WELFARE ECONOMICS AND PUBLIC CHOICE THEORY

City & Metropolitan Economics Week 01 – Intro to Urban Economic Concepts January 11, 2018

Agenda We’ll try to take on the following areas over the next few class meetings:

1. Welfare economics: how do we decide who gets what, who pays what, who lives where, etc?

2. What are public goods and externalities?

3. How does space (e.g., distance, time, etc.) interact with economics (i.e. decision-making frameworks)?

Two Requests 1. Please ask questions, to explain things in depth, etc.

2. Please call me Jack, and remind me your name (at least for the first few classes).

Level-setting with Basic Economic Concepts for Exchange

My grad school diet • I consumed ramen and redbulls.

• Ramen was an inexpensive source of food and energy; redbulls were a relatively more expensive (i.e. by price per unit) source of “food” and energy.

Indifference curve describing a consumer's tradeoff between food and entertainment

0

10

20

30

40

50

60

0 1 2 3 4 5 6

Entertainment

Fo od

MRS=20

MRS= 10

MRS=5 MRS = 2

A

B

C

Ramen

Redbull

Indifference curve: describing my tradeoff between ramen and redbull

(MRS = marginal rate of substitution)

D

A: 50 ramen, 1 redbull

B: 30 ramen, 2 redbull

C: 20 ramen, 3 redbull

D: 15 ramen, 4 redbull

E: 13 ramen, 5 redbullE

Tradeoff between entertainment and all other goods

920

930

940

950

960

970

980

990

1000

1010

0 1 2 3 4 5 6

entertainment

m on

ey

MRS = 50

MRS= 10

MRS = 5

MRS = 3

Entertainment

$ or AOG

Tradeoff between entertainment and all other goods ($ or AOG)

A

B

Effect of a price increase

0

10

20

30

40

50

60

0 1 2 3 4 5 6

food

en te

rt ai

nm en

t before price change in food after price change in food

Effect of a price increase -- food

Food

En te

rt a

in m

e nt

First theorem of welfare economics (see Stiglitz Ch. 3) • Competitive markets under ideal conditions lead to an

efficient allocation of resources

• Or if you prefer, “If everyone trades in the marketplace to maximize satisfaction, and all mutually beneficial trades are completed, the resulting equilibrium allocation will be economically efficient.”

Second Theorem • It is both possible and desirable to separate efficient resource

allocation (which is attained through markets) from questions of the distribution of wealth

• Or, if you prefer, rational people or firms will exchange to maximize satisfaction without a central planning agency

Second Theorem • Initial allocations do not matter – if markets are competitive

and everyone trades freely, efficiency will be achieved

• Government may decide to intervene to change the resources that people possess and with which they engage in utility- maximizing trading activity – but this has efficiency costs

How does redistribution of income and wealth create inefficiency?

“Indifference Curves” Utility Before Trading

0

4

8

12

16

20

24

0 4 8 12 16 20 24 Copper(Juan)

Tr ee

s( Ju

an )

-24

-19

-14

-9

-4

Copper(Maria)

Tr ee

s( M

ar ia

)

Juan_0 Maria_0

24 012

Initial Allocation

Trees (Maria)

Copper (Juan)

Trees (Juan)

Copper (Maria)

Utility Improved Through Trade

0

4

8

12

16

20

24

0 4 8 12 16 20 24 Copper(Juan)

Tr ee

s( Ju

an )

-24

-19

-14

-9

-4

Copper(Maria)

Tr ee

s( M

ar ia

)

Juan_0 Juan_1 Maria_0 Maria_1

24 012

Utility Maximized Through Trades

0

4

8

12

16

20

24

0 4 8 12 16 20 24 Copper(Juan)

Tr ee

s( Ju

an )

-24

-19

-14

-9

-4

Copper(Maria)

Tr ee

s( M

ar ia

)

Juan_0 Juan_1 Juan_2 Maria_0 Maria_1 Maria_2

24 012

Other optimal allocations

0

4

8

12

16

20

24

0 4 8 12 16 20 24 Copper(Juan)

Tr ee

s( Ju

an )

-24

-19

-14

-9

-4

Copper(Maria)

Tr ee

s( M

ar ia

)

Juan_0 Juan_1 Juan_2 Maria_0 Maria_1 Maria_2

24 012

Any allocation within this area is Pareto optimal (i.e. both parties will be better off).

