Economic Efficiency

Economic Efficiency:
 
Chapter Summary:

The central idea of this chapter is Adam Smith’s invisible hand. Free-market competition will make sure that the allotment of resources is economically proficient. Though the buyers and sellers act selfishly, the total outcome is at least as good as the best efforts of the most enlightened and well-informed main planner. This applies to markets for services and goods and also capital.

The similar general principle applies in an organization. Through decentralization, management can attain proficient use of scarce resources. This means charging a transfer price for items generated and consumed in the organization.

Government policies like price floors, price ceilings and taxes cause deadweight losses and impede economic effectiveness. The extent of such deadweight losses based on the price elasticity of demand and supply. There will be no deadweight loss when either the demand or the supply is much inelastic.
 
Key Concepts:

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General Chapter Objectives:

A) State three sufficient conditions for economic effectiveness.

B) Discuss about Adam Smith’s invisible hand, that is, the market price, attains economic efficiency in a perfectly competitive market.

C) Apply the three conditions for economic efficiency to a single association and discuss about the efficiency of de-centralization.

D) Discuss the role of bankruptcy and capital markets.

E) Examine the economic effects of price ceilings and price floors.

F) Examine the economic effects of taxes.

Notes:

1) Concept of economic efficiency:

a) An allocation of resources (that is, quantity) is economically proficient where no reallocation can make one person (that is, human being or business) better off devoid of making the other worse off.

i) A guide to managing resources in an organization and across whole economies.

ii) Recognizes opportunities for profit (that is, there is a way to form money by resolving the economic inefficiency).

iii) A way to evaluate government intervention.

iv) It assesses resource allotments in terms of each individual user’s assessment of the benefit.

b) Three adequate conditions for the economic efficiency:

i) All users attain similar marginal benefit;

ii) All suppliers operate at similar marginal cost; and

iii) Every user’s marginal benefit = every supplier’s marginal cost. Whenever marginal benefit is less than the marginal cost, society overall could gain by decreasing provision of that item, and vice-versa.

c) An economically proficient allocation is equal to maximum (or sum of) buyer surplus and seller surplus.

d) Internal organization:

i) Moonlight Paper (business: production and delivery of wood) illustration:

  • Users: paper mills.
  • Suppliers: forests.

ii) Three conditions:

  • Similar marginal benefit: When one paper mill gets more gain than the other, the company must switch some wood supplies to the higher gain mill. Buyer surplus will rise. The company’s overall gain will be greater.
  • Similar marginal cost: When one forest can generate wood at a lower marginal cost than the other, then the company must direct the lower cost forest to generate more and the higher cost forest to generate less. Seller surplus will rise. The company’s overall gain will be much higher.   
  • Marginal benefit = marginal cost.  If the marginal profit of wood to the paper mills is less than the marginal cost of production wood, then the company must cut back production. 
  • The reduction in profit would be less than the decrease of cost.  The company’s overall gain will be higher. The sum of buyer and seller excess will rise.  

e) Economic efficiency differentiated from technical efficiency.

i) Technical efficiency: It is the provision of an item at minimum possible cost; doesn’t imply scarce resources are being well employed.

ii) Economic efficiency expands beyond the technical efficiency.
 
2) Adam Smith’s Invisible Hand:

a) Perfect competition attains economic efficiency.

i) In a competitive market, sellers and buyers acting independently and selfishly, channel scarce resources into economically proficient uses (that is, satisfying all three conditions).  The invisible hand that guides sellers and buyers is the market price.

ii) Market prices assign scarce resources in an economically proficient manner. Prices lead to a proficient allocation of resources by giving information and incentives:

  • Users purchase until marginal benefit equivalents price (that is, to maximize profit); 
  • Producers supply till marginal cost equivalents price (that is, to maximize gain); 
  • Producers and users and face similar price.

b) Market or price system: It is the economic system in which resources are allocated via the independent decisions of sellers and buyers, guided by freely moving prices. The market system is much efficient than central planning. Beneath central planning:

  • The company or government headquarters gathers information about revenues and costs and decides on production.
  • Work incentives are usually very weak.

c) The invisible hand in an individual organization.

i) Decentralized management: Attaining economic efficiency in an organization.

  • When there is a competitive market for an item, then the transfer price (that is, a price charged for the sale of an item in an organization) must be set equivalent to the market price.
  • Right of outsourcing: consuming units in an organization must be permitted to outsource (that is, purchase services or supplies from an external source).
  • Producing unit must be capable to sell the product to external buyers.
  • The three conditions for economic efficiency are fulfilled. The interior market will be integrated with the exterior market.

ii) Moonlight Paper (business: production and delivery of wood) illustration:

  • Users: paper mills. Every mill maximizes gain and is allowed to buy wood at the market price (that is, up to the point where marginal benefit balances the market price) from any supplier, whether Moonlight’s forests or an exterior source. As all mills face similar market price, their marginal benefits will be equivalent.
  • Suppliers: forests. Managers of each and every forest maximize gain and sell wood at the market price (that is, up to the point where marginal cost balances the market price) to either Moonlight’s own paper mills or external buyers. As all forests face similar market price, their marginal costs will be equivalent.
  • As the mills and the forests face similar market price, marginal benefit equivalents marginal cost. 

d) Capital market:

i) Including sellers and buyers of investment funds in communication with one other for voluntary exchange.

ii) Allocates investment funds (or resources) more efficiently than central planners. Central planners might:

  • Not contain all the required information;
  • Not be able to influence all individuals to fulfill with directives; or
  • Deliberately direct resources inadequately.

iii) Bankruptcy:

  • Definition: It is a set of legal provisions which take effect whenever an entity can’t meet its obligations to the lenders.
  • Ensures a proficient allotment of resources.
  • Does not demolish the productive resources.

