Figure
QX
to answer that question.
to answer that question.
I.A.6
Allocative or economic
efficiency includes the values or relative prices of outputs and inputs. The
benefit or value of a choice is represented by the product of the price and
quantity of each good or output (value of output = PxQx +PyQy + . . . +PnQn).
The value of the inputs or cost is represented by the product of the prices and
quantities of the inputs (cost = PLL + PKK + …+ PiQi). Allocative efficiency is
229
11.2 Criteria to evaluate alternatives
attained when we maximize the value of the outputs relative to the value of
the inputs. The cost is minimized for a given output or output is maximized for
a given cost. The economically efficient solution must lie on the production
possibilities function.
Pareto efficiency is the condition where there are no alternatives that will
increase the welfare (utility) of one person without reducing the welfare
(utility) of any other person(s). Once an output combination on the production
possibility function is attained, that output combination is Pareto Optimal.
The output combination at point H is not Pareto Optimal.
The output combination at point H is not Pareto Optimal.
Irrespective of individual preferences a move from point
Q A
Irrespective of individual preferences a move from point
Y
B
H to output combinations at point B or D (or any where
H to output combinations at point B or D (or any where
C
in the area HDB represent “Pareto Improvements.”
in the area HDB represent “Pareto Improvements.”
Each alternative in the area HDB is “Pareto Superior” to
Each alternative in the area HDB is “Pareto Superior” to
the alternative represent by point H.
D
the alternative represent by point H.
If the current output combination were at point E, it
If the current output combination were at point E, it
H
would be Pareto Optimal even if it were not he highest
would be Pareto Optimal even if it were not he highest
valued output. Any increase in good Y (or X) would
E
valued output. Any increase in good Y (or X) would
require a decrease in good X (or Y). The individuals who
require a decrease in good X (or Y). The individuals who
prefer X (or Y) to Y (or X) would be “worse off” (their
prefer X (or Y) to Y (or X) would be “worse off” (their
utility or welfare is lower).
F
utility or welfare is lower).
If the output is currently at point H, the area HDB is
If the output is currently at point H, the area HDB is
Figure
QX
called “Pareto Safe.”
called “Pareto Safe.”
I.A.6
Pareto efficiency is a
restrictive criteria and tends to promote the status quo. Most choices involve
marginal benefits and marginal costs that change the welfare or utility of more
than one individual. The Pareto efficiency criterion fails to justify choices that
result in the highest valued use of resources (economic efficiency). To remedy
this problem the criterion of Pareto Potential is used. Pareto Potential
justifies the choice of an alternative so long as the “winners” (individuals
whose utility increased) can hypothetically compensate the “losers”
(individuals whose utility decreased) and still be better off. This is the
foundation of criteria such as Benefit/cost analysis, rate of return on
230
11.2 Criteria to evaluate alternatives
investment and internal rates of return. The problem with Pareto Potential is
that it introduces the question of equity. Consider the problem of breaching
dam is the Pacific Northwest. There are winners and losers. Environmentalists,
individuals who benefit from anadromous fish and agents who earn income
from tourists are some of the winners. Electricity generators and farmers are
examples of losers. Even if the marginal benefits of breaching the dam
exceeded the marginal costs, there is no mechanism to insure the winners
would compensate the losers. There is necessarily a judgment about the
morality of the dams and the imposition of costs and benefits of various
groups of individuals. This example also illustrates the issue that the status
quo tends to be supported by the Pareto Optimality criterion. Building the
dams imposed costs and conferred benefits on different groups of people just
as breaching the dams will. As societies and individuals change their
preferences, technology and environments change and alter the objectives
and optimal use of scarce resources. In an ideal world, informed individuals
engaged in voluntary exchanges will result in transfers of property rights that
are Pareto improvements and lead to economic efficiency.
(2)Equity is a judgment about the rightness or wrongness of the objective.
Earlier, deontological and consequentialist ethics were discussed. Any
objective can be ethical or unethical based on the type of ethical system used.
