Management Engineering - Business & Industrial Economics

Module B

Divided by topic

24/02 MARKETS, EFFICIENCY AND MARKET FAILURES Resources are sca rce, there is a limited amount of resources. When resources are scares there are three key issues to solve: - What to produce à food or weapons? If more food, less weapons - How to produce à in the most efficient way not to waste resources - How to distribute the wealth that results of production The mechanism of price is the best way to solve these issues: markets . A market enable s buyers and sellers to interact and, thus, to determine the equilibrium price and quantity of a good. - Almost every good has a price measuring monetary value - Prices channel information on buyers’ willingness to buy and sellers’ willingness to sell - Prices are the terms under which buyers and sellers exchange goods What to produce : what buyers vote How to produce : depends on efficiency considerations: Usually at the minimum costs to be efficient. To p roduce at the minimum costs = competition To increase price (earning a premium price): innovation To reduce costs: process innovation (automation, etc.) There is another innovation to reduce costs: organizational innovation. We can reduce costs by better organizing the processes (ex. reduces costs of organizing production and commercialization of goods). Wealth distribution : it depends mainly on demand and supply in the markets for inputs. There are markets for outputs and markets for inputs. Wealth distribution depends on markets for inputs and the way markets for inputs works is very similar to the way markets for output works. We have prices also in markets for inputs. Markets for inputs determine salaries , which are the prices of individuals’ spare time. The rare r your skills, the more expensive is your spare time. The wealth distribution depends on the price of the input, and the price of the input depends on its availability and its quality. The wealth of a country: GDP Planned economy : The opposite of a market economy . Planned economies are disappearing in the current economic systems. Russia in the past had a planned economy, China also but it is moving toward market economy. Cuba still has a planned economy. What to produce, how and how to distribute is controlled by a central planner (Government, State). They are disappearing because at the end they do not work. Their idea on how to allocate scares resources behind is good but they have a l ot of issues to manage it. The central planner cannot have all necessary information. Overcharging idea: economic activities must benefit the whole society In a market economy, this enormous amount of information is embedded in prices . The current econ omic systems are extensively based on market transactions and they are characterized by the presence of firms . This is an intermediate solution between planned economy and pure market economy (happen among atomistic economic agents, which engage in indivi dual transactions) . Firms engage in transactions on the market (decentralization) and centrally plan their economic activities (centralization). EFFICIENCY AND THE WELFARE THEOREMS As resources are scares, what are the best economic criteria for allocating them? Pareto - efficiency (optimality): an allocation of resources is efficient if it is not possible to improve the utility (welfare, wellbeing) of an economic agent without reduci ng the utility of another economic agent. The Pareto - efficiency is a criterion to allocate efficiently resources. Issues: - Cannot solve inequality issues (look at the contract curve) An allocation can be pareto efficient but it can be unequal. An allocation in which an agent owns all resources, while others have nothing is Pareto - efficient, but it is unequal. - Has limited predictive power Many Pareto - efficient allocations exists, which of them does emerge? In general, Pareto - efficient allocati ons are less vulnerable: over time inefficient allocations disappear and efficient ones survive. The answer is THE EFFICIENCY PRINCIPLE The efficiency principle: if economic agents can trade effectively, finally, they will reach a Pareto - efficient allocat ion of resources. Markets are the best way to allocate resources. How does it work? Simplest economic system: 2 people and 2 goods. How to achieve the pareto efficiency? Trading We can change the allocation but we cannot increase the quantity of our goo ds. Which allocation would they choose? The ones, which is the best for both of them. Are we happy with the initial situation? Or better, do you prefer this allocation to another allocation of resources? We consider indifference curves : other options that have the same level of preference, happiness. A strong assumption: the more goods in dividuals have, the better they feel . It is true in most of the cases. Money is a clear example of this assumption. It is true up to a level called saturation point: you do not feel better but you feel worst. The next step: to combine the two preferences. Starting from here, is it possible to improve efficiency? Omega: specific resource allocations X: in general, any feasible allocation All the possibilities in the black areas are better for both the two players. Now we can start exchanging quantities, reaching parent improvements, moving to a better indifference curve. We stop trading when the two indifference curves are tangent. Becau se the area of pareto improving allocation diminish and collapse to a point. Each agent has infinite number of indifference curves. We focused on one before because we had an initial point . More in general, there are many initial possible points, hence more indifference curves. The contract curve (curva dei