Economic Assessment of Urban Transformation 30 (I + II Parziale)

Economic assessment of urban transformation

23 February 2021

Fundamental theorems of welfare economics

Perfect competition model

Assumptions:

• Excludability
• Price system as a vehicle of market signals
• Price-taking behaviour
• Perfect information

Welfare economics

Welfare economics (the economics of welfare – Pigou)

Object: analysis of the reason, the main determinants, why welfare is so different across different Regions, Country, …

Researchers in this field try and provide policy advice for Country and Local authorities, with the goal of maximise economic welfare of people living in a given area.

Three principle of Utilitarist theory this school, works out on the basis of the following principles: à

• Welfarism: evaluating alternative circumstances, the only criterion for a correct evaluation is the welfare or satisfaction that people derive from doing what they prefer. Evaluate things not on the basis of ethical principles but on the basis of the level of happiness of people.
• Consequentialism: just look at the consequence of a given action. Rationale for the choice of actions: actions must be compared only in terms of the consequences they engender
• Sum-ranking: the correct aggregation criterion must be the sum of individual welfare levels, sum of the level of individual’s happiness.

Principle of Pareto-efficiency

Principle of Pareto-efficiency fundamental criterion that underlines the idea above welfare economics. à

A resource allocation is pareto-efficient if the welfare level of everyone is improved.

A welfare state is Pareto-optimal if and only if there’s no alternative state of the world in which an individual is better off, and no one is worse off.

A pareto efficient policy allows the increase in the welfare of one part, without increase the welfare level of the other part (ex: Politecnico di Milano, Rettore introduce una policy che permette agli studenti di essere più soddisfatti del loro livello di apprendimento, senza variare il livello di soddisfazione del Docente).

Fundamental theorems of welfare economics

• I. States that a competitive equilibrium is Pareto-efficient an allocation is efficient if there’s no à alternative allocation s.t. an individual is better off, and no one is worse off.
• A competitive equilibrium leads to a Pareto-efficiency for people. If the mechanism of perfect à competition works, we obtain a Pareto-efficient.
• II. States that we can get a pareto-efficient allocation of resources through a competitive equilibrium with the intervention of an actor: social planner.

They are complementary. à Taken together, these two theorems have important policy implications and provide the rationale for the free market and competition among economic actors.

They seem to suggest that there’s little role for public sector so, why do we have public sector?

There are two main arguments that justify the public intervention in the economy:

• Efficiency, related to the aggregate level of economic activity;
• Equity, related to the distribution of the benefits stemming from economic activity.

Efficiency

Can an economy be efficient without public sector? Economy could not work without two things that the government is doing: they are paramount for the market to work à

• Maintain property rights, rules defining what is legitimacy possessed by someone;
• Contract regulation, contract: whatever type of agreement signed between two parties, they are based on virtual agreements; the government set all the rules for governing trade.

Equity

One reason that incentives public intervention in the economic is related to wealth inequality.

Therefore, whenever a government decides which policy must be undertaken it faces two conflicting goals:

• Make the best use of economic resources.
• Pay attention to the distribution of these resources and to the effects of the policies, same opportunities.

Is there a trade-off between these two apparently conflicting goals?

Public interventions take place as a reaction to the violation of perfect competition model market à failures exists whenever any of the assumptions underlying the perfect competition model is violated and so, the economy doesn’t reach an efficient allocation, pareto-efficient allocation of resources.

Public expenditure as percentage of World GDP, 1970-2018

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Public expenditure as % of World GDP, 1970-2018

World public expenditure over the last 50 years has constantly increased in terms of ratio to GDP.

18 17 16 15 14 2010 2020 1990 2000 1970 1980 Year Government expenditure (% of GDP) Time trend Source of raw data: World Bank

How can that be? Wagner’s law tries to explain this trend on the basis of three mechanisms:

1. Economic growth engenders an increase in the system’s complexity (societies have a growing need for laws and more complex regulations);
2. The urbanisation process causes new costs (infrastructure, pollution), urbanization causes huge costs, increase in the demand for types of good and services that are managed by government, such as: education, sanity.
3. Economic growth produces an increase in the demand for specific goods that are typically produced and distributed by the public sector (education, healthcare).

Assumptions of the perfect competition model

1. Goods cannot be consumed by more than an individual simultaneously (if Adam eats an apple, the same apple can no longer be eaten by Eve);
2. The actions of an individual (or firm) have no direct effect on other individuals, other than through the price system;
3. Consumers and firms act as price-takers;
4. Consumers and firms have full information about the quality and availability of goods on the market, as well as about relative prices.

First assumption for market failures: public good

Principle of defence: all citizens of a given Country are simultaneously protected.

Whenever more than one consumer benefits from the consumption of a unit of the same good.

Public good requests that two main conditions should be contemporary valid:

1. Non excludability, so no one can be prevented from its consumption.
2. Non rivalry, a bit more complex, it takes place whenever the consumption of a public good from an individual does not exclude others from consuming the same good. (ex: everybody could listen to a radio station, the only variable is the signal/frequency, radio waves, if there’s signal everybody can listen to it).

