Overview

1
Overview

• Efficiency
• Efficiency and competitive markets
• Efficiency in exchange
• Efficiency in production

2
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

3
Efficiency

• Bobs Utility
• 
  
• 
  Anns utility

Consider the Utility of two individuals
4
Efficiency

• Bobs Utility
• 
  
• 
  Anns 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
5
Efficiency

• Bobs Utility
• 
  
• 
  Anns utility

In fact any point in the shaded area represents
a Pareto improvement
Z
X
S
6
Efficiency

• Bobs Utility
• 
  
• 
  Anns utility

But how do we choose between Z and S? They are
both Pareto efficient!
Z
X
S
7
Efficiency

• Bobs Utility
• 
  
• 
  Anns 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
But we cannot compare allocations along the
Pareto frontier!
X
S
8
Efficiency

• Bobs Utility
• 
  
• 
  Anns utility

A choice between Z and S involves a
distributional choice, an ethical decision, a
political choice!
Z
X
S
9
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

10
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, Id 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

11
Efficiency and competitive markets

• Inefficiencies in production occur when someone
  is making something that could be made at a
  cheaper cost

12
Efficiency

• In any case, we are trying to keep the pie
  intact, even though we do not know how equitably
  shared the pie is...

13
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

14
Edgeworth Box

• It can be used to explain how the competitive
  equilibrium is efficient

15
Edgeworth Box
16
Edgeworth Box
17
A competitive equilibrium

• In a perfectly competitive market prices adjust
  so that the quantity supplied is equal to the
  quantity demanded

18
A competitive equilibrium
19
A competitive equilibrium

• A perfectly competitive equilibrium is efficient
  because MRSMRT 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

20
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.

21
A competitive equilibrium
22
A competitive equilibrium
Rawls proposed this type of social welfare
function
23
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
• gt at the margin the WTP for ALL individual
  agents ends up being equal

24
Edgeworth perspective on exchange efficiency

• http//www.sscnet.ucla.edu/ssc/labs/cameron/e1f98/
  imapedge.html

25
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

26
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

27
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 MWTAMWTP for all buyers and
  sellers!

28
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
• gtCompetitive markets are efficient!

29
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

30
Overview

• The First Theorem of Welfare Economics
• The Second Theorem of Welfare Economics
• Conditions for a market to work

31
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
32
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

33
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

34
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

35
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

36
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!!!

37
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!

38
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!

39
Conditions complete information

• Remember that another condition for competition
  to arise is that all agents (all consumers and
  all producers have perfect information)

40
Conditions zero transaction cost

• There cannot be non-negligible transaction costs
• It must be costless to attach prices to good and
  trade them

41
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

42
MWTP MC

• If Marginal Cost MWTP then the sum of Consumer
  Surplus and Producer Surplus is maximized

43
MWTP MC
MCSupply
Demand MWTP
44
MWTP MC
MCSupply
price
Demand MWTP
45
MWTP MC
MCSupply
Consumers Surplus
price
Demand MWTP
46
MWTP MC
MCSupply
Consumers Surplus
price
Producers Surplus
Demand MWTP
47
MWTP MC
The sum of CSPS is maximum when MC MWTP
MCSupply
Consumers Surplus
price
Producers Surplus
Demand MWTP
48

• 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

49

• We will need to learn carefully how to go from
  the individual to the aggregate demand and supply
  curves

50
MCMB

• 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

51
MCMB

• remember that how much we value something might
  easily include non-market 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.

52
MCMB

• 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)

53
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

54
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! ?

55
Key terms

• Marginal Willingness to Pay
• Marginal Cost
• Consumer Surplus
• Producer Surplus

56
Key terms

• Competitive equilibrium
• price-takers
• monopoly
• property rights
• Market failure
• Marginal rate of substitution
• Production Possibility Frontier