contratti) is the set of all the Pareto - optimal allocations. The welfare theorems The two theorems that rule market economies : 1. By trading in perfectly competitive markets , economic agents can a ttain a Pareto - efficient allocation of resources 2. For any Pareto - efficient allocation of resources, there are prices and an initial allocation , which make that Pareto - efficient allocation attainable by trading in perfectly competitive markets à we have diff erent indifference curves, according to this theorem it is possible to achieve any allocation in the contract curve. Adam Smith: perfectly competitive markets achieve efficient allocations of resources (via the mechanism of prices). We both think about our interests and we are both happy. Unfortunately, this is not always true. This mechanism of invisible hand does not work in very important contingencies. Do welfare theorems hold in the real - world so that trading always leads to an efficient allocation of resources? The assumption of the welfare theorems is that markets are perfectly competitive and it does not hold due to market imperfections . Markets sometimes fail in achieving efficient allocations. A perfectly competitive market is a market with no market imperfections. In reality is not like this. Markets are dominated by big firms, they are oligopolies. There are markets that are not competitive at all. Natural monopoly means that the markets go natural to mon opoly ex. Infrastructure. Market imperfections: - Some goods have peculiar features à public goods - Some goods have a value but not a price (ex. clean air, silence) à externalities - Information is not perfect à information asymmetries - Some markets are not c ompetitive at all à natural monopolies The policymaker (ex: the State, the government) plays a key role for correcting market imperfections and remedying to market failures. Firms want and have to maximize their profits. Policymaker wants to maximize s ocial welfare (assumption: benevolent policymaker) Firms have a private objective whereas a policymaker has a public goal. In a planned economy, the central planner is the policymaker. In market economy the policymaker defines and enforces property rights, trading is not possible without property rights. Correct market imperfections is a key role of a policymaker , to increase efficiency by - Providing public goods - Internalizing externalit ies - Increasing information set - Promoting competition In addition, it reduces inequalities and promotes macroeconomic stability and growth. 01 /0 3 PUBLIC GOODS (or Services) A good is a public good if it is both non - excludable and non - rival in consumption . - Non - excludable : agents can consume the good although they did not contribute to produce it, hence without paying any price for it. - Non - rival in consumption : each agent can consume the good without reducing the consumption possibilities of the others. Ex: public infrastructure, air, parks, national defense, healthcare system, etc. Both conditions need to be visible. Public goods work up to the point of congestion. Universi ty lectures are public so everyone can join the class without reducing my possibility to join unless there are no more seats available (congestion). Key question: given the features above, are economic agents willing to contribute to the provision of pub lic goods (PPPG) ? The two cases: 1. On - off decision: agents must decide whether to buy or not the public good . 2. Variable quantity: agents must decide how much public good to buy . 1. An example of ON - OFF DECISION : buying a smart TV Public goods may have a price. Once the tv is bought, everyone can use it. Is it worth for the two roommates to buy the tv? Pareto efficiency It is worth if they are both better off having the tv than not having it. Reservation price : maximum price you are willing to pay for something I’m willing to pay 3 (reservation price) I pay 2.5 à surplus/saving of 0.5 If the price is 4 I do not buy If the price is 3 I’m indifferent Allocation 1: situation without tv Allocation 2: I have money – the share of the tv and we have the tv 2. An example of VARIABLE QUANTITY : How much of a public good do the agents buy? Ex: lighthouses, which are public goods. The public good is provided up to the level at which the marginal benefit (benefit of an additional unit) equals the marginal cost (cost of an additional unit). If marginal revenues > marginal costs, then I add a unit If marginal revenues < marginal costs, then I reduce the provision of one unit If marginal revenues = marginal costs, then I reached the optimal quantity In the case of public goods, the marginal bene fits correspond to the sum of all marginal benefits of all agents in the economy, because they all benefit from an additional unit being non - excludable and non - rival in consumption. = Total marginal benefit In case of two agents in the economy, the total marginal benefit is the sum of their two marginal benefits. After having checked that it is a Pareto efficiency, we look at the marginal benefits. If the marginal benefits of both for buying the tv are highe r than the marginal costs, we buy the tv. Generally speaking, m arginal benefits are not always higher than marginal costs . Cleaning lady: I benefit 5 and you benefit 2, she charges 10 à we do not hire her for an additional hour. THE FREE RIDING PROBLEM OF THE PUBLIC GOODS We need coordination because if we consider only the economic mechanisms, agents tend to free ride. They wait until others contribute. If everyone does like this, the public good is not provided. The probability of free riding depe nds on how many agents are involved the provision of the public good. Ex: group size. In a