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1 16.4 Competitive Market Efficiency Pareto Efficient »No alternate allocation of inputs and goods makes one consumer better off without hurting another.

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Presentation on theme: "1 16.4 Competitive Market Efficiency Pareto Efficient »No alternate allocation of inputs and goods makes one consumer better off without hurting another."— Presentation transcript:

1 Competitive Market Efficiency Pareto Efficient »No alternate allocation of inputs and goods makes one consumer better off without hurting another consumer If another allocation improves AT LEAST ONE CONSUMER (without making anyone else worse off), the first allocation was Pareto Inefficient.

2 Competitive Market Efficiency Pareto Efficiency has three requirements: 1)Exchange Efficiency  Goods cannot be traded to make a consumer better off 2) Input Efficiency  Inputs cannot be rearranged to produce more goods

3 Competitive Market Efficiency 3) Substitution Efficiency  Substituting one good for another will not make one consumer better off without harming another consumer

4 4 1) Exchange Efficiency Model Assumptions Assumptions: –2 people –2 goods, each of fixed quantity  This allows us to construct an EDGEWORTH BOX – a graph showing all the possible allocations of goods in a two- good economy, given the total available supply of each good

5 5 1) Edgeworth Box Example Two people: Maka and Susan Two goods: Food (f) & Video Games (V) We put Maka on the origin, with the y-axis representing food and the x axis representing video games If we connect a “flipped” graph of Susan’s goods, we get an EDGEWORTH BOX, where y is all the food available and x is all the video games:

6 6 1) Maka’s Goods Graph Video Games Food u O x Maka Ou is Maka’s food, and Ox is Maka’s Video Games

7 7 1) Edgeworth Box Video Games Food u O x Maka O’w is Susan’s food, and O’y is Susan’s Video Games w r y O’ Susan s Total food in the market is Or(=O’s) and total Video Games is Os (=O’r) Each point in the Edgeworth Box represents one possible good allocation

8 8 1) Edgeworth and utility We can then add INDIFFERENCE curves to Maka’s graph (each curve indicating all combinations of goods with the same utility) –Curves farther from O have a greater utility We can then superimpose Susan’s utility curves –Curves farther from O’ have a greater utility Remember that:

9 9 1) Maka’s Utility Curves Video Games Food O Maka Maka’s utility is greatest at M 3 M1M1 M2M2 M3M3

10 10 1) Edgeworth Box and Utility Video Games Food O Maka Susan has the highest utility at S 3 r O’ Susan s At point A, Maka has utility of M 3 and Susan has Utility of S 2 M1M1 M2M2 M3M3 S1S1 S2S2 S3S3 A

11 11 1) Edgeworth Box and Utility Video Games Food O Maka If consumption is at A, Maka has utility M 1 while Susan has utility S 3 r O’ Susan s By moving to point B and then point C, Maka’s utility increases while Susan’s remains constant M1M1 M2M2 M3M3 S3S3 A B C

12 12 1) Exchange Efficiency Video Games Food O Maka Point C, where the indifference curves barely touch is EXCHANGE EFFICIENT, as one person can’t be made better off without harming the other. r O’ Susan s M1M1 M2M2 M3M3 S3S3 C

13 13 1) Pareto Improvement When an allocation is NOT exchange efficient, it is wasteful (at least one person could be made better off)… A PARETO IMPROVEMENT makes one person better off without making anyone else worth off (like the move from A to C)… However, there may be more than one pareto improvement:

14 14 1) Pareto Improvements Video Games Food O Maka If we start at point A: -C is a pareto improvement that makes Maka better off -D is a pareto improvement that makes Susan better off -E is a pareto improvement that makes both better off r O’ Susan s M1M1 M2M2 M3M3 S3S3 C S5S5 S4S4 A D E

15 15 1) The Contract Curve Assuming all possible starting points, we can find all possible exchange efficient points and join them to create a CONTRACT CURVE All along the contract curve, opposing indifferent curves are TANGENT to each other Since each individual maximizes where his indifference curve is tangent to his budget line:

