IMBA Managerial Economics Jack Wu Economic Efficiency IMBA Managerial Economics Jack Wu

Economic Efficiency Intellectual foundation for capitalist system: markets work better than central planning; to some extent, similar principle applies within an organization -- internal markets; study limitations of internal markets later in Chapter 12 (Asymmetric Information) and 13 (Incentives and Organization) This Chapter concludes presentation of Competitive Markets.

Econ Efficiency: Conditions for all users, same marginal benefit for all suppliers, same marginal cost marginal benefit = marginal cost

Equal Marginal Benefit if not equal provide more to user with higher marginal benefit take away from user with lower marginal benefit

Equal Marginal Cost if not equal supplier with lower marginal cost should produce more supplier with higher marginal cost should produce less

Marginal Benefit/Cost if marginal benefit > marginal cost, produce more of the item if marginal benefit > marginal cost, produce less of the item

Economic efficiency v.s. Technical Efficiency Contrast economic efficiency vis-à-vis technical efficiency Technical efficiency producing at lowest possible cost doesn’t consider how much benefit the item provides

ADAM SMITH’S INVISIBLE HAND: PRICE Competitive market achieves three sufficient condition for economic efficiency: buyers and sellers in a market system act independently and selfishly, yet the overall outcome is efficient i) users buy until marginal benefit equals price; ii) producers supply until marginal cost equals prices; iii) users and producers face same price.

Invisible Hand Outcome of price competition in market Marginal benefit = price Marginal cost = price Single price in market Competitive market achieves three sufficient condition for economic efficiency: buyers and sellers in a market system act independently and selfishly, yet the overall outcome is efficient i) users buy until marginal benefit equals price; ii) producers supply until marginal cost equals prices; iii) users and producers face same price.

Example of Invisible Hand Major policy issue: how to allocate licenses for 3G wireless telecommunications; “beauty contest” -- France auction – Germany, UK, US pioneer: in early 1990s, US Federal Communications Commission showed that spectrum licenses were worth billions; created pressure on other governments to allocate by auction and not favoritism. Auction ensures that item goes to user with highest marginal benefit.

Invisible Hand Market system (price system): Economic system in which resources are allocated through the independent decisions of buyers and sellers, guided by freely moving prices. Successes of market system West/East Germany North/South Korea China after Deng Xiaoping’s reforms

De-centralization create internal market if there is a competitive market for an item, set transfer price equal to market price consuming units should be allowed to outsource Note: Transfer price: price charged for the sale of an item within an organization; Outsourcing: purchase of services or supplies from external sources

Decentralization Within organization For all users, marginal benefit = transfer price For all producers, marginal cost = transfer price Marginal benefit = transfer price = marginal cost Decentralization achieves conditions for economic efficiency

UCLA Anderson School, 1989 Half an invisible hand is worse than none priced photocopying paper free bond paper

Tax: Commodity Tax “the only two sure things in life are death and taxes” buyer’s price - tax = seller’s price payment vis-à-vis incidence US: airlines pay tax Asia: passengers pay

Tax: Equilibrium $10 804 e supply Price ($ per ticket) 800 b 794 h demand 900 920 Quantity (Thousand tickets a year)

Tax: Surpluses buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg $10 804 f e supply Price ($ per ticket) 800 d g b 794 j h demand 900 920 Quantity (Thousand tickets a year)

Incidence incidence and deadweight loss depend on price elasticities of demand and supply ideal tax (no deadweight loss): inelastic demand/supply who pays the tax not relevant

Retailing: How should manufacturer cut price? Wholesale price cut: Will retailers pass on the price cut? Coupons: Will this provide consumers with more effective price cut? Apply competitive market model

Incidence: Reducing retail prices Incidence the same with wholesale price cut and coupons (assuming all consumers use coupons)

Discussion Question Consider a company that manages a network of hospitals across several counties in one state. Household incomes and the cost of living are higher in urban than rural areas. The company, however, has set the same prices for pharmaceuticals and services in all of its hospitals. It has also paid the same salaries for doctors, nurses, and other professional staff throughout the state.

Discussion Question:continued Management has noticed that there are long waiting lists for treatment at its urban hospitals. Can you explain this problem? The company has had great difficulty in recruiting professional staff for its urban hospitals. Can you explain this problem? What advice would you give to management?