Efficiency
Chapter 4
Main Issues
• What is economic efficiency?
• When are markets inefficient?
• When are governments inefficient?
• How much efficiency do we want?
Efficiency in Resource Allocation
Definition. An allocation of resources that satisfies wants as fully as
possible is called allocative efficiency.
Definition. An efficient allocation of resources in the short run is called
static allocative efficiency.
Definition. An efficient allocation of resources in the long run is called
dynamic allocative efficiency.
We concentrate on the static efficiency and the problems with
achieving it by the private market and the government.
Demand as Marginal Benefits
Definition. A curve that depicts the benefits from each additional,
or marginal, unit is called marginal benefit (demand) curve.
• Height of the demand curve indicates the maximum buyers
are willing to pay for this particular apartment
• The demand curve is also a marginal benefit curve
Supply as Marginal Costs
Definition. A curve that depicts the costs of providing each
additional, or marginal, unit is called marginal cost (supply)
curve.
• Height of the supply curve for apartments indicates the
minimum monthly rent the suppliers (landlords) must receive
for a particular apartment
• The supply curve for apartments is also a marginal cost
curve.
Total Benefits
• The area under the demand curve
measures total benefits to buyers
• This area is equal to the sum of the
individual marginal benefits over all
apartments
• The marginal benefit of the marginal
unit at equilibrium is the lowest and is
exactly equal to the market price
Total Costs
• The area under the supply curve
measures total costs to suppliers
• This area is equal to the sum of the
individual marginal costs over all
apartments
• The marginal cost of the marginal unit
at equilibrium is the highest and is
exactly equal to the market price
Total Net Benefits and Costs
Definition. Total benefit minus total cost is called total net
benefit.
• Total net benefit is equal to the area between demand
and supply for some level of output
• Total net benefit for the marginal unit at equilibrium
is equal to zero
• Producing a marginal unit for which marginal benefit
exceeds marginal cost increases total net benefit.
• Producing all units below the equilibrium level
increase total net benefit
• Producing one more unit beyond the equilibrium
level decreases total net benefit
Maximum Total Net Benefit
• Total net benefit is maximized when
the equilibrium number of units is
traded in the market
• Total net benefit at its maximum is
equal to the area of the triangle
formed by Demand, Supply and the
vertical axis
• Competitive markets will automatically
attain allocative efficiency!
Market Failures: Private Sector
Definition. A situation in which a market allocation of resources is
inefficient is called market failure.
• Monopoly
• External benefits and costs
• Public goods
• Imperfect insurance markets
Monopoly
Definition. A situation in which only
one seller exists in a particular
market is called a monopoly.
Definition. The price per unit times
the quantity sold is called total
revenue.
Note. Total revenue is not equal to
total benefit: it is the area of a
rectangle, not the area below the
demand curve for the same output.
Total Revenue: Practice
Compute total revenue for
100, 200, and 300 units.
Profits
Definition. Total revenue minus
total cost for a specific number of
output units is called profits.
• Profits are maximized at the
level of 300 thousand units
(check)
• Monopolist will rent 300
thousand units, which is less
than efficient
• Monopolist will charge $600,
which is higher than efficient
Monopolistic Inefficiency
• At a monopolistic profit-maximizing
output level, total net benefit is NOT
maximized
• However, a monopolist will not produce
anything beyond 300 since that will
decrease his profits
Definition. Maximum total net benefit
minus actual total net benefit is called
allocative efficiency loss (deadweight
loss)
Monopolistic Deadweight Loss
• Graphically, monopolistic
deadweight loss is given by the
area of a rectangle mME
• Pure monopoly cases are rare, but
in many industries one firm
dominates the market (e.g.
Microsoft)
• Public utilities supplying electricity
and natural gas are pure
monopolies by government decree
• Total deadweight losses due to
monopoly in the US about 2% GDP,
or $240 billion in a $12 trillion
economy
External Benefits
Definition. A benefit created by a market that is realized by individuals
other than the buyers and sellers is called an external benefit.
Example. Some people commute from far away just to view the
apartments. Commuting costs are $100 per apartment, which is an
estimate of the marginal external benefit to each apartment above the
benefits already received by the tenants.
Definition. External benefit on the additional, or marginal, unit is called a
marginal external benefit on that unit.
Marginal Social Benefit
Definition. The sum of the
marginal benefit and the marginal
external benefit on a particular
unit is called marginal social
benefit on that unit.
The relevant demand curve now
is marginal social benefit
curve: the sum of the marginal
benefit curve PLUS the marginal
external benefit
Socially Optimal Output
• Socially optimal output is greater
than the privately optimal output
• Providing renters with a subsidy of
$100 per apartment will move
equilibrium quantity to the socially
efficient level
• However: cost of subsidy is $50 000
000 for the net benefits of $2 500 000
• No problem from the point of view of
allocative efficiency! $50 mn is just a
redistribution
External Benefits: Other Examples
• Primary and secondary education
• Public health
• Vaccination
• Gardening
External Costs
Definition. A cost created by a market
that is paid by individuals other than the
buyers and sellers is called an external
cost.
Definition. The external cost on the
marginal unit is called marginal
external cost.
Definition. The sum of the marginal cost
and the marginal external cost is called
marginal social cost.
Example. Each apartment burns coal to
produce heat.
External Costs: Socially Optimal Output
• Socially optimal output is now
lower than the one given by
the private market
• Government could levy a tax
per one apartment equal to the
marginal external cost
Public Goods
Definition. A good that provides benefits from which no one can be excluded is
called a public good.
Example. National security, police force, public parks, public libraries, public roads
Free riding problem occurs because nobody wants to pay for the public good
provision knowing the government would provide it anyway.