16 16 1) The Contract Curve Video Games Food O Maka r O’ Susan s

17 17 1) Example: House and Chase Assume that House and Chase have the following utilities for books and coffee: The Exchange Efficiency Condition therefore becomes:

18 18 1) MATH – House and Chase If there are 10 books, and 4 cups of coffee, then the contract curve is expressed as: If House has 6 books, an exchange efficient allocation would be:

19 19 1) MATH – House and Chase Therefore, House would have 6 books and 2.4 cups of coffee, and Chase would have 4 (10-6) books and 1.6 (4-2.4) cups of coffee, for utilities of:

20 20 2) Input Efficiency Model Assumptions Assumptions: –2 producers/firms –2 inputs (Labor and Capital), each of fixed quantity  This lead to a EDGEWORTH BOX FOR INPUTS– a graph showing all the possible allocations of fixed quantities of labor and capital between two producers

21 21 2) Edgeworth Box For Inputs Example Two firms: Apple and Google Two inputs: Labor (L) and capital (K) We put Apple the origin, with the y-axis representing capital and the x axis representing labor If we connect a “flipped” graph of Google’s inputs, we get an EDGEWORTH BOX FOR INPUTS, where y is all the capital available and x is all the labor:

22 22 2) Apple’s Input Graph Labor Capital u O x Apple Ou is Apple’s capital, and Ox is Apple’s labor.

23 23 2) Edgeworth Box For Inputs Labor Capital u O x Apple O’w is Google’s capital, and O’y is Google’s labor w r y O’ Google s Total capital in the market is Or(=O’s) and total labor is Os (=O’r) Each point in the Edgeworth Box represents one possible input allocation

24 24 2) Edgeworth and Production We can then add ISOQUANT curves to APPLE’s graph (each curve indicating all combinations of inputs producing the same output) –Curves farther from O produce more We can then superimpose Google’s Isoquants –Curves farther from O’ produce more Remember that the slope of the Isoquant is MRTS and:

25 25 2) Apple’s Isoquants Labor Capital O Apple Apple produces the most at A 3 A1A1 A2A2 A3A3

26 26 2) Edgeworth Box for Inputs Labor Capital O Apple Google produces the most at G 3 r O’ Google s At point A, Apple makes A 3 Google produces G 2 A1A1 A2A2 A3A3 G1G1 G2G2 G3G3 A

27 27 2) Edgeworth Box and Utility O If production is at A, Apple produces A 1 while Google produces G 3 r O’ s By moving to point B and then point C, Apple produces more while Google’s production remains constant A1A1 A2A2 A3A3 G3G3 A B C Labor Capital Apple Google

28 28 2) Input Efficiency O Point C, where the isoquant curves barely touch is INPUT EFFICIENT, as one firm can’t produce more without the other firm producing less. r O’ s A1A1 A2A2 A3A3 G3G3 C Labor Capital Apple Google

29 29 2) Pareto Improvement When an input allocation is NOT input efficient, it is wasteful (at least one firm COULD produce more)… A PARETO IMPROVEMENT allows one firm to produce more without reducing the output of the other firm(like the move from A to C) However, there may be more than one pareto improvement:

30 30 2) Pareto Improvements O If we start at point A: -C is a pareto improvement where Apple produces more -D is a pareto improvement where Google produces more -E is a pareto improvement where both firms produce more r O’ s A1A1 A2A2 A3A3 G3G3 C G5G5 G4G4 A D E Labor Capital Apple Google

31 31 2) Input Contract Curve Similar to the goods market, a contract curve can be derived in the input market: All along the contract curve, opposing isoquant curves are TANGENT to each other Since each firm maximizes where their isoquant curve is tangent to their isocost line:

32 32 2) Input Contract Curve O r O’ s Labor Capital Apple Google

33 33 2) Example: Apple and Google Assume that Apple and Google have the following production functions: The Exchange Efficiency Condition therefore becomes:

34 34 The isoquant slope for Apple is:

