Session 7
Microeconomics
SESSION 7 – The Role of Organisations and Institutions
In this subsection we are going to look in a bit more detail at the role
of institutions and organisation in microeconomics. Institutions and
organisations are important in microeconomics for while the market
is the main way in which goods and services will be exchanged in the
economy, this is not the only way in which transactions can occur.
In this session we are going to discuss the concept of public goods
and their externalities in more detail in addition to exploring the free
rider problem.
We will also be considering the nature of collective goods and the
role of both state and non-state governance in microeconomics. We
will be exploring the nature of market design.
We will also be discussing the concept of Arrow’s Impossibility
Theorem before we finally conclude this session by looking at the
influence of policy upon the market and economy.
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Microeconomics
Here, we’re going to be exploring the role of institutions and
organisations in microeconomics particularly in relation to
governments, government policy, and public goods.
Public Goods
A public good can be defined as a good that can be consumed by
more than one individual at a time. Examples of public goods could
include a fireworks display, a local pool or national defence. This is the
opposite of a private good which can only be consumed by a single
individual. Examples of private goods could include a sandwich, a
jacket, or a bicycle.
One of the main key economic differences between public and private
goods is that public goods are non-rivalrous while private goods are
rivalrous. In reality when we are considering goods we should think
of them existing on a continuum of non-rivalrous to rivalrous as most
goods are not usually extreme in this way. If a good is completely
non-rivalrous this would mean that we could keep adding consumers
without any enjoyment of the good being taken any from others. An
example of this type of good would be a country’s national defence
in which another consumer can be added and enjoy the benefit of
defence without anyone else being adversely affected.
Goods can also be further defined as being excludable or nonexcludable.
If a good is non-excludable it means that others cannot
be excluded from enjoying goods. An example could be a fireworks
display in which anyone who is close enough will be able to view the
fireworks without needing to obtain permission or pay for the goods.
If a good is excluded others can be easily excluded from enjoying the
good. An example of an excludable good could include a television
set in a private house.
Because of their characteristics it is likely that producers who are
seeking profits will be more willing to produce excludable public or
private goods than they are willing to produce non-excludable goods.
One potential problem when considering public goods which are
non-rivalrous but non-excludable is known as the free-rider problem
and we will now discuss this in more detail.
The Free-Rider Problem
The free-rider problem is an externality associated with the production
of public goods. When a pure public good is supplied decentralised,
individual behaviour does not result in optimal outcomes. This is
because of the strategic decisions that guide individual behaviour
when externalities are present.
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Microeconomics
The problem with free-riders is that if too many individuals seek
to get “a free ride” based on the contributions of others, the total
contributions collected will fail to meet the cost of the goods and
services that are provided.
The free-rider problem is an example of the prisoner’s dilemma. This
is an element of game theory in which it is in each individual’s best
interest not to contribute no matter what the actions of others are.
But, if nobody contributes the result is bad for everyone.
Ways in which to solve the free-rider problem include government
intervention, by using market forces to provide some public goods,
or using incentive systems in order to make telling the truth in
individual’s best interests.
In addition to applying to what are known as public goods the freerider
also applies to goods known as collective goods. While the terms
public goods and collective goods are very similar we are just going
to explore the unique features of collective goods now.
Collective Goods
Collective goods are very similar to public goods and relate to goods
and services which are used jointly by a number of individuals. In the
case of collective goods it is generally not possible to leave payment
for collective goods to the individual as this process will usually
fail. This is due to the fact that each individual will generally try to
minimise their contribution towards the cost of the good or service
and once again we will see the free-rider problem emerging.
As we have now discussed public and collective goods and have
seen the issues associated with the free-rider problem, let’s now
turn our attention to the role of state and non-state governance in
microeconomics.
State and Non-state Governance
So far, we have discussed the influence of government policies a
number of times. This is because at various times most modern
economies have relied upon state laws and organisations in order
to enforce laws and to provide security to transactions and contracts
made in the economy.
It is also the case however that at times the majority of states have had
institutions and organisations which were too weak, slow, inefficient
or biased to resolve issues in a state’s economy. When this occurs
it is often the case that societies develop alternative institutions to
provide economic governance. Consider for instance the role of the
mafia and black markets.
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Microeconomics
In addition to governance influencing the economy, the way in which
the market is designed and operates can also affect how transactions
are undertaken. So let’s look in a bit more detail at market design.
Market Design
In addition to the main economic market there may be some situations
in which some specialised transactions are better served through the
creation of a specialised market or market-like platform. Examples of
alternative markets include the internet which has been described as
a “sharing economy” and includes new market places such as Ebay.
More local examples of specialised markets could include babysitting
clubs.
In addition to specialised markets we may also see a number of
different types of market designs being used. The most common
form of market is a matching market but other forms of markets can
include systems such as auctions.
