EC302 Microeconomic Analysis: Competitive Markets

EC302 Microeconomic Analysis: Competitive Markets

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

Overview

• Economic Efficiency: Includes meanings of Efficiency
• Efficiency in a Single Market: Covers efficiency conditions.
• Conditions for Efficiency in all Markets: Outlines the technical conditions for efficiency across all markets.
• Efficiency, Equity, and Social Welfare: Discusses the relationship between these three concepts.
• Competitive Markets and Efficiency: Explores the First Welfare Theorem, linking competitive markets with efficiency.
• Competitive Markets and Equity: Investigates the Second Welfare Theorem, relating competitive markets to equity.
• Conclusions: Summarizes key findings on the subject.

Economic Efficiency

• Efficient Economy: An efficient economy utilizes resources optimally to maximize the goods desired by individuals.
• Overall Efficiency Subsets: This requires three types of efficiency: productive, consumption, and product-mix efficiency.
• Productive Efficiency (PPF): Maximum output given resources; any point on the Production Possibility Frontier (PPF) is productive efficient.
• Consumption Efficiency: Optimal allocation of goods to individuals to maximize overall utility, meaning no further redistribution can boost any individual's utility without decreasing someone else's.
• Product-Mix Efficiency: Choosing the optimal combination of goods given technology and consumer preferences from the feasible production frontier.
• Pareto Efficiency: Resources cannot be reallocated to make one person better off without harming another.
• Potential Pareto Efficiency: Reallocations for efficiency improvement with potential for adjustment.

Efficiency in a Single Market

• Competitive Equilibrium: A competitive equilibrium represents a Pareto-efficient outcome in a single market.
• Partial Equilibrium Analysis: Analysis of a single market, focusing on market conditions and interactions within an industry.
• Efficiency Requirements: Essential conditions for efficiency, including cost minimization (P = MR = MC), which ensures that marginal benefit (MB) equals marginal cost (MC).
• Welfare Maximization: Competitive markets with no externalities maximize welfare by maximizing consumer surplus and producer surplus.

Conditions for Efficiency in all Markets

• Efficient Production: Includes all inputs and technology, requiring economic output to be on the PPF and full employment of factors.
• Efficient Consumption: Efficient allocation of goods and services among consumers.
• Efficient Product Mix: Optimal combination of goods and services, given available resources and preferred ratios of goods by consumers, on the PPF.

Conditions for Efficient Production

• Marginal Rate of Technical Substitution (MRTS): The rate at which one input can be substituted for another while maintaining the same output. MRTS for all inputs and products must be equal.

Conditions for Efficient Consumption

• Marginal Rate of Substitution (MRS): The rate at which one good can be exchanged for another while keeping the same level of utility. MRS for all goods must be equal across all consumers.

Conditions for Product-Mix Efficiency

• Marginal Rate of Transformation (MRT): The rate at which one good can be transformed into another with the existing production technologies and factors. The MRT must be equal to the MRS between all consumer goods.

Work-Leisure Efficiency

• Compensation for Leisure: Compensation for giving up leisure must equal the marginal product of labor. The MRS (marginal rate of substitution) must equal MRT (marginal rate of transformation).

Efficiency, Equity, and Welfare

• Introduction of Equity: Discusses distributional issues in economics.
• Utility Frontier: Derived from the PPF.
• Relationship between UPF and PPF: The relationship between optimal consumption bundles and productive conditions.
• Social Welfare Function: A function incorporating individual utilities to determine total well-being (W = f(u₁, U₂... un))

Competitive Markets and Efficiency

• First Welfare Theorem: Perfect competitive markets lead to a Pareto optimal outcome.
• Conditions for the First Welfare Theorem: Productive, consumption and product mix efficiency are achieved.

Perfect Competition: Efficiency

• Perfect Competition & Productive Efficiency: In perfect competition, input prices equal the value of the marginal product. The ratio of marginal products for factors determines factor price ratios.
• Perfect Competition & Exchange Efficiency: Individuals maximize utility when the marginal rate of substitution for goods is inversely proportional to their relative prices.
• Perfect Competition & Product-Mix Efficiency: In a PC, producers expand their output until marginal cost equals price. This produces market efficiency in production.

First Welfare Theorem: Implications

• Pareto Efficiency: Perfectly competitive markets lead to Pareto efficiency.
• Government Role: Limited to maintaining markets; it is not necessarily involved in the allocation of resources.

Second Welfare Theorem

• Achieving Any Pareto-Efficient Allocation: Any desired distribution of resources can be attained with appropriate initial conditions and/or lump-sum transfers.
• Decentralized Markets: Markets can achieve any possible Pareto efficient output allocation and distribution.
• Lump-Sum Transfers: Taxes or grants are possible but must be a one-off and non-distortionary. This contrasts with other tax/subsidy methods.

Conclusions

• Market Efficiency: Driven by prices, competition, and incentives in markets. Overall economic efficiency requires three conditions (production, consumption, and product mix).
• Perfectly Competitive Market: Condition to achieve market equilibrium, efficient use of resources.
• The Analysis' Nature: Static, meaning it analyzes a single point in time.

Conclusion (cont.)

• Perfect Competition's Inadequacy: Perfect competition is rarely an accurate representation of any real-world economy.
• Government's Role: Market failures, inequities create a role for government intervention.
• Efficiency-Equity Tradeoff: Often a conflict between making an economy efficient and making it equitable.