1. IMBA Managerial Economics Jack Wu
Economic Efficiency
IMBA Managerial Economics
Jack Wu

2. 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.

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

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

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

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

7. 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

8. 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.

9. 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.

10. 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.

11. 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

12. 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

13. 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

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

15. 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

16. TAX: EQUILIBRIUM $10 804 e supply Price ($ per ticket) 800 b 794 h
demand
900
920
Quantity (Thousand tickets a year)

17. 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)

18. 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

19. 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

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

21. 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.

22. 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?