Now we have considered how the design of the market can affect the
way in which the market operates, we are going to consider briefly
the concept of Arrow’s Impossibility Theorem.
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Microeconomics
Arrow’s Impossibility Theorem
Arrow’s Impossibility Theorem is named after Kenneth Arrow who
devised this theory of social choice. Arrow’s Theorem is a paradox
that illustrates that it is impossible to have an ideal voting structure
that reflects specific fairness criteria such as pareto efficiency. In other
words Arrow’s impossibility theorem indicates that a clear order of
preference cannot be established while adhering to principles of fair
voting procedures.
In order to demonstrate how this theorem operates let’s consider
an election in which voters are asked to rank their preference for
candidates Mr A, Mrs B, and Miss C.
When voting, 50 people vote to indicate that they prefer Mr A over
Mrs B and prefer Mrs B over Miss C. 45 people vote to indicate that
they prefer Mrs B over Miss C and prefer Miss C over Mr A. Finally 35
people vote to indicate that they prefer Miss C over Mr A and prefer
Mr A over Mrs B.
In this election candidate Mr A has the most votes and would win
this election however if Mrs B was not standing in the election Miss
C would be the winner as more people prefer candidate Miss C over
Mr A. The result of this election would therefore demonstrate Arrow’s
Impossibility Theorem.
In microeconomics, a number of different tools are available to model
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Microeconomics
the effects of economic choice and enable economists to think about
the decisions people make in a political context.
In order to conclude this subsection we are now going to briefly
consider the influence of policy upon the market and economy in a
bit more detail.
The Influence of Policy upon the Market and Economy
Government policy can be effective at controlling and influencing the
market and the economy. Nonetheless, governments do not have a
free hand to impose any policies they wish on the market.
In reality, democratic systems and checks have been developed to
ensure that proposals for legislation that may harm the economy
are limited and must be discussed at a range of committees and
subcommittees. These will debate any proposals and will recommend
only policies with which they are in agreement. Once proposals have
been agreed, it is then usual for these to be debated further in the
government before voting on occurs. The way in which governments
therefore are able to ensure policy is managed, is known as voting
equilibrium. It results in what is known as a “structure-induced”
equilibrium. It is so-called because the process results in a policy
proposal that lies in the middle of where all individual ideal points
would be for those who have considered the idea.
Session Summary:
In this subsection we explored the role of institutions and organisations
in microeconomics. We saw that institutions and organisations are
important actors in microeconomics and is one of the ways outside
of the market in which transactions will take place.
We also considered the definition of a public good. We explored public
goods in more detail and have looked at one of the externalities of
public goods in terms of the free-rider problem. We saw that the freerider
problem is something that exists for public goods and is a form
of the prisoner’s dilemma. We discussed the free-rider problem in
some detail including how and why this occurs and how this can be
dealt with.
We also considered the nature of collective goods and sought to
define collective goods in more detail. We discussed the role of both
state and non-state governance in microeconomics considering
what happens if state governance fails to take charge of a situation.
Following our discussions of governance we discussed some of
the different market designs that can be developed outside of the
traditional market design and structure.
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Microeconomics
We also discussed the concept of Arrow’s Impossibility Theorem and
looked at some of the issues voting preferences can have and the
paradox that can be created from this.
Finally, we concluded this session by considering the influence of
policy upon the market and the economy and one of the ways in
which governments ensure that radical and harmful policy is not
imposed upon the market.
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VIDEO
COMMENTARY
SESSION 7
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Microeconomics
SESSION 7 – The Role of Organisations and Institutions
In our seventh we are going to look at ways to think about politics in
economic terms. Specifically, in this session we are going to consider
the Median Voter Theorem.
To consider the Median Voter Theorem, we are going to use an
example of a school board. The school board is comprised of five
members who need to agree the level of spending that will be made
next year. In order to reach an agreement the democratic process of
pairwise voting is used until a winner is found. The process will end
when a Condorcet winner is found. The Condorcet winner is the name
given to the proposal that has defeated all other proposals in pairwise
voting.
In order to explore how voting will proceed let’s assume that the five
voters will have single-peaked preferences over the level of spending.
The voter whose peak is in the middle is known as the median voter
and is labelled with ym. If the median voter’s proposed policy was up
against any proposal that fell to the left of it, we could assume that
any voter whose preference is to the right will be more likely to vote
for ym than any proposal further to the left of this. In this case voters
4 and 5 will join with voter 3. If the proposal was against the right
the same would occur with voters 1 and 2 voting for ym rather than
anything to the right.
As there is not a proposal that can beat ym this proposal will be
declared the Condorcet winner. The Median Voter Theorem can be
applied to any situation in which an odd number of voters exist.
