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 Consider the Utility of two individuals

Efficiency Bob’s Utility Z X S X is not Pareto-efficient: Ann’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

Efficiency Bob’s Utility In fact any point in the Ann’s utility In fact any point in the shaded area represents a Pareto improvement Z X S

Efficiency Bob’s Utility But how do we choose between Ann’s utility But how do we choose between Z and S? They are both Pareto efficient! Z X S

Efficiency Bob’s Utility Z X S Ann’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 But we cannot compare allocations along the Pareto frontier! X S

Efficiency Bob’s Utility A choice between Z and S Ann’s utility A choice between Z and S involves a distributional choice, an ethical decision, a political choice! Z X S

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/cameron/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 MC=Supply Consumers’ Surplus price Demand = MWTP

MWTP = MC MC=Supply Consumers’ Surplus price Producers’ Surplus Demand = MWTP

MWTP = MC The sum of CS+PS is maximum when MC = MWTP MC=Supply Consumers’ Surplus price 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 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.

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