Pareto Efficiency and Government Intervention

  

The main idea associated with Vilfredo Pareto is that, where price is equal to marginal cost, no one can be better off without someone else being worse off. This means that the Pareto point shows allocative efficiency, or an economy in which everyone has everything at its ‘true’ value. This is distinct from productive efficiency, in which everything is produced at the marginal efficient scale, or lowest long-run average cost. 

Both forms of efficiency are predicated on the idea that the equilibrium price in a market reflects both social marginal costs and benefits, and private marginal costs and benefits. An additional assumption is that a situation in which firms essentially produce in perfect competition (the only market structure in which allocative and productive efficiency arise) is the best use of resources.

A moment’s reflection, however, illustrates that this is not true. Negative and positive externalities of production and consumption exist, for instance. These externalities represent the extra cost or benefit which accrues to society of an economic transaction, and they are neither paid for nor contemplated in a market transaction. There is therefore usually a loss to society, and a failure of price discovery where externalities exist, which in turn means that the market equilibrium is not the social optimum.

If price reflected Marginal Social Cost—the cost of each extra item of a good or service to society, including the private marginal cost and the public marginal cost, then optimal allocation of resources would occur.

Another difficulty arises in the unreality of perfect competition. The market structure is one in which there are many producers, each of whom is a price taker. Consumers are sovereign and infinitely elastic, meaning that average revenue is the same as marginal revenue, and perfect information and knowledge exist, so every producer knows everything in the long run about the costs and production methods of every other producer, no one can erect any sustained barriers to entry and exit to the market, and consumers always know where the lowest price is and seek it out. The good is also fully homogenous—it is the same from all suppliers.

This is fantasy. Even within markets in which fungible items are traded in real time with no transportation or delivery costs, such as the largely electronic markets in foreign currency, or in the construction and food industries, there are often barriers to information, economies of scale, and forms of arbitrage. In agricultural markets, farmers and consumers often differentiate goods.

Entrepreneurs do not start businesses to make normal profit, though they may be content with a profit which covers opportunity cost (which is what normal profit is) or even at times a slight loss, so long as they gain other benefits, such as working for themselves. Hedonic analysis in economics assumes that the gap between gains for such entrepreneurs and the apparent revenue which they have is thus explained by intangible benefits that can be priced by the gap.

No allowance is made for resilience, hope in the future, obligation, or barriers to exit. Most small businesses are also funded by sole traders or private limited companies, and therefore intimately tied to banking practices, disposable incomes, and the attitude of regulators and government to larger firms with monopoly power.

The model of pareto efficiency is still a powerful one, however. This is because it essential forms, like that of perfect markets, an aspiration (however utopian) towards a fair allocation of resources whilst appearing to stand aside from value judgments on the point. In that regard, it drives policy, emphasizes the real-world benefits of dynamic efficiency and policies to encourage competition and draws from the roots of economics in political economy.

Most markets—defined as social structures in which supply and demand meet at an equilibrium price which reflects marginal cost-- fail in the sense that the price is not optimal at most times. Sometimes, this is because they contain firms with a degree of monopoly power which is used to transfer consumer surplus into abnormal profit for the benefit of the firm. Consumers, who often do not simply focus on price, are often happy with this situation as they trade choice and product differentiation for a race to the lowest price. This may not always be true—at times of cost-push inflation, deprivation, or falling real incomes, consumers might actively embrace the lowest price and set aside quality or other product or service characteristics. It is made easier, however, if government intervenes to prevent the most egregious market failures.

There are other ways for markets to fail, however. One lies in the nature of a good, which could be a public, merit, demerit, or Giffen good. A public good is one which is non-excludable and non-rivalrous. It cannot be provided by a market and no rational consumer would pay for it rather than being a free rider (unless by agreement people took turns to pay.)

 Public goods, like defence, law and order, and many forms of basic infrastructure, are essential to the operation of ‘higher markets’ and societies, however, and must be provided by the government. Similarly, merit goods, which can be provided by the market, will generally be overpriced and under produced if the market does so. This means that the substantial positive externalities associated with merit goods will be lost to society, that welfare is not maximised, and that the allocation of goods and services is not optimal. Demerit goods, which have negative externalities, and which are overproduced and underpriced by the market, will likewise produce a deadweight loss for society.

It follows that, to maximise the allocation of resources, any government would provide public goods and at least attempt to ensure the provision of merit goods whilst suppressing demerit goods. Governments might also attempt to equalise bargaining power between consumers and producers, to rebalance situations in which asymmetric information exists, and to control or suppress the abuse of monopoly power by large enterprises. They might do so through direct or indirect taxes, subsidy, regulation, state provision, prohibition and regulation, and the state provision of information.

Such attempts on the part of governments can lead to further market distortion. For instance, by providing merit goods centrally, governments might limit innovation and enterprise within an economy, even if merit goods would otherwise be underprovided. Government provision of goods or services could lead to the creation of self-centred bureaucracies which find reasons to perpetuate their existence, as predicted in public choice theory, and which form a barrier to the entry of new and innovative firms. The way in which governments provide things—such as free at the point of delivery healthcare, for instance, or mass higher education—might lead to moral hazard, in the form of people who do not look after their health or who understand the difference between opinion and expertise.

Economics tends to assume, because of a focus grounded in calculus (and not, for instance, geometry, topography, decision analysis, or matrices) that governments, producers, and consumers make up the entirety of ‘stakeholders’ and those stakeholders constitute society. Families and collective groups and cultures also influence decisions and perspectives, however, and as the observation above on moral hazard shows, might (without resorting to historical materialsim) lead to more nuanced economic policies and perspectives.

Governments which intervene in markets to eliminate externalities can sometimes be very effective in countering or negating one externality, but then might by doing so create another. For instance, a maximum price below equilibrium may well eliminate legal price-gouging, but will create queues, rationing, shortages, and illegal markets as the ‘real’ demand for a good asserts itself given that the price control disincentivises suppliers from legally extending supply. A minimum price above equilibrium, or a buffer stock requirement with the same effect, might stabilise and guarantee agricultural production, but at the cost of oversupply and any associated environmental externalities.

Gas markets in the UK are a good example of multiple reciprocal and unintended government failures. Allowing the appearance of competition, for instance, with a largely pointless price cap above equilibrium, encouraged firms into the market and did create a degree of dynamic efficiency. This emphasised low costs. Low costs meant low storage. When wholesale gas prices inevitably went up, smaller companies went bust, returning customers to larger companies with storage, but given that this storage was not enough, and that there was a gas price cap, government opted to subsidise consumers to be able to afford the higher prices, and to encourage self-rationing. This in turn encourages the gas companies to add the subsidy in part to the price, on the basis that consumers can afford a higher price, and to operate at or near the cap.

A government windfall tax on the profits of energy companies would do nothing to encourage storage, and regulators (assuming that there is no issue of regulatory capture) cannot order shareholders to create more investment. The possibility arises that, in fact, gas company shareholders may simply sell their shares, and gas companies themselves might leave the market, forcing the government to renationalise, should wholesale prices rise further.

One final form of government activity designed to accommodate failings in markets might come in the form of the provision of information, licensing, or regulation to reassure customers and to cope with the problem of asymmetric information. In an age of information, this is a service which, though valuable, might at least be said to suffer from diminishing marginal returns to public investment unless government could guarantee an absolutely respected and high quality of unbiased information.

Optimal allocation of resources cannot therefore be guaranteed by government intervention, or at least by government intervention predicated on the idea that allocative efficiency is the main aim of the provision of goods and services.