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

ECONOMIC ASSESSMENT OF URBAN TRANSFORMATION

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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 (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:

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- 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 induvial’ happiness.

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

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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 student 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

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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

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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

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- 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

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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.

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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:

I. Non excludability, so no one can be prevented from its consumption.

II. 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

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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

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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

Excludable Private good Club goods some kind of membership

In the case of a pure public good, the marginal cost (MC), i.e. the cost to

Gym, Payed TV (Sky, Netflix, …)

provide it to an additional person, is equal to zero and it is not

Non excludable Common resources Public goods

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

In the case of a pure public good, the marginal cost (MC) is equal to zero and it is not possible to exclude

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

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dramatically.

consumption! Marginal cost of Pure private good

use Pure public good

(Defense, empty road) Excludability

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.

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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.

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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

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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

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 be/er to use car

e

40

Travel For longer trip it’s be/er to use train 37

30 o

Market failures: assumption 2 (externalities) (4)

From this point, travel by car will take more 6me

20 than travel by train, because there are too much

people driving

10 Externali6es: whoever will enter the street is causing an increase in traffic situa6on,

Ex. 2. Monetary externalities.

un6l reaching the point “e” from which is be/er 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 marke

% of car travelelrs

Externalities don’t influence the price, they influence equilibrium quantities, they don’t take into account

will yield a Pareto-efficient result.

the final price.

• 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)

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

• 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)

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 a4ribute 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)

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 n

70 If the price consumers must pay does not

fully reflect the production cost

of that good (negative externality), Market without externali0es

e

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 collec.ve benefits exist in addi.on

to private ones (posi.ve externality), an insufficient

20 amount of that good will be produced (compare

ewith p).

10 Nega%ve slope demand

0 1 2 3 4 5 6 7 8 9 10

Quantity 42

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 schedul, 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:

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

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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

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missing and needed market.

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

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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,