Today

Economic EfficiencyEconomic Efficiency Producer’s surplusProducer’s surplus Perfect competition and economic Perfect competition and economic

efficiencyefficiency Return exams at end of classReturn exams at end of class

Economic Efficiency

Reading: end of Chapter 21Reading: end of Chapter 21

Definition Economic EfficiencyEconomic Efficiency: When goods are : When goods are

produced in the least costly manner and produced in the least costly manner and distributed to those who value them most. distributed to those who value them most.

Requires:Requires: Productive EfficiencyProductive Efficiency Allocative EfficiencyAllocative Efficiency

Productive Efficiency There is no way to re-direct production There is no way to re-direct production

among firms to increase total output.among firms to increase total output.

Perfect Comp and Productive Efficiency In LR firms produce at lowest possible LRAC. In LR firms produce at lowest possible LRAC.

There is no way to cut costs by changing plant There is no way to cut costs by changing plant size.size.

Since all firms take the same price, all firms have Since all firms take the same price, all firms have same MC (why?)same MC (why?) There is no way to re-direct production to other There is no way to re-direct production to other

firms and get lower marginal costs.firms and get lower marginal costs. Productive efficiency holds.Productive efficiency holds.

Allocative Efficiency Goods are consumed by those who most Goods are consumed by those who most

value them.value them. There is no alternative comb. of goods that There is no alternative comb. of goods that

could be produced that would increase could be produced that would increase society’s well-being.society’s well-being.

Measuring Allocative Efficiency

The sum of consumers’ surplus and The sum of consumers’ surplus and producers’ surplus.producers’ surplus.

2

Recall: Consumers’ Surplus

The difference The difference between what a between what a consumer is willing to consumer is willing to pay & what he does pay & what he does pay.pay.

D

1 2 3 4 5 6 7

6

4

8

$/unit

units

A

B

Producers’ Surplus-SR perspective The difference between the amount of The difference between the amount of

revenue the firm earns and the minimum revenue the firm earns and the minimum amount necessary to get the firm to produce amount necessary to get the firm to produce that quantity of the good in the short run.that quantity of the good in the short run.

PS = Revenue - total variable costs.PS = Revenue - total variable costs.

2

Producers’ Surplus-Market

Selling 4 units Selling 4 units @$6/unit. @$6/unit.

Total revenue = B + C.Total revenue = B + C. TVC for all firms is TVC for all firms is

represented by the area represented by the area under the SRS curve under the SRS curve (why?) = C(why?) = C

B = producers’ surplusB = producers’ surplusD

1 2 3 4 5 6 7

6

4

8

$/unit

units

B

SRS

C

2

Allocative Efficiency A + B = The sum of A + B = The sum of

consumers’ and consumers’ and producers’ surplus.producers’ surplus.

Vertical distance Vertical distance between D and S is the between D and S is the difference between difference between value to consumer and value to consumer and MC to producer.MC to producer.

What Q maximizes What Q maximizes CS+PS?CS+PS?

D

1 2 3 4 5 6 7

6

4

8

$/unit

units

B

SRS

C

A

Allocative Efficiency & Perfect Competition Perfectly competitive markets provide the Perfectly competitive markets provide the

allocatively efficient quantity of a good.allocatively efficient quantity of a good.

Perfect Comp and Econ Efficiency Conclusion: Perfectly competitive markets Conclusion: Perfectly competitive markets

are economically efficient!are economically efficient! This is one reason why we use them as a This is one reason why we use them as a

benchmark for our study of other market benchmark for our study of other market structures.structures.

Excise Taxes and Allocative Efficiency Assume the market for wheat is perfectly Assume the market for wheat is perfectly

competitive.competitive. Shade in the sum of consumers’ and Shade in the sum of consumers’ and

producers’ surpluses for the competitive producers’ surpluses for the competitive market equilibrium.market equilibrium.

Wheat

Bushels of wheat

Price/Gal. Identify the Identify the market market equilibrium equilibrium price and price and quantity.quantity.

Shade in the CS Shade in the CS + PS.+ PS.D

S

1.00

5

0.75

4

1.25

6

Excise Tax

Add an excise tax of $0.50 per bushel to Add an excise tax of $0.50 per bushel to this market.this market.

What happens to market price and quantity?What happens to market price and quantity? Shade in CS + PS in light of the tax.Shade in CS + PS in light of the tax. Compare your answer to before the tax. Is Compare your answer to before the tax. Is

it allocatively efficient to tax this industry?it allocatively efficient to tax this industry?

0.50

Excise tax on wheat-50¢

Bushels of wheat

Price/Gal. Price paid by Price paid by elevator is $1.25elevator is $1.25

Price kept by Price kept by farmer is $0.75.farmer is $0.75.

What is quantity?What is quantity?

How is CS + PS How is CS + PS affected?affected?D

S

S’

1.00

5

0.75

4

1.25

6

Conclusions on Taxes & Efficiency An excise tax cuts the quantity exchanged An excise tax cuts the quantity exchanged

below the optimal level.below the optimal level. This reduces the surplus that consumers and This reduces the surplus that consumers and

producers receive.producers receive. Conclusion: Excise taxes reduce market Conclusion: Excise taxes reduce market

efficiency.efficiency.

Next Time

Note: We are now one class period behind Note: We are now one class period behind the syllabus. the syllabus.

April 2-4: Monopoly, Ch. 22April 2-4: Monopoly, Ch. 22

April 9-11: Oligopoly and Monopolistic April 9-11: Oligopoly and Monopolistic Competition, Ch. 23Competition, Ch. 23