3) Government controls on prices:

A) Price ceiling: It is a legal upper limit which sellers can charge and buyers can pay.

i) Rent control: It is a price ceiling in the market for housing. It bites whenever the limit drops beneath the free market equilibrium rent.

  • Stimulates demand and dispirits supply, therefore, might result in surplus demand. The more elastic the demand or supply, the bigger the shortage.
  • Rises buyer surplus for some, whereas decreasing it for others. Net result doubtful.
  • Decreases seller surplus.
  • Decreases seller surplus by more than the profit in buyer surplus. Outcomes in inefficient allotment of resources and deadweight loss.

ii) Deadweight loss:  It is a loss of sellers or buyer surplus which is not transferred to the other party.

  • The deadweight loss from a price ceiling based on the price elasticity of demand and supply. 
  • Occurs whenever sellers are willing to offer an item that buyers are willing to pay and which provision does not take place. (At free market equilibrium rent, the landlords are willing to rent some units at a marginal cost lower than the equivalent marginal benefit to rentals.)
  • Equivalents to the sum of differences among the buyer’s marginal benefits and the seller’s marginal costs for all units not given. 

B) Price floor: It is a legal minimum limit which sellers can charge and buyers can pay.

i) Minimum wage: It is a price floor in the labor market. It bites whenever the limit surpasses the free market equilibrium. The buyers are businesses and the sellers are people.

  • Might outcome in surplus supply.
  • Decreases buyer surplus.
  • Rises seller surplus for some, whereas decreasing it for others.
  • Decreases buyer surplus by more than the profit in seller surplus. 
  • Outcomes in inefficient allotment of resources and deadweight loss.

ii) Deadweight loss and impact on net earnings.

a) The deadweight loss from a price ceiling based on the price (or wage) elasticity of demand and supply of labor.
Compared with the free market equilibrium, the wage is greater however employment is lower.  
The greater elastic the demand for labor, the more probable a minimum wage will decrease total earnings. When demand for labor is inelastic, a minimum wage will raise total earnings.

b) Equivalents to the sum of differences between the buyer’s marginal benefits and the seller’s marginal costs for all the work which is not provided.

c) Persuades employers to replace away from low skilled labor to:

  • Automation.
  • Skilled labor (therefore skilled labor unions support lowest wage provisions).

C) Taxes:

i) A tax can be graphically symbolized by either:

  • Shifting up the supply curve (that is, rising the marginal cost for sellers at all quantities); or
  • Shifting down the demand curve (that is, decreasing the marginal benefit for buyers at all quantities).

ii) The tax:

a) Will:

  • Decrease the buyer’s price.
  • Increase the seller’s price.

b) Produce revenue for the govt.

c) Decrease buyer surplus (that is, as she pays more and forms fewer trips) and seller surplus (as it obtains less and sells less ticket).

d) Decrease buyer and seller surplus by more than the profit in govt. revenue, and therefore outcomes in deadweight loss.

iii) Tax incidence: the real burden of a tax in terms of price or buyer/seller surplus. Who pays a tax doesn’t verify who bears the tax. The deadweight loss and incidence from a tax based on the price elasticity of demand and supply.

a) With moderate demand and supply elasticity, the buyer’s price will increase by less than the amount of tax and the seller’s price drop by less than the amount of tax, and quantity will drop by some amount.

b) Whenever demand is extremely inelastic, the tax: decreases buyer’s surplus doesn’t influence seller’s surplus, outcomes in no deadweight loss. The tax incidence drops totally on the buyer.

c) Whenever supply is very inelastic, the tax: decreases seller’s surplus doesn’t influence buyer’s surplus, outcomes in no deadweight loss. The tax incidence drops totally on the seller.

iv) Tax collection: The new buyer’s price, new seller’s price and quantity given are similar whether the tax is collected from the buyer or seller. Tax incidence based on price elasticity of demand and supply. Who pays the tax does not verify who bears the tax.

Question-Answer:

Venus Airport has capacity for 60 takeoffs and landings per hr. All the peak-hour takeoff and landing rights were allocated lots of years ago. Some airlines employ such rights to operate small commuter flights. New airlines, even such planning to provide wide-body cross-country service, can just secure rights at less popular off-peak hrs.  Venus Airport Authority is considering a proposal that would permit airlines to re-sell rights to the other airlines.

a) Give the condition of economic efficiency which is probably being violated with the present allocation of peak-hour takeoff and landing rights?

b) How would the re-sale proposal solve the economic inadequacy?

c) Graphically state the market equilibrium with re-sale of peak-hour takeoff and landing rights.
 
Answer:

a) The condition which all users attain similar marginal benefit. Airlines operating small commuter services are possibly getting lower marginal benefit from the takeoff and landing rights than airlines which would operate wide-body cross country service.

b) Airlines with comparatively low marginal benefit would re-sell their rights to the other airlines with high marginal benefit, till all achieve the similar marginal benefit.

c) Market demand for the peak-hour takeoff and landing rights would be horizontal summation of the demands of different airlines for such rights.

Supply is fixed at 60 rights per hour. At equilibrium price p, the quantity demanded equivalents 60 rights per hour.

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