay for the goods. If a good is excluded others can be easily excluded from enjoying the good. An example of an excludable good could include a television set in a private house. Because of their characteristics it is likely that producers who are seeking profits will be more willing to produce excludable public or private goods than they are willing to produce non-excludable goods. One potential problem when considering public goods which are non-rivalrous but non-excludable is known as the free-rider problem and we will now discuss this in more detail. The Free-Rider Problem The free-rider problem is an externality associated with the production of public goods. When a pure public good is supplied decentralised, individual behaviour does not result in optimal outcomes. This is because of the strategic decisions that guide individual behaviour when externalities are present. 2 Microeconomics The problem with free-riders is that if too many individuals seek to get “a free ride” based on the contributions of others, the total contributions collected will fail to meet the cost of the goods and services that are provided. The free-rider problem is an example of the prisoner’s dilemma. This is an element of game theory in which it is in each individual’s best interest not to contribute no matter what the actions of others are. But, if nobody contributes the result is bad for everyone. Ways in which to solve the free-rider problem include government intervention, by using market forces to provide some public goods, or using incentive systems in order to make telling the truth in individual’s best interests. In addition to applying to what are known as public goods the freerider also applies to goods known as collective goods. While the terms public goods and collective goods are very similar we are just going to explore the unique features of collective goods now. Collective Goods Collective goods are very similar to public goods and relate to goods and services which are used jointly by a number of individuals. In the case of collective goods it is generally not possible to leave payment for collective goods to the individual as this process will usually fail. This is due to the fact that each individual will generally try to minimise their contribution towards the cost of the good or service and once again we will see the free-rider problem emerging. As we have now discussed public and collective goods and have seen the issues associated with the free-rider problem, let’s now turn our attention to the role of state and non-state governance in microeconomics. State and Non-state Governance So far, we have discussed the influence of government policies a number of times. This is because at various times most modern economies have relied upon state laws and organisations in order to enforce laws and to provide security to transactions and contracts made in the economy. It is also the case however that at times the majority of states have had institutions and organisations which were too weak, slow, inefficient or biased to resolve issues in a state’s economy. When this occurs it is often the case that societies develop alternative institutions to provide economic governance. Consider for instance the role of the mafia and black markets. 3 Microeconomics In addition to governance influencing the economy, the way in which the market is designed and operates can also affect how transactions are undertaken. So let’s look in a bit more detail at market design. Market Design In addition to the main economic market there may be some situations in which some specialised transactions are better served through the creation of a specialised market or market-like platform. Examples of alternative markets include the internet which has been described as a “sharing economy” and includes new market places such as Ebay. More local examples of specialised markets could include babysitting clubs. In addition to specialised markets we may also see a number of different types of market designs being used. The most common form of market is a matching market but other forms of markets can include systems such as auctions. Now we have considered how the design of the market can affect the way in which the market operates, we are going to consider briefly the concept of Arrow’s Impossibility Theorem. 4 Microeconomics Arrow’s Impossibility Theorem Arrow’s Impossibility Theorem is named after Kenneth Arrow who devised this theory of social choice. Arrow’s Theorem is a paradox that illustrates that it is impossible to have an ideal voting structure that reflects specific fairness criteria such as pareto efficiency. In other words Arrow’s impossibility theorem indicates that a clear order of preference cannot be established while adhering to principles of fair voting procedures. In order to demonstrate how this theorem operates let’s consider an election in which voters are asked to rank their preference for candidates Mr A, Mrs B, and Miss C. When voting, 50 people vote to indicate that they prefer Mr A over Mrs B and prefer Mrs B over Miss C. 45 people vote to indicate that they prefer Mrs B over Miss C and prefer Miss C over Mr A. Finally 35 people vote to indicate that they prefer Miss C over Mr A and prefer Mr A over Mrs B. In this election candidate Mr A has the most votes and would win this election however if Mrs B was not standing in the election Miss C would be the winner as more people prefer