Download Topic_6 2.42MB 2017-04-22 15:56:37

BASIC ECONOMIC
IDEAS & RESOURCE
ALLOCATION
BROAD TOPIC AIMS:
To describe efficient resource
allocation.
To explain market failure
To describe the CBA in decision
making
Introduction & review:
What is the basic/ fundamental economic
problem?
Scarce resources relative to unlimited
wants.
Give examples for the various economic
agents
The fundamental econ problem causes
economic agents to make___________ of
what to sacrifice during consumption.
This leads to __________________ cost.
It’s a problem of ____________& ______________
• Economics attempts to solve this
by allocating resources efficiently
among the many and competing
human wants
• Economic efficiency occurs when
scarce resources are used in the best
possible way.
• Top tip: “how well an economy
allocates scarce resources to meet the
needs and wants of consumers”.
• Task: Copy the definition of
economic efficiency from page 130
• It represents the best possible
solution to the basic economic
problem of scarcity and choice
• Give examples of how economic
efficiency can be achieved in a flower
farm or in a car manufacturing
plant
Parts of economic efficiency
Productive efficiency
• It exists when firms can produce at
the lowest possible cost
• It is achieved when a firm produces
its output at the lowest average
cost curve or at a point on the PPC.
• Top tip: Production on the lowest
point at the lowest AC is called
“technical efficiency”
• E.g Use of Robots in the Toyota
manufacturing plant in Japan enables
cheap & mass prodn of cars.
• It can be graphically represented using
the PPC/PPF and Average cost curve.
•  RECALL: PPF shows the maximum
prodn points for combinations of any
2 products
• Show cost and PPF diagrams from
131.
 Observations for PPF 
• Point x is productively inefficient
since the economy is not operating at
its full capacity.
• Point Y is productively efficient since
its not possible to produce more
because of the basic economic
problem.
• Top tip 
• Firms that seek to maximize profits
by minimizing costs will achieve
productive efficiency.
• Competition will lead to productive
efficiency.
• E.g. the entry of many mobile
telecommunication firms in Kenya
has made the market highly
competitive while calling rates have
fallen!
• Show the equilibrium under perfect
competition
• Equilibrium occurs when
MC=AC=AR=MR
• MC cuts AC at its lowest point
• This means that perfectly
competitive firms are productively
efficient.
Allocative efficiency
• It deals with the production of the
‘right products’ that will achieve
maximum social benefit
• It occurs when price is equal to MC
and firms are producing the most
wanted products. (P=MC or AR=MC)
• MC is a measure of the opportunity
cost of the resources used to make a
product.
• When P=MC consumers are prepared
to pay what it costs to produce
• Its not possible to illustrate allocative
efficiency on the PPF- Why?
• It is defined by consumer preferences
which could be at any point on the
PPF.
• Competitive markets are forced to
produce the ‘most wanted products’
hence they achieve allocative efficiency
Top tip
• Productive efficiency + allocative
efficiency leads to optimum resource
allocation.
• Only perfectly competitive markets
are able to attain both efficiencies in
theory.
• Task- Discussion (Ref page 130 & 2)
• Explain how the use of scarce
resources e.g. oil, water and timber
can promote economic inefficiency
observations
• When MSC=MSB allocative
efficiency is achieved &
community surplus is maximized.
• i.e. the market is said to be socially
efficient.
• Allocative efficiency exists where
Community Surplus is maximized.
• E is the allocatively efficient
output
• PARETO OPTIMALITY
• Developed by Italian economist
Vilfredo Pareto (1848-1923)

• http://www.economyprofessor.co
m/pareto-optimality-1906
• Occurs when its impossible to
make someone better off without
making another worse off.
• It involves resource allocation and
can be illustrated by a movement
along the PPC
PPC & Pareto Efficiency 
Observations
• Point A is Pareto efficient since a
movement from A to B causes
_____units of goods to be given up in
order to produce _____more units of
services.
• Point C is Pareto inefficient since It
is possible to increase either without
leading to a decline in the output of
the other
Practical examples
• Discussion point- describe real life
cases where Pareto efficiency holds.
• Construction of a road bypass:
Reduces journey times & travel costs
but may cause displacement of
people from their homes.
• What if they are compensated?
• sentimental attachment and it’s a
political decision
CLASS TASK
• Watch the video clip on
economic efficiency and make
short notes pareto efficiency,
efficiency & justice/equity
Pareto efficiency video
00:06:57
• C:\Users\pnduati\Documents\Class
notes 2013\A 2 Econ\Basic econ
ideas\ECONOMIC EFFICIENCY videos
• https://www.youtube.com/watch?v=i
ctUYjkQeZU
Top tip
• A Pareto efficient economy doesn’t
necessarily lead to socio-economic
justice/equity.
• There will always be some producers
& consumers who can not operate
at the equilibrium price.
