Economic Efficiency and the Competitive Ideal © 2003 South-Western/Thomson Learning

Economic Efficiency Economic Efficiency and the Competitive and the Competitive

IdealIdeal

© 2003 South-Western/Thomson Learning© 2003 South-Western/Thomson Learning

The Meaning of The Meaning of EfficiencyEfficiency

Economic efficiency is Economic efficiency is achieved when there is no achieved when there is no

way to rearrange the way to rearrange the production or allocation of production or allocation of goods in a way that makes goods in a way that makes

one person better off one person better off without making anyone else without making anyone else

worse off.worse off.

The Meaning of The Meaning of EfficiencyEfficiency

An efficient economy An efficient economy is not necessarilyis not necessarily

a fair economy.a fair economy.

Pareto ImprovementsPareto Improvements

Pareto ImprovementPareto Improvement

An action that makes at An action that makes at least one person better off least one person better off

and harms no oneand harms no one


Economic EfficiencyEconomic Efficiency

A situation in which every A situation in which every Pareto improvement has Pareto improvement has

occurredoccurred


Side Payments:Side Payments: One side makes a One side makes a special payment to the other sidespecial payment to the other side

Some actions that by themselves Some actions that by themselves would not be Pareto would not be Pareto

improvements can be improvements can be converted converted intointo Pareto improvements if Pareto improvements if

accompanied by an appropriate accompanied by an appropriate side payment.side payment.

The Elements of The Elements of EfficiencyEfficiency

•Productive EfficiencyProductive Efficiency•Allocative EfficiencyAllocative Efficiency

Productive EfficiencyProductive Efficiency


When it is impossible to When it is impossible to produce more of one good produce more of one good

without producing less of some without producing less of some other good.other good.

In order to be productively In order to be productively efficient, an economy must be efficient, an economy must be

operation on its PPFoperation on its PPF


Number of Internet Hookups

Quantity of All

Other Goods

CD

A

B

Production Possibilities Between Internet Connections and Other Goods

Three Requirements Three Requirements for Productive for Productive

EfficiencyEfficiency1.1.The economy must use all of The economy must use all of

its available resources.its available resources.

2.2.Each firm must produce the Each firm must produce the maximum amount possible maximum amount possible from the resources available to from the resources available to it.it.

3.3.The allocation of inputs among The allocation of inputs among firms must produce the firms must produce the maximum possible amount of maximum possible amount of output.output.

Requirement 1Requirement 1

Full Employment of ResourcesFull Employment of Resources

To be productively efficient, To be productively efficient, the overall economy must the overall economy must

operate at operate at full employmentfull employment, , making use of all resources making use of all resources offered by resource owners.offered by resource owners.


Maximum Production from Maximum Production from Given InputsGiven Inputs

Productive efficiency requires Productive efficiency requires that every firm in the economy that every firm in the economy produce the maximum possible produce the maximum possible

output from the resources output from the resources being used. being used.


Efficient Allocation of Inputs Efficient Allocation of Inputs Among FirmsAmong Firms

Productive efficiency requires Productive efficiency requires that resources be allocated that resources be allocated

among firms in such a way the among firms in such a way the the economy cannot increase the economy cannot increase the production of one good the production of one good

without decreasing the without decreasing the production of some other production of some other

good. good.

Perfect Competition Perfect Competition and Productive and Productive

EfficiencyEfficiency

Perfectly competitive Perfectly competitive markets tend to be markets tend to be

productively efficient.productively efficient.


Efficiency Efficiency

•Profit maximization and full Profit maximization and full employmentemployment•Profit maximization and Profit maximization and maximum production with given maximum production with given inputsinputs•Perfect competition and the Perfect competition and the best allocation of inputs among best allocation of inputs among firmsfirms


Efficiency Efficiency

Productive efficiency is Productive efficiency is necessary for economic necessary for economic

efficiency.efficiency.

Allocative EfficiencyAllocative Efficiency


When there is no change in When there is no change in quantity consumed of any good quantity consumed of any good by an consumer that would be by an consumer that would be

a Pareto improvementa Pareto improvement


The height of the The height of the market market demand curvedemand curve at any quantity at any quantity shows the marginal benefit of shows the marginal benefit of

the last unit of a good the last unit of a good consumedconsumed


The height of the The height of the market market supply curvesupply curve at any quantity at any quantity

shows the marginal cost of the shows the marginal cost of the last unit of a good suppliedlast unit of a good supplied

Perfect Competition Perfect Competition and Allocative and Allocative

EfficiencyEfficiencyThe efficient level of production of The efficient level of production of any good is where the demand, or any good is where the demand, or marginal benefit, curve crosses marginal benefit, curve crosses

the supply, or marginal cost, the supply, or marginal cost, curve. curve.

At any other level of output, a At any other level of output, a Pareto improvement is possible by Pareto improvement is possible by

changing production.changing production.

Economic Efficiency and Economic Efficiency and Perfect Competition: A Perfect Competition: A

SummarySummary

Perfectly competitive markets Perfectly competitive markets tend to be economically tend to be economically efficient - that is, both efficient - that is, both

productively and allocatively productively and allocatively efficient.efficient.