small group free riding is more limited than in a large group. If few agents are involved, it is easier to coordinate the agents and to collect the contribution hence the free riding is smaller. Reputation is an incentive to contribute. If we are 1000+ people I feel my contribution is so small, if we are 5 people, I feel my contribution is higher. Other reasons why there is no free ride: Ex: Open source software (OSS) à once the software is there everyone can use it. Contribution: 1. altruism 2. fun to contribute 3. sense of community belonging sometimes there is a dilemma; some goods are very costly and they are not interested for all agents. But we need a bigger support. The policymaker engages on the provision of socially - relevant public goods à public provision of public goods. Public provis ion of public goods is usually financed by taxation, occurs by direct production or by subsidizing. Ex: Italy provides the national healthcare system to all its citizens and offers tax discounts to those who contribute to private provision of public good s. 03 /0 3 EXTERNALITIES An externality is a cost or a benefit which an economic agent causes on another economic agent that is innocent outside the activity of the first economic agent. Benefit: positive externality à a pleasant perfume worn by the person seated next to me C ost: negative externality à loud parties next door or second - hand cigarette smoke Positive and negative externalities cause inefficiencies. Ex: silence. No price for silence so we have an incentive to talk a lot. The issue of the quality of the registration is the only thing that work not to talk and to be silence. Firms do not have incentives to innovate because innovating they generate knowledge that is a public good and competitors can take advantage of it. Too many resources are allocated to activities that cause negative externalities à those who engage in these activities do not fully bear their costs and thus they have strong incentives to devote resources to them. Too few resources are allocated to activities that cause positive externalities à those who engage in these activities do not fully appropriate their benefits and thus have limited incentives to devote resources to them. Market is not enough to allocate resources and in order to model this, for the sake of simplicity and sake of rigor, we distinguish between consumption and production externalities. Consumption externalities Positive or negative caused by the consumption activities of one or more agents . Model setting : two agents and two goods A: smoke and money are positive B: smoke is negative and money is positive Agent B is the one receiving a negative externality from the smoke of agent A. Then: Pareto effici ent allocations on the contract curve. The two cannot reach an efficient allocation because smoking (and clean air) doesn’t allow trade. Clean air does not have a price, hence there is no trade possible that can lead to efficiency. Outcome is inefficient. The choice of each agent is not on the Contract Curve. There is either too much or too little smoke. Both choose the optimal place on the better indifference curve so no efficient allocation as shown below. What can be done? Coase’s insight Consumption externalities exists because there is no proper definition of property right . A and B do not possess the air in the room, hence ther e is no possibility to trade it with money. No property right, no market. Policies fix the issue. What happen if property rights are created? 1. Ownership of the air to the non - smoker: now the smoker can transfer an amount of money . Establishing a market setting a price , thanks to the prior setting of property rights , restore the condition of the theorem and we reach an efficient allocation. 2. Ownership of air to the smoker: the no - smoker gives money to me to incentivize me not to smoke (or to reduce it at least) The key condition is to establish and assign the property rights. The policy makers usually do that. Sometimes the property rights (ex: of the air) is set according to assets ownership (ex: the air in my flat). A comp arison: Exception: Is there a case in which there is the same smoke intensity no matter who is assigned the property right? Coase’s theorem: if agents’ preferences are quasi - linear in money, then there is the same smoke intensity no matter what agent i s assigned the property rights. Quasi - linear in money means that the utility is linear in money a nd different for smoke. The utility function has a linear component (money) and a non - linear component (smoke). Production externalities Positive or negative caused by the production activities of one or more agents. A: owns a steel mill that produces steel and water pollution The water pollution adversely affects a nearby fishery Perfectly competitive market: the firms are price takers, they do not set the prices. Profit function in production activities is the same as the utility function i n consumption activities. This is the maximization of a function with two variables Profit = P - C The firm produces up to the point in which the marginal cost is equal to the price. Marginal cost = marginal benefit 3. Derivative with respect of s 4. Derivative with respect to x Profit maximization exercise à check notes None of the two party has the pr operty right on water. The policy maker now allocates the property right to one of the two agents. Internalizing the externalities. To fight climate change countries are creating prices to natural resources. To do so, first of all they are creating prope rty rights to the natural resources and they are allocating them to some agents. Now the fishery has its own profit plus the profit coming from