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Chapter 12

Economics 101: Chapter 12

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University of British Columbia
ECON 101
Robert Gateman

Economics 101: Principles of Microeconomics Chapter 12 12.1 Productive and Allocative Efficiency  Efficiency does require that all factors of production are fully employed o Even when resources are fully employed, there may be inefficiencies 1. A firm is not using the least-cost method of production 2. If the marginal cost of production is not the same for ever firm in the industry (industry inefficiency) 3. Too much of one product and not enough of another product is being produced Productive Efficiency:  Two aspects, one concerning production within each firm, and another, among all firms in an industry  Firm productive efficiency: the firm produces any given level of output at the lowest possible cost o In the short run the firm uses enough of the variable factor to produce the desired level of output o In the long run more than one method of production is available  Profit maximizing firm will always try to be productively efficient no matter what industry  Industry productive efficiency: the industry's output is evenly distributed among firms so the total cost in the industry is minimized o If the industry is productively inefficient, it is possible to reduce cost by reallocating production o Requires that the marginal cost of production be the same for each firm Productive Efficiency and the Production Possibilities Boundary:  Firms that are productively efficient are minimizing costs, no other way to increase production  An industry producing inside the PPC is productively inefficient o Could produce more of one good, without producing less of one good o Firms are not minimizing costs, or production is not equalized across firms  If firms and industries are productively efficient the economy will be on the PPC, not inside Allocative Efficiency:  The quantities of the various products to be produced  Pareto efficient: when the combination of goods is allocatively efficient  The economy is allocatively efficient when, for each good produced, its marginal cost of production is equal to price  Market price is equal to the consumers marginal value of a good  Condition for allocative efficiency to be that, for each good produced, marginal cost = marginal value o If marginal cost exceeds marginal value, too much of that good is being produced o If marginal cost is less than marginal value, not enough of that good is being produced Economics 101: Principles of Microeconomics Allocative Efficiency and the Production Possibilities Boundary:  Relative price: price of one product, relative to another product  Allocative efficiency will be achieved when in each market the marginal cost of producing the good is equal to the marginal value of consuming the good Efficient Market Structures:  Marginal cost should be equal to the price in each industry Perfect Competition:  No one firm could reduce its cost by altering its own production o Every firm in perfect competition is therefore productively efficient o Marginal cost will be the same for all firms in the industry  In perfectly competitive industries, the industry is as a whole productively efficient o Perfectly competitive firms maximize profits at an output level where MC = market price o Price is equal to the marginal cost in each industry  If an economy was made up of all perfectly competitive industries it would be productively efficient Monopoly:  Monopolists have an incentive to be productively efficient o Profits will be maximized when they adopt the lowest cost production method o Profit maximizing monopolists will operate on their LRAC curve and be productively efficient  Monopolists will choose a price that is greater than marginal cost  Monopoly is not allocatively efficient because its price always exceeds marginal cost Other Market Structures:  A firm that has market power has marginal revenue that is less than its price o When MR = MC, marginal cost will be less than price o This inequality implies allocative inefficiency  Oligopolies and monopolistic competition are allocatively inefficient o Produce more satisfactory results than monopolies  Monopolistic practices: output restriction by firms with complete monopoly power and anticompetitive behaviour among firms that are operating in oligopolistic industries Consumer and Producer Surplus:  Producer surplus: the difference between the actual price received and the lowest price the producer is willing to accept for a sale o To accept any amount less than the marginal cost would reduce the firm's profits  For each unit sold, producer surplus is the difference between price and marginal cost o Total producer surplus: difference between price and marginal cost divided by units sold o Total surplus is the area above the marginal cost curve and below the price line  Perfectly competitive industry supply curve is the horizontal sum of all firm's MC curve Economics 101: Principles of Microeconomics Allocative Efficiency of Perfect Competition Revisited:  Market allocative efficiency exists in a market if the total economic surplus is maximized  Allocative efficiency occurs when the sum of consumer and producer surplus is maximized  Occurs under perfect competition when the supply and demand curves intersect  At Q* there is maximized surplus, beyond Q* there is negative producer surplus o Marginal cost on units beyond Q* have marginal cost greater than price o Consumers surplus on units above Q* is also negative  Marginal value is less than price  The sum of producer and consumer surplus is maximized only at the perfectly competitive level output o Only level of output that is allocatively efficient Allocative Inefficiency of Monopoly Revisited:  Lower monopoly output must result in smaller total consumer/producer surplus  Equilibrium imposed by monopolists depends on the amount of power it has over the market o Output level below the competitive level, market price is higher than perfect competition  Consumer surplus is diminished, producer surplus is increased  When output is below the competitive level there is a net loss in total surplus o Amount of consumer surplus lost is more than the amount of producer surplus gained  Deadweight loss of monopoly: surplus lost measured by the difference in output between the competitive level and the output level of a monopolist  Conflict between monopolist interest and public interest creates ground for government intervention to restrict or monitor actions of a monopolist Allocative Efficiency and Market Failure:  Externalities: economic agents that impose costs on market transactions o Not directly involved in the market transaction o Raise the possibility that market outcomes will be allocatively inefficient  When production causes pollution, the quantity produces in a perfectly competitive industry will exceed the efficient amount  An important public policy is how government can increase allocative efficiency in the market 12.2 Economic Regulation to Promote Efficiency  Monopoly practices: non-competitive practices (monopoly, cartel, price fixing oligopolists)  Competition policy: encourage competitive behaviour, and discourage monopoly practices o Used to promote allocative efficiency by increasing competition in the marketplace  Public ownership or economic regulation of privately owned firms can be used as a substitute for competition Regulation of Natural Monopolies:  Natural monopoly: industry in which economies of scale are so dominant there is room for at most one firm to operate at the minimum efficient scal
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