Principles of Economics Twelfth Edition Chapter 12 PDF

Principles of Economics Twelfth Edition Chapter 12 General Equilibrium and the Efficiency of Perfect Competition...

Principles of Economics Twelfth Edition Chapter 12 General Equilibrium and the Efficiency of Perfect Competition Copyright © 2017 Pearson Education, Inc. 10-1 1-1 Chapter Outline and Learning Objectives 12.1 Market Adjustment to Changes in Demand Discuss the relationship between general equilibrium and demand shifts. 12.2 Allocative Efficiency and Competitive Equilibrium Explain the principles of economic efficiency. 12.3 The Sources of Market Failure Describe four sources of market failure. 12.4 Evaluating the Market Mechanism Understand the way that market imperfections may interfere with the ability of the market to achieve efficiency. Copyright © 2017 Pearson Education, Inc. 10-2 1-2 Chapter 12 General Equilibrium and the Efficiency of Perfect Competition (1 of 3) Our discussion has revolved around the two fundamental decision-making units (households and firms) that interact in two basic markets (input and output markets). Input and output markets cannot be considered as if they were separate entities or as if they operated independently. Although it is important to understand the decisions of individual firms and households and the functioning of individual markets, we now need to add it all up so we can look at the operation of the system as a whole. Copyright © 2017 Pearson Education, Inc. 10-3 1-3 Chapter 12 General Equilibrium and the Efficiency of Perfect Competition (2 of 3) In talking about general equilibrium, we continue our exercise in positive economics. Later in the chapter, we turn to normative economics, as we begin to judge the economic system. partial equilibrium analysis The process of examining the equilibrium conditions in individual markets and for households and firms separately. general equilibrium The condition that exists when all markets in an economy are in simultaneous equilibrium. Copyright © 2017 Pearson Education, Inc. 10-4 1-4 Chapter 12 General Equilibrium and the Efficiency of Perfect Competition (3 of 3) In judging the performance of any economic system, we use two criteria: efficiency and equity (fairness). efficiency The condition in which the economy is producing what people want at least possible cost. Copyright © 2017 Pearson Education, Inc. 10-5 1-5 Market Adjustment to Changes in Demand All economies, particularly market systems, are dynamic. Markets experience shifts of demand, costs and technology change, and prices and output change. Our discussion begins with the more general case of market connections. Copyright © 2017 Pearson Education, Inc. 10-6 1-6 FIGURE 12.1 Adjustment in an Economy with Two Sectors Initially, demand for X shifts from D0X to D1X. This shift pushes the price of X up to P1X, creating profits. Demand for Y shifts down from D0Y to D1Y, pushing the price of Y down to P1Y and creating losses. Firms have an incentive to leave sector Y and an incentive to enter sector X. Exiting sector Y shifts supply in that industry to S1Y, raising price and eliminating losses. Entry shifts supply in X to S1X, thus reducing and eliminating profits. Copyright © 2017 Pearson Education, Inc. 10-7 1-7 ECONOMICS IN PRACTICE More Corn to Burn, Less to Eat Until January 2012, U.S. refiners were given a government subsidy of $0.45 for every gallon of ethanol they blended into their fuel. Refiners also face mandates requiring them to blend some corn-based ethanol into their fuel. When corn is moved into fuel, the price of corn for food rises, affecting many people throughout the world. THINKING PRACTICALLY 1. Use general equilibrium supply and demand analysis to show the impact of requiring more corn ethanol on the market for food. Treat corn as good X and all other foods as Y. Copyright © 2017 Pearson Education, Inc. 10-8 1-8 Allocative Efficiency and Competitive Equilibrium Pareto Efficiency Pareto efficiency or Pareto optimality A condition in which no change is possible that will make some members of society better off without making some other members of society worse off. For a definition of efficiency to have practical meaning, we must answer two questions: 1. What do we mean by “better off”? 2. How do we account for changes that make some people better off and others worse off? Copyright © 2017 Pearson Education, Inc. 10-9 1-9 Pareto Efficiency Example: Budget Cuts in Massachusetts Several years ago, in an effort to reduce state spending, the budget of the Massachusetts Registry of Motor Vehicles was cut substantially by reducing the number of clerks in each office. Estimates showed that taxpayers in Massachusetts saved about $80,000 per year by having fewer clerks at that office. Copyright © 2017 Pearson Education, Inc. 10-10 1-10 The Efficiency of Perfect Competition (1 of 6) All societies answer these basic questions in the design of their economic systems: ‒ What gets produced? What determines the final mix of output? ‒ How is it produced? How do capital, labor, and land get divided up among firms? In other words, what is the allocation of resources among producers? ‒ Who gets what is produced? What determines which households get how much? What is the distribution of output among consuming households? Copyright © 2017 Pearson Education, Inc. 10-11 1-11 The Efficiency of Perfect Competition (2 of 6) Under perfect competition: – Resources are efficiently allocated among firms. – Final products are