the property rights on water. How many fishes does he has to produce now? Now there is an additional source of revenues. Another solution to solve production externalities is the merger of the two firms. à check notes 04 /0 3 INFORMATION ASYMMETRIES One condition of perfectly competitive markets is that economics agents are perfectly informed. They should know the quality and the price of the good, the best seller etc. In most of markets, the information is far from transparent. Information asymme tries are when one side of the transaction (typically the buyer but it could also be the seller) lack information on important aspects of the transaction. Information asymmetries negatively affect the functioning of markets causing: 1. Adverse selection : when a hidden information problem exists (ex - ante information asymmetry) . Remedy = signaling 2. Moral hazard: when a hidden action problem exists (ex - post information asymmetry). Remedy = Incentive contracts ADVERSE SELECTION AND REMEDIES Ex: we consider a market of used cars with two types of cars a good car and a bad car. As long as the buyer can distinguish a good from a bad car, no problem. If the buyer cannot distinguish them, there is a hidden information problem. q is the fraction of bad cars 1 – q is the fraction of good cars Probabilities are known Simple risky situation so we can compute the expected value (EV) à average value A separately equilibrium is when only one type of car is traded on the market Remedies: adverse selection results from a lack of information and how to reply? Sending a signal. Signals are observable attributes/actions/outcomes that provide information about unobservable attributes/actions/outcomes. In order to be efficient, signals must be: - Observable - Interpretable - Costly To be effective they need to be costly because only agents with better unobservable attributes/actions/outc omes (high - quality agents) have incentives to bear the cost of sending the signals. In so doing, they distinguish themselves from the low - quality agents. The signal should be costly so that no everyone sends it but only high - quality agents send it as for them is worthy paying for the signal in order to be separated from the low - quality ones. Ex: a patent for a startup is a signal . Signals play a leading role in the labour market . MORAL HAZARD AND REMEDIES Moral hazard likely occurs when, once a transaction is concluded (ex - post) , one party of the transaction lacks information on the actions of the other party. Ex: the seller is not informed about the buyer’s actions and it results from a hidden action problem , which causes an ex - post information asymmetry . This typically happens when one party can hardly monitor the behavior of the other (e.g. in case of relati on between managers and their teams, external investors and investee firms, politicians and their voters). Undermines the efficiency of transactions as: - One party (typically the seller) would like to offer more/provide more good/effort , but it is unwill ing to do so; - ... since, ex - post , this will change the actions of the other party (e.g., the buyer) in a way that is detrimental to the first one. Example: I am a venture capitalist and I invest in a company, I cannot observe the company’s effort and I would like to provide it more money but as I don’t see its effort, I am worried to give more money to the company. Example: Suppose an insurance firm offers insurance for bicycle theft: • All bicycle owners (buyers) live in areas with identical probabilit ies of theft; • The probability of theft depends on owners’ actions: if they do not lock their bikes or use only flimsy locks, bicycles are more likely to be stolen; • Taking care of their bikes is costly for buyers. The insurance firm must consider buyers ’ incentives to take care of their bikes, i.e., to take the appropriate action: • If there is no insurance, buyers have an incentive to take the maximum possible amount of care; • If there is insurance, buyers can purchase full bicycle insurance, then their cost of having their bicycles stolen is much lower: They report thefts to the insurance firm and get money to buy new bikes. When the insurance company completely reimburses buyers, they have no incentive to take care → Moral hazard likely occurs. A crucial issue: is the amount of care observable? 1. 1) YES: There is no problem of moral hazard. Insurance firm bases its prices on the amount of care taken: the less the care, the higher the prices; 2. 2) NO: Moral hazard likely occurs and determines a trade - off. The moral hazard causes a trade - off: Each buyer would like to buy more insurance, but the insurance firm knows that if buyers can buy more insurance, they rationally choose to take less care. Thus, the insurance firm tends to raise prices and reduces it offering: The consequence is under - provision : the quantity exchanged on the market is lower than the optimal/efficient quantity . How to remedy to moral hazard? By designing incentive contracts that induce parties not to behave opportunistically. Coming back to the insurance example, in general, insurance firms do not offer complete insurance t o buyers. Insurance contracts: 1. Include a deductible (franchigia), an amount that buyers must pay in any claim The deductible is an incentive for the buyer to take some amount of care as they bear part of the costs of not taking care. 2. Usually discriminate among buyers depending on their (present or past) actions that influence the probability of damage. Higher rates for: - Smokers in health insurance → The smoker pays more, there is an incentive to stop smoking; - People who caused car accidents in car i nsurance → Incentive to be careful.