Public research: must be accessible to anyone, but private firms lack incentives to
produce it unless property rights are protected.
Public goods are produced inefficiently by the private markets.
Imperfect Insurance Markets
• Markets insure against the risks: for instance, you pay $50 every
month in exchange for hospital expense payment if you break your
leg.
• Moral hazard: the risk that insurance for an event will increase the
probability of an event occurring
• Adverse selection: self-selection that results in a pool of insured
individuals dominated by high-risk, high-cost individuals
Adverse selection and moral hazard increase insurance costs so
too few people are covered by insurance
Adverse Selection and Student Loans
• Some students will not repay their loans
• Collateral is impossible in case of a student loan
• Insurance companies will charge an inefficiently high interest rate,
which will result in the problem of adverse selection: the student
borrowers will be dominated by the students least likely to repay
the loan
• Government must serve as a guarantor on the student loans to
remove allocative inefficiency: a government guarantee then plays
the role of a collateral
Government Failure
Definition. Allocative inefficiency resulting from government activities.
• When markets fail, governments often step in in order to correct
for the market failure
• Ironically, though, governments themselves may become a source
of resources misallocation
• In this case we are talking about government failure
Rent Controls
• Rent control is an upper limit, or
a price ceiling, on the rent
• Rent controls keep the rental
rate below the equilibrium level
• At rent control Pc only Qc
apartments are rented, and
marginal benefit at M exceeds
marginal cost at C
• The area MEC is not received by
the society
Agricultural Price Supports
• Governments often maintain price floors for the agricultural
products, i.e. they make it illegal to sell agricultural goods below
the price floor level
• Farmers produce more than market-clearing quantities
• Allocative efficiency is lower with price floors
Agricultural Price Supports
• With price supports, farmers
produce Qs > Qe, the equilibrium
amount
• Farmers overproduce compared
to the efficient level
• The society loses area ESM
Subsidies to Medical Care
• Medicare: government support program for the elderly (85%)
• Medicaid: government support program for the poor (100%)
• The marginal cost as perceived by the patient is very low
• Medical services are overconsumed
Government-Sponsored Medical Care
• Line Pc represents the
marginal costs of medical care
as perceived by the patient
• Patients will claim Qc in
medical services
• Area ESM is lost to the
society
Minimum Wage
• US: minimum of $7.25 / hour
• At minimum wage Wm, only Nm
workers are hired
• Ne-Nm workers are likely to be fired
after the minimum wage is instituted
• Society does not receive area MEm
Taxes
• General sales tax: a percentage of
the price at which goods and
services are sold, 4% to 11% in the
US
• Sellers’ supply price increases by
the amount of the tax
• After-tax supply curve is S+T, where
T increases with the price
• Consumers’ price: Pb
• Producers’ price: Ps
Taxes
• Total tax revenue: yellow
rectangle
• Tax lowers quantity from Qp to
Qa
• Inefficiently small amount is sold
after tax
• Area BPS is not realized, called
excess burden of the tax, or
deadweight loss from taxation
Taxes and Deadweight Losses
• All taxes generate deadweight losses
• Jorgenson and Yun: 30 cents in deadweight loss for each $1
collected in taxes
Deductible Interest Costs
• Suppose the individual income tax rate is 25%
With an annual income of $75000, you must pay 25% x $75000 = $18750 in
taxes
• Because you are paying $10000 in mortgage interest, this amount
is deductible from your income tax base
• As a result, you are paying a tax on $75000 - $10000 = $65000,
which means instead of $18750 you are paying $16250
• Alternatively, your income tax payment of $18750 decreases by
$2500 = $10000 x 25%
Tax Subsidies for Home Ownership
• With $10000 deductible from the
income tax base, the marginal cost
of owning a home decreases from
MC to MCt
• Demand for homes increases to Ht
• Society loses EST in the form of lost
benefits
• Allocative inefficiency is in place
again
T1
Efficiency versus Equity
• Reducing excess burden of taxation
Eliminate tax exclusions, deductions and credits
Reduce highest marginal tax rate
Tax burden shifted toward low-income earners (equity problem)
Eliminate child-care tax credit
Again low-income earners would suffer the most
• Improving tax-related efficiency often implies equity problems
Weighing Poor versus Rich
• Suppose $1 is worth twice as much to the poor compared to
the rich person
• Changes in tax burden due to efficiency-improving measures
could be evaluated using these weights
• These weights can be applied to both benefits and costs
• The problem: how do we discover the weights?
Efficiency versus Innovation
• Competitive markets allocate resources efficiently
• Monopolies underproduce compared to the efficient level
• Government regulation often targets monopolies for that reason
• Knowledge-dependent industries
 Computer hardware and software, pharmaceuticals
 R&D costs are required for start-up and production
 To justify these costs, P>MC!
There is a tradeoff between efficiency and innovation!
Efficiency and Equity:
Not Always a Tradeoff
• Agricultural price supports
Large wealthy farmers benefit the most
Removing price support for agriculture unlikely to create significant equity
problems
• Minimum wage
Most gainers and losers are low-income earners
Eliminating minimum wage inefficiency will not affect equity issues
significantly
• Medicare and Medicaid
Provide vouchers rather than medical costs coverage
Efficiency Offsets to Inefficiency
• Smoking creates external costs, e.g. secondhand smoke
• Without excise (per-unit) taxes on cigarettes, there would be too much
smoking
• Cigarette taxes
 Create allocative inefficiency in the market for cigarettes
 Diminish efficiency losses due to secondhand smoke
 Excise tax works as a corrective measure
• Gasoline taxes
 Allocative inefficiency in the gasoline market
 Diminished efficiency losses due to less pollution