candidate Miss C over Mr A. The result of this election would therefore demonstrate Arrow’s Impossibility Theorem. In microeconomics, a number of different tools are available to model 5 Microeconomics the effects of economic choice and enable economists to think about the decisions people make in a political context. In order to conclude this subsection we are now going to briefly consider the influence of policy upon the market and economy in a bit more detail. The Influence of Policy upon the Market and Economy Government policy can be effective at controlling and influencing the market and the economy. Nonetheless, governments do not have a free hand to impose any policies they wish on the market. In reality, democratic systems and checks have been developed to ensure that proposals for legislation that may harm the economy are limited and must be discussed at a range of committees and subcommittees. These will debate any proposals and will recommend only policies with which they are in agreement. Once proposals have been agreed, it is then usual for these to be debated further in the government before voting on occurs. The way in which governments therefore are able to ensure policy is managed, is known as voting equilibrium. It results in what is known as a “structure-induced” equilibrium. It is so-called because the process results in a policy proposal that lies in the middle of where all individual ideal points would be for those who have considered the idea. Session Summary: In this subsection we explored the role of institutions and organisations in microeconomics. We saw that institutions and organisations are important actors in microeconomics and is one of the ways outside of the market in which transactions will take place. We also considered the definition of a public good. We explored public goods in more detail and have looked at one of the externalities of public goods in terms of the free-rider problem. We saw that the freerider problem is something that exists for public goods and is a form of the prisoner’s dilemma. We discussed the free-rider problem in some detail including how and why this occurs and how this can be dealt with. We also considered the nature of collective goods and sought to define collective goods in more detail. We discussed the role of both state and non-state governance in microeconomics considering what happens if state governance fails to take charge of a situation. Following our discussions of governance we discussed some of the different market designs that can be developed outside of the traditional market design and structure. 6 Microeconomics We also discussed the concept of Arrow’s Impossibility Theorem and looked at some of the issues voting preferences can have and the paradox that can be created from this. Finally, we concluded this session by considering the influence of policy upon the market and the economy and one of the ways in which governments ensure that radical and harmful policy is not imposed upon the market. 7 VIDEO COMMENTARY SESSION 7 8 Microeconomics SESSION 7 - The Role of Organisations and Institutions In our seventh we are going to look at ways to think about politics in economic terms. Specifically, in this session we are going to consider the Median Voter Theorem. To consider the Median Voter Theorem, we are going to use an example of a school board. The school board is comprised of five members who need to agree the level of spending that will be made next year. In order to reach an agreement the democratic process of pairwise voting is used until a winner is found. The process will end when a Condorcet winner is found. The Condorcet winner is the name given to the proposal that has defeated all other proposals in pairwise voting. In order to explore how voting will proceed let’s assume that the five voters will have single-peaked preferences over the level of spending. The voter whose peak is in the middle is known as the median voter and is labelled with ym. If the median voter’s proposed policy was up against any proposal that fell to the left of it, we could assume that any voter whose preference is to the right will be more likely to vote for ym than any proposal further to the left of this. In this case voters 4 and 5 will join with voter 3. If the proposal was against the right the same would occur with voters 1 and 2 voting for ym rather than anything to the right. As there is not a proposal that can beat ym this proposal will be declared the Condorcet winner. The Median Voter Theorem can be applied to any situation in which an odd number of voters exist. 9 CASE STUDY SESSION 7 10 Microeconomics SESSION 7 - The Role of Organisations and Institutions The Role of Government In a Market Economy Introduction: In this briefing we’re going to look at the role of institutions and governments within microeconomics in a bit more detail. We are going to do this by considering an article by Libby Rittenbery and Timothy Tregarthen entitled “The Role of Government in a Market Economy”. By reviewing this article, we are going to consider the role of governments in responding to market failures of public goods, external costs and benefits, and imperfect competition. We are also going to look at merit and demerit goods, and discuss the ways in which governments redistribute income. Rittenberg and Tregarthen begin this article by stating that we want a great deal more from governments than we did several