Appendix 3: Some economic terms
Extracts from:
Bannock G, Baxter R & Rees R, The Penguin Dictionary of Economics,
Penguin, Harmondsworth, 3rd ed. 1984
Pearce D W ed., The MIT Dictionary of Modern Economics, MIT Press,
Cambridge Massachusetts 1986
consumer's surplus
`The excess of the amount a consumer is prepared to pay for a good (rather
than go without it) over the amount he actually does pay for it....' [Bannock
et al. 1984]
economic efficiency/ allocative efficiency
`The production of the `best' or optimal combination of outputs by means
of the most efficient combination of inputs. `Optimal' output might be
determined in various ways, but in welfare economics it is generally held
to be that output combination which would be chosen by individual consumers
responding in perfect markets to prices which reflect true costs of production.
The efficient combination of inputs is that which produces output at the
least opportunity cost...' [Pearce 1986]
economic welfare
`That part of human welfare which results from the consumption of goods
and services.... Although welfare was originally regarded as being synonymous
with satisfaction or utility, some economists have objected that
welfare is an ethical concept in that to say that the satisfaction of
an individual's desires increases his welfare is to make a value judgement
that the satisfaction of those desires is a good thing. Other economists
would persist in arguing that `economic welfare' has a precise meaning
and has no ethical overtones. Further difficulties and limitations arise
when we wish to measure welfare... In attempting to resolve these difficulties,
economists have employed the concept of a social welfare function
which seeks to relate the welfare of a given group to that of the individuals
composing the group...' [Pearce 1986]
externalities
`Externalities in consumption exist when the level of consumption of
some good by one consumer has a direct effect on the welfare of another
consumer, an effect which is not transmitted through the price
mechanism... Examples of consumption externalities are: 1. A, wanting
privacy, builds a high fence, which reduces the amount of sunshine flooding
in through B's window; 2. A, in making a right turn on a busy road, causes
a large traffic jam to build up behind him...
`The essence of externalities... is that their costs or benefits are
not reflected in market prices, so the decision of the consumer or firm
creating the externalities on the scale of the externality-creating activity
does not generally take its effect into account. Hence, since the time
of A C Pigou, economists have argued that social welfare would be increased
if the private consumption or production decision were modified so as
to take the external effect into account. The means of doing this were
traditionally held to be the imposition of taxes on activities which created
losses in welfare or increases in costs, and payment of subsidies on activities
which increased welfare or lowered costs...' [Bannock et al. 1984]
`Externalities are variously known as external effects, external economies
and diseconomies, spillovers and neighbourhood effects...' [Pearce 1986]
marginal cost
`The extra cost of producing an extra unit of output.... marginal cost
is determined by variable costs only. In the long run marginal costs may
rise, fall or stay constant depending on the presence of economies or
diseconomies of scale.' [Pearce 1986]
`The increase in cost resulting from a small increase in the rate of
output of a good or service.... It is necessary to distinguish between
short-run and long-run marginal cost. Suppose the firm is deciding upon
its output levels for the coming month. Although it will be able to vary
the quantities of some of the factors of production it uses, for example,
energy, raw materials and some kinds of labour services, there will factors
whose quantities cannot (or would be prohibitively costly in such a short
period) vary, for example its stock of machinery and buildings, and perhaps
some kinds of highly skilled labour. It must then calculate the cost of
changes in output, taking into account the fact that only some of its
inputs are variable. The corresponding marginal cost is then a short-run
marginal cost. Suppose on the other hand that the firm is planning output
for a month so far into the future that, over the intervening period,
it is possible to change all input levels. For example, it is long
enough for the firm to plan, buy and install more machinery, construct
new buildings and hire or train the skilled labour, It can then calculate
the cost of changes in output in that future period on the basis that
all inputs are variable, and the associated marginal cost will be long-run
marginal cost.
