ECONOMIC EFFICIENCYManagerial Economics

Jack Wu

ECONOMIC EFFICIENCY

ECON EFFICIENCY: CONDITIONS

for all users, same marginal benefit for all suppliers, same marginal cost marginal benefit = marginal cost

EQUAL MARGINAL BENEFIT

if not equal provide more to user with higher marginal

benefit take away from user with lower marginal

benefit

EQUAL MARGINAL COST

if not equal supplier with lower marginal cost should

produce more supplier with higher marginal cost should

produce less

MARGINAL BENEFIT/COST

if marginal benefit > marginal cost, produce more of the item

if marginal benefit > marginal cost, produce less of the item

ECONOMIC EFFICIENCY V.S. TECHNICAL EFFICIENCY

Contrast economic efficiency vis-à-vis technical efficiency

Technical efficiency producing at lowest possible cost doesn’t consider how much benefit the item

provides

ADAM SMITH’S INVISIBLE HAND: PRICE

Competitive market achieves three sufficient condition for economic efficiency:

buyers and sellers in a market system act independently and selfishly, yet the overall outcome is efficient

i) users buy until marginal benefit equals price; ii) producers supply until marginal cost equals prices; iii) users and producers face same price.

INVISIBLE HANDOutcome of price

competition in market Marginal benefit =

price Marginal cost = price Single price in market

EXAMPLE OF INVISIBLE HAND Major policy issue: how to allocate licenses for

3G wireless telecommunications; “beauty contest” -- France auction – Germany, UK, US

pioneer: in early 1990s, US Federal Communications Commission showed that spectrum licenses were worth billions;

created pressure on other governments to allocate by auction and not favoritism.

Auction ensures that item goes to user with highest marginal benefit.

INVISIBLE HAND

Market system (price system): Economic system in which resources are allocated through the independent decisions of buyers and sellers, guided by freely moving prices.

Successes of market system West/East Germany North/South Korea China after Deng Xiaoping’s reforms

DE-CENTRALIZATION

create internal market if there is a competitive market for an item,

set transfer price equal to market price consuming units should be allowed to

outsource

Note: Transfer price: price charged for the sale of

an item within an organization; Outsourcing: purchase of services or supplies

from external sources

DECENTRALIZATION

Within organization For all users, marginal benefit = transfer price For all producers, marginal cost = transfer price Marginal benefit = transfer price = marginal cost

UCLA ANDERSON SCHOOL, 1989

Half an invisible hand is worse than none priced photocopying paper free bond paper

PRICE CEILING

Upper limit that sellers can charge and buyers can pay rent control regulated price for electricity

0

1100

290 300 310

supply

demand

b

equilibriumexcess demand

Quantity (Thousand units a month)

Pri

ce (

$ p

er

month

)

RENT CONTROL: EQUILIBRIUM

1000 900

0

1100

290 300 310

supply

demand

b

Quantity (Thousand units a month)

Pri

ce (

$ p

er

month

)

RENT CONTROL: SURPLUSES

1000 900

d

g

e

buyer surplus gain = cfeg buyer surplus loss = dgbseller surplus loss = cfeg + geb

c

f

RENT CONTROL: LOSSES

deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur

price elasticities of demand and supply _demand more inelastic --> larger loss _ supply more elastic --> larger loss

PRICE FLOOR

Lower limit that sellers can charge and buyers can pay minimum wage agricultural price supports

0

4.20

8 10 11

supply

demand

a

b

c

equilibrium

excess supply

Quantity (Billion worker-hours a week)

Wage (

$ p

er

hour)

MINIMUM WAGE: EQUILIBRIUM

4.00

0

4.20

8 10 11

supply

demand

a

b

c

Quantity (Billion worker-hours a week)

Wage (

$ p

er

hour)

MINIMUM WAGE: SURPLUSES

4.00

f

d

e

g

seller surplus gain = fdgeseller surplus loss = ghb buyer surplus loss = fdge + egb

h

MINIMUM WAGE: LOSSES

deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur

price elasticities of demand and supply _supply more inelastic --> larger loss _demand more elastic --> larger loss

TAX: COMMODITY TAX

“the only two sure things in life are death and taxes” buyer’s price - tax = seller’s price payment vis-à-vis incidence

US: airlines pay tax Asia: passengers pay

0

800

900

e

Quantity (Thousand tickets a year)

Pri

ce (

$ p

er

tick

et)

supply

demand

$10

TAX: EQUILIBRIUM

b

h

804

794

920

0

800

900

e

Quantity (Thousand tickets a year)

Pri

ce (

$ p

er

tick

et)

supply

demand

$10

TAX: SURPLUSES

b

h

804

794

920

f

d

j

buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg

g

INCIDENCE

incidence and deadweight loss depend on price elasticities of demand and supply

ideal tax (no deadweight loss): inelastic demand/supply

who pays the tax not relevant

RETAILING: HOW SHOULD MANUFACTURER CUT PRICE?

Wholesale price cut: Will retailers pass on the price cut?

Coupons: Will this provide consumers with more effective price cut?

INCIDENCE: REDUCING RETAIL PRICES