In this module, you're going to have

the fine privilege of meeting one of the great economists in history.

An Italian gentleman named Alfredo Pareto,

with whom I share if not greatness,

then at least the same birthday. Go figure.

At any rate, Pareto is important because his legacy has left

us with a way of defining the efficiency of allocating resources,

and he is going to help us distinguish between two specific types of efficiency;

productive efficiency and allocative efficiency.

Here is how the story goes.

Productive efficiency simply means that the firm is using

the minimum amount of resources to produce any particular output.

Here, we can also say that productive efficiency occurs

when price equals minimum average total cost.

Of course, we now know that this particular condition of market conduct will

hold when a competitive industry is in long run equilibrium.

By the way, implicit in this observation is that the firm is

also using the best available least cost technology.

If it doesn't, it will not survive

Allocative efficiency

is a slightly more difficult concept,

and in economics, you may encounter

several different definitions of allocative efficiency.

One of the most cumbersome describes the condition of

so-called Pareto Optimality or Pareto Efficiency,

first identified by the aforementioned Alfredo Pareto.

Here's the key definition.

An allocation of resources is Pareto optimal when

no possible reorganization of production can make

anyone better off without making someone else worse off.

To repeat that. An allocation of resources is Pareto optimal when

no possible reorganization of production can make

anyone better off without making someone else worse off.

In this sense, the concept of allocative efficiency goes beyond

the productive efficiency illustrated by

our now familiar production possibilities frontier.

As we have learned,

an economy is clearly inefficient if it operates inside its PPF.

And no one needs suffer decline in utility by moving to the PPF frontier.

Therefore at a minimum,

an efficient economy is on its production possibility frontier.

That said, allocative efficiency goes one step further and

requires not only that the right mix of goods be produced,

but also that these goods be allocated among consumers to maximize consumer satisfaction.

Let me repeat that too.

Allocative efficiency goes one step further and

requires not only that the right mix of goods be produced,

but also that these goods be allocated among consumers to maximize consumer satisfaction.

Now, I know this all may seem a bit complicated but let's not get confused.

All we are really talking about here is

the best possible allocation of a given society's resources.

And knowing what we already know,

it's easy to prove that perfect competition yields this result.

In fact, that is what this whole discussion of Pareto optimality has been leading up to,

namely, that perfect competition leads to Pareto optimality.

Which is why we used perfect competition as the benchmark to compare

all other forms of competition.

Of course, you don't have to take my word,

then when all of the assumptions of perfect competition hold,

the market outcome will be allocatively efficient.

Instead, let's go ahead and prove that.

For starters, we know that the demand curve reflects the willingness of

the consumer to pay for the product under the assumptions of perfect competition.

We also know, that the demand curve must reflect the social benefits of that product.

Now, on the supply curve side,

we know that the supply curve reflects the cost of

production and if the assumptions of perfect competition hold,

the supply curve must therefore reflect the social cost of producing the product.

Do you see where I'm heading with this?

Because, it must follow from these observations that

in a perfectly competitive market in which equal leveling occurs,

where supply intersects demand,

it must be that social benefits equal social costs.

Moreover at this point of equilibrium,

the marginal cost of production will exactly

equal the marginal benefit or utility of consumption.

Just how do we know this last condition to be true?

How about you pause the presentation now and think about that for a bit.

And then write down your answer on a piece of paper or your computer. Give it a try now.

Why does the marginal cost of production exactly equal

marginal benefit or utility of consumption at the point of equilibrium?

So why is the marginal cost of production exactly equal the marginal

benefit or utility of consumption at the point of equilibrium?

Well, from our lesson on consumer theory,

we learned that consumers choose purchases up

to the point where price equals marginal utility.

At the same time in this lesson,

we've already proved that in a competitive market,

price will equal marginal cost.

Therefore marginal utility, MU must equal the marginal cost, MC.

Now, let me show

you one more and quite intriguing way of looking at allocative efficiency.

Let's start by drawing a demand curve.

In economics, we call the area under the demand curve the consumer surplus.

For example, the area of this shaded triangle A provides a dollar measure of

the difference between what consumers would have been willing to

pay and what they actually pay at the market price.

That's the key definition of consumer surplus.

Got it? Okay.

Now by the same token,

there is also a producer surplus.

This is depicted in our graph by the shaded triangle B.

It measures the area above the supply curve.

Specifically, in this key definition,

producer surplus measures the difference

between the price at which producers would have been willing to supply a

good and the price they

actually receive at market.

Now we can use the concepts of producer and

consumer surplus to do two really interesting things.

First, we can measure the efficiency loss of a deviation from

the perfect competition equilibrium that is

going be embodied in a measure known as the deadweight loss.

Second, we can assess the distributional implications

of the market outcome in terms of consumers versus producers.

Here's an example to illustrate what I mean using

the market for ice cream cones in a perfectly competitive equilibrium.

Note that the price is p_sub_e and the quantity is q_sub_e.

At this equilibrium, what is the consumer surplus and what is the producer surplus?

Here are some choices for you to ponder,

as you pause the presentation to jot down your answer.

Well, the correct answer is number two.

The consumer surplus is the triangle C and

the producer surplus is the triangle E. And if you didn't get this right,

please remember these key definitions.

Consumer surplus measures the difference between what

consumers would have been willing to pay and what they actually pay,

and the producer surplus is the difference between the price at which producers would

have been willing to supply a good and the price they actually receive.

Now, let's thicken this plot a bit.

Suppose a monopolist, let's call him the evil Mr. Hagen house,

corners the market for ice cream cones and raises the price to p_sub_m.

In this case, you can see that quantity falls to q_sub_m. Now here's your first question.

What is the distributional impact of

this monopoly pricing on consumers and the monopolist producer?

That is who wins and who loses from

the new market outcome and how do we measure the gain and loss?

We pause now to sort out

the various triangles and rectangles and answer this important question.

Well, the correct answer is number one here.

Did you get it right?

Consumers have to pay more for less quantity and

the rectangle B is transferred to the monopolist.

That means consumers are poor and the monopolist is richer.

Not good, at least for consumers.

Now, here's the really big question of this exercise.

Take a look again at the figure.

What portions of consumer and producer surplus represent the loss of

allocative efficiency or deadweight loss from monopoly pricing?

Let me give you a hint now.

The efficiency loss on the consumer side comes from

the consumption of the ice cream that is foregone under monopoly pricing.

By the same token,

the loss of efficiency on the producers side comes about by a reduction

in output and an undersupply of resources to the ice cream market.

So please, pause the presentation now and try to really nail this answer.

What's the deadweight loss?

Well, the correct answer here is number two.

The loss of consumer surplus is measured by the triangle C while

a loss of producer surplus is measured by the triangle E. And yes,

indeed, the triangle C and D do measure

the loss in allocative efficiency from the monopoly pricing.

The so-called and famous deadweight loss.

Of course, from this example you can see why people don't like monopoly.

It not only transfers income from the many to the few,

it also creates an efficiency loss in the process.

We'll talk more about that in the next lesson and even entertain

at least one school of economics that says that monopoly can actually be a good thing.

But for now, we have one more short module in this lesson.

When you're ready, have at it.

Allocative vs. Productive Efficiency; Pareto Optimality; Consumer and Producer Surplus and Deadweight Loss

Strategic Business Management - Microeconomics

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