1. Chapter 4: Efficiency and Imperfect Markets
“We want the spirit of America to be efficient; we want American character to be efficient; we want American character to display itself in what I may, perhaps, be allowed to call spiritual efficiency--clear disinterested thinking and fearless action along the right lines of thought.”
Woodrow Wilson (former President of the U.S.)
“I don't like a man to be too efficient. He's likely to be not human enough.”
Author: Felix Frankfurter (former Supreme Court Justice)

2. Efficiency Concept: Pareto Optimality
Definition: Pareto optimality. A situation is Pareto optimal if it is impossible to make any person better off without making at least one person worse off. In other words, Pareto optimality requires that all possible opportunities for efficient production and mutually beneficial trade have been fulfilled.
Definition: Pareto improvement. An action leads to a Pareto improvement if it makes at least one person better off without making at least one person worse off.
The Two Conditions for a Pareto Improvement:
(1) Total benefits must be greater than total costs.
(2) Losers (if any) must be fully compensated for their net losses.
Relation: If a situation is Pareto optimal, no Pareto improvement is possible.

3. Your Turn 4-1: Will the following actions produce Pareto improvements?
A. Robin Hood robs Prince John to feed his merry men.
B. The Sheriff of Nottingham arrests Robin Hood, thereby preventing further theft.
C. The U.S. government increases aid to the homeless, paying for the program with a slight increase in the corporate income tax.
D. The Salvation Army feeds the hungry with voluntary donations from the well-to-do.

4. Efficiency in a Pure Exchange Economy: The Edgeworth Box
The Edgeworth box model assumes that there are two individuals,
who we will label Dottie and Schwartz, and two goods. Each individual
starts with fixed quantities of the two goods. These initial quantities
represent the endowment point.

5. Pareto Optimality (P.O.) after Exchange: Any Point of Tangency on the Black Contract Curve is P.O.

6. Lessons of Pareto optimality
Pareto Optimality maximizes the well-being of both parties given any initial distribution of goods.
Pareto optimality and Pareto improvement vary with the initial allocation of goods.
An allocation of goods that leaves one person with everything and another with nothing will be Pareto optimal since transferring goods from the person with everything will cause him or her to be worse off.
Therefore, it is often important to include ethical considerations as well as efficiency when analyzing the social impact of a public policy.

7. The Kaldor-Hicks Principle
Definition: The Kaldor-Hicks Principle (also known as the Fundamental Rule of Policy Analysis) states that a policy should be adopted if the winners could IN PRINCIPLE compensate the losers. This principle requires that the total benefits outweigh the total costs but does not require that the losers actually be compensated.
The One Condition for Meeting the Kaldor Hicks Principle: Total benefits must be greater than total costs.

8. Review: Net Gains from a Private Competitive Equilibrium
In a Private Market (with only buyers and sellers),
Net Gains equal the sum of Consumer and Producer Surplus (areas A and B in Figure 4-3)

9. Claim: A Competitive Equilibrium is Pareto optimal
This claim has been formally proven mathematically for many years.
Note that if the price rises consumer surplus Falls
If price falls producer surplus falls
If the quantity decreases from 10, one or
both of the surpluses must also fall.

10. Markets May Not Be Perfect
There may not be many buyers and sellers.
A market with a single seller is called a monopoly.
A market with a few sellers is called an oligopoly.
A market with one buyer is called a monopsony.
Information may be incomplete and unequally distributed.
Markets may not be complete, creating what are called externalities.
Mobility (entry and exit) may be costly, and other costs of buying and selling may exist.

11. Demand for A Competitive Firm vs. a Monopoly (A single seller)

12. Monopoly Demand and Marginal Revenue
Concepts: total revenue (or total spending) equals price x quantity
marginal revenue equals the change in total revenue for each one unit change in quantity.
Your Turn: Explain why the marginal revenue of the third unit in Table 4-1 is less than the price of $14.

