CHAPTER 13 Efficiency and Equity

2 What you will learn in this chapter: How the overall concept of efficiency can be broken down into three components—efficiency in consumption, efficiency in production, and efficiency in output levels How a perfectly competitive market for a single good achieves efficiency in all three components Why an economy consisting of many perfectly competitive markets is typically, but not always, efficient The limits of the concept of efficiency—in particular, why efficiency is about how to achieve goals but not about which goals are chosen

3 Supply, Demand, and the Virtues of the Market We have learned that a perfectly competitive market maximizes total surplus except in cases of market failure. But why is this true, and what are the conditions that make this possible? To see why a market maximizes total surplus, we rule out various ways in which you might think total surplus could be increased: It turns out that total surplus can’t be increased by reallocating consumption, and it can’t be increased by rearranging production. The level of output at market equilibrium is also the right one to maximize surplus.

4 Why a Market Maximizes Total Surplus

5 Why Markets Work So Well The effectiveness of markets depends on the power of two important features of a well-functioning market: property rights and the role of prices as economic signals.  Property rights are the rights of owners of valuable items, whether resources or goods, to dispose of those items as they choose.  An economic signal is any piece of information that helps people make better economic decisions. But under conditions in which prices give incorrect economic signals, markets can fail.

6 Efficiency in the Economy as a Whole A competitive market economy is an economy in which all markets, for goods and for factors, are perfectly competitive. An economy is in general equilibrium when the quantity supplied is equal to the quantity demanded in all markets. An economy is efficient in consumption if there is no way to redistribute goods among consumers that makes some consumers better off without making others worse off.

7 Efficiency in the Economy as a Whole An economy is efficient in production if there is no way to produce more of some goods without producing less of other goods. Equivalently, an economy is efficient in production if it is on its production possibility frontier. An economy has an efficient allocation of resources if there is no way to reallocate factors of production among producers to produce more of some goods without producing less of others.

8 The Production Possibility Frontier and Efficiency in Production Here A and B are efficient production points—at each point the economy can produce more of one good only by producing less of the other. C is not an efficient production point because more corn and more wheat can be produced.

9 Efficiency in Output Levels An economy is efficient in output levels if there isn’t a different mix of output that would make some people better off without making others worse off.

10 Efficiency in the Economy as a Whole To achieve efficiency, an economy must be efficient in consumption, efficient in production, and efficient in output levels. When prices perform properly as economic signals, a competitive market economy in general equilibrium is efficient.  It is efficient in consumption because goods and services are allocated to consumers according to their prices, which are signals of consumers’ willingness to pay.  Second, it is efficient in production because factors of production are allocated to producers according to their prices, signals of producers’ valuation of those factors.  Finally, it is efficient in output levels because everyone faces the same prices, the mix of goods and services will be the mix that people prefer.

11 How an Economy Achieves Efficiency in Output Levels If at current employment levels VMPL corn > VMPL wheat, then corn producers will increase their profits by hiring workers away from wheat producers, who will, in turn, increase their profits by laying off workers. This process is illustrated for a corn producer in panel (a). As a corn producer hires workers, until she reaches her optimal employment level, the number of workers at which VMPL corn = W, the market wage rate. Similar logic applies to the wheat producer in panel (b).

12 Efficiency in the Economy as a Whole Markets for goods and services are linked via the factor markets. Any change in the amount of one good or service produced will ultimately affect the amounts of other goods and services as factors of production shift from one sector to another. The following figure helps us make sense of the interconnectedness of markets for goods and services and factor markets in a market economy.

13 Efficiency in Output Levels in a Circular-Flow Framework

14 The factor markets bring the supply of labor from households and the demand for labor by firms into equilibrium, and the markets for goods and services bring the supply of goods and services from firms and the demand for goods and services by households into equilibrium. Efficiency in Output Levels in a Circular-Flow Framework

15 But supply and demand in all these markets are interrelated: households’ earnings in the labor market determine their demand for goods and services, and vice versa; firms’ profits from hiring labor in the labor market and producing output determine their supply of goods and services, and vice versa. Efficiency in Output Levels in a Circular-Flow Framework (continued)

16 Any change in one market will ultimately generate corresponding changes in all the other markets. When every market for goods and services and every factor market in the economy is in equilibrium, the economy as a whole is in general equilibrium. But what happens when prices go astray? The same factors that lead to market failure lead to inefficiency of the economy as a whole, with prices failing to perform properly as economic signals and mutually beneficial transactions going unexploited. Inefficiency in the Economy: When Prices Go Astray

17 It’s important to remember that efficiency is about how to achieve goals; it does not say anything about what your goals should be. Saying that the market outcome is efficient doesn’t mean that that outcome is necessarily desirable. In fact, in some circumstances a well-thought-out economic policy may deliberately choose an outcome that is not efficient. When can an outcome be efficient without being desirable? When it’s not fair. Efficiency and Equity

18 We want an economy to be fair—to deliver equity— as well as efficiency. There is, however, no agreed- upon definition of fairness. For Inquiring Minds: Theories Of Justice The attempt to define fairness has led to some fascinating debates among philosophers; we describe the views of one influential thinker, John Rawls. Rawls asks the following question: “Suppose that you knew you would be a human being but you did not know whether you would be rich or poor, healthy or sick, and so on. What kind of policies would you want?” What’s fair?

19 Rawls’ answer is that you would probably choose policies that placed a high weight on the utility of the worst-off members of society: after all, you might end up being one of them. And because of diminishing marginal utility, having a few dollars more would do you a lot of good if you find yourself poor, but having a few dollars less wouldn’t do you much harm if you find yourself well-off. Considering the fact that there is a lack of agreement on what fairness means, sometimes economic analysis alone cannot be used to decide between alternative policies. To see why, let’s introduce a new concept, the utility possibility frontier. What’s fair?

20 A useful concept for illustrating the limitations of efficiency as a goal is the utility possibility frontier. It shows that there are usually many efficient outcomes for an economy and that economics alone cannot tell us which one is better. It’s not necessarily true that everyone prefers a given efficient outcome to a given inefficient one. There are many efficient policies, but you might prefer a given inefficient policy to some efficient policies. The Utility Possibility Frontier

21 The Utility Possibility Frontier A utility possibility frontier shows how well-off one individual or group could be for each given total utility level of another individual or group.

22 Efficiency Versus Equity Suppose that for some reason the policy choices that are available are restricted: you can choose only between the efficient outcome A and the inefficient outcome C. Does this mean that A is preferable? Not necessarily. If you place a high enough weight on the utility of Easterners, you may be willing to trade efficiency for equity.

23 The End of Chapter 13 coming attraction: Chapter 14: Monopoly