But… rational people don’t “trade away” utility

0

4

8

12

16

20

24

0 4 8 12 16 20 24 Copper(Juan)

Tr ee

s( Ju

an )

-24

-19

-14

-9

-4

Copper(Maria)

Tr ee

s( M

ar ia

)

Juan_0 Juan_1 Juan_2 Maria_0 Maria_1 Maria_2

24 012

Juan will not trade to improve Maria’s utility if his decreases unless 1. incentivized (e.g., with

something else, like money)

2. compelled to (e.g., central planner redistributes wealth for a specific reason)

Initial Allocation

Welfare Theorem 1 Assumptions • Negative transitivity of preferences

• (all things have prices and all prices are comparable)

• Choice function is non empty • (you prefer something)

• Insatiability • (more is better)

More welfare theorem 1 assumptions • Perfect competition (no firm can “move the market”)

• Actor i’s preferences do not depend on actor j’s transactions

• No externalities

• Actors know quality, contingencies and prices • No information asymmetries • No transaction costs

When do economists think it is appropriate for government to intervene to allocate resources more efficiently?

Important Terminology

Failure of competition

• Occurs when the costs of market entry are prohibitively high for firms

• Could be a result of market power or “predation”

“Natural monopoly” • results from a specific cost structure

(e.g., high fixed costs, economies of scale, low marginal costs, declining average costs) such that efficiency requires one, rather than many, producers

Positive Externality • a market transaction in which

“spillover” benefits are created for which the producer is not compensated

• My flower farm • A rehabilitated façade

Positive Externality • Government may subsidize

activity with positive externality effects

• Education • The arts • Green design features

Negative externality

• A transaction involving “spillover” costs which the producer does not pay

• My hog farm (e.g., water quality issues) • A 20-story ultra-modern building next to a

3-story sterling example of Greek revival architecture

Government has typically responded to positive externalities through incentives (e.g., historic tax credits, subsidized education, etc.)

Government has typically responded to negative externalities through regulation and taxation (new approaches like cap and trade systems are emerging as well)

Public Goods • Demanded, but underprovided (or

not provided) by the market

• A “pure public good” is one that is both non-rival and non-excludable

Pure public good – two tests

• Must be non-rival - consumption of the good by one individual does not reduce the amount of the good available to others

AND

• Non-excludable – hard to keep people who don’t pay (“free riders”) from using the good

Merit goods • Predicated on the idea that the

individual does not always act in his own best interest

• For example: • People would fail to consume seat belts

absent regulation • People would underconsume education

absent subsidy

Basic Urban Economic Concepts

Economics + City/Metro Issues = ? What’s the relationship between economics and space?

1. Economics explores frameworks for decision-making; specifically the production, allocation, and consumption of resources.

2. Everything is related to everything else, but near things are more related than distant things. (Waldo Tobler’s First Law of Geography, 1969)

Fundamental Planning Question In essence, what is the appropriate relationship between the government and markets?

How to achieve “good places” with • Complexity • Scarcity • Uncertainty

Arthur O’Sullivan’s 5 Axioms 1. Spatial equilibrium

2. Agglomeration

3. Externalities cause inefficiency

4. Economies of scale

5. Competition eventually leads to zero economic profit

1. Spatial Equilibrium An economist says, “competitive markets under ideal conditions lead to an efficient allocation of resources.”

Or, by “trading/exchanging,” we / sort / move based on maximizing our satisfaction (utility), and our choices will reach equilibrium.

Or, if I have no incentive to trade, I’m not trading. I’m satisfied.

2. Agglomeration Co-locating is a good thing (attracts attention)

• critical mass creates a focal point for potential customers • people (labor) locates near jobs, particularly skilled labor • exchange ideas—critical mass enhances innovation • when physical proximity is necessary

3. Externalities Cause Inefficiency Transactions (one buyer, one seller) are efficient. When costs or benefits are borne by a third-party, that’s an externality.

Inaction or action can result in externalities. • Negative: the peeling paint on my windows probably bothers my

neighbor. • Positive: getting an education (and investing in myself) increases

my productivity, commands higher wages, provides options, etc.

Govt: tax or subsidize behaviors for the desired response.

4. Economies of Scale Occurs when the more we do / make of something costs less with each additional unit.

For example: I have a 10,000 sqft shoe factory. It costs X to build and Y to produce. I want to maximize production to reduce X. Eventually, my 10,000 sqft facility will max out its production.

Or, with complex activities, I’m better off hiring the right people for the right role.

5. Competition Generates Zero Economic Profit IMHO this is:

• At least, believes too much in rational action. • To a degree, conflicts with agglomeration. • Is very much wonky.

In short, competition will move in if you’re creating profit to the point where profit is exhausted.

Questions