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CASE STUDY
SESSION 7
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Microeconomics
SESSION 7 – The Role of Organisations and Institutions
The Role of Government In a Market Economy
Introduction:
In this briefing we’re going to look at the role of institutions and
governments within microeconomics in a bit more detail. We are
going to do this by considering an article by Libby Rittenbery and
Timothy Tregarthen entitled “The Role of Government in a Market
Economy”.
By reviewing this article, we are going to consider the role of
governments in responding to market failures of public goods,
external costs and benefits, and imperfect competition. We are also
going to look at merit and demerit goods, and discuss the ways in
which governments redistribute income.
Rittenberg and Tregarthen begin this article by stating that we want
a great deal more from governments than we did several decades
ago. They note that this has resulted in total government spending
per capita (when adjusted for inflation) increasing more than six fold
since 1929.
Rittenberg and Tregarthen continue by considering the different
types of government spending that may occur. This includes not only
goods and services that are produced for the public, but also transfer
payments.
The article next provides a summary of government revenue sources
and expenditures in 2007 for both the USA and EU. Rittenberg and
Tregarthen note that for the USA, revenue mainly came from personal
income tax and payroll taxes. Expenditure, meanwhile, was mainly
spent on transfer payments to individuals. For the EU, a greater share
of revenue comes from taxes on production and imports, and far less
is spent on defence than in the USA.
The authors note that to understand the role of government, it is
useful to distinguish between four types of government involvement
in the economy. These are:
1. Government attempts to respond to market failures to allocate
resource efficiently.
2. Government agencies act to encourage or discourage the
consumption of certain goods and services.
3. Government redistributes income through programs such as
welfare and social security.
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Microeconomics
4. Government uses spending and tax policies to influence the
level of economic activity and price level.
Rittenberg and Tregarthen note that the first three of these types of
government involvement are related to microeconomics, whilst the
fourth is related to issues of macroeconomics. The first three of these
areas are therefore discussed in more detail within the article.
The first area discussed in more detail is responding to market
failure. The authors note that when the market’s output of goods and
services falls short of the efficient level, it is possible that government
intervention will move production levels closer to their efficient
quantities.
In the next section, Rittenberg and Tregarthen discuss public
goods. They note that public goods include goods such as national
defence and law enforcement. The authors note that the difficulty in
producing public goods is that they are freely available to everyone,
and therefore the free rider problem occurs.
The authors, therefore, argue that the theory of public goods
demonstrates an important reason for government involvement in
the economy.
Next, external costs and benefits, which are also known as externalities,
are discussed. The authors note that due to the lack of a market
transaction, the person responsible for the external cost or benefit
will not face the full cost or benefit of the choice involved. Rittenberg
and Tregarthen provide the example of a computer memory chip
firm which generates water pollution to demonstrate this point. The
authors indicate that, because the firm producing the good does not
face all of their production costs, the price can be expected to be
lower and the quantity produced can be greater than the efficient
level.
The authors also provide the example of infectious disease
inoculations and note that these lead to external benefits, but as
this exceeds the private benefit, the market is likely to produce less
than the efficient quantity. In this case, the government may need to
provide such goods and services.
The final area discussed in the article relates to imperfect competition.
The authors note that in a perfectly competitive market, price will
equal marginal cost. However, if competition is imperfect, individual
firms would face downward-sloping demand curves and will charge
prices greater than marginal cost. In this type of market, firms will
produce less of a good than is efficient. In response, governments
may legislate against uncompetitive behaviour such as monopolies.
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Microeconomics
Rittenberg and Tregarthen note that in each of these three cases
there is the potential for government intervention in order to try
to move the market towards a more efficient model. The authors
provide a number of figures that review the potential gains that
may be generated as a result of government intervention in cases of
market failure.
Following the discussion of market failures, the authors of this article
next discuss merit and demerit goods. They provide an explanation of
merit and demerit goods and discuss the reasons why governments
may sometimes provide merit goods and prohibit demerit goods.
Finally in this article, Rittenberg and Tregarthen discuss the concept of
income redistribution. They discuss the nature of income distribution
and note that distribution of income generated by a private economy
might not be satisfactory for a number of reasons. The authors note
that government intervention in income redistribution will often be
seen as a public goods argument.
To conclude this article, Rittenberg and Tregarthen provide some
examples of actual and proposed government programmes which
each relate to government intervention within the market, before
finally providing a case study of government involvement within the
oil pricing of the USA in 2008.
Take a moment to discuss these points from the session.
• Discuss the possible microeconomic reasons for government
involvement within the market and its potential effect on the
market.
• Discuss the difference between merit and demerit goods. In what
ways can a government seek to control such goods?
• Discuss the advantages and disadvantages of public goods and
the free rider problem.
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