Market failures: assumption 1 (public goods) (2)

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Market failures: assumption 1 (public goods) (2) radio station, the only variable is the signal/frequency, radio waves, if there’s signal everybody can Types of goods: they can be characterised by a different combination of listen to it).

Rivalry and excludability in consumption:

Private good: both rival and excludable in consumption. computer is a private good, I can exclude à everyone else in its consumption.

Private and public goods are two extreme cases, there’s could be also combinations of excludability and rivalry: Rival in Non-rival in 27 consumption consumption

Market failures: assumption 1 (public goods) (3)

Private in nature, they required some kind of membership.

Gym, Payed TV (Sky, Netflix, …)

In the case of a pure public good, the marginal cost (MC), i.e. the cost to provide it to an additional person, is equal to zero and it is not possible to exclude any individual from its consumption.

They have something public in their nature, NB: several goods provided by the public sector are actually impure an example is BEACH -> if too many people come up the quality in public goods! the “live of the space” decrease.

Example. The cost for an additional traveller on an empty road is very low, but it is not exactly equal to zero. Besides, whenever the road is any individual from its consumption. Ex: the cost to provide it to an additional person, jammed, the marginal cost of an additional traveller increases.

NB: several goods provided by the public sector are actually impure public goods these rivalry in the à dramatically. consumption!

Marginal cost of Pure private good use Pure public good (Defense, empty road) Excludability

In the case of a pure public good, the marginal cost (MC) is equal to zero and it is not possible to exclude any individual from its consumption. Ex: the cost to provide it to an additional person,

Examples:

The cost for an additional traveller on an empty road is very low, but it isn’t exactly equal to zero. Besides, whenever the road is jammed, the marginal cost of an additional traveller increases dramatically.

Public health care system. Like in the current health emergency situation, where there’s rivalry in consumption, because there’s not enough space inside hospitals for all the patients, a lot of people wasn’t able to do the regular check for prevention.

Why can the private sector not sell public goods?

We have a large shipmaker (A) and several smaller ship owners (from 1 to n; e.g., fishermen), using the same harbour. Everyone would need a lighthouse. A evaluates her costs and benefits before deciding whether or not to build the lighthouse.

Let’s assume that CA > BA Consequently, A will decide not to build the lighthouse. à

However, this investment would be profitable if we took all benefits into account: CA < BA+ B1+ B2+ ...+Bn (Benefit of A but also the benefits related to the community) free riding problem. à

Therefore, a single individual is not willing to pay for the public good, but what would happen if all shipmakers/users would form a union and would jointly build the lighthouse sharing the bill? Free riding problem: some shipowners will refuse to pay (example: contribution campaign)

It’s necessary to have a Government for public goods because it will contribute to the supply of them, it has to do the “dirty job” for realize things that will be beneficial for the community.

Even if there could be some form of supply of public goods even in the absence of the public sector, in general we need public intervention in order to supply public goods, because the government can force taxpayers to contribute for them. Government do the dirty jobs in order to build things that are useful for the community.

Common resources (rival in consumption + non-excludable)

Club goods (non-rival in consumption + excludable)

Local public goods:

Second assumption of market failures: externalities

An externality of the price system is an interaction between economic agents taking place outside the economy.

There’s an externality any time the welfare of some economic agents, utility levels of consumer or profit level of firms, is directly influenced from the behaviour of other agents, such as consumer or producers.

What I’m doing will cause some positive or negative things to another one. “directly” we exclude any à effect that is mediated by the price system.

The demonstration of the efficiency of the market depends on the following assumptions:

• The welfare of each consumer depends only on her consumption level (Adam is not interested in what Eve is doing, Eva gets satisfaction in eating the apple). Externality: I’m eating a sandwich while my neighbour is smoking;
• The production of each firm depends only on its decisions about production factors (inputs) to be employed and the quantity (output) to produce. We may have an externality whenever other firms also acting in the same market and could influence our output. Ex, externality: production of fishermen on a lake is influenced by how much pollution the refinery located upstream generates.

Market failures: assumption 2 (externalities) (2)

Market failures: assumption 2 (externalities) (2) 35 also acting in the same market and could influence our output. Ex, externality: production of fishermen on a lake is influenced by how much pollution the refinery located upstream generates.

Travel time by car Travel time by train 80 Ex. 1: traffic jams 70 60 50 time For small trips it’s better to use car 40 Travel For longer trip it’s better to use train 37 30 o

Market failures: assumption 2 (externalities) (4)

From this point, travel by car will take more time 20 than travel by train, because there are too much people driving 10 Externalities: whoever will enter the street is causing an increase in traffic situation, Ex. 2. Monetary externalities. until reaching the point “e” from which is better for everybody switch from car to train 0 0 10 20 30 40 50 60 70 80 90 100.

