EFFICIENCY AND MARKETS
CHAPTER 4
THE GENERAL QUESTION
Last Chapter 3: How to make social decisions based on individual preferences
For a given good (e.g. clean water)…
how much should be produced, and
who should produce and consume it
Specifically in the case of pollution…
What is the right amount of pollution control?
How do we assign the responsibility to reduce pollution?
EXAMPLE: CLEAN WATER
About half of Africa’s population does not have regular access to clean water.
Some of this is because clean water is costly. (Study development econ.)
Some of this is because of market failures. (Study environmental econ.)
WHAT IS EFFICIENCY?
Here, we use the weakest criterion from
the last lecture: Pareto
Definition: The Pareto Frontier consists
of all allocations for which there are no
feasible allocations that are Pareto
preferred.
Alternatively, the Pareto Frontier
consists of all allocations that cannot be
improved in the Pareto sense.
Definition: An allocation is efficient or
Pareto-optimal if it is on the Pareto
frontier
PARETO FRONTIER AND EFFICIENCY
Here, allocations A, S, R, Z, and B are efficient.
Note that the efficiency criterion is
uninformative on comparisons along the A-B
curve.
A perfectly competitive economy may be
efficient in the Pareto sense…
…even when some people are rolling in luxury
and others are near starvation, as long as the
starvers cannot be made better off without
cutting into the pleasures of the rich
In short, a society or an economy can be
Pareto optimal and still be perfectly disgusting
EFFICIENCY AND COMPETITIVE MARKETS
Now that we have defined efficiency, can we expect markets to arrive at it?
Efficiency can be discussed in two contexts: exchange and production.
I will demonstrate that a competitive market is efficient (on the Pareto frontier).
EFFICIENCY IN EXCHANGE (1)
Assume: 2 people (JP, HA) and 2 goods (water,
numeraire good (other stuff)).
We can construct either agent’s budget line and
indifference curves in the following way
Suppose CD is JP’s budget line.
Indifference curves are concave
JP prefers to have water and stuff rather than just
one of them.
The slope of the indifference curve is the MRS
(marginal rate of substitution)
JP’s willingness to trade off water for the
numeraire, holding utility constant.
U(X*) > U(C) or U(D)
EFFICIENCY IN EXCHANGE (2)
Now let’s consider how trade might occur
in the absence of prices.
We construct an Edgeworth Box.
Here, we invert HA’s indifference curves and
superimpose them on the previous figure.
Any point in the box represents an allocation
of water and the numeraire between JP and
HA.
The endowment of water is the vertical
length of the box
World endowment of the numeraire is the
horizontal length of the box
EFFICIENCY IN EXCHANGE (3)
Suppose A is the initial endowment.
At this allocation, AB is JP’s indifference curve
and AC is HA’s indifference curve.
Any allocation in the area enclosed by A-B-C is
a Pareto improvement because both will be
on a higher indifference curve.
Therefore, A cannot be on the Pareto frontier.
Any allocation at which indifference curves
of JP and HA are tangent to each other lies
on the Pareto frontier or contract curve
This is denoted by the curve XY in the
Edgeworth box.
EFFICIENCY IN EXCHANGE (4)
Along this XY curve, one person can
increase his utility only by decreasing the
other’s utility
this is precisely the criterion necessary for
the Pareto frontier.
Whatever the initial endowment, people
will end up on the contract curve
all equilibrium allocations lie on this curve.
EFFICIENCY IN EXCHANGE (5)
Since indifference curves are tangent
along the contract curve, at any Pareto
optimum
the MRS between any two goods should be
identical across all individuals.
To conclude: In this simple model, free
exchange leads to a Pareto optimal
division of goods
efficiency is achieved.
MARKETS AND EXCHANGE (1)
Now we introduce prices with individuals as price-takers so prices are given
What will the market equilibrium be?
In equilibrium, for each individual, the value of the post-trade allocation must equal the value of the
initial endowment.
Suppose the initial endowment is () and the post-trade endowment is ().
The pre-trade value (wealth) is:
The post-trade value is:
MARKETS AND EXCHANGE (2)
Budget Balancing: =
Solving for
Line with constant and slope
At the market equilibrium, both individuals will choose so that their indifference curves are
tangent to the budget line:
JP’s MRS = = HA’s MRS
MARKETS AND EXCHANGE (3)
Given an initial endowment A, the market
equilibrium is an allocation and prices
and . This allocation is on the contract
curve.
