E CONOMIC E FFICIENCY Managerial Economics Jack Wu

E CONOMIC E FFICIENCY

E CON E FFICIENCY : C ONDITIONS for all users, same marginal benefit for all suppliers, same marginal cost marginal benefit = marginal cost

E QUAL M ARGINAL B ENEFIT if not equal provide more to user with higher marginal benefit take away from user with lower marginal benefit

E QUAL M ARGINAL C OST if not equal supplier with lower marginal cost should produce more supplier with higher marginal cost should produce less

M ARGINAL B ENEFIT /C OST if marginal benefit > marginal cost, produce more of the item if marginal benefit > marginal cost, produce less of the item

E CONOMIC EFFICIENCY V. S. T ECHNICAL E FFICIENCY Contrast economic efficiency vis-à-vis technical efficiency Technical efficiency producing at lowest possible cost doesn’t consider how much benefit the item provides

A DAM S MITH ’ S I NVISIBLE H AND : P RICE 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.

I NVISIBLE H AND  Outcome of price competition in market  Marginal benefit = price  Marginal cost = price  Single price in market

E XAMPLE OF I NVISIBLE H AND 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.

I NVISIBLE H AND 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

D E - 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

D ECENTRALIZATION Within organization For all users, marginal benefit = transfer price For all producers, marginal cost = transfer price Marginal benefit = transfer price = marginal cost

UCLA A NDERSON S CHOOL, 1989 Half an invisible hand is worse than none priced photocopying paper free bond paper

P RICE C EILING Upper limit that sellers can charge and buyers can pay rent control regulated price for electricity

supply demand b equilibrium excess demand Quantity (Thousand units a month) Price ($ per month) RENT CONTROL: EQUILIBRIUM

supply demand b Quantity (Thousand units a month) Price ($ per month) RENT CONTROL: SURPLUSES d g e buyer surplus gain = cfeg buyer surplus loss = dgb seller surplus loss = cfeg + geb c f

R ENT C ONTROL : L OSSES deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn ’ t occur price elasticities of demand and supply _demand more inelastic --> larger loss _ supply more elastic --> larger loss

P RICE F LOOR Lower limit that sellers can charge and buyers can pay minimum wage agricultural price supports

supply demand a b c equilibrium excess supply Quantity (Billion worker-hours a week) Wage ($ per hour) MINIMUM WAGE: EQUILIBRIUM 4.00

supply demand a b c Quantity (Billion worker-hours a week) Wage ($ per hour) MINIMUM WAGE: SURPLUSES 4.00 f d e g seller surplus gain = fdge seller surplus loss = ghb buyer surplus loss = fdge + egb h

M INIMUM W AGE : L OSSES deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn ’ t occur price elasticities of demand and supply _supply more inelastic --> larger loss _demand more elastic --> larger loss

T AX : C OMMODITY T AX “ 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

e Quantity (Thousand tickets a year) Price ($ per ticket) supply demand $10 TAX: EQUILIBRIUM b h

e Quantity (Thousand tickets a year) Price ($ per ticket) supply demand $10 TAX: SURPLUSES b h f d j buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg g

I NCIDENCE 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

R ETAILING : H OW SHOULD MANUFACTURER CUT PRICE ? Wholesale price cut: Will retailers pass on the price cut? Coupons: Will this provide consumers with more effective price cut?

I NCIDENCE : R EDUCING RETAIL PRICES