35 35 The isoquant slope for Google is:

36 36 2) MATH – Apple and Google If there are 1000 workers, and 125 capital in Silicon valley, then the contract curve is expressed as:

37 37 2) MATH – Apple and Google Is the market input efficient if Apple has 200 workers and 50 capital? No – Apple needs fewer capital (Google needs more capital) AND/OR Google needs fewer workers (Apple needs more workers)

38 38 3) Substitution Efficiency Substitution Efficiency can be analyzed using the PRODUCTION POSSIBILITIES CURVE/FRONTIER –The PPC shows all combinations of 2 goods that can be produced using available inputs –The slope of the PPC shows how much of one good must be SUBSTITUTED to produce more of the other good, or MARGINAL RATE OF TRANSFORMATION (x for y) (MRT xy )

39 39 Production Possibilities Curve Robots Pizzas Here the MRTS pr is equal to (7- 5)/(2-1)=-2, or two robots must be given up for an extra pizza. The marginal cost of the 3 rd pizza, or MC p =2 robots The marginal cost of the 6 th and 7 th robots, or MC r =1 pizza Therefore, MRT xy =MC x /MC y Therefore, MRT pr =2/1=2

40 40 3) Substitution Efficiency and Production If production is possible in an economy, the Pareto efficiency condition becomes:  Assume MRT pr =3 and MRS pr =2. -Therefore Maka could get 3 more robots by transforming 1 pizza -BUT Maka would exchange 2 robots for 1 pizzas to maintain utility -Therefore 1 pizza is sacrificed for 3 robots, increasing Maka’s utility through the 3 rd robot -The Market isn’t Pareto Efficient

41 41 The First Fundamental Theorem Of Welfare Economics IF 1)All consumers and producers act as perfect competitors (no one has market power) and 2) A market exists for each and every commodity Then Resource allocation is Pareto Efficient

42 42 First Fundamental Theorem of Welfare Economics Proof: From microeconomic consumer theory, we know that: Since prices are the same for all people: Since prices are the same for all people: Therefore perfect competition leads to exchange efficiency Therefore perfect competition leads to exchange efficiency

43 43 First Fundamental Theorem of Welfare Economics Proof: From microeconomic theory of the firm, we know that: Since each firm in an industry faces the same wages and rents: Since each firm in an industry faces the same wages and rents: Perfect competition leads to input efficiency Perfect competition leads to input efficiency

44 44 First Fundamental Theorem of Welfare Economics Origins From the PPF, we know that Therefore a perfectly competitive market is Pareto Efficient: Therefore a perfectly competitive market is Pareto Efficient:

45 45 Efficiency≠Fairness If Pareto Efficiency was the only concern, competitive markets automatically achieve it and there would be very little need for government: –Government would exist to protect property rights Laws, Courts, and National Defense But Pareto Efficiency doesn’t consider distribution. One person could get all society’s resources while everyone else starves. This isn’t typically socially optimal.

46 46 Fairness Video Games Food O Maka r O’ Susan s A C B Points A and B are Pareto efficient, but either Susan or Maka get almost all society’s resources Many would argue C is better for society, even though it is not Pareto efficient

47 47 Fairness For each utility level of one person, there is a maximum utility of the other Graphing each utility against the other gives us the UTILITY POSSIBILITIES CURVE:

48 48 Utility Possibilities Curve Susan’s Utility Maka’s Utility O Maka All points on the curve are Pareto efficient, while all points below the curve are not. Any point above the curve is unobtainable A C B

49 49 Fairness Typical utility is a function of goods consumed: U=f(x,y) Societal utility can be seen as a function of individual utilities: W=f(U 1,U 2 ) This is the SOCIAL WELFARE FUNCTION, and can produce SOCIAL INDIFFERENCE CURVES:

50 50 Typical Social Indifference Curves Susan’s Utility Maka’s Utility O Maka An indifference curve farther from the origin represents a higher level of social welfare.

