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 EfficiencyProductive Efficiency Allocative EfficiencyAllocative 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 Number of Internet Hookups Quantity of All Other Goods C D A B Production Possibilities Between Internet Connections and Other Goods

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 employmentProfit maximization and full employment Profit maximization and maximum production with given inputsProfit maximization and maximum production with given inputs Perfect competition and the best allocation of inputs among firmsPerfect competition and the best allocation of inputs among firms

Perfect Competition and Productive Efficiency Productive efficiency is necessary for economic 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

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 aaa a Boxes of Corn flakes Price per Box $3 $2 $1 7,00010,000 A Marginal Revenue Marginal Cost Demand = Marginal Benefit

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 are ways that markets can fail to perform? What can we do when an economy will not achieve economic efficiency?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 aaa 4,000 Price $25 $23 $21 $19 $17 $15 $13 Demand = Marginal Benefit The sum of consumer surplus… is the total net benefits gained in this market. and producer surplus… Number of lessons per week Supply = Marginal Cost (a) aa 4,000 Price $25 $23 $21 $19 $17 $15 $13 Demand = Marginal Benefit 3,000 When quantity is 3,000 and price is $19… Number of lessons per week Supply = Marginal Cost and producer surplus… the sum of consumer surplus… is not maximized. The unshaded triangle is potential surplus not achieved. (b)

Total Surplus and the Inefficiency of Imperfect Competition aa a Boxes of Corn flakes Price per Box $3 $2 $1 7,00010,000 A B C Marginal Revenue Marginal Cost Demand = Marginal Benefit When this imperfectly competing firm charges $3, consumer surplus is the blue shaded area… while producer surplus is the red shaded area. The unshaded area ABC represents potential surplus that is not achieved.