DYNAMIC EFFICIENCY
• The BMW production line
• https://www.youtube.com/watch?v=
QW8ExNMAKU8
• It’s a form of productive efficiency
by large scale firms overtime.
• Occurs when firms meet changing
needs of consumers by introducing
new production processes that lower
LR prodn costs.
• E.g. in 1920’s, Henry Ford’s car
factory was one of the most efficient
firms in the world..
• What about today?
• Toyota company uses robots to
produce cars which is less costly and
benefits consumers
Dynamic efficiency diagram
Observations
• The LRAC shifts downwards as the
firm invests more in capital
intensive production
• Discussion point
• Explain how our local companies
migh achieve dynamic efficiency in
• A) Fast foods manufacture
• B) Livestock farming.
MARKET FAILURE
• Occurs when a free market fails to
deliver efficiency in the use of scarce
resources
i.e.
When the invisible hands of the
market (dd & ss) do not lead to
productive and/or allocative efficiency
A review of sources of market failure
1. Provision of Merit and demerit
goods (AS)
2. Information failure(AS)
3. Provision of Public & quasi
public goods (AS)
4. Adverse selection & moral
hazard(AS)
5. Presence of externalities.
6. Abuse of monopoly power
EXTERNALITIES
• These are ‘spillover/side effects’ of
economic activities to 3rd parties
who are not directly involved with
the activity.
• They can occur from the production
or the consumption side of the
market and can be positive or
negative.
Definitions
• What are negative externalities?
• Side effects that have negative
impacts & impose costs to 3rd
parties
• What are positive externalities?
• Side effects that have positive
impacts & provide benefits to 3rd
parties
Practical examples
• Categorize the following on the basis
of whether they are production or
consumption externalities
• Passive smoking
• Dangerous fumes from a coal mine
in china
• Invention of an Ebola vaccine
• Free tertiary education in the UK
• Radioactive emissions in to the air
from a power station in Japan
Externalities & inefficient
resource allocation
• Negative externalities
• Occurs where there’s a divergence
between social costs (SC) & private
costs (PC) of an activity .
• Recall: 
• S.C = P.C + E.C (external costs)
• Task:
• Copy the definitions of social, private
and external costs from page 135
Top tip
• When there’s a negative externality,
costs paid for by third parties are
called external costs.
• If there’s no externality, External
costs = 0 hence there’s efficient
resource allocation.
• Discussion:
• Describe practical cases where
SC=PC i.e. all the costs are paid by
the firm

• Describe practical cases where
SC ≠PC e.g. a decision to use a
private car instead of public
transport
Positive externalities:
Occurs where there’s a divergence
between social benefits (SB) &
private benefits (PB) of an activity .
Task
• Write down the definitions of social,
external and private benefits from
page 136.
• The difference btn SB and PB is
called external benefits & they are
internalized by the society
• When SB = PB then, EB = 0 and
there’s efficient resource allocation.
Top tip 
• If SB of health care or education are
>PB then positive externality occurs.
• E.g. an inoculation against a highly
communicable disease like Ebola
protects not only the individual but
also the entire community since the
transmission rates fall.
Problems of externalities
• They cause inefficient allocation of
resources in a free market i.e.
overproduction & underproduction.
• Notes:
• MPB/MSB= demand curve
• MPC/MSC = supply curve
• Overproduction caused by a negative
externality
• Reading task: page 136: The
problem created by externalities.
Observations
• The MPC represents the firm's supply
curve.
• The MSC represents the true supply
curve for society which includes the
external cost of production.
• The external cost is represented by the
vertical distance between the two supply
curves (AB).
• The triangle ABC represents the total
deadweight loss to society as a result of
the negative externality
Top tip.
• The market has failed since too many
scarce resources are being used to
produce this product.
• The equilibrium price for the firm is at
B where MPB=MPC.
• The socially optimal point for society is
at C where MSC=MSB
Underproduction caused by a Positive
externality
Task: draw the diagram
Observations
• Firms equilibrium occurs when MPB=MPC
at point G
• Socially optimal equilibrium is at H
where MSC=MSB
• The ignorance of external benefits
leads to an under production (Q6-Q5)
which is positive externality.
• Vertical distance J-G represents the
external benefit
Top tip
• There is dead weight loss as result of
underproduction as shown by area J H
G.
• This implies that the govt must
subsidise education to make it
affordable by all
Students task
• Self assessment task page 137
• India reveals worlds cheapest car
Page 138
Revision
• What is global economic efficiency?
• Its when all the countries are using
all the worlds resources in the best
possible way and sustainably.
• Describe how the inefficient use of
natural resources like oil, timber and
water can lead to economic failure
[10]
1. Which condition must be met for
economic efficiency to be achieved?
• A Marginal social costs are zero in
the production of all goods.
