L24 - The Efficiency of Markets Flashcards
What is the difference between Efficiency and Fairness (or Equity)?
Two main components that of whether something is socially desirable:
i) efficiency and ii) equity (or fairness)
- Use a pie as a metaphor –> the size of the pie depends upon how EFFICIENT the pie-making process
- how the pie is divided determines FAIRNESS
We’re going to mainly focus on efficiency
Why?
1) whether a process is efficient is objective (it is not a matter of opinion)
2) make “the pie as big as possible”, then adjust the resulting distribution of the pie
(through use of lump-sum taxes)
For the Most part, when do markets work well and do better than alternatives?
We know that, for the most part, markets work well & do better than alternatives:
i) Better information
ii) Greater flexibility
iii) Better adaptability
iv) Decentralisation of power
On occasions, markets may fail to allocate resources efficiently
What is meant by Efficiency?
- Efficiency can be thought of in terms of: productive and allocation efficiency
1) Productive efficiency
i) allocation of resources within a firm
- each firm should produce at the lowest cost possible
ii) allocation of resources among firms
- total output should be produced at the lowest cost
2) Allocative efficiency
- No gain should be made by reallocating resources
- Gains are maximised
How is Efficiency linked to the Production Possibility Frontier?
- With two Products on the x and y-axis we a quarter circle curve
- Productive Efficiency occurs at any output on the line –> as the firm is producing optimal
- Allocative efficiency –> the point on the line produces the highest gains for those in the market –> usually when averages are better than extremes –> is allocative efficiency
What is Pareto Optimality?
- A 19th century economist named Vilfredo Pareto was one of the first economists to define what a social planner may perceive as an efficient allocation of resources
- He claimed that a given allocation of resources would be efficient if:
- it is not possible to make one person better off without making another person worse off
- An allocation of resourses with this property is a “Pareto optimal”
- (Sloman, Wride and Garratt also use the term “social efficiency”)
What is Pareto Improvement?
- A “Pareto improvement” is when an allocation is not a Pareto optimal
- it is possible to make one person made better off without making another worse off
- Note that: at a Pareto optimal allocation of resources, there are no Pareto improvements to be made
What is an Edgeworth Box?
- The Edgeworth box depicts every possible outcome from trade between person x and person y
- In the bottom left hand corner is the origin of person x and the top left hand corner is the origin of y
an example of an outcome is: - On the x-axis there is berries and on the y-axis there is water
- by drawing a horizontal line across to depict the split of the water between the two people and a vertical line to depict the share of the berries
- at the point these lines cross shows an outcome of trade between two people at that share of the resources
For Edgeworth Boxes what are some of the rules from indifference curves that can be used to find out the optimal outcome?
- Recall that indifference curves joins the bundles of goods for which a consumer is indifferent between, i.e. bundles that give the same amount of utility/satisfaction
- Averages preferred to extremes
- More preferred to less
- Indifference curves can’t cross
How do you add indifference curves to the Edgeworth box?
- Treating the two corners as the origin of the graph for person x and person y
- treat it like a normal graph with two sides next to their respective origins as a graph axis and draw indifference curves like normal
- Person x’s utility increases with more water and more berries
- Person y’s utility increases with more water and more berries
How can Pareto Optimal allocation of resources be applied to Edgeworth boxes?
- the entire gap between two indifference curve of the difference person is a pareto improvement –> as you can make own person better off without making the other worse off
- Pareto Optimality occurs when the two curves are at a point of tangency with each other –> as you cannot make someone better off with out making the other worse off
- You can move either one of the indifference curve to make them a tangent to the other which can create multiply points of Pareto Optimality
- If you connect all these points you get the core line –>which contains all the Pareto optimal allocations, given they are Pareto improvements
- This line usually doesnt go further than the optimal points on the original indifference curves
When is there Private efficiency in a market?
- private efficiency if: marginal private benefit (MPB) = marginal private cost (MPC)
When is there Social Efficiency in a market?
- social efficiency if: marginal social benefit (MSB) = marginal social cost (MSC)
Why is there private and social efficiency in a perfectly competitive market?
There is private & social efficiency in a perfectly competitive market because:
MSB = MPB = P = MPC = MSC
1- - all markets will generally be privately efficient
2- markets are socially efficient when the trade has no effect on third parties
So, social efficiency is the same as Pareto optimality because:
If MSB > MSC, there is a Pareto improvement from increasing the activity
How does socially efficiency in perfect competition look like on a graph?
- If there is Price on the y-axis and Quantity on the x-axis
- with a down sloping demand curve –> which can also be considered as the marginal private benefit (MPB = MSB)
- curved supply curve –> Also can be consider the marginal private cost (MPC= MSC)
- equilibrium occurs at the interception
- private is equal to social costs and there is not effect on any third parties just the buyers and sellers
- Looking at the vertical interpretation of the two curves:
- to the left of equilibrium –> MPB > MPC - producing one extra unit is a Pareto improvement as it makes supplier better off without making the buyer worse off
- to the right of equilibrium –> MPB < MPC - producing one less unit is a Pareto improvement as it makes the buyer better off without making the supplier worse off
