Transcript Efficiency in Output Levels

CHAPTER 13
Efficiency and Equity
PowerPoint® Slides
by Can Erbil and Gustavo Indart
© 2005 Worth Publishers
© 2005 Worth Publishers, all rights
reserved
Slide 13-1
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

How a perfectly competitive market for a single
good achieves efficiency in all three components

Why an economy consisting of many perfectly
competitive markets is typically, but not always,
efficient

The limits of the concept of efficiency—in
particular, why efficiency is about how to achieve
goals but not about which goals are chosen

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Slide 13-2
Supply, Demand, and the Virtues
of the Market
We have learned that a perfectly competitive market
maximizes total surplus except in cases of market
failure

 But why is this true, and what are the conditions
that make this possible?
To see why a market maximizes total surplus, we rule
out various ways in which you might think total surplus
could be increased:

 It turns out that total surplus can’t be increased
by reallocating consumption, and it can’t be
increased by rearranging production
The level of output at market equilibrium is also
the right one to maximize surplus
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Slide 13-3
Why a Market Maximizes Total Surplus
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Slide 13-4
Why Markets Work So Well
The effectiveness of markets depends on the power
of two important features of a well-functioning
market: property rights and the role of prices as

economic signals
Property rights are the rights of owners of
valuable items, whether resources or goods, to
dispose of those items as they choose

An economic signal is any piece of information
that helps people make better economic decisions

But under conditions in which prices give incorrect
economic signals, markets can fail

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Slide 13-5
Efficiency in the Economy as
a Whole
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

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

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Slide 13-6
Efficiency in the Economy as
a Whole (cont’d)
An economy is efficient in production if there
is no way to produce more of some goods without
producing less of other goods

Equivalently, an economy is efficient in
production if it is on its production possibility
frontier
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

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Slide 13-7
The
Production
Possibility
Frontier and
Efficiency in
Production
Here A and B are efficient production points—at each point the economy
can produce more of one good only by producing less of the other. C is not
an efficient production point because more corn and more wheat can be
produced.
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Slide 13-8
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.
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Slide 13-9
Efficiency in the Economy as a Whole
To achieve efficiency, an economy must be efficient in
consumption, efficient in production, and efficient in
output levels. When prices perform properly as economic
signals, a competitive market economy in general
equilibrium is efficient.
It is efficient in consumption because goods and
services are allocated to consumers according to their
prices, which are signals of consumers’ willingness to pay

Second, it is efficient in production because factors
of production are allocated to producers according to their
prices, signals of producers’ valuation of those factors

Finally, it is efficient in output levels because
everyone faces the same prices, and the mix of goods and
services will be the mix that people prefer

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Slide 13-10
How an Economy Achieves Efficiency in Output Levels
If at current employment levels
VMPLcorn > VMPLwheat, then corn
producers will increase their profits by
hiring workers away from wheat
producers, who will, in turn, increase
their profits by laying off workers. This
process is illustrated for a corn
producer in panel (a).
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As a corn producer hires
workers, until she reaches her
optimal employment level, the
number of workers at which
VMPLcorn = W, the market
wage rate. Similar logic applies
to the wheat producer in panel
(b).
Slide 13-11
Efficiency in the Economy
as a Whole
Markets for goods and services are linked via
the factor markets

Any change in the amount of one good or
service produced will ultimately affect the
amounts of other goods and services as
factors of production shift from one sector to
another
The following figure helps us make sense of the
interconnectedness of markets for goods and
services and factor markets in a market economy

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Slide 13-12
Efficiency in Output Levels in a
Circular-Flow Framework
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Slide 13-13
Efficiency in Output Levels in a
Circular-Flow Framework
The factor markets bring the supply of labour from
households and the demand for labour by firms into
equilibrium

The markets for goods and services bring the supply of
goods and services from firms and the demand for goods and
services by households into equilibrium


But supply and demand in all these markets are interrelated:
 Households’ earnings in the labour market determine
their demand for goods and services, and vice versa
 Firms’ profits from hiring labour in the labour market
and producing output determine their supply of goods and
services, and vice versa
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Slide 13-14
Inefficiency in the Economy:
When Prices Go Astray
Any change in one market will ultimately generate
corresponding changes in all the other markets

When every market for goods and services and
every factor market in the economy is in equilibrium,
the economy as a whole is in general equilibrium

But what happens when prices go astray?
The same factors that lead to market failure lead to
inefficiency of the economy as a whole, with prices
failing to perform properly as economic signals and
mutually beneficial transactions going unexploited

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Slide 13-15
Efficiency and Equity
It’s important to remember that efficiency is about
how to achieve goals; it does not say anything
about what your goals should be

 Saying that the market outcome is efficient
doesn’t mean that that outcome is necessarily
desirable
 In fact, in some circumstances a well-thoughtout economic policy may deliberately choose an
outcome that is not efficient
When can an outcome be efficient without being
desirable? When it’s not fair

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Slide 13-16
What’s Fair?
We want an economy to be fair—to deliver equity—as
well as efficiency. There is, however, no agreed-upon
definition of fairness.
For Inquiring Minds: Theories of Justice
The attempt to define fairness has led to some
fascinating debates among philosophers; we describe
the views of one influential thinker, John Rawls. Rawls
asks the following question:
“Suppose that you knew you would be a human being
but you did not know whether you would be rich or
poor, healthy or sick, and so on. What kind of policies
would you want?”
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Slide 13-17
What’s Fair?
Rawls’ answer is that you would probably choose policies
that placed a high weight on the utility of the worst-off
members of society: after all, you might end up being one
of them

 And because of diminishing marginal utility, having a
few dollars more would do you a lot of good if you find
yourself poor, but having a few dollars less wouldn’t do
you much harm if you find yourself well-off
Considering the fact that there is a lack of agreement on
what fairness means, sometimes economic analysis alone
cannot be used to decide between alternative policies

 To see why, let’s introduce a new concept, the utility
possibility frontier
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Slide 13-18
The Utility Possibility Frontier
A useful concept for illustrating the limitations of
efficiency as a goal is the utility possibility frontier

It shows that there are usually many efficient
outcomes for an economy and that economics
alone cannot tell us which one is better
It’s not necessarily true that everyone prefers a
given efficient outcome to a given inefficient one

There are many efficient policies, but you
might prefer a given inefficient policy to some
efficient policies
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Slide 13-19
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.
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Slide 13-20
Efficiency
Versus
Equity
Suppose that for some reason the policy choices that are available are
restricted: you can choose only between the efficient outcome A and the
inefficient outcome C. Does this mean that A is preferable? Not necessarily.
If you place a high enough weight on the utility of Easterners, you may be
willing to trade efficiency for equity.
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Slide 13-21
The End of Chapter 13
Coming Attraction:
Chapter 14:
Monopoly
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Slide 13-22