Principles of Microeconomics: Efficiency
EFFICIENCY
Definition: Productive Efficiency is optimal output from given resources or minimal cost for a
given output.
We have already seen the concept of productive efficiency in our discussion of Production
Possibilities.
Definition: Allocative Efficiency is the optimal allocation of resources
Allocative Efficiency implies not only the optimal output from given resources (Productive
Efficiency) but also the optimal output desired by society. Allocative Efficiency is the output
that maximizes the net social benefit of society, i.e., maximizes the difference between total
benefit and total cost to society.
Maximum Net Social Benefit => P = MC
Maximum Net Social Benefit implies the output where the benefit to society of an
additional unit of output equals the cost to society of an additional unit of output. It is the output
where Marginal Benefit equals Marginal Cost (MB = MC). Since we measure the marginal
benefit by willingness to pay, the market Demand for a commodity measures the Marginal
Benefit of a commodity. We can therefore say that the allocation of resources is optimal at the
output where Price equals Marginal Cost (P = MC).
Pareto Efficient Allocation (Pareto Optimality) => P = MC
Definition: Pareto Optimality is the allocation of resources where no person is worse off from
trading (allocation) and any addition trade (allocation) will make some person worse off.
The Pareto Optimality condition is also satisfied by the output where P = MC.
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Principles of Microeconomics: Efficiency
Efficiency Loss (aka Welfare Loss or Deadweight Loss)
We measure the efficiency loss of an output Qo by the difference between Price and
Marginal Cost (Supply) between the output Qo and optimal output at P = MC. It is the
difference between Demand and Marginal Cost (Supply) between given output and optimal
output. We will see that this is equivalent to the net loss of consumers’ surplus and producers’
surplus at the output relative to optimal output.
Competition => Optimum Allocation (Allocation Efficiency, 0 Efficiency Loss)
Since firms and households are price-takers in a competitive market, competitive market
equilibrium implies that P = MC, which implies that competitive markets give the optimal
allocation of resources.
Monopoly Regulation
Monopolies create efficiency loss by reducing output below competitive output and
increasing price above competitive price. Governments cannot regulate monopolies through
taxation, though, since per unit taxes decrease monopoly output by shifting up Marginal Cost and
fixed taxes do not change monopoly output since marginal cost doesn’t change.
Governments attempt to eliminate the efficiency loss caused by a monopoly by requiring
that a ‘normal’ monopoly produce the output where Price equals Marginal Cost (P = MC) and
that a natural monopoly produce the output where Price equals Average Cost.
1. Marginal Cost Pricing
The principal concern of government regulation of monopoly is to eliminate efficiency loss
not to eliminate monopoly profits. Marginal Cost Pricing (P = MC) as the requirement that the
monopoly produce the output where Price equals Marginal Cost is therefore the preferred option
for government regulation. The upper diagram below shows the efficiency loss due to a normal
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Principles of Microeconomics: Efficiency
monopoly above and the lower diagram below shows the output, price, and economic profit and
loss of the monopoly given marginal cost pricing. You will note that marginal cost pricing
results in 0 efficiency loss but still leaves the monopoly with an economic profit. The monopoly
can still exist with greater than normal profits while society achieves optimal allocation of
resources. (This is only the short-run optimum allocation since firms would enter the competitive
market in the long-run so that 0 efficiency loss would occur where price equals marginal cost at
minimum average cost)
P = 80 - 2Q; TC = Q 2/2+5Q+200 => AC = Q/2 + 5 + 200/Q and MC = Q + 5
P, Cost/unit, MR
80
60
Pm
MC
40
Efficiency
Loss AC
20
Demand
MR
0
0 10 Qm 20 30 40 50 Q
P = 80 - 2Q; TC = Q 2/2+5Q+200 => AC = Q/2 + 5 + 200/Q and MC = Q + 5
P, Cost/unit, MR
80
60
MC
40
PMC
Economic Profit AC
20
Demand
MR
0
0 10 20 QMC 30 40 50 Q
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Principles of Microeconomics: Efficiency
2. Average Cost Pricing
Marginal Cost pricing is unattainable for a Natural Monopoly because there is an economic
loss at the output where price equals marginal cost. Average Cost Pricing is the regulatory option
in this case since the output where price equals average cost is the maximum output that would
not entail economic loss for the monopoly. The monopoly makes 0 economic profit but there is
an efficiency loss at this output. The upper diagram below shows the efficiency loss of a natural
monopoly at monopoly equilibrium and the lower diagram below shows the price (P*), output
(Q*), and efficiency loss at average cost pricing.
