Economic Efficiency

1
Economic Efficiency

• Hall and Lieberman, 3rd edition, Thomson
  South-Western, Chapter 14

2
Part I Efficiency

• Government acts as a social planner, aiming to
  improve the welfare of the people
• Sharp disagreement about the role of the
  government should play in our economic life
• Widespread agreement that certain goods and
  services should be provided by government
• Such as general police protection, the court
  system, and national defense
• Much of this agreement is based on ideas about
  economic efficiency

3
The Meaning of Efficiency

• Economic efficiency is achieved when there is no
  way to rearrange the production or allocation of
  goods in a way that makes one person better off
  without making anybody else worse off
• An efficient economy is not necessarily a fair
  economy
• Economists put stress on efficiency rather than
  fairness
• Issues of fairness must be resolved politically

4
Pareto Improvements

• Definition a trade in which both parties are
  made better off, and no one is harmed
• Named after Italian economist, Vilfredo Pareto
  (1848-1923)
• Economic efficiency achieved when every possible
  Pareto improvement is exploited
• Perfectly competitive markets tend to be
  economically efficient, and
• Well-functioning market economics tend to lie
  close to the economically efficient end of the
  spectrum

5
Part II Consumer Surplus and Producer Surplus

• Reservation Price
• Supply Side Lowest price that would induce
  someone to provide a product to the market
• Demand Side Highest price that a consumer would
  pay to acquire a product

6
Figure 1 The Marginal Benefit From Guitar
Lessons
Flo
25
Joe
23
Flo (again)
21
Bo
19
Zoe
17
Demand
1
2
3
4
5
7
Reinterpreting the Demand Curve

• Maximum price someone would be willing to pay for
  each unit of good (Figure 1)
• Tells us how much that unit is worth to the
  person who buys it
• In part, this is because consumers differ in
  their incomes and tastes

8
Reinterpreting the Demand Curve

• Figure 1
• For each individualvalue of additional lessons
  declines as more lessons are taken
• Height of market demand curve at any quantity
  shows us valueto someoneof last unit of good
  consumed

9
Consumer Surplus

• Useful to measure the benefits consumers receive
  from their economic activities
• A buyers consumer surplus on a unit of a good is
• Difference between its value to buyer and what
  buyer actually pays for the unit

10
Figure 2 Consumer Surplus in a Small and Large
Market for Guitar Lessons
25
23
21
19
17
Demand
1
2
3
4
5
11
Consumer Surplus

• Total consumer surplus enjoyed by all consumers
  in a market is called market consumer surplus
• Sum of consumer surplus on all units
• Market consumer surplus at any pricemeasured in
  dollarsis total area under market demand curve
  and above market price

12
Figure 3 Consumer Surplus in a Small and Large
Market for Guitar Lessons
19
Market Price
Demand
4,000
13
Figure 4 The Marginal Costs of Guitar Lessons
Supply
21
McCollum
19
Martin (again)
17
Gibson
15
Martin (again)
13
Martin
1
2
3
4
5
14
Reinterpreting the Supply Curve

• The minimum price a seller must get in order to
  supply that lesson (Figure 2)
• Because offering lessons is costly to guitar
  teachers, it take higher prices to get more
  lessons
• Why?
• Height of market supply curve at any quantity
  shows additional costto some producerof each
  unit of good supplied

15
Producer Surplus

• An individual sellers producer surplus on a unit
  of a good
• Difference between what seller actually gets and
  additional cost of providing it
• Total producer surplus gained by all sellers in a
  market is called market producer surplus
• Aggregation of individual producer surplus in
  market
• Market producer surplus at any pricemeasured in
  dollarsis total area above market supply curve
  and below market price

16
Figure 5 Producer Surplus From Selling Guitar
Lessons
Supply
21
19
17
15
13
1
2
3
4
5
17
Figure 6 Producer Surplus From Selling Guitar
Lessons
Supply
Market Price
19
4,000
18
Figure 6 Total Net Benefits -- Sum of Consumer
and Producer Surplus (Guitar Lessons Market
Example)
S
Equilibrium Price
19
D
4,000
19
Part III. The Efficient Quantity of a Good

• Whenever demand curve is higher than supply
  curve, value of last unit to consumer is greater
  than its additional cost to some producer
• Producing one more good is a Pareto improvement
• Not true when demand curve lies below supply curve

20
The Efficient Quantity of a Good

• Efficient quantity the quantity at which all
  Pareto improvements are exploitedis where the
  demand curve and supply curve intersect
• At this quantity, value of the last good produced
  will be equal toor possibly a tiny bit greater
  thanthe cost of providing it

21
Figure 7 Efficiency In The Market For Guitar
Lessons
Flo
25
Supply
Joe
23
Flo
21
McCollum
19
Martin
Bo
17
Zoe
Gibson
15
Martin
13
Demand
Martin
1
5
2
3
4
22
Perfect Competition and Efficiency The Total
Benefits View

• Each time we make a Pareto improvement in a
  market
• We make at least one party better off and make no
  one else worse off
• Therefore, a Pareto improvement will increase
  total net benefits available in a market
• Thus, we have a new way of viewing efficiency
• A market is efficient when sum of producer and
  consumer surplus is maximized in that market

23
Markets and Economic Efficiency

• In a market system, firms and consumers are
  largely free to produce and consume as they wish,
  without anyone orchestrating the process from
  above
• Can we expect such unsupervised trading to be
  economically efficient?
• Yesas long as trading takes place in perfectly
  competitive markets

24
Perfect Competition and Efficiency

• Important idea in economics perfect competition
  delivers an efficient economy
• where many buyers and sellers each try to do the
  best for themselves
• where total net benefits are maximized
• Adam Smith coined term invisible hand to
  describe the force that leads a competitive
  economy relentlessly and automatically toward
  economic efficiency