Remember that microeconomics relies primarily on a consequential ethic called
“Utilitarianism” and is directly related to the concept of Pareto Potential. If the
benefits exceed the costs of an action, the consequence is an increase in
utility. This does not mean that deontological ethics (based on duty) are not
necessary for a reasonably functioning society. It is important to consider the
morality of our objectives and the sacrifices that must be made to achieve
them.
231
11.2.1 Marginal Analysis
11.2.1 MARGINAL ANALYSIS
R
F
T he Marginalist Revolution in economics
during the last half of the 19th century provided
F’
economists with a useful tool to find maximums
and minimums given functional relationships
R’ between variables. Basically, this Marginalist
Revolution was the application of calculus to economic analysis. One of the
purposes of economics is to maximize of minimize a given variable by making
choices. Choices are always made at the margin. A saying attributed to some
anonymous Chinese philosopher is “The longest journey begins with the first
step.” This is used here to point out that every decision is a change from an
initial state. In production, the manager must understand that a change in an
input such as labor “causes” a change in output. A consumer must understand
that a change in quantity consumed alters the level of utility. A seller must
understand that a change in price alters the quantity sold and the total
revenue. Marginal analysis is the analysis of rates of changes in variables.
Every time the word “marginal” is used in economics it is related to a change
in a dependent variable “caused” by a change in an independent variable. The
rate of change can be interpreted as the slope of a line. The slope of a line is
often defined as “rise over run. ” The rise is usually the change in the
dependent variable while the run is the change in the independent variable.
For example, the cost of producing more of one good, given full employment,
requires a sacrifice of some other good. This was demonstrated in a
Production Possibilities model. The slope of the PPF is called the “Marginal Rate
of Transformation” (MRT). This is shown in Figure VI.1. The PPF function
shows all combinations of Yawls (Y) and Xebecs (X) that can be produced
given inputs and technology.
232
11.2.1 Marginal Analysis
At point B, an increase in X (∆ X=15, the run) requires a
sacrifice of 15 units of Y (∆ Y=-15) This tradeoff is called
)
A
50
A
B
45
the Marginal Rate of Transformation (MRT) and is
ls (Y
A
aw
illustrated by the line RR’. When the MRT (or slope) is
Y
C
30
A
calculated by subtracting values (∆ ), the marginal value is
the slope of an arc between the points.
D
19
A
When the slope is calculated by a derivative, the value of ∆ X
approaches 0, so the marginal value is represented by the
E
slope of a tangent. In this example, it the slope of FF’ at
A
200
35
38 40
point B.
Xebecs (X)
Figure VI.1
If the output were at X = 20, Y = 45 (shown as point B in Figure VI.1), an
increase in Xebecs would require a decrease in the output of Y. The increase in
X from 20 to 35 is 15 units of X. This is labeled as ∆X = 15 (35-20=15) and is
the “run.” The change in Y (∆Y) is -15 (30-45= -15) and is called the “rise.”
The line RR’ represents the change in Y (∆Y) caused by the change in X (∆X).
rise
ΔY
Slope of RR' =
=
, or the change in Y caused by a change in X
run
ΔX
The slope of RR’ is
-15 ( rise ) =−1
15 ( run )
Calculus lets the change in X approach 0. When the change in X
approaches 0, the change in Y is shown by the line FF’ which is tangent to the
PPF at point B. In principles of economics calculus is not normally required so
the term marginal is calculated by differences and is represented by the slope
of a straight line. When a function is nonlinear, the slope between two points
is the slope of an arc.
233
11.2.1 Marginal Analysis
It is crucial to remember that the marginal value (cost, benefit, etc) is the
value associated with a specific choice.
(1) marginal benefit (MB) is the change in total benefits associated with a
choice. For an individual MB might be MU for a firm it may be MR
(2) marginal cost (MC) is the change in total cost (or variable cost since
fixed costs don’t change) caused by a change in and activity, usually
production.
(3) marginal decision rule You should engage in any activity so long as the
MB > MC, the optimal level of activity is where MB = MC, when MC>MB you
should not undertake the activity. There is a variation of this rule called the
equimarginal rule.