distributed efficiently among households. – The system produces the things that people want. Copyright © 2017 Pearson Education, Inc. 10-12 1-12 The Efficiency of Perfect Competition (3 of 6) Efficient Allocation of Resources among Firms The assumptions that factor markets are competitive and open, that all firms pay the same prices for inputs, and that all firms maximize profits lead to the conclusion that the allocation of resources among firms is efficient. Each individual firm needs only to make decisions about which inputs to use by looking at its own labor, capital, and land productivity relative to prices. Copyright © 2017 Pearson Education, Inc. 10-13 1-13 The Efficiency of Perfect Competition (4 of 6) Efficient Allocation of Resources among Firms Because all firms face identical input prices, the market economy achieves efficient input use among firms. Prices are the instrument of Adam Smith’s “invisible hand,” which allows for efficiency without explicit coordination or planning. Copyright © 2017 Pearson Education, Inc. 10-14 1-14 The Efficiency of Perfect Competition (5 of 6) Efficient Distribution of Outputs among Households People have different tastes and preferences, and they buy very different things in very different combinations. As long as everyone shops freely in the same markets, no redistribution of final outputs among people will make them better off. If you and I buy in the same markets and pay the same prices and I buy what I want and you buy what you want, we cannot possibly end up with the wrong combination of things. Free and open markets are essential to this result. Copyright © 2017 Pearson Education, Inc. 10-15 1-15 The Efficiency of Perfect Competition (6 of 6) Producing What People Want: The Efficient Mix of Output The condition which ensures that the right things are produced is: P = MC Society will produce the efficient mix of output if all firms equate price and marginal cost. Copyright © 2017 Pearson Education, Inc. 10-16 1-16 FIGURE 12.2 The Key Efficiency Condition: Price Equals Marginal Cost If PX > MCX, society gains value by producing more X. If PX < MCX, society gains value by producing less X. Copyright © 2017 Pearson Education, Inc. 10-17 1-17 FIGURE 12.3 Efficiency in Perfect Competition Follows from a Weighing of Values by Both Households and Firms Copyright © 2017 Pearson Education, Inc. 10-18 1-18 Perfect Competition versus Real Markets (1 of 2) We have built a model of a perfectly competitive market system that produces an efficient allocation of resources, an efficient mix of output, and an efficient distribution of output. The perfectly competitive model is built on a set of assumptions: ‒ All firms and households are price-takers in input and output markets. ‒ Firms and households have perfect information. ‒ All firms maximize profits. Copyright © 2017 Pearson Education, Inc. 10-19 1-19 Perfect Competition versus Real Markets (2 of 2) These assumptions do not always hold in real-world markets. When these assumptions do not hold, the conclusion breaks down that free, unregulated markets will produce an efficient outcome. Copyright © 2017 Pearson Education, Inc. 10-20 1-20 The Sources of Market Failure market failure Occurs when resources are misallocated, or allocated inefficiently. The result is waste or lost surplus. There are four important sources of market failure: – Imperfect market structure, or noncompetitive behavior – The existence of public goods – The presence of external costs and benefits – Imperfect information Copyright © 2017 Pearson Education, Inc. 10-21 1-21 Imperfect Competition In imperfectly competitive markets, with fewer firms competing and limited entry by new firms, prices will not necessarily equal marginal costs. As a consequence, in a market with firms that have some market power, where firms do not behave as price-takers, we are not guaranteed an efficient mix of output. Copyright © 2017 Pearson Education, Inc. 10-22 1-22 Public Goods public goods, or social goods Goods and services that bestow collective benefits on members of society. Generally, no one can be excluded from enjoying their benefits. The classic example is national defense. Copyright © 2017 Pearson Education, Inc. 10-23 1-23 Externalities externality A cost or benefit imposed or bestowed on an individual or a group that is outside, or external to, the transaction. Copyright © 2017 Pearson Education, Inc. 10-24 1-24 Imperfect Information imperfect information The absence of full knowledge concerning product characteristics, available prices, and so on. Copyright © 2017 Pearson Education, Inc. 10-25 1-25 Evaluating the Market Mechanism Freely functioning markets in the real world do not always produce an efficient allocation of resources, leading to a potential role for government in the economy. However, many believe that government involvement in the economy creates more inefficiency than it cures. In addition to the criterion of efficiency, economic systems and policies must be judged by many other criteria, such as equity, or fairness. Indeed, some contend that the outcome of any free market is ultimately unfair. Copyright © 2017 Pearson Education, Inc. 10-26 1-26 REVIEW TERMS AND CONCEPTS efficiency externality general equilibrium imperfect information market failure Pareto efficiency or Pareto optimality partial equilibrium analysis public goods or social goods Equation: key efficiency condition in perfect competition: PX = MCX Copyright © 2017 Pearson Education, Inc. 10-27 1-27