Download Muarmy = Mucivilian_good

Module 6 – Economic Efficiency
6.1 Introduction
 People are better off when they specialize in the production of something and exchange it for other
goods that other people are better off at producing
 Total Utility will be greater with trade or exchange
 Specialization increases the quality and quantity of goods and services produced, and therefore the
materialistic well being of society is enhanced
 If markets are freely competitive, the tendency is for a capitalist economy to be technologically efficient
due to self interest and the desire to be profitable
 For an economy to be called economically efficient, it must also produce the combination of goods and
services that satisfies consumers wants as fully as possible
6.2 The Marginal Equivalency Conditions
 A consumer will maximize utility from a given income when that income is allocated to goods and
services so that
MUa = MUb = …… =Mun
Pa
Pb
Pn
 A competitive firm will maximize profits by producing at that level of output at which Pa = Mca
 In a two good world composed of profit maximizing producers and utility maximizing consumers, the
following must hold
MUa = MUb
MCa
MCb
 This equates as saying the utility gained by a consumer from the last dollars worth of resources in the
production of good A equals that of good B
 Market forces will re-allocate resources until the ratios are equal
 If
MUa > MUb, then resources will move from the production B to A. This will cause less of B to be
MCa
MCb
produced and so the law of diminishing marginal utility will cause MUb to increase and MUa to decrease
as more of A and less of B are produced. So equilibrium is achieved over time
 So, when:
MUa = MUb
MCa
MCb
the total utility would be maximized and society will experience the highest utility possible given its limited
resources (i.e. economic efficiency). This formula is termed marginal equivalency.
 Since MC = price, each good is also being produced in a technically efficient manner
 So, a competitive market economy tends to be economically efficient as well as technically efficient
 There are several reasons why a competitive economy may not result in an economically efficient one:
- New goods and services are always entering the market and so firms may never reach long
term equilibrium (where LRMC = MR = P)
- Changing technology
- Changing fashions etc.
6.3 Resource allocation and Profit maximizing behavior in the short run
 In a competitive market, the equilibrium price and quantity is determined by the intersection of the
supply and demand curves
 In the short term, the firm will use different amounts of the variable inputs of production to vary the
output
 If the demand for beer decreases and for tea increases, variable factors will move from the beer
industry to the tea industry until the quantity produced in the tea market is increased so that the market
is in equilibrium again
 Consumers will also re-allocate their income from beer to tea until the ratio of marginal utility to price
equals out again.
6.4 Resource allocation and Profit maximizing behavior in the long run
 In the short run, a firm is in equilibrium (P=MC=MR) with the following curves:
MC
ATC
Pe
AVC
Qe
 However, because its making above normal profits (Pe>ATC)
 The following curve shows a firm in long run equilibrium:
LMC
MC
ATC
LAC
Pe
Qe
 For a firm to be in long run equilibrium, it must be earning normal profits – ie. producing at an output
where ATC and LAC are minimized and P=LMC=MC
 For an economy to be in long run equilibrium:
MUa = MUb = …….MUn
MCa
MCb
MCn
ie. no consumer in the economy would increase total utility by reallocating income from one commodity to
another
 There is only one optimally sized firm:
ATC1
ATC2
ATC
Pe
LAC
Qe
In the graph above, the plant size represented by ATC1 is too small and ATC2 is too big. Both would
suffer losses because ATC1>Pe and ATC2>Pe. Only ATC represents the optimally sized plant because
at Pe the firm is in equilibrium.
 Only if LAC were flat bottomed could different sized plants exist in the long run
6.5 The Wonderful World of Adam Smith vs. the Real World
 Adam Smith in the 18th century came up with the following conclusions:
- utility seeking and profit maximizing behaviors tend to lead to an efficient solution to the
problem posed by limited resources and unlimited wants
- Market forces by themselves would not gurantee economic efficiency under all
circumstances, collective action and planning would be necessary in certain areas of
economic activity
 There are several reasons why a competitive market may not achieve economic efficiency:
- New goods are constantly appearing and old ones disappearing, this can prevent firms frim
reaching long term equilibrium
- Changes in factor prices and supplies may inhibit a firm from reaching long term equilibrium
- Rapid technological change can make existing plant and equipment obsolete and prevent the
attainment of long run equilibrium
Notes:
 General Equilibrium implies that no economic unit in the entire economy wants to change its behavior
Review Questions:
1. D
2. A
3. C
4. b
5. c
6. c
7. a
8. c
9. a
10. b
11. c
Case Study 6.1
1. Like any other product of service, the marginal benefit of spending the last pound on the army should
equal the benefits of spending it on any other service. To maximize economic efficiency
Muarmy = Mucivilian_good
Mcarmy = Mccivilian_good
2. The volunteer service uses the intersection of the demand and supply curves to define the equilbrium
point. This gives the supply of resources and their price to the army
3. The pay is higher and quantity smaller, as conscription uses a price ceiling
4. With conscription, the conscripts have a lower income but civilian society has a higher income
5. The deal struck between the would be conscript and the civilian would not effect the welfare of society
6. Volunteer is more economically effective because it takes into account the welfare that a civilian
offers society and they only become soldiers if there is more utiltiy
7. No