Economics 2010 Lecture 9 Markets and efficiency

Competition and Efficiency  The Key Question  Allocative Efficiency  The Invisible Hand  Obstacles to Efficiency

The Key Question  In a market, millions of individuals each make their own decisions about what to sell and what to buy  Nobody coordinates these individual plans

 Nobody thinks about other agents’ welfare  They are trying to get the best deals for themselves!

 Do markets produce the efficient quantities of goods and services?  Or do they produce too much of some items and too little of others?  This is the key question The Key Question

Allocative Efficiency  Allocative efficiency occurs when no resources are wasted  In more technical language, allocative efficiency occurs when no agent can be made better off without some other agent being made worse off

 Three conditions are met when the allocation of resources is efficient: £ Consumer efficiency £ Producer efficiency £ Exchange efficiency Allocative Efficiency

Consumer Efficiency  Consumer efficiency occurs when consumers cannot make themselves better off by reallocating their budgets  by reorganizing the way they spend their money

Consumer Efficiency  consumer efficiency occurs when consumers are on their demand curves  The demand curve tells us the quantity that consumers plan to buy at a given price

Consumer Efficiency  Also, the demand curve tells us the maximum amount that consumers are willing to pay for a given quantity  In the absence of external benefits, the demand curve is a marginal social benefit curve

 Marginal social benefit is the amount that a consumer is willing to pay for the last unit bought plus the value of the last unit bought to other people  The value to other people of the last unit bought is called an external benefit. An example is the benefit from new knowledge Consumer Efficiency

Producer Efficiency  Producer efficiency occurs when firms cannot increase their profits by changing the quantity produced or by changing the method of production  Equivalently, we will see later in the year that producer efficiency occurs when firms have maximized profit

Producer Efficiency  Profit is maximized when the marginal cost equals marginal revenue  In perfect competition, marginal revenue equals price  So, producer efficiency is achieved when marginal cost equals price  the marginal cost is given by the supply curve, as you know

Producer Efficiency  Producer efficiency occurs when firms are on their supply curves  The supply curve tells us the quantity that producers plan to sell at a given price when they are maximizing profit

Producer Efficiency  Also, the supply curve tells us the minimum amount that producers are willing to accept for a given quantity  In the absence of external costs, the supply curve is a marginal social cost curve

 Marginal social cost is the cost of the last unit bought plus the cost imposed on other people  The costs imposed on other people are called external costs. They are opportunity costs that fall on third parties. Examples are the costs of pollution or congestion Producer Efficiency

Exchange Efficiency  Exchange efficiency occurs when all the available gains from trade have been realized.  The gains from trade for consumers are measured by consumer surplus  Consumer surplus is explained in Chapter 6, which we skipped  However, the concept is very easy...

Exchange Efficiency  Here, consumer surplus is shown by the green triangle  Consumer surplus is the value placed on the good minus the amount paid for it

Exchange Efficiency  The gains from trade for producers are measured by producer surplus  Producer surplus is total revenue minus the opportunity cost of production

Exchange Efficiency  Here, producer surplus is shown by the blue triangle  Producer surplus is the revenue received minus the cost of production

Exchange Efficiency  The total gains from trade are the sum of consumer surplus and producer surplus

 Allocative efficiency occurs when all three conditions: £ consumer efficiency £ producer efficiency £ exchange efficiency are satisfied Allocative Efficiency

 We show here allocative efficiency  Consumer efficiency is achieved at all points along the demand curve, D  they are happy there... Allocative Efficiency

 Producer efficiency is achieved at all points along the supply curve, S  they are happy there... Allocative Efficiency

 Exchange efficiency is achieved at the quantity Q* and the price P*  At this price and quantity, the gains from trade are maximized Allocative Efficiency

The Invisible Hand  When firms are producing on their supply curves and households are consuming on their demand curves, each is doing the best they can with their resources, given the prices prevailing in markets  Competitive markets bring these two sets of decisions together

The Invisible Hand  Equilibrium in a competitive market occurs at the price that equates the quantity demanded and the quantity supplied  In a competitive equilibrium, producers’ marginal costs equal consumers’ marginal benefits for all goods and services

 When there are no external costs, a firms’ marginal cost equals marginal social cost  When there are no external benefits, the price paid by the household is the marginal social benefit  In the absence of externalities, the competitive market is efficient The Invisible Hand

 Competitive markets send resources to their highest-value uses The Invisible Hand