Government Failure

Sometimes we see governments intervening in markets in an attempt to make them more efficient. However, it is very often the case that they aren't any better at managing resources than the free market - this is known as government failure. We'll look at example involving land conversion and biodiversity loss.

Land conversion is the main reason for biodiversity loss around the word - both grassland and forest cover is declining rapidly in some parts of the planet. We use a diagram similar to the one used in the last post which looks at the interaction between a firm's marginal net private benefit and the marginal external cost of land conversion. The definitions in this case are as follows:

• Marginal net private benefit (MNPB) = the profit associated with a one unit increase in land conversion.
•  Marginal external cost (MEC) =  External cost of a one unit rise in land conversion.

The market for this looks as follows:

Let us describe the market. We have an initial over-conversion because of the market failure. Lp is converted when the socially optimal level would be L*. This is all explained in the last post I made. The government failure, however, comes in the form of the subsidy. The government may be subsidising farmers' incomes, or something of the sort, but this is encouraging more land to be converted. The subsidy increases the marginal net private benefit of land conversion for the firm and therefore the amount of land converted has moved further away from the socially optimal level. We have to remove the government failure before we can remedy the market failure.

We've assumed a constant upwards sloping marginal external cost curve here, but it may be a good time to mention other plausible curves. We could have a curve that increases at a constant rate and once a threshold point is reached it increases faster. Or, we could even have a downwards sloping MEC curve. How? Imagine a view being ruined by a factory. The first factory has a massive effect on the view but subsequent factories have a lesser effect because the damage has already been done by the previous factories.

Government failure occurs a lot in the real world. One example would be with the Common Agricultural Policy. It aimed to provide farmers with a steady income by offering a guarantee price for their goods. This meant overproduction was rife - farmers knew that the best technique was to farm as much as they possibly could to get the most revenue. Land was farmed more intensively and more land was converted to farming to expand production. This will/has caused degradation of the land and biodiversity loss.

Another example is subsidies in developing countries. Governments there tend to impose subsidies to keep prices below the market price so that food and the like is affordable. This encourages over use of the land once again and makes the economic activity look artificially appealing, attracting more firms in. It is also a waste of financial resources that are needed elsewhere.

As we can see government failure is something that is very real. It can occur fairly easily and it needs to be stopped before any market failure can be addressed. How do we stop it, though? I'll be going into this in later posts, stay tuned. Thanks for reading.

Sam.

Markets and Market Failure

When it comes to a firm deciding what output to produce, they generally take into account only two things: How much they can sell the good for and how much it costs to produce. Using this information, they set out to maximise profit by producing where the marginal costs are equal to the marginal revenue. This means there is a strong incentive for the firm to keep costs as low as possible to maximise profits.  

Many environmental goods do not come with a price tag, they are treated as being free by the firm. This 0 price tag means that firms put no effort into using these resources efficiently. The costs that the firm should incur when using these goods are known as the external costs. They do not get taken into account by the firm when making production decisions and therefore we experience over production. External costs are the difference between the social cost of an economic decision and the private costs (costs to the one making the decision).

Here we can clearly see that at the price P the optimal production would be Q*, if the social costs were taken into account. But production is actually at Q because only the firms private costs are looked at when deciding how much to produce. This is an obvious overproduction and it is due to environmental goods not having a price and therefore being treated as free.

Another way to map this out is using marginal external costs versus the marginal net private benefits of production. The marginal net private benefit is the additional benefit the producing firm gains from each additional unit of production. The marginal external cost is the cost to the third party of each additional unit of production. Each additional unit of production adds an increasing amount to the costs but a decreasing amount to the benefits, hence the shape of the curves you're about to see.

In the scenario here, the firm produces at the point Q. Why? Well, they do not care about the marginal external cost of their actions so we can ignore that curve for now. At point Q, benefit for the firm is maximised. Any more production past point Q and benefit to the firm will start to decline. Any point before Q will mean there is more potential benefit to gain. The socially optimal point of output/pollution would be at Q*. This is where the profit from producing the last unit of pollution equals the cost of producing it. Essentially, here, benefits = costs. The external cost has been paid for and the true value of the environmental good has been taken into account. The problem is getting firms to produce at this point. There needs to be a form of incentive to encourage firms to reduce production and therefore pollution to the socially optimal point. How to do this?

