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Chapter 4

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Karen Huff

EC238 Chapter 4 – Economic Efficiency and Markets Week 3 Economic Efficiency -The central idea of economic efficiency is that there should be a balance between the marginal benefits and marginal costs of production -Efficiency must also have a reference point -When we refer to marginal costs we must include all the costs of producing the particular item in question, no matter to whom them accrue and whether or not these costs have a market-determined price -Social efficiency requires that all market and non-market values be incorporated into the marginal benefits and marginal costs of production. If this is the case, social efficiency is obtained when marginal benefits equal marginal costs of production -Equating marginal willingness to pay and the aggregate marginal cost curve yields the socially efficient equilibrium -When a rate of output is at the socially efficient level, the net social value, defined at total willingness to pay minus total costs, is as large as possible -It is also called net social value, or net benefits, or the social surplus -Efficiency in our models is static efficiency, that is, it deals with markets and actions at a point in time -Dynamic efficiency looks at the allocation of resources over time Efficiency and Equity -Production is at an efficient level when marginal benefits equal marginal production costs, that is, when net benefits are maximized, no matter to whom those net benefits accrue -Pareto optimality refers to an equilibrium for which a stronger statement about the well-being of individuals can be made -A Pareto optimum is an efficient equilibrium -Equity is tied closely to the distribution of wealth in a society Markets -They key question is whether a market system gives us results that are socially efficient -A market system will normally give us better economic results, overall, than any other system -A market is an institution where buyers and sellers of goods or services or factors of production carry out mutually agreed-upon exchanges -The ‘rules’ and norms under which markets operate reflect society’s values, ethics, regulations, laws and customs Markets and Social Efficiency -Market failures cause the divergence -Market failures can affect both the supply and demand sides of the market -On the supply side, market failures can drive a wedge between normal market supply curves and true or social marginal cost curves -On the demand side, market failures can create a divergence between market demands and social marginal willingness to pay -Market failures cause a divergence between market and social values and can prevent a decentralized competitive market from reaching the socially efficient equilibrium External Costs -Private costs – the costs that show up in the firm’s profit-and-loss statement -Any firm that has the objective of maximizing its profits will try to keep its production costs as low as possible -Firms will try to find ways of reducing costs when the relative prices of inputs change -In many production operations there is another type of cost that represents a true cost to society but EC238 Chapter 4 – Economic Efficiency and Markets Week 3 does not show up in the firm’s profit-and-loss statement – external or social costs -One of the major types of external cost is the cost inflicted on people through environmental degradation Social cost = Private costs + External (environmental) costs -Ex. Developers build on land without taking into account the degradation of the visual environment of local inhabitants -The simplest case is when there are just two parties involved – one polluter and one party suffering damages (the pollutee) -Ex. An upstream pulp mill and a downstream firm that uses the river water in its production operations Open-Access Resources -A resource or facility that is open to uncontrolled access by individuals who find it profitable or useful in some way to use the resource -Ex. An ocean fish
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