• B Marginal social costs are at a
minimum in the production of all
goods.
• C Marginal social benefits are at a
maximum in the production of all
goods.
• D Marginal social costs equal
marginal social benefits in the
production of all goods. Q 1
9708/31/M/J/12
2. When is economic efficiency
achieved in an economy?
• A when nobody can become better
off without somebody else becoming
worse off
• B when the economy is operating at
its natural rate of unemployment
• C when the level of social costs is
minimised
• D when the rate of economic growth
is maximized Q1.
9708/32/M/J/12
3. In an economy, no one can be
made better off without making
someone else worse off.
• What does not necessarily follow
from this?
• A The conditions for allocative
efficiency have been met.
• B The conditions for productive
efficiency have been met.
• C The distribution of income is
socially acceptable.
• D The economy is operating at a
point on its production possibility
frontier. Q1 9708/31/O/N/12
4. Analyse what is meant by economic
efficiency and assess whether
efficiency is always achieved in a
market. [13]
Q 2b 9708/42/O/N/11
Cost benefit analysis(CBA)
• It’s a model for decision making used to
appraise large scale investment projects
based on costs & benefits involved.
• What is to appraise?
• Assess the desirability.
• It assesses public expenditure
programmes e.g. creation of public goods
where consumers aren’t charged directly
e.g....Euro tunnel, Suez canal etc…
Students task
• Watch the clip on building the suez
canal.
• Tabulate the possible costs and
benefits of the ten year project.
• CBA seeks the establish & quantify
all the relevant costs (Private and
external).
• It is used to reduce market failure by
minimizing the difference between
costs & benefits.
• It quantifies the opportunity cost to
the society of various production
activities so as to minimize negative
externalities.
• It imputes shadow prices on costs and
benefits where no market prices are
available. e. g valuation of the benefits
of clean air in a residential environment.
Top tip
• The general principle of cost-benefit
analysis is that a project is desirable if
the economic and social benefits are
greater than economic and social costs.
Framework of CBA
Stage 1
• Identification of all relevant costs and
benefits
Stage 2
• Putting a monetary value on all
relevant costs and benefits
Stage 3
• Forecasting future costs& benefits
(where appropriate)
Stage 4
• Decision making- Interpretation of the
results
1. Identification of all
relevant costs & benefits
• Determination of the private costs &
benefits and also the external costs and
benefits.
• External costs & benefits are hard to
determine since they have no market
prices.
• Shadow prices are used: prices used
when there’s no recognized market price
available.
2. Assigning a monetary
value on costs & benefits
• Its easy when market prices are
available e.g. the social benefits from a
new retail outlet can be the jobs
created.
• For other issues e.g. the value of costs
on accidents where lives are lost,
shadow prices are used.
3. Forecasting the
future costs & benefits
• It involves estimating the future costs
and benefits that will occur from a
project in the future.
• This is to assess the extent of
externalities from the project.
• E.g. predicting costs & benefits for a
new nuclear power plant.
4. Decision making
• It involves making a decision on whether
the project is viable or not.
• Note:
• If social benefits > social costs, the
project is worthwhile
• If social benefits < social costs, the
project is not worthwhile
Limitation of the CBA
• 1. Difficulties in determining which
costs and benefits to include.
• 2. Difficulties in how to assign the
shadow prices where no prices are given
directly.
• 3. Public investment projects are
controversial and subject to political
interference by politicians hence the
CBA may not give valid conclusions
• 4. CBA does not reflect the
distributional effects of certain
decisions particularly in the public
sector.
• i.e. it doesn’t say whether external
benefits will be fairly distributed.
Students tasks
•
•
•
•
Read the case study on page 140-1.
Do self assessment task on page 142.
Prep:
Exam style questions – page 143
Further revision
• 1. A CBA analysis is carried out to
decide whether the construction of a
major road should go ahead. It is
estimated that the social benefit of the
scheme would be $500 million and the
external cost $200 million. On the basis
of the CBA, the government rejects the
scheme.
• What does this decision indicate must
have been true about the costs of this
scheme?
a) Private cost exceeds $300 million
b) Private cost exceeds private benefit
c) Social cost is less than social benefit
d) Social cost minus private cost equals
$300 million
• 14 In which situation are there
definitely positive externalities?
• A Private benefits exceed private costs.
• B Private benefits exceed social
benefits.
• C Social benefits exceed private
benefits.
• D Social benefits exceed private costs.
• Correct use of cost-benefit analysis
should produce an outcome where
• A social costs are minimised and social
benefits are maximised.
• B social benefits are in excess of social
costs.
• C marginal private benefits equal
marginal social benefits.
• D marginal social benefits equal marginal
social costs.
Further practice (paper 1’s)
•
•
•
•
Q16 M/J 2007
Q16 M/J 2008
Q15 O/N 2003
Q 15 O/N 2004
•THE  END