`The relevant marginal cost to use is always unambiguous: it is determined
by the precise period for which output is being planned and the possibilities
of varying inputs for that period.' [Bannock et al. 1984]
marginal cost pricing
`A pricing practice pursued by private firms or public corporations in
which price is made equal to marginal cost.... In the public sector,
nationalized industries are recommended to use marginal cost pricing,
the rationale being that it maximizes economic welfare.' [Pearce 1986]
[see also `non-rival consumption']
`A method of setting price, by which the price at which an output can
be sold on the market is equated with the marginal cost of producing
that output...
`Marginal cost pricing is often recommended as an appropriate policy
for public enterprise and regulated industries, on the grounds that it
is the pricing policy which maximizes social welfare... The marginal
cost of the good shows the value of the resources absorbed in producing
the marginal unit of output, and hence the value of the other goods and
services which the economy could have produced with those resources. Now,
if price and output were chosen such that price exceeded marginal cost,
that would mean consumers place a higher value on the marginal portion
of their consumption than it costs to divert resources from other uses
to produce that portion. It would therefore be possible to increase net
consumer benefits in the economy by supplying more of the output. Thus
no price greater than marginal cost can be consistent with maximizing
net consumer benefit or social welfare. Likewise, if price and output
were such that marginal cost exceeded price, the value of the resources
absorbed in producing the marginal portion of output exceeds consumers'
valuation of that output, and net benefit can be increased by reducing
output. If it is not to be possible to make such welfare-increasing output
adjustments, it is necessary that price be set equal to marginal cost.
`Clearly, the whole argument rests on two underlying propositions: a)
that output price is a correct measure of the benefit consumers derive
from their marginal consumption, and b) that marginal cost is a correct
measure of the value of the resources absorbed in producing the marginal
bit of output. If one or both of these propositions is not true,
the `marginal cost pricing rule' may have to be modified. [Bannock et
al. 1984]
merit good
`A good the consumption of which is deemed to be intrinsically desirable.
In the case of such goods it is argued that consumer sovereignty does
not hold and that if consumers are unwilling to purchase `adequate' quantities
of such goods they should be compelled or encouraged to do so.... Many
economists would reject this reasoning but in any case there is a difficulty
in determining who is to decide which goods are merit goods....' [Pearce
1986]
`...It should be noted that there is an element of paternalism in policies
towards merit goods. Society decides that the preferences of individuals
cannot be left to determine the levels of consumption of such commodities.'
[Bannock et al. 1984]
mixed good
`Goods, the benefit of consuming which is neither confined solely to
one individual nor available equally to everyone. A mixed good thus lies
between the polar extremes of a private good the consumption of which
is rival (ie one person's consumption precludes anyone else benefiting
from the same unit) and a public good which is non-rival in
consumption (the benefits of the good are equally available to everyone),
containing elements of both. For example, inoculation against disease
is a mixed good since it benefits the community at large (by reducing
risk of illness) as well as the individual, though the benefits are not
equally distributed. In such cases, private consumption confers a beneficial
externality on the rest of the community... Mixed goods are certainly
more common than pure public goods and possibly more common than private
goods - thus their analysis is of great importance....' [Pearce 1986]
non-rival consumption
`When one individual's consumption of a good in no way diminishes the
supply of that good to other individuals, the good is said to be non-rival
in consumption. There is no opportunity cost of consumption of
such a good. Non-rivalness is a characteristic of public goods.