The market equilibrium is Pareto Optimal.
Markets are Efficient
EFFICIENCY IN PRODUCTION (1)
So far, we have looked at ways to divide a fixed
pie among consumers.
Here, we turn to the production side and see if
there is a way to achieve efficiency in
production.
Assume: It uses numeraire (stuff) and produces
water
At A, no stuff is used, and no water produced
At B, lots of water is produced
AB is the PPF (production possibility frontier).
The firm should never produce at a point like D
because it is still feasible to produce more water
with less stuff (e.g., E).
EFFICIENCY IN PRODUCTION (2)
Where along the PPF will the firm produce?
Firm’s profits:
Iso-profit line gives all possible values of W and N
that can generate a given profit of π.
Iso-profit equation:
Constant of and slope of
A firm with iso-profit lines as shown on the graph
produces at E, which is the highest level of
profits on the PPF
EFFICIENCY IN PRODUCTION (3)
Slope of the PPF at any point (the rate at
which the output of one good must be
sacrificed to increase the output of the
other) is
Marginal rate of transformation (MRT)
between the two goods.
If MRT > then firm could increase profits
by reducing , and if MRT < , then the firm
could increase profits by increasing N
At Profit Maximizing Point, MRT= -
MRT must be Equal Across all Producers.
EFFICIENCY WITH AND WITHOUT MARKETS (1)
The question here is how we can put production and consumption together
The conditions necessary for economic efficiency are:
For any two firms, the MRT must be equal
For any two consumers, the MRS must be equal
In a simple exchange economy a competitive market generates prices so that the MRS is
equal for all consumers and equal to the ratio of prices of the two commodities.
In a production economy a competitive market generate prices so that the price ratio is
equal to the MRT of all firms.
MRS = MRTS = -
EFFICIENCY WITH AND WITHOUT MARKETS (2)
1st Theorem of Welfare Economics: In a competitive economy, a market equilibrium is
Pareto optimal.
2nd Theorem of Welfare Economics: In a competitive economy, any Pareto optimum can be
achieved by market forces, provided the resources of the economy are appropriately
distributed before the market operates.
Assumptions necessary for the welfare theorems:
Complete property rights (no external costs)
Atomistic participants (consumers and producers take prices as given)
Complete information (agents know current and future prices)
No transaction costs (it must be costless to attach prices to goods traded)
We will see later that pollution violates some of these assumptions.
SUPPLY, DEMAND, AND EFFICIENCY
Market equilibrium is Pareto Optimal:
Demand Reveals marginal willingness to pay
(MWTP) for an additional unit of wine
The market equilibrium is
To see that this is Pareto optimal, consider
alternative production levels and
At : MWTP > Cost to Produce
At : MWTP < Cost of Production
Total surplus is maximized at the market
equilibrium.
CONSUMER AND PRODUCER SURPLUS
Demand curve and Supply curve can be
used to determine consumer surplus and
producer surplus.
D curve gives MWTP for an extra unit of the
good
S curve gives MC of an extra unit
Total surplus = Consumer + Producer
Surplus = Area under D – Area under S
Total surplus is maximized at market
equilibrium.
SUPPLY AND DEMAND FOR BADS
Can we alter our models to allow for bads?
Viewing garbage as a commodity, it has a negative
price
To live near a wine plant that spews garbage, a person
would require compensation in the form of a payment
For the right to spew, a plant would have to pay < 0
D is downward sloping—one must be paid more to live
near garbage.
S is upward sloping—producers of garbage will not
make much if price is high.
But we can switch this around to have positive prices:
Call garbage producer a consumer of garbage disposal.
Then supply and demand curves will look like those for
normal goods.
WHERE DOES S AND D FOR BADS COME FROM? (1)
Supply: As price of garbage approaches 0,
the profit maximization point on the PPF
involves more garbage production (i.e. point
C), and the slope increases.
WHERE DOES S AND D FOR BADS COME FROM? (2)
Demand: – At high garbage prices,
garbage consumption is low—not paid
enough to consume it.
It is crucial to recognize that we are
talking about individual, not aggregate,
supply and demand curves here.
SURPLUS MEASURES FOR BADS (A NUMERICAL EXAMPLE):
ABCDEF = consumer benefits excluding
payments
CDE = consumer surplus
BCE = producer surplus
ABEF = cost of providing the services
BCDE = total surplus
We can see increasing MC and declining
MWTP.