That's market failure in an environmental sense. Thank you for reading, comment if you have questions.. blah blah blah. Have a good day.

Sam.

Interactions Between the Economy and the Environment

The economy and the environment is a topic that divides opinion. There are groups of people that feel very strongly either way and a bunch sitting on the fence. One thing is for certain - it is an important issue that needs addressing. The interaction between the economy and the environment is vast, almost all economic action has some impact on the economy and vice versa.

The interaction can be summarised fairly easy. Environmental inputs are taken from the environment for use in the economy and are exchanged with waste created from their use. While this is going on the environment and the economy also operate independently. If the link was broken then both would suffer.

Where does this all come from then? Well, we assume the economy functions in a circular motion. (P)Production produces (C) consumer goods and (K) capital goods, which produce more (C). This yields societies (U) welfare:

So where does the environment come into this? Well, the environment starts off the chain. We can add (R) the flow of natural resources leading to (P) production. We can also add waste (W). At each stage of the process waste is created and fed back into the environment. Using the First Law of Thermodynamics that states we cannot create or destroy energy and matter, the amount of waste used in a time period must be equal to the amount of resources used. The start of the chain now looks something like this:

Now the final stage to convert this into the circular system is to add in recycling (r). This gives us the full circular system. Natural resources add to production which adds to consumer/capital goods. All three of these create waste which is fed back into the environment. Some of this waste is taken to be recycled and fed back into the system as a natural resource. Ultimately the consumer/capital goods lead to consumer welfare. The environment also adds to consumer welfare as it is.

This is how the system works, but can it be improved? Yes, yes it can. We can reduce R by using energy more efficiently. This will in turn reduce waste which is of course a good thing. We have to take care of the assimilative capacity of the environment. This is the ability for the environment to break down waste, it becomes more and more limited with higher amounts of waste. Therefore, the more waste we create, the less can be broken down naturally by the environment - a bad thing.

The question now might be why don't we recycle all waste? That way the assimilative capacity of the environment would never get strained and natural resources could remain very much intact. Well, we can't because of the Second Law of Thermodynamics. This states that energy can change states and become unusable. The word for this dissipation is 'entropy'. Unused resources have low entropy but once they've been used it becomes high entropy. This explains why we cannot recycle everything.

So, we've essentially covered the three main economic functions of the environment above: a supplier of natural resources, an assimilator of waste and a source of utility. Environment damage occurs because us as the consumer do not value these functions correctly. We treat them as free when in actual fact if they were marketable goods they would have higher prices.

The concept of sustainable development can be touched upon here. There are many different definitions for this phrase, you've just got to pick one. The one I like is "Development that meets the needs of the present without compromising the ability of future generations to meet their own needs".

How do we ensure that future generations can meet their wellbeing needs? We need to make sure we look at the ideas of intergenerational and intergenerational equity. This means providing for the most needy in today's society (intra) but also meeting the needs of the next generation (inter). A good way of doing this is to ensure that we leave a stock of capital at least as large as the current one. This comes in two forms: weak and strong sustainable development. Weak will involve maintaining the aggregate level of capital stock. A fall in natural stock can be substituted by a rise in man-made capital. Strong differentiates between the two types of stock, it understands that some natural stock is a necessity. It encourages the need to be cautions and beware of irreversibility.

Sam.

Externalities and Public Goods

Externalities are the effect on the third party of an action made by an individual or a firm - whether it be for the better or the worse. A lot of the time externalities are negative, pollution for example, and this is the example we will use here. We'll look at a firm in industry creating a good that means they are polluting the atmosphere.

