Download Efficiency

Overview
•
•
•
•
Efficiency
Efficiency and competitive markets
Efficiency in exchange
Efficiency in production
Efficiency
• We will use the criterion of Pareto
efficiency
• Pareto efficient allocation: an allocation
whereby no agent can be made better off
without making someone worse off
• An allocation is inefficient in the sense of
Pareto if some agent can be made better off
without having to make someone worse off
Efficiency
Bob’s Utility
Consider the Utility of
two individuals
»
»
Ann’s utility
Efficiency
Bob’s Utility
X is not Pareto-efficient:
both Z and S are better for
one of them, without being
worse for the other
Z
X
S
»
»
Ann’s utility
Efficiency
Bob’s Utility
In fact any point in the
shaded area represents a
Pareto improvement
Z
X
S
»
»
Ann’s utility
Efficiency
Bob’s Utility
But how do we choose between
Z and S? They are both Pareto
efficient!
Z
X
S
»
»
Ann’s utility
Efficiency
Bob’s Utility
The Pareto efficiency criterion
allow us to find allocations that
do not leave “food on the table”,
which is something most people
will agree with
Z
X
S
But we cannot compare
allocations along the
Pareto frontier!
»
»
Ann’s utility
Efficiency
Bob’s Utility
A choice between Z and S
involves a distributional choice,
an ethical decision, a political
choice!
Z
X
S
»
»
Ann’s utility
Efficiency and competitive markets
• From now on we will use Pareto efficiency
and efficiency as synonyms
• We will watch out for inefficiencies now
• These can arise in production and in
exchange
Efficiency and competitive markets
• Inefficiencies in exchange exist when resources
could be reallocated among agents without making
anyone worse off
• Example: If I do not like chocolates and you love
them, I’d better give them to you, instead of
keeping them myself
• Example: Big populated towns in warm climates
might dislike garbage more than small almost
empty towns in colder areas: if they cannot move
the garbage to the small towns, there will be an
inefficiency
Efficiency and competitive markets
• Inefficiencies in production occur when
someone is making something that could be
made at a cheaper cost
Efficiency
• In any case, we are trying to keep the pie
intact, even though we do not know how
equitably shared the pie is...
Exchange Efficiency and competitive
markets
• If we let people freely barter with each
other, they can reach a Pareto efficient
allocation
• The Edgeworth Box illustrates this idea for
two agents
Edgeworth Box
• It can be
used to
explain how
the
competitive
equilibrium
is efficient
Edgeworth Box
Edgeworth Box
A competitive
equilibrium
• In a perfectly
competitive
market prices
adjust so that the
quantity supplied
is equal to the
quantity
demanded
A competitive equilibrium
A competitive equilibrium
• A perfectly competitive equilibrium is
efficient because MRS=MRT for all
producers and consumers
• This is because MRS is made equal to the
ratio of prices for all consumers (so that
they maximize utility) and also equal to the
MRT for each producer who wants to
maximize profit
A competitive equilibrium
• There is no way to rearrange things in
consumption or in production in such a way that
someone can be made better off without having to
make someone else worse off
• Whether this is fair or not is another issue!!!
• But remember any of the Pareto efficient results
can be achieved given a suitable reallocation of
initial endowments
• Society can choose which of the many competitive
equilibria possible is most desirable, more
equitable for example.
A competitive equilibrium
A competitive equilibrium
Rawls proposed
this type of
social welfare
function
Production Efficiency and competitive
markets
• The market will achieve exchange efficiency,
because all agents face the same price and
• all of them will want to choose the quantities they
buy of different goods until their individual WTP
are equal to that same price
• => at the margin the WTP for ALL individual
agents ends up being equal
Edgeworth perspective on exchange
efficiency
• http://www.sscnet.ucla.edu/ssc/labs/camero
n/e1f98/imapedge.html
Production Efficiency and competitive
markets
• In the same way, producers, trying to
maximize profit, will try to equalize their
particular marginal cost (MC) with the
price of the good they sell
• That is they produce and sell a good only up
to the point at which their marginal
willingness to accept (given by the MC)
reaches the price
Production Efficiency and competitive
markets
• Since all producers do this and they all face
the same price, production efficiency is
achieved
• That is: all producers produce at the same
marginal cost
• We will refer to this as the equimarginal
principle
Production Efficiency and competitive
markets
• But remember that we had also the equality
between MWTP for each individual buyer
and the price
• And now we add the equality between
individual MWTA and the price
• This means that the MWTA=MWTP for all
buyers and sellers!
Production Efficiency and competitive
markets
• We just cannot rearrange things, either in
production or in consumption, in order to make
someone better off without making someone
worse off!!!!
• The total net benefits are maximized because the
marginal net benefits are driven to zero. I mean,
we leave no gaps between the marginal WTP and
the marginal WTA for the good
• =>Competitive markets are efficient!
Production Efficiency and competitive
markets
• The aggregation of total consumer surplus
plus total producer surplus is the maximum
possible
• Nothing is wasted!