Economic Efficiency and Economic Efficiency and Perfect Competition: A Perfect Competition: A

SummarySummaryEconom ic E ffic iency

Productive Effic iency

A llocative E ffic iency

Effi cient Allocation of Inputs

O ccurs in perfectly com petitive product and factor m arkets.

M axim um Production

by Each F irm

O ccurs in any econom y in which firm s are free to m axim ize profit.

Full Em ploym ent of R esources

O ccurs in any econom y in which firm s are free to m axim ize profit.

O ccurs in econom iesw ith perfectly com petitive product m arkets.

Effic ient Q uantities of D ifferent G oods

The Inefficiency of The Inefficiency of Imperfect Imperfect

CompetitionCompetition

In an imperfectly competitive In an imperfectly competitive market, the equilibrium price market, the equilibrium price exceeds the firm’s marginal exceeds the firm’s marginal

cost of production.cost of production.

The Inefficiency of The Inefficiency of Imperfect CompetitionImperfect Competition

Boxes ofCorn flakes

Priceper Box

$3

$2

$1

7,000 10,000

A

MarginalRevenue

MarginalCost

Demand =Marginal Benefit



Monopoly and imperfectly Monopoly and imperfectly competitive markets, in which competitive markets, in which firms charge a price greater firms charge a price greater than marginal cost, produce than marginal cost, produce too little output at too high a too little output at too high a

price.price.



In imperfect competition, it is In imperfect competition, it is the inability of firms to make the inability of firms to make separate side deals through separate side deals through

price discrimination that price discrimination that prevents Pareto improvements prevents Pareto improvements

from being carried out.from being carried out.

Where Do We GoWhere Do We Gofrom Here?from Here?

•What are ways that markets What are ways that markets can fail to perform?can fail to perform?

•What can we do when an What can we do when an economy will not achieve economy will not achieve

economic efficiency?economic efficiency?

Consumer Surplus, Consumer Surplus, Producer Surplus, and Producer Surplus, and


An individual’s consumer An individual’s consumer surplus on a unit of a good is surplus on a unit of a good is the difference between the the difference between the most she’d be willing to paymost she’d be willing to pay

and what she and what she actually paysactually pays for for the unit.the unit.

Consumer SurplusConsumer Surplus

The total benefit all consumers The total benefit all consumers gain from participating in a gain from participating in a

market is called market is called market market consumer surplusconsumer surplus, and is , and is

approximately equal to the approximately equal to the area below the market demand area below the market demand

curve and above the market curve and above the market price.price.

Producer SurplusProducer Surplus

An individual seller’s An individual seller’s producer producer surplussurplus on a unit of a good is on a unit of a good is the difference between what the difference between what

the seller actually gets and the the seller actually gets and the smallest amount that the seller smallest amount that the seller would accept in exchange for a would accept in exchange for a

good. good.

Producer SurplusProducer Surplus

The total benefit all sellers The total benefit all sellers gain from participating in a gain from participating in a competitive market is called competitive market is called

market producer surplusmarket producer surplus, and , and is approximately equal to the is approximately equal to the area below the market price area below the market price and above the market supply and above the market supply

curve.curve.

Total Net Benefits in a Total Net Benefits in a MarketMarket

The sum of consumer and The sum of consumer and producer surplus in that producer surplus in that

marketmarket

Perfect Competition Perfect Competition and Allocative and Allocative


A market is allocatively A market is allocatively efficient when the sum of efficient when the sum of producer and consumer producer and consumer

surplus are maximized in surplus are maximized in that market.that market.

The Inefficiency of The Inefficiency of Imperfect CompetitionImperfect Competition

Monopoly and imperfectly Monopoly and imperfectly competitive markets are competitive markets are

generally inefficient.generally inefficient.

Price is too high and output Price is too high and output is too low to maximize the is too low to maximize the

sum of producer and sum of producer and consumer surplus.consumer surplus.

Total Surplus and the Total Surplus and the Efficiency of Imperfect Efficiency of Imperfect


4,000

Price$25

$23$21

$19$17

$15

$13Demand = Marginal Benefit

The sum of consumersurplus…

is the total net benefitsgained in this market.

and producersurplus…

Number oflessons

per week

Supply = Marginal Cost

(a)

4,000

Price

$25

$23

$21

$19

$17

$15

$13Demand = Marginal Benefit

3,000

When quantity is 3,000and price is $19…

Number oflessonsper week

Supply = Marginal Cost

and producersurplus…

the sum of consumersurplus…

is not maximized. The unshadedtriangle is potential surplus

not achieved.

(b)

Total Surplus and the Total Surplus and the Inefficiency of Imperfect Inefficiency of Imperfect


Boxes ofCorn flakes

Priceper Box

$3

$2

$1

7,000 10,000

A

B

C

MarginalRevenue

MarginalCost

Demand =Marginal Benefit

When this imperfectly competingfirm charges $3, consumer surplusis the blue shaded area…

while producer surplusis the red shaded area.

The unshaded area ABCrepresents potential surplusthat is not achieved.

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Economic Efficiency and the Competitive Ideal © 2003 South-Western/Thomson Learning