The marginal decision rule can be illustrated by the decision to gather wild
blackberries (good X). The cost of travel to the blackberry patch is treated
here as a sunk (fixed) cost, we are already at the patch. How many berries
shall we pick? The answer depends on our analysis of the benefits and costs of
each unit of berries we pick. Generally, the marginal benefits of berries will
tend to decrease primarily because of diminishing marginal utility. The
marginal benefit (MB) of each unit of berries is shown in Figure VI.2. Typically
we will gather the berries that are easiest to pick first. These are the berries
MB and MC
MC
B
E
P= MB= MC
MB
C
R
0
73
Berries/ut
234
Figure VI.2
11.2.1 Marginal Analysis
that are approximately waist level and on the outside of the bushes. As we
pick more berries we have to reach further up or down and into the bushes
where there are thorns. The marginal cost (MC) of berries rises. The MC of
each unit of berries is also shown in Figure VI.2. The MB function decreases as
more berries are obtained. The area under the MB function up to the quantity
obtained represents the total benefits (TB). In Figure VI.2 when 73 units are
picked, TB is the area 0REB. The MC rises as berries become more difficult to
pick. MC represents the marginal cost of each unit. The total costs (TC) is the
area under the MC function. When 73 units of berries are picked, the TC will
be represented by the area 0REC (the area in blue). The first units of berries
are picked because the marginal benefit of each unit (MB) is greater than the
marginal cost (MC). There is a net benefit obtained from each unit. Seventy-
three units of berries are picked because the MB of the first 73 units is greater
than the MC of those units. The TB is 0REB: the TC is 0REC. The net benefit is
the area CEB (in yellow). Net benefits are maximized when MB = MC.
This rule has several applications.
•
Where MR = MC, profits are maximized
•
Where MB = P (cost), utility is maximized
This rule was first clearly stated by the French engineer/economist, Jules
Dupuit in the 1830’s.
235
11.2.2 Market Exchange and Efficiency
11.2.2 MARKET EXCHANGE AND EFFICIENCY
T he ideal market has two important characteristics:
•
Individuals voluntarily contract among themselves. There is no coercion and each
is informed of their preferences (objectives) and alternatives. They make informed
judgments about the outcomes of their choices.
•
The individuals exchange goods that are characterized by nonattenuated property
rights. Nonattenuated property rights are exclusive, enforceable and transferable. The
benefits and cost associated with the production or consumption of any good falls only
on the agents engaged in the contract or transaction.
Under these conditions, from a utilitarian perspective, no one would
rationally engage in a voluntary exchange if it made them worse off.
Therefore, any voluntary exchange must lead to Pareto superior results.
Individual agents know their preferences (objectives) and react to any
changes by altering their choices. The idealized market results in individuals
who constantly reappraise their objectives and alternatives and alter choices
to maximize their welfare. Since exchanges are perceived to be voluntary, no
individual would choose to make themselves worse off. Voluntary markets of
goods with nonattenuated property rights are consistent with the Utilitarian
Ethic and Pareto Efficiency.
236
11.2.3 Prices as Information
MB and MC
MC
B
E
P= MB= MC
MB
C
R
0
73
Berries/ut
Figure VI.2
11.2.3 PRICES AS INFORMATION
The function of the market is to coordinate the preferences and behavior of
the buyers and sellers. There are two important elements that are necessary if
markets are to perform this task of coordination. First, buyers and sellers must
have information. Prices, or more precisely relative prices perform this task.
Secondly, buyers and sellers must have an incentive to respond to the
information contained in prices.
Using Figure VI.2 again, the role of prices can be shown. The MB function
represents the buyers’ evaluations of their marginal benefits. As the quantity
of berries increases, the marginal value goes down, The MB function is
negatively sloped and resembles a demand function. It is not a demand
function because it does not include the ability to buy the goods. It only
measures the buyers’ evaluation of marginal benefits. Notice the MB of the
73rd unit to the buyers is P. Similarly, the MC function represents the
opportunity cost or producing each unit. The MC of producing the 73rd unit is
also P. For all unit of berries, up to and including, the 73rd unit, the MB is
greater than the MC. We could restate this: the marginal benefit from each of
237
11.2.3 Prices as Information
the first 73 units is greater than its opportunity cost. The value (MB) that
buyers have for each of the first 73 units is greater than the market price of P.
