What you will learn in this chapter: ➤ How the overall concept of efficiency can be broken down into three components—efficiency in consumption, efficiency in production, and efficiency in output levels ➤ Why an economy consisting of many perfectly competitive markets is typically, but not always, efficient ➤ Why it is easier to determine if an economy is efficient than to determine if it is fair or equitable ➤ What externalities are and why they can lead to inefficiency in a market economy and support for government intervention ➤ What public goods are and why markets fail to supply them efficiently Goods produced in centrally planned economies (consider the East German–produced Trabant at left) are notorious for their poor quality compared to stylish, high-quality goods produced in market economies (consider the West German–produced Mercedes at right).

Efficiency The economy as a whole consists not of one but of many, many markets, all interrelated in two ways: ■ On the consumption side, the demand for each good is affected by the prices of other goods. ■ On the production side, producers of different goods compete for the same factors of production. A competitive market economy is an economy in which all markets, for goods and for factors, are perfectly competitive.

Efficiency A competitive market economy is an economy in which all markets, for goods and for factors, are perfectly competitive. An economy is in general equilibrium when the quantity supplied is equal to the quantity demanded in all markets.

Efficiency Efficiency in Consumption An economy is efficient in consumption if there is no way to redistribute goods among consumers that makes some consumers better off without making others worse off. An economic signal is any piece of information that helps people make better economic decisions.

Efficiency Efficiency in Production An economy is efficient in production if there is no way to produce more of some goods without producing less of other goods.

Efficiency Efficiency in Production An economy has an efficient allocation of resources if there is no way to reallocate factors of production among producers to produce more of some goods without producing less of others.

Efficiency Efficiency in Output Levels

Efficiency Efficiency in Output Levels An economy is efficient in output levels if there isn’t a different mix of output that would make some people better off without making others worse off. (10-1) (10-2)

Efficiency Efficiency in Output Levels

Efficiency Efficiency in Output Levels

Efficiency and Equity What’s Fair?

Efficiency and Equity The Utility Possibility Frontier

Efficiency and Equity The Utility Possibility Frontier A utility possibility frontier shows how well-off one individual or group could be for each given total utility level of another individual or group.

Efficiency and Equity The Utility Possibility Frontier

Market Failure: The Case of Externalities Market failure occurs when a market fails to be efficient.

Market Failure: The Case of Externalities An external cost is an uncompensated cost that an individual or firm imposes on others. An external benefit is a benefit that an individual or firm confers on others without receiving compensation. External costs and benefits are known as externalities; external costs are negative externalities, and external benefits are positive externalities.

Market Failure: The Case of Externalities Private versus Social Costs

Market Failure: The Case of Externalities Private versus Social Costs The marginal social cost of a good or activity is equal to the marginal cost of production plus its marginal external cost. Environmental Policy Taxes designed to reduce external costs are known as Pigouvian taxes.

Market Failure: The Case of Externalities Private Solutions to Externalities According to the Coase theorem, even in the presence of externalities an economy can always reach an efficient solution as long as transaction costs – the costs to individuals of making a deal – are sufficiently low. When individuals take external costs or benefits into account, they internalize the externality.

Market Failure: The Case of Externalities Private versus Social Benefits A technology spillover is an external benefit that results when knowledge spreads among individuals and firms.

Market Failure: The Case of Externalities Private versus Social Benefits

Market Failure: The Case of Externalities Private versus Social Benefits The marginal social benefit of a good or activity is equal to the marginal benefit that accrues to consumers plus its marginal external benefit. A Pigouvian subsidy is a payment designed to encourage activities that yield external benefits. An industrial policy is a policy that supports industries believed to yield positive externalities.

Market Failure: The Case of Public Goods Private Goods and Public Goods A good is excludable if the supplier of that good can prevent people who do not pay from consuming it. A good is rival in consumption if the same unit of the good cannot be consumed by more than one person at the same time. A good that is both excludable and rival in consumption is a private good.

Market Failure: The Case of Public Goods Private Goods and Public Goods A public good is both nonexcludable and nonrival in consumption. When a good is nonexcludable, the supplier cannot prevent consumption by people who do not pay for it. A good is nonrival in consumption if more than one person can consume the same unit of the good at the same time. Goods that are nonexcludable suffer from the free-rider problem: individuals have no incentive to pay for their own consumption and instead will take a “free ride” on anyone who does pay.

Market Failure: The Case of Public Goods Providing Public Goods Some public goods are supplied through voluntary contributions. Some public goods are supplied by self-interested individuals or firms. Some potentially public goods are deliberately made excludable. It is up to the government to provide public goods. Economic theory tells us that the provision of public goods is one of the crucial roles of government.

Market Failure: The Case of Public Goods How Much of a Public Good Should Be Provided?

Market Failure: The Case of Public Goods Cost-Benefit Analysis Governments engage in cost-benefit analysis when they estimate the social costs and social benefits of providing a public good.

K E Y T E R M S Property rights Economic signal Competitive market economy General equilibrium Efficient in consumption Efficient in production Efficient allocation of resources Efficient in output levels Utility possibility frontier Market failure External cost External benefit Externalities Negative externalities Positive externalities Marginal social cost of a good or activity Pigouvian taxes Coase theorem Transaction costs Internalize the externality Technology spillover Marginal social benefit of a good or activity Pigouvian subsidy Industrial policy Excludable Rival in consumption Private good Public good Nonexcludable Nonrival in consumption Free-rider problem Cost-benefit analysis