decades ago. They note that this has resulted in total government spending per capita (when adjusted for inflation) increasing more than six fold since 1929. Rittenberg and Tregarthen continue by considering the different types of government spending that may occur. This includes not only goods and services that are produced for the public, but also transfer payments. The article next provides a summary of government revenue sources and expenditures in 2007 for both the USA and EU. Rittenberg and Tregarthen note that for the USA, revenue mainly came from personal income tax and payroll taxes. Expenditure, meanwhile, was mainly spent on transfer payments to individuals. For the EU, a greater share of revenue comes from taxes on production and imports, and far less is spent on defence than in the USA. The authors note that to understand the role of government, it is useful to distinguish between four types of government involvement in the economy. These are: 1. Government attempts to respond to market failures to allocate resource efficiently. 2. Government agencies act to encourage or discourage the consumption of certain goods and services. 3. Government redistributes income through programs such as welfare and social security. 11 Microeconomics 4. Government uses spending and tax policies to influence the level of economic activity and price level. Rittenberg and Tregarthen note that the first three of these types of government involvement are related to microeconomics, whilst the fourth is related to issues of macroeconomics. The first three of these areas are therefore discussed in more detail within the article. The first area discussed in more detail is responding to market failure. The authors note that when the market’s output of goods and services falls short of the efficient level, it is possible that government intervention will move production levels closer to their efficient quantities. In the next section, Rittenberg and Tregarthen discuss public goods. They note that public goods include goods such as national defence and law enforcement. The authors note that the difficulty in producing public goods is that they are freely available to everyone, and therefore the free rider problem occurs. The authors, therefore, argue that the theory of public goods demonstrates an important reason for government involvement in the economy. Next, external costs and benefits, which are also known as externalities, are discussed. The authors note that due to the lack of a market transaction, the person responsible for the external cost or benefit will not face the full cost or benefit of the choice involved. Rittenberg and Tregarthen provide the example of a computer memory chip firm which generates water pollution to demonstrate this point. The authors indicate that, because the firm producing the good does not face all of their production costs, the price can be expected to be lower and the quantity produced can be greater than the efficient level. The authors also provide the example of infectious disease inoculations and note that these lead to external benefits, but as this exceeds the private benefit, the market is likely to produce less than the efficient quantity. In this case, the government may need to provide such goods and services. The final area discussed in the article relates to imperfect competition. The authors note that in a perfectly competitive market, price will equal marginal cost. However, if competition is imperfect, individual firms would face downward-sloping demand curves and will charge prices greater than marginal cost. In this type of market, firms will produce less of a good than is efficient. In response, governments may legislate against uncompetitive behaviour such as monopolies. 12 Microeconomics Rittenberg and Tregarthen note that in each of these three cases there is the potential for government intervention in order to try to move the market towards a more efficient model. The authors provide a number of figures that review the potential gains that may be generated as a result of government intervention in cases of market failure. Following the discussion of market failures, the authors of this article next discuss merit and demerit goods. They provide an explanation of merit and demerit goods and discuss the reasons why governments may sometimes provide merit goods and prohibit demerit goods. Finally in this article, Rittenberg and Tregarthen discuss the concept of income redistribution. They discuss the nature of income distribution and note that distribution of income generated by a private economy might not be satisfactory for a number of reasons. The authors note that government intervention in income redistribution will often be seen as a public goods argument. To conclude this article, Rittenberg and Tregarthen provide some examples of actual and proposed government programmes which each relate to government intervention within the market, before finally providing a case study of government involvement within the oil pricing of the USA in 2008. Take a moment to discuss these points from the session. • Discuss the possible microeconomic reasons for government involvement within the market and its potential effect on the market. • Discuss the difference between merit and demerit goods. In what ways can a government seek to control such goods? • Discuss the advantages and disadvantages of public goods and the free rider problem. 13