• There is no way to make someone better-off
without having to make someone else
worse-off
Overview
• The First Theorem of Welfare Economics
• The Second Theorem of Welfare Economics
• Conditions for a market to work
Efficiency
• Pareto efficiency applied if no agent could be
made better off without making someone worse
off
Efficiency
in production
Pareto efficiency = efficiency
Efficiency
in exchange
First theorem of Welfare Economics
In a competitive economy, a market equilibrium is
Pareto efficient
If there is a competitive equilibrium such that…
• all goods can be traded,
• no individual (buyer or seller) can affect the prices
• producers are maximising their profits and
consumers are maximising their utilities
• all markets clear
• and there is free and complete information, the
resulting allocation of resources is Pareto optimal
Second theorem of Welfare Economics
• In a competitive economy, any Pareto optimum
can be achieved by market forces, as long as the
resources of the economy are appropriately
distributed before the market is allowed to operate
• This means that market transactions will lead to
efficient and equitable outcomes if we first
redistribute the initial wealth
Conditions for market to succeed
• So markets seem to be very successful, so
why do we still have problems???
• …apart from equity issues...
• because of market failure
• It is not that the market fails to work
• It is that there was not a market to begin
with
Conditions for market to succeed
• Recall:
• If there is a competitive equilibrium such that: all
goods can be traded, no individual and no firm
can affect the prices, producers are maximising
their profits, consumers are maximising their
utilities, all markets clear, and there is free and
complete information, then the resulting allocation
of resources is Pareto optimal
Conditions: complete markets
• Then there need to be complete markets,
complete property rights over all relevant
goods in the economy
• All the benefits must accrue to the owner of
those goods
• There cannot be no-man lands
• We cannot have externalities or public
goods or public bads!!!
Conditions: atomistic agents
• Recall:
• If there is a competitive equilibrium such that: all
goods can be be traded, no individual and no
firm can affect the prices, [...]
• we do not want to have increasing returns to scale that
would lead to natural monopolies! We do not want any
other monopolies either!
Conditions: atomistic agents
• Producers and consumers must be small
relative to the market
• They cannot individually affect prices: they
are price-takers
• That is, as you know, a precondition for
competition
• We should not have monopolies or
monopsonies!
Conditions: complete information
• Remember that another condition for competition
to arise is that all agents (all consumers and all
producers have perfect information)
Conditions: zero transaction cost
• There cannot be non-negligible transaction costs
• It must be costless to attach prices to good and
trade them
The supply-demand perspective
• An efficient allocation occurs where the
Marginal Willingness to Pay (MWTP) for
a good is equal to its Marginal Cost (MC)
• The inverse demand curve will show the
MWTP for different quantities of the good
• The Supply curve is the MC curve beyond
the shutdown point
MWTP = MC
• If Marginal Cost MWTP then the sum of
Consumer Surplus and Producer Surplus
is maximized
MWTP = MC
MC=Supply
Demand = MWTP
MWTP = MC
MC=Supply
price
Demand = MWTP
MWTP = MC
price
Consumers’
Surplus
MC=Supply
Demand = MWTP
MWTP = MC
price
Consumers’
Surplus
MC=Supply
Producers’
Surplus
Demand = MWTP
MWTP = MC
The sum of CS+PS is
maximum when MC = MWTP
price
Consumers’
Surplus
MC=Supply
Producers’
Surplus
Demand = MWTP
• These calculations apply both to goods and
bads
• Note however that it is easier to think of
bads looking at the service of getting rid of
them, or cleaning them up
• We will need to learn carefully how to go
from the individual to the aggregate demand
and supply curves
MC=MB
• We should keep in mind that, for efficiency
to prevail, marginal costs should be kept
equal to marginal benefits
• At the margin, what something costs needs
to be equal to how much we value it!
• Marginal Net Benefits (MB-MC) should be
zero so that the total net benefit is
maximized
MC=MB
• remember that how much we value
something might easily include nonmarket values
• Example: you cannot buy gray wolves, but
society might still place a value on them
• the same goes for clean air, clean water, etc.
MC=MB
• Also remember that how much something
costs might easily include non-market
costs
• Example: we pollute the air and we pay
nobody for that, we do not throw money to
the planet when we use up its resources
(like when we fish)
Social efficiency
• Social Efficiency requires that all market
and non-market values be incorporated into
the marginal costs and marginal benefits of
production and consumption
• If this is the case, social efficiency is
obtained when marginal costs are equal to
marginal benefits
Market failure
• market failure is pervasive in real life
economies
• If market failure did not exist, the market
would do the job of achieving efficiency…
• …and Economists would be unemployed!

Key terms
•
•
•
•
Marginal Willingness to Pay
Marginal Cost
Consumer Surplus
Producer Surplus
Key terms
•
•
•
•
•
•
•
Competitive equilibrium
price-takers
monopoly
property rights
Market failure
Marginal rate of substitution
Production Possibility Frontier