With externalities being ignored, the firm will hire workers and capital according to the rule: (Marginal revenue product of labour = marginal cost of labour = wage = marginal cost of labour)

In Layman's terms, this means they'll employ labour up until the point where the marginal revenue product of labour is equal to the marginal cost of labour, meaning profits are being maximised. If the producer had to clean up the pollution as well then the amount they'd employ would become:

What has been added is a new Price, the price of cleaning pollution. This is taken away from the price of the product they're producing which will overall leave a lower figure. If we rearranged above we could achieve this:

The marginal cost of the good will now be the wage plus the marginal cost of cleaning up the pollution. This means the social cost of the firms actions have been taken into account. Previously, the marginal cost of production was below the marginal social cost - leading to an overproduction. Here it is graphically:

Q2 is the social optimum when the cost of clearing the pollution is taken into account. If MSC is greater than MC then there are external costs of production, if it's the other way round there are external benefits to production.

Now for a quick look at public goods, a fairly simple sub-topic. A public good is one that has the characteristics 'non rival' and 'non excludable'. What does this mean? It means that my consumption of the good does not stop other people consuming it (non rival) and I cannot be prevented from consuming the good once it is provided (non excludable). Street lighting is a good example. It's a good that generally has to be provided by a government because no individual or firm would pay for it - they'd just wait for someone else to buy and free ride. A good that has only one of the characteristics stated above but not both is known as a 'quasi-public good'.

That's all boys and girls! Comment if you need more help, share the blog if it has assisted you. Cheers!
Sam.

The 5 Minute Guide to the "Credit Crunch"

So, "credit crunch" is a phrase that has been tossed around way too much in the last few years. I find it tremendously cheesy and I'm not ashamed to say that it makes me cringe a bit when I read it. But, it seems to have reached that stage where it is now a socially acceptable term (ugh!) and therefore we have to roll with it. I'm taking a wild stab in the dark here assuming that a lot of people know what the "credit crunch" is but don't know how it came about, or how we ended up slap bang in the middle of it! Fear not, I am here to talk you through it in 5 minutes (don't hold me to that).

So, we roll back the clock to the early to mid 2000's. We are in America and looking at the US mortgage market. Around this time most things economical are going well, generally the world is in a stable position and growing well - meaning confidence is high. What is important to note is that, due to this, property prices in the USA were on the rise. High confidence and rising house prices put the mortgage lenders in a fairly arrogant position. We saw an expansion of what is known as the 'sub prime' mortgage market. These are essentially risky mortgages - mortgages given out to people who may have trouble meeting the repayment schedule. Why do this? Well, the banks felt safe because the rising house prices meant if the recipient of the mortgage couldn't make the payment then the bank would inherit an asset that was rising in value - increasing their profit.

Everything was all well and good until we reach 2007. Towards the end of the year inflation in the USA rises and this forces interest rates up (higher interest rates are a method of bringing prices/inflation down). The mortgage default rate begins to rise now because the low introductory interest rate of the mortgages start to come to an end. The mortgage recipients now have to pay the higher national interest rate on their repayments and many could not do this and were forced to default.

Coinciding with this, the housing boom collapses and house prices plummet. Now the banks are left with a defaulted mortgage and a worthless house - they have entered a very sticky situation and their balance sheets are severely hit. A key part of the finance sector is banks lending to each other when needed, they do this at special rates and it is the cheapest way of generating short term funds. This stops. Banks stop lending to one another because their balance sheets were hit by the defaulting mortgages and worthless properties.

This essentially is the problem. Some banks cannot afford to keep going due to the losses they've made and with no access to short term funding from other banks they have no option but to declare bankruptcy - Lehman Bros for example. It becomes a global crisis because of the integration of the world economy. Countries are so intertwined now due to trading, international agreements that something like this can spread around the world in a matter of months. It took roughly 3 months from when the USA entered recession for the UK to enter recession. In the space of a few months a crisis in one country has become a global financial crisis.

That's it. Sub-prime mortgages increase -> inflation causes interest rates to rise -> housing market collapses -> default rates increases -> banks stop lending to one another -> recession -> spreads around the world.
This is a very simple look at the credit crunch, of course there is a lot more to it. For the normal person, this is as much detail as you need to understand, essentially, what went on and why we are where we are now.
Cheers guys,
Sam.

Lorenz Curve and Gini Coefficient

These two concepts are used in conjunction with one another to measure the distribution of something you're interested in. The most used example is for the distribution of income, but it can be applied to anything.