An example of a good which is non-rival in consumption is a broadcast
television signal; one person's use of that signal does not diminish its
availability to other individuals. Economists generally argue that goods
which are non-rival should be provided at zero price for marginal or incremental
units, on the grounds that if an additional unit of consumption can be
provided at zero cost then that consumption should not be prevented by
the charging of a price.' [Pearce 1986] [see also `marginal cost pricing']
opportunity cost
`Perhaps the most fundamental concept in economics, the opportunity cost
of an action is the value of the forgone alternative action...' [Pearce
1986]
Pareto improvement
`A reallocation of resources which makes at least one person better off
without making anyone worse off.... Despite its analytical importance,
the Pareto criterion is highly restrictive since it provide no guidance
to choice between alternatives which involve one person becoming better
off at the expense of another. Since almost any economic policy will act
to someone's disadvantage, this is a serious restriction. In order to
overcome this, some economists have sought to supplement the Pareto criterion
with criteria based on distributional equity while others have considered
the use of compensation tests... A `potential Pareto improvement' exists
when the gainers from a change are hypothetically able to compensate those
who lose, so that it is possible for no-one to be any worse off after
the change and for at least one person to be better off.' [Pearce 1986]
price elasticity of demand
`...the percentage change in demand that occurs in response to a percentage
change in price...' [Pearce 1986]
public good
`A commodity or service which if supplied to one person can be made available
to others at no extra cost. A public good is this said to exhibit non-rival
consumption: one person's consumption of the good does not reduce
its availability to anyone else... The extreme or `polar' case of a `pure'
public good has been defined by Paul A. Samuelson as a good which is:
1. non-rival in consumption; 2. has the characteristic of non-excludability
- that is, if the good is provided the producer is unable to prevent anyone
from consuming it. This latter characteristic prevents private markets
from functioning since a seller would be unable to ensure than only those
individuals who paid for the good could obtain it... Where exclusion is
possible or where consumption is not completely non-rival we have an example
of a mixed good (or impure public good)...
`Where consumption of a good is non-rival, the charging of a price for
the good or service is, in terms of the Pareto principle, inefficient.
This is so because adding an extra unit of consumption provides a benefit
to the consumer without imposing any costs, while the charging of a price
would prevent some consumption from taking place - thus causing a net
loss of satisfaction or utility. It follows that, even when it
is possible, the provision of a public good through a private market will
not enable the best or `optimal' level of output to be produced. As we
have seen, in the case of non-excludability, a market cannot operate at
all.
`The provision of a public good is a matter of collective choice. Generally,
we expect to find public goods provided by governments and paid for through
compulsory taxation. An alternative solution would be for all the members
of a community to make a voluntary agreement to provide and pay for the
good. The difficulty with this solution is that individuals may conceal
their true valuation of the good in order to escape payment (ie they may
seek to be free riders)....'
`Examples of public goods include national defence, street lighting,
and environmental protection...' [Pearce 1986]
`Goods which, because they cannot be withheld from one individual without
withholding them from all, must be supplied communally. For example, it
would not be possible to exclude any one individual from `consuming' national
defence, street lighting or general police protection.... Since the state
can raise revenues by taxation, it alone can finance the provision of
public goods... Note that this definition does not apply to all
goods publicly supplied. Many of the goods supplied by the state could
be supplied privately, and some indeed are; the best examples being housing,
education and specific police protection. The non-pure, or `quasi' public
goods, are supplied by the state and financed out of taxation because
it is considered that their quality and/or quantity of supply would be
inadequate under private provision.' [Bannock et al. 1984]
social welfare
`The well-being of the society or community at large. In defining social
welfare we face two sets of problems. The first problem concerns the `social'
aspect. In general, social welfare is seen as some aggregation of the
welfare of individual members of a society - this raises the question
of how the aggregation is to be achieved. The second problem relates to
the concept of `welfare'. I M D Little has argued (see his Critique
of Welfare Economics, 2nd ed., Oxford University Press, Oxford 1957)
that `welfare' is an ethical concept since to define something as contributing
to welfare is to make a value judgement about whether that thing is good
or bad. Alternatively it has been argued that welfare should be equated
with the satisfaction of individual preferences and regarded as a `technical'
term...' [Pearce 1986]
utility
`Widely construed in economics to be synonymous with `welfare', economic
welfare, satisfaction and, occasionally, happiness. More strictly, however,
to say that someone derives utility from a good or event is to say that
they prefer the good to exist rather than not to exist...' [Pearce 1986]
willingness to pay
`The valuation placed by an individual on a good or service in terms
of money. Its use as an indicator of valuation is controversial in two
respects. First, it will be constrained by ability to pay so that those
with higher incomes will appear to value goods more highly than those
with lower incomes. This may contradict some concept of fairness or justice.
Secondly, it is open to moral objection when the good in question is the
removal of a nuisance such as noise or pollution, since it might be argued
that it is unjust that the sufferer should have to pay for the removal
of the nuisance, when most people would expect that the sufferer should
be compensated by the wrong-doer.' [Pearce 1986]
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