• They imply no inefficiency, because mediation on competitive % of car travellers Externalities don’t influence the price, they influence equilibrium quantities, they don’t take into account will yield a Pareto-efficient result.
• Public policies limiting access to professions are thus not justifiable

Monetary externalities

They don’t imply inefficiency, because mediation on competitive markets will yield a Pareto-efficient result.

Public policies limiting access to professions are thus not justifiable.

Income of architects Income of planners 120000 The % of architects is negative associated with income of architects.

At the same time the income level on planners increase with the % of architects. 100000 more architects there are, the more planner will obtain an high wage. 80000 60000 e 40000 20000 Negatively associated with the increase in planners 0 0 10 20 30 40 50 60 70 80 90 100 % of architects

Market failures: assumption 2 (externalities) (5)

Market failures: assumption 2 (externalities) (5)

Negative externalities and excess of supply.

• In the basic Microeconomics lecture we learned how to build individual and aggregate supply and demand schedules.
• Demand is negatively sloped: the lower the price, the more Negative externalities and excess of supply consumers are willing to buy.

Demand is negatively sloped: the lower the price, the more consumers are willing to buy. Prices increase à consume decrease.

• Supply schedule is positively inclined: the higher the price, the more consume decrease. firms are willing to produce.

Supply schedule is positively inclined: the higher the price, the more firms are willing to produce.

P P Demand Supply 39

Market failures: assumption 2 (externalities) (6)

Market failures: assumption 2 (externalities) (6)

Q Q It represents the set of all consumer that will be willing to pay more for a specific product. (ex: se sono un amante di libri, sono disposto a pagare di più per un libro).

P Supply Consumer surplus Market prices are equal to the value EQUILIBRIUM consumers attribute to the last unit of the e good and to the cost firms must pay in order to produce that last unit of output.

All the firms that will be willing to supply Demand Producer 40 or sell the same product for a lower price surplus with respect to the market price.

Market failures: assumption 2 (externalities) (7)

Market failures: assumption 2 (externalities) (7)

Q In e, market prices are equal to the value consumers attribute to the last unit of the Demand Supply Quantity supplied (with positive externalities) Quantity supplied (with negative externalities) good and to the cost firms must pay in order to produce that last unit of output.

Higher education, it comes with a number Negative externalities: environmental pollution, 100 of extraordinary externalities. the production of plastic is so negative for environment.

It allows people to become more efficient Prices of produce plastic is inexpensive but it doesn’t workers and citizens -> benefits to society, 90 consider the negative externalities on environment. collectivity 80 For the same demand: price is higher -> quantity is lower n70 If the price consumers must pay does not fully reflect the production cost of that good (negative externality), Market without externalities 60 consumers will demand too much of that good, and an excessive quantity will be produced by firms (compare e with n).

Price 50 If for a society collective benefits exist in p addition to private ones (positive 40 externality), an insufficient amount of that good will be produced 30 If for a society collective benefits exist in addition to private ones (positive externality), an insufficient 20 amount of that good will be produced (compare e with p). 10 Negative slope demand 0 1 2 3 4 5 6 7 8 9 10 Quantity 42

Market failures: assumption 2 (externalities) (8)

Market failures: assumption 2 (externalities) (8)

Demand Supply Supply with negative externalities S2 100 Social marginal cost of producing steel Market supply Steel’s production 90 S1 -> negative externalities: pollution, … 80 D = market S2 = marginal 70 demand social cost of e' schedule, producing steel 60 e marginal benefits (S1 + externality) 50 stemming from e: market equilibrium with ext. steel e’: market equilibrium without ext. 40 consumption S1= market supply Move from e to e’ it’s possible thanks 30 schedule, marginal to TAXES imposed by government. private cost of 20 Market demand producing steel 10 How can we move the D -> through TAXES equilibrium from e to e’? 0 1 2 3 4 5 6 7 8 9 10

Solutions to negative externalities

Solutions to negative externalities:

Taxes, the government tax could levy a tax on enterprises that are involved in activities that produce a lot of negative externalities (such as the production of steel)

Licensing, since externalities influence quantities being both produced and consumed, the government could decide they can be produced within a given quantity and only for those being officially licensed. By creating a market for licenses, we would be sure that they would only be bought by those making the best use of them (i.e. reaping the highest benefit).

Internalisation, externality control is carried out by means of forcing a merger between different units causing externalities to one another. Ex.: beekeeper and nurseryman.

Through licensing and internalising we do attribute a money value to externalities (a tax, the cost of a à license) = we set their prices.

The consequence is that if there is a competitive market for externalities, the market reaches an efficient allocation. Therefore, on the basis of the efficiency principle Government will intervene only to create à missing and needed market.

Third assumption: consumers and firms act as price-takers

III: Consumers and firms act as price-takers, price-taking behaviour imperfect competition à

Product differentiation can be both:

• Vertical, products can be unambiguously classified in terms of quality, therefore price competition takes place;
• Horizontal, there are different types of the same product,