13. Monopoly Profit Maximization
Steps for Monopoly Profit Maximization:
Find the Quantity where Marginal Revenue = Marginal Cost (Qm in Figure 4-8)
Go up to the Demand Curve to find the highest price consumers are willing to pay for that quantity
(Pm in Figure 4-8)
Effects of Monopoly:
(1)Quantity falls and price rises
(2)consumer surplus falls
(3)producer surplus generally rises
(4)Total net gains falls, leaving a
“deadweight loss”

14. Deadweight Loss
Concept: Deadweight Loss equals the lost net gains due to a market inefficiency or government policy. It equals the total net gains under a perfectly competitive equilibrium MINUS the total net gains under any other market situation.

15. The Efficiency Effects of Monopoly vs. Competition
Table 4-2:
Market
Condition
Consumer
Surplus
Producer
Net Gain
Deadweight
Loss
Competition
A+B+C
D+E
A+B+C+D+E
None
Monopoly A
B+D
A+B+D
C+E
Difference
-B-C
B-E
-C-E

16. Unequal Information: When consumers receive lower benefits than they expect
In Figure 4-10 the consumer thinks she is receiving the value associated with D2,
but after buying the product will actually receive the benefits under demand curve D1.
Consumer Surplus in Figure 4-10
Market
Condition
Total
Value
Total Spending
Consumer Surplus
(Value-Spending)
Competition
B+C+F+G+I+J
F+G+I+J
B+C
Unequal Information
B+C+F+G+I+
J+H+K
C+D+F+G+I+J+E+H+K
B-D-E
(The dotted areas)
The Efficiency Effects of Unequal Information
Market
Condition
Consumer
Surplus
Producer
Net Gain
Deadweight
Loss
Competition
B+C
F+I
B+C+F+I
None
Unequal Information
B-D-E
C+D+F+I
B+C+F+I-E E
Difference
-C-D-E
C+D -E

17. Externalities: Effects of a market on those not participating in that market
Private cost = the cost of production to the firm. This generally does not include external costs to outsiders from pollution or other effects. The usual market supply curve is based on the marginal costs of producers.
External cost = the negative effect of production of a good on parties who are not involved with the production or consumption of the good. Positive externalities can be thought of as negative external costs.
Social cost = private cost of production to the firm + external cost to others.
For goods whose production or consumption leads to external harms, the good’s social cost will be higher than its private cost. However, a good which offers external benefits, such as the beekeeper’s honey bees or a beautiful building, will have a social cost which is lower than its private cost.
Marginal social cost = the change in society’s total cost for a given change in output. It also equals marginal private cost + marginal external cost. In this case the two costs are added vertically

18. Social Versus Private Cost

19. Inefficiency in a Market with Negative Externalities
external surplus = external benefits - external costs, or the net benefits experienced by persons or firms not directly involved in production of a particular good.
Net Gains now include:
Consumer Surplus
Producer Surplus
External Surplus

20. Efficiency: Private Versus Social Equilibrium
Table 4-6: The Efficiency Effects of Negative Externalities
Market
Condition
Consumer
Surplus
Producer
External
Net Gain
Deadweight
Loss
Private Equilibrium Price
A+B+C+D
E+F+G
-C-F-H-D-G
A+B+E-H H
Social Equilibrium
Price A
B+C+E+F
-C-F
A+B+E
None
Difference
-B-C-D
B+C-G
H+G+D

21. The Effects of Monopoly by the Numbers: The Competitive Result
Demand: P=30-2Q
Marginal Revenue: MR=30-4Q
Supply or Marginal Cost: P=0+Q
Step 1: Find the competitive equilibrium
where Demand = Supply
30 – 2Q = Q
Qc=10
Pc = $10 from either demand or supply.
Competitive Consumer Surplus = ½ * (30-10)*10 = 100
Competitive Producer Surplus = ½*10*10 = 50
Net Gains =150