51 51 Fairness If we superimpose social indifference curves on top of the utilities possibilities curve, we can find the Pareto efficient point that maximizes social welfare This leads us to the SECOND FUNDAMENTAL THEOREM OF WELFARE ECONOMICS

52 52 Maximizing Social Welfare Susan’s Utility Maka’s Utility O Maka ii is preferred to i, even though ii is not Pareto efficient i ii iii The highest possible social welfare, iii, is Pareto efficient

53 53 Second Fundamental Theorem of Welfare Economics The SECOND FUNDAMENTAL THEOREM OF WELFARE ECONOMICS states that: Society can attain any Pareto efficient allocation of resources by: 1) making a suitable assignments of original endowments, and then 2) letting people trade

54 54 Video Games Food O Maka r O’ Susan s Second Fundamental Theorem of Welfare Economics Starting Point Goal By redistributing income, society can pick the starting point in the Edgeworth box, therefore obtaining a desired point on the Utility Possibility Frontier:

55 55 Why Is Government so Big? 1)Government has to ensure property laws are protected. (1 st Theorem) 2)Government has to redistribute income to achieve equity. (2 nd Theorem) 3)Often the assumptions of the First Welfare Theorem do not hold (Econ 350)

56 56 Why Trade and Not Tax? Taxes and penalties punish income-enhancing behavior, encouraging people to work less. Subsidies and incentives give an incentive to stay in a negative state to keep receiving subsidies and incentives. Lump sum transfers have the least distortion, AND TRADE ALWAYS BENEFITS BOTH PARTIES…

57 Gains From Free Trade Trade ALWAYS makes society better off by increasing the productivity of scarce resources The basis for the gains from specialization and trade is Comparative Advantage

58 58 Theory of Comparative Advantage: Production Possibilities : –Carl and Mike: retired neighbours: hobbies are making wine and beer Carl’s Production Possibilities Mike’s Production Possibilities A B C Wine (btls) Beer (btls.) 1, PPF’s for 1 month’s production:

59 59 Carl’s Proposition “Lets each of us do what we do best and trade. This will give each of us more than we now have without either of us working any harder.” Notice that voluntary trade does not take place unless both parties benefit.

60 60 Mike’s Production Possibilities/ Opportunity Costs Bottles of beer A C In a month Mike can produce either 80 bottles of wine or 80 bottles of beer Opp cost of 80 wine is 80 beer Opp cost of 1 wine is 1 beer Opp cost of 80 beer is 80 wine Opp cost of 1 beer is 1 wine Bottles of wine BConsumption choice before trade

61 61 Carl’s Production Possibilities/ Opportunity Costs 0 Bottles of beer A C Opp cost 100 wine is 1000 beer Opp Cost 1 wine is 10 beer Opp cost of 1000 beer is 100 wine Opp Cost 1 beer is 1/10 wine Bottles of wine BConsumption choice before trade

62 62 Opportunity Cost Table Opportunity cost of 1 beer Opportunity cost of 1 wine Carl1/10 wine10 beer Mike1 wine1 beer When producer A has a lower opportunity cost of producing good A compared to another producer, then producer A is said to have a comparative advantage in the production of good A. Theory of Comparative Advantage:

63 63 Comparative Advantage: Specialization Carl has a “comparative advantage” (lowest opportunity cost producer) in the production of beer and therefore specializes in beer production. Mike has a “comparative advantage” in the production of wine and therefore specializes in wine production As long as opportunity costs differ, there is comparative advantage

64 64 Comparative Advantage: Specialization Theory of Comparative Advantage Theory of Comparative Advantage if specialization takes place according to comparative advantage (the lowest opportunity cost producer) and then trade takes place…. both parties can benefit: that is, move outside their current PPF’s.

