EC302 Microeconomic Analysis PDF

EC302 Microeconomic Analysis 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 Welf...

EC302 Microeconomic Analysis 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 provides the maximum goods that individuals want from limited resources and technology. Overall efficiency requires three sub-sets of efficiency: – Productive (technical) efficiency (on PPF) : producing maximum output of goods and services with given resources. Any point on PPF is a necessary and sufficient condition for productive efficiency. – Consumption (exchange) efficiency : goods are allocated to individuals who want them and it’s impossible to increase utility of one person without decreasing the utility of another person. – Product-mix efficiency (preferred part of PPF) : firms produce the goods that people want given available production technologies. Illustrated by Production Possibilities Frontier When three above efficiency conditions are met, they produce Pareto efficient outcome. Pareto efficient – resources can not be reallocated to make someone better off without making someone else worse off. Potential Pareto efficiency (for reallocations) Production Possibilities Frontier  Efficiency in a Single Market Core economic principle: a competitive equilibrium is Pareto efficient Partial equilibrium (one industry) analysis (Figure 3.2) Efficiency requirements: – Costs are minimised – P = MR = MC – This ensures that MB = MC This maximises welfare defined as (consumer + producer surpluses) A competitive market with no externalities meets efficiency requirements and therefore maximises welfare. Assumes all other markets are perfectly competitive. If they are not, there may be a second best problem. Efficiency in a single market  Conditions for Efficiency in all Markets Must meet the key technical conditions Efficient production (including full employment). For any supply of inputs and technology, economy must be on PPF. Efficient consumption (exchange). Any given output must be exchanged efficiently between consumers. Efficient product mix. Product mix on PPF must be optimal given existing incomes (consistent with a point on UPF).  Conditions for efficient production Marginal rate of technical substitution of inputs = for all products MRTS fKL = MRTS cKL (3.1) Outputs f = food, c = clothing Inputs K = capital, L = labour Production efficiency Conditions for efficient consumption Marginal rate of substitution of one good for another is same for all consumers (3.2) where A stands for Amy and B for Ben. Consumption efficiency  Conditions for product-mix efficiency Marginal rate at which firms can transform one good into another equals marginal rate at which consumers wish to trade the two goods (equals opportunity costs). (3.3) where MRTfc is marginal rate of transformation of food into clothing. See Figure 3.5 Overall product-mix efficiency  Work-leisure efficiency Compensation (goods) that an individual wants for giving up leisure must equal marginal product of her labour. (3.4) Marginal rate at which Amy is willing to substitute leisure for income (goods) should equal the marginal rate at which an hour or leisure foregone can be transformed into income.  Efficiency, Equity and Welfare Introducing distributional issues (equity) Deriving utility frontier from a PPF – Point utility possibility curves – Utility possibilities frontier Relationship between UPF and PPF The UPF and Pareto efficiency The need for a social welfare function – W = f (u1, u2…un) Utility possibilities frontier The UPF and social welfare Competitive Markets and Efficiency What kind of economy achieves the three efficiency conditions (3.1) to (3.3) and hence a position on the UPF? A perfectly competitive economy  First Theorem of Welfare Economics If there are perfectly competitive markets for all goods, an economy achieves a Pareto efficient outcome. A competitive economy produces productive, consumption (exchange), and product mix efficiency. How is this done?  Perfect competition produces productive efficiency In PC, prices of inputs = value of marginal product (VMP) Marginal rate at which capital is substituted for labour in each sector = ratio of marginal product of labour to marginal product of capital = price ratio of labour (w) to capital (r) (3.6) All firms face same input prices and employ same marginal rate of substitution between inputs (as in Equation 3.1). This ensures productive efficiency.  Perfect competition produces exchange efficiency Individuals maximise own utility when the marginal rate at which they substitute one good for another is in inverse proportion to the relative prices of the two goods. (3.7) In PC, all individuals face same relative prices and so have the same marginal rates of substitution. This ensures exchange efficiency.  Perfect competition produces product-mix efficiency MRT = slope of PPF at any point. Slope is the ratio of the marginal cost of producing food and producing clothing. Thus (3.8) In PC, producers expand output until MC = P. Therefore, (3.9)  Perfect competition produces product-mix efficiency (Cont.) Combining (3.7) and (3.8), the marginal rate at which food is transformed into clothing equals price ratio of clothing to food. Equation (3.6) shows marginal rates of substitution of all consumers equal the same price ratio. Therefore PC satisfies necessary conditions for product mix efficiency in (3.3).  First Welfare Theorem: Implications A complete set of competitive markets produces Pareto efficiency (on UPF) Government resource allocation role would be limited to establishing markets Three limitations 1. Market failures / second best 2. Static nature of theorem – human capital and technology are given. 3. First theorem does not deal with equity  Second Welfare Theorem Any Pareto-efficient allocation can be achieved by PC markets if society starts with the appropriate distribution of resources or if resources can be redistributed with cost. A PC economy can then achieve both efficient and equitable outcome. Given an appropriate initial distribution of resources or lump sum transfers of incomes, a competitive economy can achieve any position on UPF (Figure 3.7). Implication – decentralised markets combined with lump sum transfers can achieve any desired distribution of income. But individualised lump sum transfers (a tax or a grant) are not possible!  Conclusions Markets are efficient because of prices, competition and incentives Three conditions for overall economic efficiency in use of resources are production, consumption and product-mix efficiency Conditions require that prices of all factors of production and all goods should = their marginal cost This is achieved by perfectly competitive market The analysis in this chapter is a static (one-period) analysis. It can be extended to show efficient inter-temporal allocation of resources – Chapter 5.  Conclusions (cont.) However, perfect competition is not an accurate description of any economy Market failures create a potential role for government Also markets almost always result in inequitable outcomes so there is an efficiency / equity trade-off There is a potential role for government (if it can do better than markets)