The diagonal line is the line of complete equality between national income on the Y axis and population on the X axis. Area A on the diagram shows the inequality, the Gini coefficient puts a value on this area. The Gini coefficient is calculated by the following: A / (A+B). It takes the area of A as a proportion of the whole area under the line of perfect equality. The value of the Gini coefficient can range from 0 to 1. 0 Being complete equality and 1 being complete inequality.

If we have two Lorenz curves that do not intersect and the coefficient increases then we can see there has been an increase in inequality. If the two curves do intersect, even if there is a change in the Gini coefficient we cannot say for sure what has happened to inequality by just looking at the coefficient. We need to look at the shape of the curves and where they cross to get an accurate representation of the change. That is one limitation of the Gini coefficient.

Short but sweet. Cheers guys, over and out.

Sam.

Factor Markets

When discussing factor markets we are talking about the market for factors of production. Recall the circular flow of income (there is a post on it somewhere) - firms are demanders of factors of production and households are suppliers. Firms pay money to households in exchange for their factors of production - wages for labour, for example.

We'll be looking at perfectly competitive factor markets. Everyone in this market is a price taker, whether it be the firms, the workers or whoever. Freedom of entry and exit exists. It costs nothing for a person to leave the labour force and nor does it cost anything for someone to join it. We assume that the factors are homogenous. Everyone/everything in the market has the same level of skill and motivation. Finally, there is perfect knowledge. Workers know everything about the firm and firms know everything about the workers, for example.

Let us zoom in on the labour market more specifically. A perfectly competitive labour market looks as follows:

On the left we have the market as a whole. The wage rate is determined by the interaction of demand for workers and the supply of workers.  With this wage rate, we can look at an individual firm on the right. At wage rate W the firm would be willing to employ Q hours worth of labour.

We need to somehow ascertain how much labour would be supplied by people in the labour market. This figure is dependent on many factors. From the point of view of the worker, working involves disutility's such as sacrificing leisure time and it being tedious/boring.  The more they work the larger the disutility. The marginal disutility of work (MDU) will increase as people work more. Due to this, we see an upwards sloping supply curve of labour. To encourage people to work more hours, higher wages need to be paid in order to compensate for the higher disutility.

In general, an individual's supply of labour will look like this. The higher the wage rate, the more hours worked. However, there is a case where the shape of the individuals supply of labour actually bends backwards. This is the case when an individual feels that after a certain point they can afford to work less and have more leisure time. It looks like this:

Once wage reaches W the individual feels that they are earning enough and can afford to cut back on the amount they work should wages rise further.

The amount of labour a firm demands rests on the assumptions that firms are trying t maxisimise profits. The theory is known as the marginal productivity theory. We look at the marginal revenue product of labour in this piece of analysis (MRPL). We know that to maximise profits, marginal costs must equal marginal revenue, so therefore the firm will employ labour up until the point wages (the marginal cost) equal the marginal revenue product of labour. It looks like this:

The firm will hire Q hours worth of labour in order to maximise their profits. What about the demand curve for a firm as a whole? Well, because whatever the wage the firm will be producing where wages equal MRPL, this means that the demand curve for the firm is the MRPL curve. From the peak of the curve to the right is the demand for labour for a firm trying to maximise its profits.

There are some firms that are known as monopsomists. These firms are wage setters, not wage takers. They are a firm with monopoly power on factors of production in an area - say a single employer in a village. They have the power to restrict the amount of labour they employ to keep wage rates down. The firm faces an upwards sloping supply curve for labour, to employ more workers they need to pay a higher wage rate. This supply curve shows us what wage must be paid to attract a certain amount of labour. The wage is also the average cost of employing labour, therefore the supply curve is the AC curve. The marginal cost of labour will be above the average costs because to attract more employees the wage rate must be raised. The profit maximising point for the firm would be where MCL = MRPL with a wage of W1. If we were in a perfectly competitive market the wage rate would have been at W2 with a higher amount of labour employed. The monopsomist forces the wage rate down by restricting how many workers it employs.