Chapter 12
Economic Efficiency and
Public Policy

Productive Efficiency
-in order for production to be efficient output must be produced at the lowest possible cost
-i.e. the lowest possible opportunity cost to the economy Firm Level
-the firm must be cost minimizing, i.e. operating on its LRAC curve
-if not, it is obviously not producing at minimum cost
Industry Level
-firms in the industry must be operating where
MC is equalized across firms
-if not, transferring production from the high to the low cost firm reduces total cost of the output -if all firms and all industries satisfy these conditions we are producing output at the lowest possible cost to the economy

Productive Efficiency and the PPB
-all points on the PPB satisfy productive efficiency y

slope of PPB = -(MCx/MCy)
(opp cost at A)

A

x

-points inside the PPB imply that at least one of the goods is produced in an inefficient way
-firms not cost minimizing and/or not equalized MC across firms in the industry

Allocative Efficiency
-requires that good are produced such that the price equals marginal cost
-price measures the willingness-to-pay or benefit to consumers at the margin
-marginal cost measures the opp cost of the resources used in production at the margin y -(Px/Py) = -(MCx/MCy)

E

x

-so in the markets for x and y
$

$

S

S

D x* x

D y* y

Market Structures and Efficiency
Perfect Competition is both productively and allocatively efficient
Monopoly may be productively efficient, but is not allocatively efficient because pm > MC
Imperfect Competition market structures may be productively efficient but to the extent that market power allows p > MC they are not allocatively efficient (not as clear for monopolistic competition because of product selection issue)

Total Surplus Approach
-for judging allocative efficiency
Consumer Surplus
-consumer surplus on a given unit is the WTP for the unit (height of D) less what is actually paid
-total consumer surplus is equal to the total WTP less what is actually paid on all the units that are sold in the market
Producer Surplus
-producer surplus on a given unit is what is received for the unit less the smallest amount the firm would accept to produce the unit
-willingness-to-accept (WTA) for a given unit is the MC of producing that unit (height of S)
-total producer surplus is equal to the total amount received by firms less the WTA on all the units that are sold in the market
Total Surplus
-sum of consumer and producer surplus

-mathematically we can write out total surplus as
(where Q units are sold in the market)
TS(Q) = CS(Q) + PS(Q)
= Total WTP(Q) – Total Spent on Q
+ Total Received for Q – Total WTA(Q)
-but in a market the total amount spent by consumers equals the total amount received by firms so
TS(Q) = Total WTP(Q) – Total WTA(Q)
-i.e. the area below D and above S
-a social planner interested in maximizing total surplus would require production where the marginal total surplus would be equal to zero
∆TS(Q*) = WTP(Q*) – WTA(Q*) = 0
WTP(Q*) = WTA(Q*)
-that is, efficiency occurs where the marginal benefit to consumer equals the marginal cost of production -output levels below or above Q* imply DWL in the market

$

S(WTA=MC)

D(WTP)
Q*
Q*

Q

WTP(Q*) = MC(Q*)
-total surplus is maximized
QL < Q* WTP(QL) > MC(QL)
-also true for all units between QL and Q*
-DWL in the market
QH > Q* WTP(QH) < MC(QH)
-also true for all units between Q* and QH
-DWL in the market

Perfect Competition
-or supply and demand equilibrium
-equilibrium occurs at price p* where QS = QD
-allocative efficiency

$

S(WTA=MC)

p*
D(WT P)
Q*

Q

CS is the area below demand and above price
PS is the area below price and above supply

Monopoly
-the simple or single-price monopolist
-equilibrium occurs where MR(Qm) = MC(Qm)
-allocatively inefficient

$
MC
pm