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Economic Efficiency and the
Competitive Ideal
© 2003 South-Western/Thomson Learning
The Meaning of Efficiency
Economic efficiency is achieved
when there is no way to rearrange
the production or allocation of
goods in a way that makes one person
better off without making anyone
else worse off.
The Meaning of Efficiency
An efficient economy is not
necessarily
a fair economy.
Pareto Improvements
Pareto Improvement
An action that makes at least one
person better off and harms no one
Pareto Improvements
Economic Efficiency
A situation in which every Pareto
improvement has occurred
Pareto Improvements
Side Payments: One side makes a special
payment to the other side
Some actions that by themselves would not
be Pareto improvements can be converted
into Pareto improvements if accompanied by
an appropriate side payment.
The Elements of Efficiency
•Productive Efficiency
•Allocative Efficiency
Productive Efficiency
Productive Efficiency
When it is impossible to produce more of
one good without producing less of some
other good.
In order to be productively efficient, an
economy must be operation on its PPF
Productive Efficiency
Quantity
of All
Other Goods B
Production
Possibilities
Between
Internet
Connections
and Other
Goods
D
C
A
Number
of Internet Hookups
Three Requirements for
Productive Efficiency
1. The economy must use all of its available
resources.
2. Each firm must produce the maximum
amount possible from the resources
available to it.
3. The allocation of inputs among firms
must produce the maximum possible
amount of output.
Requirement 1
Full Employment of Resources
To be productively efficient, the overall
economy must operate at full
employment, making use of all resources
offered by resource owners.
Requirement 2
Maximum Production from Given Inputs
Productive efficiency requires that every
firm in the economy produce the
maximum possible output from the
resources being used.
Requirement 3
Efficient Allocation of Inputs Among
Firms
Productive efficiency requires that
resources be allocated among firms in
such a way the the economy cannot
increase the production of one good
without decreasing the production of
some other good.
Perfect Competition and
Productive Efficiency
Perfectly competitive markets tend to
be productively efficient.
Perfect Competition and
Productive Efficiency
•Profit maximization and full employment
•Profit maximization and maximum
production with given inputs
•Perfect competition and the best allocation
of inputs among firms
Perfect Competition and
Productive Efficiency
Productive efficiency is
necessary for economic
efficiency.
Allocative Efficiency
Allocative Efficiency
When there is no change in quantity
consumed of any good by an consumer
that would be a Pareto improvement
Allocative Efficiency
The height of the market demand curve
at any quantity shows the marginal
benefit of the last unit of a good
consumed
Allocative Efficiency
The height of the market supply curve at
any quantity shows the marginal cost of
the last unit of a good supplied
Perfect Competition and
Allocative Efficiency
The efficient level of production of any good
is where the demand, or marginal benefit,
curve crosses the supply, or marginal cost,
curve.
At any other level of output, a Pareto
improvement is possible by changing
production.
Economic Efficiency and Perfect
Competition: A Summary
Perfectly competitive markets tend to be
economically efficient - that is, both
productively and allocatively efficient.
Economic Efficiency and Perfect
Competition: A Summary
Economic
Efficiency
Productive
Efficiency
Full Employment
of Resources
Occurs in
any economy
in which firms
are free to
maximize profit.
Maximum
Production
by Each Firm
Occurs in
any economy
in which firms
are free to
maximize profit.
Allocative
Efficiency
Efficient
Allocation
of Inputs
Occurs in
perfectly
competitive
product and
factor markets.
Efficient Quantities
of Different Goods
Occurs in
economies
with perfectly
competitive
product
markets.
The Inefficiency of
Imperfect Competition
In an imperfectly competitive market,
the equilibrium price exceeds the
firm’s marginal cost of production.
The Inefficiency of
Imperfect Competition
Price
per Box
$3
Marginal
Cost
A
$2
Demand =
Marginal Benefit
$1
Marginal
Revenue
7,000
10,000
Boxes of
Corn flakes
The Inefficiency of
Imperfect Competition
Monopoly and imperfectly competitive
markets, in which firms charge a price
greater than marginal cost, produce too
little output at too high a price.
The Inefficiency of
Imperfect Competition
In imperfect competition, it is the
inability of firms to make separate side
deals through price discrimination that
prevents Pareto improvements from
being carried out.
Where Do We Go
from Here?
•What are ways that markets can fail to
perform?
•What can we do when an economy will
not achieve economic efficiency?
Consumer Surplus, Producer
Surplus, and Efficiency
An individual’s consumer surplus on a
unit of a good is the difference between
the most she’d be willing to pay and
what she actually pays for the unit.
Consumer Surplus
The total benefit all consumers gain from
participating in a market is called market
consumer surplus, and is approximately
equal to the area below the market
demand curve and above the market
price.
Producer Surplus
An individual seller’s producer surplus on
a unit of a good is the difference between
what the seller actually gets and the
smallest amount that the seller would
accept in exchange for a good.
Producer Surplus
The total benefit all sellers gain from
participating in a competitive market is
called market producer surplus, and is
approximately equal to the area below
the market price and above the market
supply curve.
Total Net Benefits in a Market
The sum of consumer and
producer surplus in that market
Perfect Competition and
Allocative Efficiency
A market is allocatively efficient
when the sum of producer and
consumer surplus are maximized
in that market.
The Inefficiency of Imperfect
Competition
Monopoly and imperfectly
competitive markets are generally
inefficient.
Price is too high and output is too
low to maximize the sum of producer
and consumer surplus.
Total Surplus and the Efficiency
of Imperfect Competition
(b)
(a)
Price
$25
$23
$21
$19
$17
$15
$13
The sum of consumer
surplus…
Supply = Marginal Cost
Price
$25
When quantity is 3,000
and price is $19…
$23
$21
and producer
surplus…
the sum of consumer
surplus…
$19
$17
is the total net benefits
gained in this market.
Supply = Marginal Cost
and producer
surplus…
$15
$13
Demand = Marginal Benefit
Demand = Marginal Benefit
is not maximized. The unshaded
triangle is potential surplus
not achieved.
4,000
Number of
lessons
per week
3,000 4,000
Number of
lessons
per week
Total Surplus and the Inefficiency
of Imperfect Competition
Price
per Box
When this imperfectly competing
firm charges $3, consumer surplus
is the blue shaded area…
Marginal
while producer surplus Cost
is the red shaded area.
$3
$2
$1
The unshaded area ABC
represents potential surplus
that is not achieved.
A
C
B Marginal
Demand =
Marginal Benefit
Revenue
7,000 10,000
Boxes of
Corn flakes