# ECON 208 Chapter Notes - Chapter 12: Pareto Efficiency, Product Differentiation, Fixed Capital

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Published on 16 Apr 2013
School
McGill University
Department
Economics (Arts)
Course
ECON 208
1
Chapter 12 Economic Efficiency and Public Policy
12.1 Productive and Allocative Efficiency (TABLE p. 280)
Efficiency requires factors of production to be fully employed; however, there may still be waste of
resources since factors of production may be used inefficiently:
o If firms don’t use the least-cost method of producing their chosen outputs = firms inefficient (cost for a
single firm producing some level of output)
o If the MC of production isn’t the same for every firm in an industry = industry inefficient (total cost for
all the firms in an industry)
o If too much of one product and too little of another product are produced = economy’s resources used
inefficiently (level of output of one product compared with another)
Product Efficiency
Productive efficiency for the firm: when the firm chooses among all available production methods to
produce a given level of output at the lowest possible cost
SR only 1 variable factor firm uses enough of the variable factor to produce the desired level of output
LR more than one method of production available firms are locate on rather than above LRAC curve
Productive efficiency for the firm requires the firm to be producing its output at the lowest possible cost; if
not efficient producing at higher costs, reducing profits
Incentive of firms to produce efficiently regardless of market structure (monopoly, perfect competition,
oligopoly, or monopolistic competition)
Productive efficiency for the industry: when the industry is producing a given level of total output at the
lowest possible/minimum cost.
If industry is productively inefficient, it’s possible to reduce the industry’s total cost of producing any given
output by reallocating production among the industry’s firms
Productive efficiency for the industry requires that the marginal cost of production be the same for each
firm
Once MC equated btwn 2 firms, there are no further cost savings to be obtained by reallocating output =
productively efficient industry
Productive Efficiency and the PPB
At productive efficiency, the industry cant increase its output without using more resources
PPB shows the combinations of output of two products that are possible when the economy is using its
resources efficiently. At a point inside the PPB, inefficiency can produce more of one good without
producing less of the other due to individual firms not minimizing their costs or b/c within an industry,
MC are not equalized across the various firms.
If firms and industries are productively efficient, the economy will be on, rather than inside, the PPB
Allocative Efficiency
Allocative efficiency: a situation in which the market price (marginal value) for each good is equal to that
good’s MC; concerns the quantities of the various products to be produced Pareto efficient
The economy is allocatively efficient when, for each good produced, its MC of production = price
When consumers face the market price for some good, they adjust their consumption of the good until
their marginal value is just =price; market price reflects consumer’s marginal value
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If the level of output of some product is such that MC to produces exceeds marginal value to consumers,
too much of that product is being produced; b/c the cost to society of the last uni produced exceeds the
benefits of consuming it. BUT if MC is < marginal value, too little being produced, cost to society of
producing the next unit is <the benefits that would be gained from consuming it
Allocative Efficiency and the PPB (284)
Vertical axis when comparing two goods relative price of the good
Allocatively efficient when each markets MC of producing good= marginal value of consuming it
Which Market Structures are Efficient?
Productive efficiency all firms must be minimizing their costs and MC should be same for whole industry
Allocative efficiency MC should be equal to price in each industry
Perfect Competition
LR each firms produces at the lowest point on its LRAC curve no firm can reduce its costs by changing its
own production every firm is already productively efficient
All firms in industry face the same price of their product equate MC to that price MC same for all firms
industry has a whole is PE
Firms maximize their profits by choosing output where MC = market price in each industry - AE
Perfectly competitive industries are productively efficient. If an economy could be made up entirely of
perfectly competitive industries, the economy would be allocatively efficient
Modern economies are neither perfectly competitive nor allocatively efficient. Even economy of all
perfectly competitive industries, point on PPB that’s allocatively efficient depends on the economy’s
distribution of income
Monopoly
Have incentive to produce efficiently since profits maximized when they adopt the lowest-cost production
method operate on LRAC curve PE
It chooses output level that’s too low (price charged>MC) to achieve AE = marginal value (price)>MC
competition preference over monopoly
Monopoly is not allocatively efficient because the monopolist’s price always exceeds its MC
Other Market Structures
Imperfectly competitive markets, oligopoly and monopolistic competition (both of which still may produce
more satisfactory results that monopoly), are allocatively inefficient.
When firm has market power (-ve sloping D curve), marginal revenue <price. When MR=MC, like all profit-
maximizing firms do, MC<P = AiE
Oligopoly important b/c minimum efficient scale in many industries is too high to support large # of
competing firms.
Monopolistic competition important in many manufactured-goods industries where economies of scale are
less but product differentiation is important market characteristic
Oligopoly better than monopoly b/c competition among oligopolists encourages innovations that result in
new products and cost-reducing methods of producing old ones. Oligopoly may be the best of available
alternatives when MES is large. Challenge to public policy is to keep oligopolists competing and using their
competitive energies to improve products and to reduce costs rather than to restrict interfirm competition
and to erect entry barriers.
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## Document Summary

Efficiency requires factors of production to be fully employed; however, there may still be waste of resources since factors of production may be used inefficiently: If firms don"t use the least-cost method of producing their chosen outputs = firms inefficient (cost for a single firm producing some level of output) If the mc of production isn"t the same for every firm in an industry = industry inefficient (total cost for all the firms in an industry) If too much of one product and too little of another product are produced = economy"s resources used inefficiently (level of output of one product compared with another) Productive efficiency for the firm: when the firm chooses among all available production methods to produce a given level of output at the lowest possible cost. Sr only 1 variable factor firm uses enough of the variable factor to produce the desired level of output.