22. The Monopoly Result Demand: P=30-2Q Marginal Revenue: MR=30-4Q
Supply or Marginal Cost: P=0+Q
Step 1: Set MR = MC to find the monopoly
Quantity Q = Qm Qm = 6
Step 2: Plug this quantity into the Demand
Equation to find the price Pm = 18
Step 3: to find producer surplus, you also need
To find the marginal cost at Q=6, MCm=6
Step 4: Find the Surplus and Gains areas
Consumer Surplus = ½*(30-18)*6 = 36
Producer Surplus (trapezoid or rectangle + triangle)
= ½*6*6 + (18-6)* 6 = 90
Net Gains = = 126
Deadweight Loss = 150 = 126 = 24 (the difference
between the competitive and monopoly net gains).

23. Imperfect Information with numbers
True demand (D1): P = 90 - Q
Perceived demand: P = Q
Supply: P = 10 + Q.
Find the price, quantity, and the dollar
values of the consumer and producer surplus
and total net gains (CS + PS) in a market with
perfect information (use true demand only).

24. Imperfect Information with numbers The Perfect Information Case
True demand (D1): P = 90 - Q
Perceived demand: P = Q
Supply: P = 10 + Q.
Set True Demand = Supply
90 – Q = 10 + Q
Q = 40
P = 50
Consumer Surplus = (1/2)($90 - $50)(40) = $800
Producer Surplus = (1/2)($40)(40) = $800
Net Gains = $1600

25. Imperfect Information with numbers The Consumer is Fooled
True demand (D1): P = 90 - Q
Perceived demand (D2): P = Q
Supply: P = 10 + Q.
Set Perceived Demand = Supply
Find new Price and Quantity,
Then find the surplus values
Hint: Consumer Surplus is not a single triangle

26. Imperfect Information with numbers The Consumer is Fooled
True demand (D1): P = 90 - Q
Perceived demand (D2): P = Q
Supply: P = 10 + Q.
110 – Q = 10 + Q
Q = 50
P = 60
Consumer Surplus = (1/2)($90 - $60)(30) –
(1/2)($60 – $40)(20) = $450 - $200 = $250
Producer Surplus = (1/2)($60 - $10)(50) = $1250
Deadweight Loss = $ $1500 = $100

27. External Costs with Numbers: Private Equilibrium
marginal private cost: MCp = 10 + Q
marginal external cost MCx = ½ Q
marginal social cost MCs = Q
demand: P = Q

28. External Costs with Numbers: Private Equilibrium
marginal private cost: MCp = 10 + Q
marginal social cost MCs = Q
demand: P = 100 – Q
A. private equilibrium price and quantity:
100-Q = 10 + Q
90 = 2Q
Q = 45
P = $55
B. Surplus Values:
CS = ½ x 45 x ($100-55) = $1,012.5
PS = ½ x 45 x ($55-10) = $1,012.5
Ex. S. = - $
Net Gains = – = $1,518.75

29. Social Equilibrium With Externalities
marginal private cost: MCp = 10 + Q
marginal social cost MCs = Q
demand: P = 100 – Q
To find equilibrium quantity and price, set MCsocial
equal to demand.
100 – Q = Q
90 = 2.5 Q
Q = 36
P = $64
Total Social Surplus is the area between
Demand and Social Cost = ½•36 •(100-10) = $1,620.

30. Public Goods
Public goods are goods for which consumption is entirely external to the individual.
Those purchasing a purely public good will consume no more of it than a neighbor who pays nothing for the same good.
A public good has no rivalry in consumption. This means that a public good can be consumed or enjoyed by more than one person simultaneously.
The second characteristic of public goods is non-excludability. Non-excludability means that one cannot prevent someone from consuming a public good if they have not paid.

31. Conclusion
This chapter discussed general efficiency concepts such as Pareto optimality, the efficiency of a perfectly competitive market, and the effects of market imperfections on market efficiency.
All of these general goals were analyzed using net benefits concepts such as producer and consumer surplus.
These concepts were then applied to mathematical examples using equations and algebra.