Economics 2010Economics 2010

Lecture 9Markets and efficiency

Competition and EfficiencyCompetition and Efficiency

The Key QuestionAllocative EfficiencyThe Invisible HandObstacles to Efficiency

The Key QuestionThe Key Question In a market, millions of individuals each

make their own decisions about what to sell and what to buy

Nobody coordinates these individual plans

Nobody thinks about other agents’ welfare

They are trying to get the best deals for themselves!

Do markets produce the efficient quantities of goods and services?

Or do they produce too much of some items and too little of others?

This is the key question

The Key QuestionThe Key Question

Allocative EfficiencyAllocative Efficiency

Allocative efficiency occurs when no resources are wasted

In more technical language, allocative efficiency occurs when no agent can be made better off without some other agent being made worse off

Three conditions are met when the allocation of resources is efficient: Consumer efficiency Producer efficiency Exchange efficiency

Allocative EfficiencyAllocative Efficiency

Consumer EfficiencyConsumer Efficiency

Consumer efficiency occurs when consumers cannot make themselves better off by reallocating their budgets

by reorganizing the way they spend their money

Consumer EfficiencyConsumer Efficiency

consumer efficiency occurs when consumers are on their demand curves

The demand curve tells us the quantity that consumers plan to buy at a given price

Consumer EfficiencyConsumer Efficiency

Also, the demand curve tells us the maximum amount that consumers are willing to pay for a given quantity

In the absence of external benefits, the demand curve is a marginal social benefit curve

Marginal social benefit is the amount that a consumer is willing to pay for the last unit bought plus the value of the last unit bought to other people

The value to other people of the last unit bought is called an external benefit. An example is the benefit from new knowledge

Consumer EfficiencyConsumer Efficiency

Producer EfficiencyProducer Efficiency

Producer efficiency occurs when firms cannot increase their profits by changing the quantity produced or by changing the method of production

Equivalently, we will see later in the year that producer efficiency occurs when firms have maximized profit

Producer EfficiencyProducer Efficiency

Profit is maximized when the marginal cost equals marginal revenue

In perfect competition, marginal revenue equals price

So, producer efficiency is achieved when marginal cost equals price

the marginal cost is given by the supply curve, as you know

Producer EfficiencyProducer Efficiency

Producer efficiency occurs when firms are on their supply curves

The supply curve tells us the quantity that producers plan to sell at a given price when they are maximizing profit

Producer EfficiencyProducer Efficiency

Also, the supply curve tells us the minimum amount that producers are willing to accept for a given quantity

In the absence of external costs, the supply curve is a marginal social cost curve

Marginal social cost is the cost of the last unit bought plus the cost imposed on other people

The costs imposed on other people are called external costs. They are opportunity costs that fall on third parties. Examples are the costs of pollution or congestion

Producer EfficiencyProducer Efficiency

Exchange EfficiencyExchange Efficiency

Exchange efficiency occurs when all the available gains from trade have been realized.

The gains from trade for consumers are measured by consumer surplus

Consumer surplus is explained in Chapter 6, which we skipped

However, the concept is very easy...

Exchange EfficiencyExchange EfficiencyHere, consumer

surplus is shown by the green triangle

Consumer surplus is the value placed on the good minus the amount paid for it

Exchange EfficiencyExchange Efficiency

The gains from trade for producers are measured by producer surplus

Producer surplus is total revenue minus the opportunity cost of production

Exchange EfficiencyExchange EfficiencyHere, producer

surplus is shown by the blue triangle

Producer surplus is the revenue received minus the cost of production

Exchange EfficiencyExchange Efficiency

The total gains from trade are the sum of consumer surplus and producer surplus

Allocative efficiency occurs when all three conditions: consumer efficiency producer efficiency exchange efficiency

are satisfied

Allocative EfficiencyAllocative Efficiency

We show here allocative efficiency

Consumer efficiency is achieved at all points along the demand curve, D

they are happy there...

Allocative EfficiencyAllocative Efficiency

Producer efficiency is achieved at all points along the supply curve, S

they are happy there...

Allocative EfficiencyAllocative Efficiency

Exchange efficiency is achieved at the quantity Q* and the price P*

At this price and quantity, the gains from trade are maximized

Allocative EfficiencyAllocative Efficiency

The Invisible HandThe Invisible Hand

When firms are producing on their supply curves and households are consuming on their demand curves, each is doing the best they can with their resources, given the prices prevailing in markets

Competitive markets bring these two sets of decisions together

The Invisible HandThe Invisible Hand

Equilibrium in a competitive market occurs at the price that equates the quantity demanded and the quantity supplied

In a competitive equilibrium, producers’ marginal costs equal consumers’ marginal benefits for all goods and services

When there are no external costs, a firms’ marginal cost equals marginal social cost

When there are no external benefits, the price paid by the household is the marginal social benefit

In the absence of externalities, the competitive market is efficient

The Invisible HandThe Invisible Hand

Competitive markets send resources to their highest-value uses

The Invisible HandThe Invisible Hand