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Canada (162,403)
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ECON 110 (199)
Chapter 12

Chapter 12 notes.docx

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ECON 110
Ian James Cromb

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Chapter 12: Economic Efficiency and Public Policy Productive and Allocative Efficiency  Efficiency requires that factors of production are fully employed o However, full employment is not enough to prevent the waste of resources  Even when resources are fully employed, they may be used inefficiently o Not using the least-cost method to produce outputs o If marginal cost of production is different for each firm - industry is inefficient o Too much of one prod and not enough of another - resources are inefficiently used Productive Efficiency  Productive efficiency has two aspects, one concerning production within each firm and one concerning the allocation of production among firms in the industry  Productive efficiency for the firm requires firm produce a level of output at lowest cost o SR, firm uses enough of the variable factor to produce the desired level of output o In the long run, more than one production method is available – firms must choose the least costly method  Firms are located on their LRAC curves  Productive efficiency for the industry requires that the industry‟s total output be allocated among its individual firms in such a way that the total cost in the industry is minimized o Requires that the marginal cost of production be the same for each firm o If an industry is productively inefficient, it is possible to reduce the industry‟s total cost of producing any given output by reallocating production among the firms Productive Efficiency and the Production Possibilities Boundary  If firms are productively efficient, they are minimizing their costs – they cannot make more output unless they use more resources – they are producing on their PPB  If an industry is productively efficient, the industry as a whole is producing as the lowest possible cost – this means that they are producing on their PPB  If they are not producing on their PPB, it means they are using resources inefficiently o This could occur because individual firms are not minimizing their costs or because, within an industry, marginal costs are not equal across the firms Allocative Efficiency  This is a situation in which the market price for each good is equal to that good‟s MC  If the level of output of some product is such that marginal cost t producers exceeds marginal value to consumers, too much is being produced o The cost to society of the last unit exceeds the benefits of consuming it Allocative Efficiency and the Production Possibilities Boundary  The vertical axis of the supply/demand graphs show the relative price of Y to X  It illustrates how the allocation of supplies changes as we move along the PPB  Allocative efficiency will be achieved in each market when marginal cost of producing the good is equal to the marginal value of consuming it Which Market Structures are Efficient?  We know that for productive efficiency, all firms must be minimizing their costs and marginal cost should be equal to price in each industry  For Allocative efficiency, marginal cost should be equal to price in each industry Perfect Competition  We saw that in the long-run, each firm produces at the lowest point on its LRAC curve o Therefore every firm is productively efficient  We also saw that each firm faces the same price of their product and they will equate marginal cost to that price – marginal cost will be the same for all firms o Therefore, the industry as a whole is productively efficient Monopoly  Monopolists have an incentive to be productively efficient because their profits will be maximized when they adopt the lowest-cost production method o Hence, they will operate on their LRAC curves and thus be productively efficient  Although they are productively efficient, they will choose a level of production that is too low to achieve Allocative efficiency - since they choose a price greater than marginal cost o Now price, or marginal value, exceeds the marginal cost of production Other Market Structures  The allocative inefficiency of monopoly extends to other imperfectly competitive market structures – whenever a firm has any market power, its marginal revenue will be less than its price therefore marginal cost will also be less than the price o Oligopolies and firms in monopolistic competition are allocatively inefficient  Oligopolies are, however, important in today‟s economies because in many industries the MES is simply too high to support a large number of competing firms  Monopolistic competition is important in the many manufactured-goods industries in which E.o.S. are not extreme but product differentiation is an imp. market characteristic Allocative Efficiency and Total Surplus  A different way of thinking of allocative efficiency is with producer & consumer surplus Consumer and Producer Surplus  Recall that consumer surplus is the difference between a p‟s price and the consumer‟s willingness to pay for that unit  Producer Surplus is an analogous concept to consumer surplus – it is the difference between the actual sale price of the good and the lowest price the y would have accepted  For a producer that sells many units, total producer surplus is the difference between price and marginal cost summed over all the area above MC and below the price line The Allocative Efficiency of Perfect Competition Revisited  Allocative efficiency occurs where the sum of consumer & producer surplus is max‟d  The allocatively efficient output occurs where quantity demanded = quantity supplied The Allocative Efficiency of Monopoly Revisited  The lower monopoly output results in a smaller total consumer and producer surplus  Since the monopolist chooses a lower output and charges a higher price, consumers have a diminished surplus, and the producer has an increased surplus  However, there is a net loss of total surplus in the industry, more surplus is lost by consumers than is gained by the producer – some is deadweight loss Allocative Efficiency and Market Failure  An important problem arises when market transactions – production & consumption – impose costs or confer benefits on economic agents who are not involved in transaction  Cases like these, called externalities because they involve economic effects that are external to the transaction, generally cause market outcomes to be allocatively inefficient o Generally, when the production of a good causes pollution, the quantity produced in a perfectly competitive industry will exceed the efficient amount  One of the most important issues in public policy is whether, and under what circumstances, gov‟t action can increase the allocative efficiency of market outcomes Economic Regulation to Promote Efficiency  Monopoly Practices are those practices which are non-competitive – such as monopolies, cartels, and price fixing agreements among oligopolies, whether explicit or tacit  The laws and other instruments that are used to encourage competitive behaviour and discourage monopoly practices make up competition policy  Federal, provincial, and municipal gov‟ts also employ economic regulations, which prescribe the rules under which firms can do business and ,sometimes, at a what price  Competition policy is used to promote allocative efficiency by increasing competition  Where competitive behaviour is not possible (like natural monopolies), public ownership or economic regulation of privately-owned firms can be used to substitute competition  Consumers can then be protected from high prices and restricted output The Regulation of Natural Monopolies  Natural Monopoly: An industry characterized by economies of scale being so large that only one firm can most efficiently supply the entire market demand  One response is for gov‟t to assume ownership of the firm – in Canada these are called Crown Corporations o The gov‟t appoints managers who are supposed to set prices in nation‟s interest  Another response is to allow private ownership and regulate the monopoly‟s behaviour  Whether one or the other is used, the industry‟s pricing policy is determined by the gov‟t o The industry is typically required to fol
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