ECONOMIC EFFICIENCY

ECONOMIC EFFICIENCY

ECON EFFICIENCY: CONDITIONS

for all users, same marginal benefit for all suppliers, same marginal costmarginal benefit = marginal cost

EQUAL MARGINAL BENEFIT

if not equalprovide more to user with higher marginal benefittake away from user with lower marginal benefit

EQUAL MARGINAL COSTif not equalsupplier with lower marginal cost should produce moresupplier with higher marginal cost should produce less

MARGINAL BENEFIT/COSTif marginal benefit > marginal cost, produce more of the itemif marginal benefit > marginal cost, produce less of the item

ECONOMIC EFFICIENCY V.S. TECHNICAL

EFFICIENCY Contrast economic efficiency vis-à-vis

technical efficiency Technical efficiency

producing at lowest possible cost doesn’t consider how much benefit the item

provides

ADAM SMITH’S INVISIBLE HAND: PRICE

Competitive market achieves three sufficient condition for economic efficiency:buyers and sellers in a market system act independently and selfishly, yet the overall outcome is efficienti) users buy until marginal benefit equals price; ii) producers supply until marginal cost equals prices; iii) users and producers face same price.

INVISIBLE HANDOutcome of price

competition in market Marginal benefit =

price Marginal cost = price Single price in market

EXAMPLE OF INVISIBLE HAND

Major policy issue: how to allocate licenses for 3G wireless telecommunications;“beauty contest” -- Franceauction – Germany, UK, US

pioneer: in early 1990s, US Federal Communications Commission showed that spectrum licenses were worth billions;created pressure on other governments to allocate by auction and not favoritism.

Auction ensures that item goes to user with highest marginal benefit.

INVISIBLE HAND Market system (price system):

Economic system in which resources are allocated through the independent decisions of buyers and sellers, guided by freely moving prices.

Successes of market system West/East Germany North/South Korea China after Deng Xiaoping’s reforms

DE-CENTRALIZATIONcreate internal marketif there is a competitive market for an item, set transfer price equal to market priceconsuming units should be allowed to outsource

Note: Transfer price: price charged for the sale of an item within an organization;Outsourcing: purchase of services or supplies from external sources

DECENTRALIZATION Within organization

For all users, marginal benefit = transfer price

For all producers, marginal cost = transfer price

Marginal benefit = transfer price = marginal cost

UCLA ANDERSON SCHOOL, 1989

Half an invisible hand is worse than nonepriced photocopying paperfree bond paper

TAX: COMMODITY TAX“the only two sure things in life are death and taxes” buyer’s price - tax = seller’s price payment vis-à-vis incidenceUS: airlines pay tax Asia: passengers pay

0

800

900

e

Quantity (Thousand tickets a year)

Price

($ p

er ti

cket

)

supply

demand

$10

TAX: EQUILIBRIUM

b

h

804

794

920

0

800

900

e

Quantity (Thousand tickets a year)

Price

($ p

er ti

cket

)

supply

demand

$10

TAX: SURPLUSES

b

h

804

794

920

f

d

j

buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg

g

INCIDENCEincidence and deadweight loss depend on price elasticities of demand and supplyideal tax (no deadweight loss): inelastic demand/supplywho pays the tax not relevant

RETAILING: HOW SHOULD MANUFACTURER CUT PRICE?

Wholesale price cut: Will retailers pass on the price cut?

Coupons: Will this provide consumers with more effective price cut?

INCIDENCE: REDUCING RETAIL PRICES