65 65 Carl & Mike Before Specialization & Trade Carl Produces & Consumes Mike Produces & Consumes Total Consumption += Wine (btls.) Beer (btls.) Carl & Mike After Specialization, but Before Trade Mike Produces & Can Consume + = Wine (btls.) Beer (btls.) 0 1, ,000 Carl Produces & Can Consume Total Production & Consumption Total Gains

66 66 Carl proposes, after specialization, that he trade Mike 175 beer for 35 wine. Carl gets wine for a reduced sacrifice –35 wine for 175 beer instead of 350 beer, the opportunity cost before trade Mike gets beer for a reduced sacrifice –175 beer for 35 wine instead of 175 wine, the opportunity cost before trade (terms of trade: 5 beer for 1 wine) Trade: The Benefits of Specialization

67 67 Terms of Trade: 1 Wine for 5 Beer Since voluntary trade requires that both parties benefit from the trade. Before trade: Carl: 1 wine “trades” for 10 beer Mike: 1 wine trades for 1 beer After trade 1 wine “trades” for 5 beer The Terms of Trade are between the personal ones that exist before trade, thus producing gains for both parties participating in the trade Carl is better off as he now only has to give up 5 beer for a wine Mike is better off as he now only has to give up 1/5 wine for a beer

68 68 Trade Between Carl & Mike 1 Wine trades for 5 Beer or 1 Beer trades for 1/5 Wine Mike (specializes in wine) Carl (specializes in beer) 175 Bottles of Beer To Trades away 35 Bottles of Wine Trades away To Before trade Mike gave up 1 wine to get 1 beer, after trade1/5 wine Before trade Carl gave up 10 beer to get a wine, after trade 5 beer

69 69 Carl & Mike After Specialization & Trade Carl Mike Produces Trades For (+) Away (-) Consumes After Trade Produced & Consumed Before Trade Gains from Trade Wine (btls.) Beer (btls.) 0 1, Produces Trades For (+) Away (-) Consumes After Trade Produced & Consumed Before Trade Gains from Trade Wine (btls.) Beer (btls.)

70 70 Mike’s Production Possibilities After Trade Bottles of beer A C Bottles of wine B D Consumption after trade Mike produces 80 wine and then trades 35 wine for 175 beer, leaving him with 45 wine and 175 beer, point D

71 71 Carl’s Production Possibilities/ Opportunity Costs, After Trade 0 Bottles of beer A C Bottles of wine B D Consumption after trade Carl produces 1000 beer and trades 175 beer to Mike for 35 wine, leaving him with 825 beer and 35 beer, point D

72 72 Absolute Advantage When a producer with of set of inputs can produce more output than another with the same inputs, the first producer has an absolute advantage in production of the output. Carl has an absolute advantage in the production of both wine and beer.

73 73 Gains from Specialization and Trade Specialization produces gains for both traders, even when one trader enjoys an absolute advantage in both endeavors. Unless two people/firms/countries have IDENTICAL opportunity costs, Trade is always beneficial

74 74 Why No Free Trade? 1)Misunderstanding: people misunderstand the facts or hold to political or ideological dogma, or confuse voluntary jobs with enforced slavery 2)Short-run effects: in the SHORT-RUN, there may be some unpopular adjustments: a)Richer, developed countries may lose jobs to developing countries with a comparative advantage b)Poorer, developing countries may have short- run environmental damage until the higher incomes lead to environmental protection

75 75 Chapter 16 Conclusions 1)General equilibrium requires simultaneous equilibrium in multiple markets 2)One change can cause a cascade of changes through markets until a new equilibrium is reached 3) An equilibrium is Pareto Efficient if no other allocation of inputs can make one person better off without making another worse off.

76 76 Chapter 16 Conclusions 4) Pareto Efficiency requires exchange efficiency (goods can’t be traded), input efficiency (more can’t be produced) and substitution efficiency (substituting production won’t improve outcome) 5) The First Fundamental Theorem of Welfare Economics states that if all perfectly competitive markets exist, allocations are Pareto Efficient

77 77 Chapter 16 Conclusions 6) The Second Fundamental Theorem of Welfare Economics states that governments can redistribute wealth to reach any pareto efficient outcome 7) Free Trade is always beneficial to all parties 8) Economic truths, when properly applied and explained, can cut through ideologies and make people cry


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