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Lecture

# Pareto Efficient Allocation .doc

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School
McGill University
Department
Management
Course
MGMT 722
Professor
Greg Matlashewski
Semester
Fall

Description
Definition: Productive Efficiency is optimal output from given resources or minimal cost for a given output. We have already seen the concept of productive efficiency in our discussion of Production Possibilities. Definition: Allocative Efficiency is the optimal allocation of resources Allocative Efficiency implies not only the optimal output from given resources (Productive Efficiency) but also the optimal output desired by society. Allocative Efficiency is the output that maximizes the net social benefit of society, i.e., maximizes the difference between total benefit and total cost to society. Maximum Net Social Benefit => P = MC Maximum Net Social Benefit implies the output where the benefit to society of an additional unit of output equals the cost to society of an additional unit of output. It is the output where Marginal Benefit equals Marginal Cost (MB = MC). Since we measure the marginal benefit by willingness to pay, the market Demand for a commodity measures the Marginal Benefit of a commodity. We can therefore say that the allocation of resources is optimal at the output where Price equals Marginal Cost (P = MC). Pareto Efficient Allocation (Pareto Optimality) => P = MC Definition: Pareto Optimality is the allocation of resources where no person is worse off from trading (allocation) and any addition trade (allocation) will make some person worse off. The Pareto Optimality condition is also satisfied by the output where P = MC. Efficiency Loss (aka Welfare Loss or Deadweight Loss) We measure the efficiency loss of an output Qo by the difference between Price and Marginal Cost (Supply) between the output Qo and optimal output at P = MC. It is the - 1 - difference between Demand and Marginal Cost (Supply) between given output and optimal output. We will see that this is equivalent to the net loss of consumers’ surplus and producers’ surplus at the output relative to optimal output. Competition => Optimum Allocation (Allocation Efficiency, 0 Efficiency Loss) Since firms and households are price-takers in a competitive market, competitive market equilibrium implies that P = MC, which implies that competitive markets give the optimal allocation of resources. Monopoly Regulation Monopolies create efficiency loss by reducing output below competitive output and increasing price above competitive price. Governments cannot regulate monopolies through taxation, though, since per unit taxes decrease monopoly output by shifting up Marginal Cost and fixed taxes do not change monopoly output since marginal cost doesn’t change. Governments attempt to eliminate the efficiency loss caused by a monopoly by requiring that a ‘normal’ monopoly produce the output where Price equals Marginal Cost (P = MC) and that a natural monopoly produce the output where Price equals Average Cost. 1. Marginal Cost Pricing The principal concern of government regulation of monopoly is to eliminate efficiency loss not to eliminate monopoly profits. Marginal Cost Pricing (P = MC) as the requirement that the monopoly produce the output where Price equals Marginal Cost is therefore the preferred option for government regulation. The upper diagram below shows the efficiency loss due to a normal monopoly above and the lower diagram below shows the output, price, and economic profit and loss of the monopoly given marginal cost pricing. You will note that marginal cost pricing results in 0 efficiency loss but still leaves the monopoly with an economic profit. The monopoly - 2 - can still exist with greater than normal profits while society achieves optimal allocation of resources. (This is only the short-run optimum allocation since firms would enter the competitive market in the long-run so that 0 efficiency loss would occur where price equals marginal cost at minimum average cost) 2 P = 80 - 2Q; TC = Q /2+5Q+200 => AC = Q/2 + 5 + 200/Q and MC = Q + 5 P, Cost/unit, MR 80 60 Pm MC 40 Efficiency Loss AC 20 Demand MR 0 0 10 20 30 40 50Q Qm P = 80 - 2Q; TC = Q /2+5Q+200 => AC = Q/2 + 5 + 200/Q and MC = Q + 5 80 P, Cost/unit, MR 60 MC 40 PMC AC Economic Profit 20 Demand MR 0 0 10 20 Q MC 30 40 50Q 2. Average Cost Pricing Marginal Cost pricing is unattainable for a Natural Monopoly because there is an economic loss at the output where price equals marginal cost. Average Cost Pricing is the regulatory - 3 - option in this case since the output where price equals average cost is the maximum output that would not entail economic loss for the monopoly. The monopoly makes 0 economic profit but there is an efficiency loss at this output. The upper diagram below shows the efficiency loss of a natural monopoly at monopoly equilibrium and the lower diagram below shows the price (P*), output (Q*), and efficiency loss at average cost pricing. Natural Monopoly
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