IBE 316 Economic Policy Stiglitz: Economics of the Public Sector

Chapter 3: Market E ciency

Keisuke OTSU
Sophia University FLA

Spring 2008

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Announcement
Slides

Slides are currently available at http://caseyohtsu.googlepages.com/ibe316 They will soon be shifted to moodle

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Overview
Focus Questions

What do economists mean when they say the economy is e cient? What conditions have to be satised if markets are to be e cient? Why is there a general presumption that competitive markets result in e ciency?

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Overview
Settings

A perfect world
perfect competition perfect information (everybody knows the prices) no externalities

In order to analyze the real world, we want to analyze the perfect world and then consider the dierences between the two

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The Invisible Hand of Competitive Markets

The Invisible Hand of Competitive Markets

Adam Smith says... competition would lead the individual in the pursuit of his private interest to pursue the public interest, as if by an invisible hand the public interest is served when each individual simply does what is in his own self-interest
if there is something that individuals value but is not produced, they will to pay for it if there is prot opportunity, an entrepreneur will produce it only the rm that produces the good at the lowest cost will survive goods and services needed by individuals will be produced in the most e cient way

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Welfare Economics and Pareto E ciency

Welfare Economics and Pareto E ciency

Welfare economics: evaluate alternative policies to nd the one that maximizes welfare of the economy Pareto optimal (e cient): no one can be made better o without someone being worse o Pareto improvement: a change which makes some individuals better o without making anyone worse o

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Welfare Economics and Pareto E ciency

Pareto E ciency and Individualism

The criterion of Pareto e ciency is individualistic It is concerned only with each individuals welfare It is each individual perception of his or her own welfare that counts s (consumer sovereignty: individuals are the best judge of there own utility)

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Welfare Economics and Pareto E ciency

The Fundamental Theorems of Welfare Economics

Theorem (First Welfare Theorem)

Every competitive economy is Pareto e cient

Theorem (Second Welfare Theorem)

Every Pareto e cient resource allocation can be attained through a competitive market mechanism, with the appropriate initial redistributions

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Welfare Economics and Pareto E ciency

The fundamental Theorems of Welfare Economics

Every Pareto e cient allocation can be attained by means of a decentralized market mechanism
Decentralized market mechanism: decisions about production and consumption are carried out by the myriad of rms and individuals Centralized allocation mechanism: all decisions are made by the central planning agency

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Analyzing Economic E ciency

Basic Conditions for Pareto E ciency

Exchange e ciency Production e ciency Product mix e ciency

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Analyzing Economic E ciency

A Mini Model

Crusoe and Friday consume apples and oranges Firms produce apples and oranges from land and labor

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Analyzing Economic E ciency

The Utility Possibilities Curve

Utility: the benets that an individual gets from consumption Utility possibility frontier (gure 3.2): maximum level of utility that may be achieved by two consumers
According to the rst welfare theorem: a competitive economy operates along the utility possibilities frontier According to the second welfare theorem: we can attain any point along the utility possibilities frontier using competitive markets (with appropriate redistribution of initial endowments)

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Analyzing Economic E ciency

Exchange E ciency

Exchange e ciency: goods are distributed in a way such that no one can be made better o without someone being worse o Marginal rate of substitution (the slope of indierence curves) = relative price of apples to oranges
Indierence curve: combinations of apples and oranges that give the same utility level

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Analyzing Economic E ciency

Exchange E ciency

Marginal rate of substitution: how many apples are you willing to give up in exchange with an extra orange?
If the marginal rate of substitution of Crusoe is dierent than Friday, they will be better o through trading In a competitive market, everybody marginal rate of substitution s becomes equal to the market (relative) price of apples to oranges because of diminishing marginal rate of substitution (gure 3.4) Competitive markets have exchange e ciency

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Analyzing Economic E ciency

Production E ciency

Production possibilities frontier (gure 3.6): combinations of apples and oranges such that the economy cannot produce more of one good without giving up some of the other good, given a xed set of land and labor
Points inside the frontier are attainable but ine cient Points along the frontier are feasible and e cient Points outside the frontier are unattainable

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Analyzing Economic E ciency

Production E ciency

Production e ciency: goods are produced in a way such that no good can be produced more without reducing the production of other goods Marginal rate of technical substitution (the slope of isoquants) = relative price of land to labor
Isoquant: combinations of land and labor which produces the same amount of apples (oranges)

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Analyzing Economic E ciency

Production E ciency

Marginal rate of technical substitution: how much additional land do you need in order to compensate a decrease in one unit of labor to attain the same production level of apples (oranges)?
If the marginal rate of technical substitution for apples diers from that of oranges, the rm can produce more by shifting labor and land across apple production and orange production without changing the total amount of inputs In a competitive market, every rmsmarginal rate of technical substitution becomes equal to the market (relative) price of land to labor because of diminishing marginal rate of technical substitution (gure 3.7) Competitive markets have production e ciency

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Analyzing Economic E ciency

Product Mix E ciency

Product mix e ciency: goods produced correspond to those desired by individuals Marginal rate of transformation (the slope of the production possibility frontier) = Marginal rate of substitution

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Analyzing Economic E ciency

Product Mix E ciency

Marginal rate of transformation: how many extra apples can the rm produce if it reduces the production of oranges by one?
From product e ciency, the economy should be on the production possibility frontier From exchange e ciency, individuals must choose E in gure 3.9 Competitive markets have product mix e ciency

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Analyzing Economic E ciency

Basic Conditions for Pareto E ciency

Competitive Economies satisfy

1

Exchange e ciency: marginal rate of substitution between any two goods must be the same for all individuals Production e ciency: marginal rate of technical substitution between any two inputs must be the same for all rms Product mix e ciency: marginal rate of transformation must equal marginal rate of substitution

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Readings
Reading for next class

Read Chapter 4

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