EC302 Microeconomic Analysis: Competitive Markets

EC302 Microeconomic Analysis: Competitive Markets

• Topic: Competitive Markets: Efficiency and Welfare
• Reading: Chapter 3 (PA)

Overview

• Economic Efficiency: Meanings
• Efficiency in a Single Market
• Conditions for Efficiency in all Markets
• Efficiency, Equity and Social Welfare
• Competitive Markets and Efficiency: First Welfare Theorem
• Competitive Markets and Equity: Second Welfare Theorem
• Conclusions

Economic Efficiency

• An efficient economy maximizes goods achievable from limited resources and technology.
• Overall efficiency involves three types:
  • Productive (technical) efficiency: Maximum output from given resources. Any point on the Production Possibility Frontier (PPF) meets this condition.
  • Consumption (exchange) efficiency: Allocation of goods maximizing utility for all consumers.
  • Product-mix efficiency: Producing goods in accordance with consumer preferences. Illustrated by the Production Possibility Frontier (PPF).
• Pareto efficient outcome: Resources are not reallocated to improve one person's situation without making someone else worse off.
• Potential Pareto efficiency: The possibility exists for a reallocation of resources to make one party better off without negatively affecting others.

Efficiency in a Single Market

• A competitive equilibrium, in partial equilibrium analysis, is Pareto efficient.
• For an efficient market, costs must be minimized (P = MR = MC). This equates marginal benefit (MB) with marginal cost (MC).
• Welfare is maximized when consumer surplus plus producer surplus is maximized.

Conditions for Efficiency in All Markets

• Efficient production: Includes achieving full employment of resources and using the best available technology. The economy must be operating on the PPF.

• Efficient consumption (exchange): Allocation of all outputs must be optimally exchanged between consumers to maximize their utility.

• Efficient product mix: Production must be on the PPF, optimal given available incomes.

Conditions for Efficient Production

• The marginal rate of technical substitution of inputs must be equal for all products.
• Formally, MRTS_KL^f = MRTS_KL^c (where f = food, c = clothing, K = capital, L = labour).

Conditions for Efficient Consumption

• The marginal rate of substitution of one good for another must be the same for all consumers.
• Formally, MRS_fc^A = MRS_fc^B (where A = Amy, B = Ben, f = food, c = clothing).

Conditions for Product-Mix Efficiency

• The marginal rate at which firms transform one good into another good must be equal to the marginal rate at which consumers wish to trade those goods.
• Formally, MRS_fc^A = MRS_fc^B = MRT_fc (where MRT_fc = marginal rate of transformation of food into clothing).

Work-Leisure Efficiency

• Compensation for giving up leisure must equal the marginal product of an individual's labour.

Efficiency, Equity, and Welfare

• Utility Frontier - describes how utility varies across people when resources are allocated differently
• Pareto Efficiency - resources cannot be shifted to improve one person's situation without affecting at least one other person adversely.
• Social Welfare - a function that describes society's well-being when aggregating individual utility levels.

First Theorem of Welfare Economics

• Perfect competition in all markets leads to a Pareto efficient outcome producing productive, consumption (exchange), and product-mix efficiency.

Perfect Competition Produces Productivity, Consumption, and Product-Mix Efficiency

• Price of each input, in perfect competition, will equal the value of its marginal product.
• This ensures that the marginal rate of substitution of one input for another is equal across sectors
• Individuals will make trades to maximize their utility, considering the inverse relationship between marginal rate of substitution and relative prices between two goods.
• The marginal rate of transformation for one good into another is equal to the marginal rate of ratio of the marginal costs of production of producing each good, leading to product-mix efficiency.

First Welfare Theorem: Implications

• Competitive markets produce a Pareto efficient allocation, but require complete markets (no market failures or externalities.)
• Government intervention is limited to creating appropriate markets and/or fixing external costs/benefits.
• Theorems are static; they don't account for technological progress, human capital, or equity.

Second Welfare Theorem

• Any Pareto efficient allocation is attainable from any initial distribution of resources or incomes using lump-sum transfers of income.
• Properly designed decentralised economies, along with lump-sum transfers (taxes/subsidies), can achieve any desired allocation. Individual transfers (taxes/grants) would not satisfy the goal of achieving a desired allocation from an arbitrary starting point.

Conclusions

• Market efficiency results from prices, competition, and incentives.
• The three conditions for overall economic efficiency are production, consumption, and product-mix efficiency. These conditions stipulate that prices of all factors of production and all goods should be equal to their marginal costs.
• Perfect competition achieves this efficiency.
• The analysis in this chapter is a static model, but extensions into inter-temporal models are discussed later.
• Perfect competition is unrealistic for all markets and there are likely to be situations where market failure or other externalities exist, requiring consideration for government intervention. Further considerations of equity also require further consideration.

This quiz covers Chapter 3 of EC302, focusing on competitive markets and their role in economic efficiency and welfare. Key topics include the First and Second Welfare Theorems, conditions for efficiency, and the relationship between equity and social welfare in markets. Test your understanding of these crucial concepts in microeconomic analysis.