The sellers sacrifice an opportunity cost of less than P on each of the first 73
units. The price of P represents the marginal value (MB) of the last unit
exchanged to the buyers. P also represents the marginal value (MC) of the last
unit exchanged to the sellers. A price of P provides information about both the
buyers and sellers evaluations. Since MB = MC produces maximum net
benefit, the ideal is where the price reflects MB and MC, MB = P = MC.
So long as the price is less than the MB of the buyers, additional units will
be purchased. Once the P > MB buyers cease to purchase the good.
When the P > MC, sellers will produce and offer units for sale. Once the P <
MC, the sellers will cease production.
238
12 Pure Competition
12 PURE COMPETITION
P urely competitive markets are used as the benchmark to evaluate
market performance. It is generally believed that market structure influences
the behavior and performance of agents within the market. Structure
influences conduct which, in turn affects performance.
12.1 MARKET STRUCTURE
N eoclassical microeconomics is an explanation of the behavior of
individuals, firms, and organizations within a market context. Their behavior is
thought to be a function of their objectives and the constraints that exist
because of technology, quantity/quality of inputs and market structure. Market
structures can be characterized by sellers or buyers or both. Most economics
texts classify markets by seller. Generally, they identify 4 basic types of
markets: (1) pure (or perfect) competition, (2) monopolistic (or imperfect)
competition, (3) oligopolistic competition, and (4) monopoly. Pure competition
is believed to produce ideal results in the allocation of resources. Monopoly is
usually depicted as having less than optimal outcomes. The basic market
structures based on sellers is shown in Figure VII.1
239
12.1 Market Structure
Figure VII.1
Ideal outcomes
Deviate from Ideal
Market Structure
Pure
Imperfect or
Competition
Monopolistic
Oligopoly
Monopoly
1. Many sellers
Competition
1. Few sellers
1. one seller
2. homogeneous
1. Many sellers
(interdependence)
2. no close
2. identical or
substitutes
products
2. differentiated
products
differentiated
3 complete BTE
3. relative ease of
3. relative ease of
product
entry
entry
3. BTE
Pure competition and Monopoly are at each end of the spectrum of
markets. In fact, probably neither occur in market economies. Pure
competition and monopoly are the boundaries and the “real world” (wherever
that is) lies somewhere between the two extremes. Pure competition provides
the benchmark that can be use to evaluate markets. The physician who
attends you knows that 98.6o is a benchmark. Your temperature may not be
precisely 98.6o, but if it deviates significantly, that deviation suggests
problems. It might be in your best interests to know what the “normal”
temperature is and the cause of the deviation from “normal.”
240
12.1.1 Characteristics of Pure Competition
12.1.1 CHARACTERISTICS OF PURE COMPETITION
T he idealized purely competitive market insures that no buyer or seller
has any market power or ability to influence the price. The sellers in a purely
competitive market are price takers. The market sets the price and each
seller reacts to that price by altering the variable input and output in the short
run. In the long rung they can alter the scale of plant (size of the fixed input in
each short run period). The conditions that ensure no seller has any market
pose are:
Large number of sellers (and buyers), no one of which can influence the
market.
• Homogeneous output, buyers see goods as perfect substitutes.
• Relatively “free” entry and exit to and from the market.
S ellers cannot charge a price above the market price because sellers see all
other goods in the market as perfect substitutes. They can buy those goods at
the market price.
12.2 THE FIRM IN PURE COMPETITION
A purely competitive market is characterized by a large number of
relatively small firms. No single firm can influence the market price and are
considered price takers. In Figure VII.2 graphs representing a purely
competitive market and one firm are shown.
Panel A.VII.2 represents the market. DM and SM represent the market
demand and supply functions. If the market is in equilibrium the equilibrium
price and quantities are PEM and QEM respectively. Notice that the quantity
measured along the Q-axis in Panel A represent large quantities.
241
12.2 The Firm in Pure Competition
SM
rice, $
rice, $
P
P
EM
D
P
f
EM