Unit 7 Efficiency and Market Failure

Types of Efficiency

• Productive

• Allocative

Productive Efficiency

Occurs when firm produces goods at the lowest possible cost, using resources efficiently.

• When MC = LRAC at the minimum point of LRAC

Allocative Efficiency

Means producing the right amount of goods — where P = MC — so that society’s wants are met optimally

• Total Welfare is Maximised

How is Equil. of Perfect Comp Productive and Allocative Efficient?

• In SR and LR

• Productive, because firm produces at lowest possible cost at lowest point on LRAC

• Allocative, because buyers is paying firm what it costs to produce the product

  • So consumers' demand is satisfied, leading to maximum total welfare.

Pareto Improvement

• Situation when an allocation of resources makes one person better off without making the other person worse off

Pareto Efficiency

When resources are allocated in a way where no one can be made better off without making someone else worse off

Interpreting indifference curves in Edgeworth Box

• Person x’s utility Increases to top right

• Person y’s utility increases to bottom left

What represent a Pareto Improvement

• Any bundle that is on x and not beyond y

• Any bundle that is within areas of indifference curves

so A, 2, and 3

Pareto Optimal Allocation fo Resources

Private Efficiency

• MPB = MPC

Marginal Private Benefit

• Max price consumer is willing to pay for Good

Marginal Private Cost

• Cost is the cost a producer or consumer directly pays for making or using one more unit of a good

Social Efficiency

MSB = MSC

Marginal Social benefit

Marginal Social Cost

Private and Social Effiecncy Under Perfect Comp

MSB = MPB = P = MPC = MSC

Externalities

• The impact of a transaction that indirectly affects third parties.

Types of Externalities

Positive: Marginal Social Benefit (MSB)

• Transaction indirectly benefits third party (e.g. G in education)

Negative: Marginal Social Cost (MSC)

• Transaction indirectly harms third party (e.g. pollution, deforestation).

Types of Goods

• Rival

• Non-rival

• Excludable

• Non-excludable

Rival vs Rival Goods

Rival

• One person consuming a good reduces availability for others.

Non-Rival

• One person’s consumption does not limit another person’s consumption of good

Excludable vs Non-excludable

Excludable

• Non-payers are prevented from using

Non-excludable

• Non-payers cannot be easily excluded

Public Goods vs Private Goods vs Common Resources

Private Goods: Rival and Excludable

• food clothing, car, beer

Public Goods: Non-excludable and non-rival

• air, road, ocean

Common Goods: Rival and Non-excludable

• fish, timber, coal

Free Rider Problem

• Why public goods are underprovided by gov

When people benefit from a good or service without paying for it, leading to underproduction or no production of that good.

e.g. Fireworks display can be seen from anywhere

Perfect vs Imperfect Information

Perfect

• Consumers know price of both firms and are willing to shop at either

Imperfect

• Consumers do not know prices and finding information is costly, so they are willing to shop at either firm.

Unravelling Principle

How firms have incentives to provided information to uninformed consumers under conditions of imperfect information.

Asymmetric Information

When only one party has more info than the other.

• Usually when buyer has less information than sellers.

Asymmetric Goods when seller has more info

1. Search Goods

2. Experience Goods

3. Credence Goods

Search

• Quality assessable pre-purchase

Experience

• Quality assessable post purchase

Credence Goods

• Quality hard to assess even post purchase

Asymmetric goods when buyer has more info

• Loans

• Insurance