Natural Monopoly
P, Cost/unit
PM
Efficiency MC
Loss AC
P*
MRM D
QM Q*
Natural Monopoly
P, Cost/unit
PM
Efficiency Loss
MC
PAC AC
P*
MRM D
QM QAC Q*
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Principles of Microeconomics: Efficiency
We also need to understand Average Cost Pricing for Natural Monopolies that have constant
Marginal Cost either greater than zero or equal to zero. We will show the MC = 0 case but make
sure that you work out the constant Marginal Cost greater than zero case. The upper diagram
below shows the Efficiency Loss as well as Economic Profit at Monopoly equilibrium for
marginal cost equal to 0. The lower diagram shows Price (PAC) and Output (QAC) at Average Cost
Pricing with 0 economic profit and an efficiency loss. Make sure that you can also show the
economic loss at Marginal Cost Pricing for such a monopoly.
P, Cost/unit
Monopoly
PM
Economic Profit
ACM
MRM
Efficiency Loss AC
P* D
MC
QM Q*
P, Cost/unit
Monopoly
D
PM
ACM
MRM
PAC
AC
Efficiency Loss
MC
QM QAC
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Principles of Microeconomics: Efficiency
Linear Example of Efficiency Loss due to Monopoly
Suppose that the Demand and Marginal Cost function for a Cholesterol Drug are:
P = 900 – 0.002Q MC = 180 + 0.001Q
(We ignore Average Cost and Economic Profit here but could easily incorporate them)
a) What is Monopoly Equilibrium Price and Output?
Equilibrium => MR = MC => 900 – 0.004Q = 180 + 0.001Q
=> Q = 144,000 and P = $612 from 900 – 0.002*144,000
b) What is the optimal Price and Quantity for society?
Equilibrium => P = MC => 900 – 0.002Q = 180 + 0.001Q
=> Q = 240,000 and P = $420 from 900 – 0.002*240,000 or 180 + 0.002*240,000
Cholesterol Drug/Month: P = 900 - 0.002Q; MC = 180 + 0.001Q
P, MC, MR ($s)
1000
800
PM 612
600
MC
P* 420 Efficiency Loss
400
324
D
200
MR
0
0 50 100 144150 200 240250 300
QM Q*
Thousands
c) What is the efficiency loss due to Monopoly equilibrium?
We need to know MR/MC at qM to bound the triangle.
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Principles of Microeconomics: Efficiency
=> MR = 900 – 0.004*144,000 = 324 = 180 + 0.001(144,000)
Efficiency Loss = (612 – 324)(240,000 – 144,000)/2 = $13,824,000
[We concentrate on measuring Efficiency Loss in this course but an examination of the
allocation of resources under Monopoly relative to Competition will show that efficiency loss is
also the net Consumers’ Surplus and Producers’ Surplus Loss. Compare the Consumer Surplus
Loss (left diagram) and the net Producer Surplus Gain (right diagram) in the diagrams below.
Note that Producers lose the Producers Surplus from the commodities they no longer produce
(the triangle) but gain Producers Surplus (and hence profit) on the sale of the monopoly quantity
at the monopoly price rather than the competitive price. Since the analysis of optimum allocation
is for society as a whole, there is no loss of surplus or efficiency on the monopoly output since
the gain in Producer Surplus equals the loss of Consumer Surplus; the shift in income from
consumers to producers is irrelevant from the perspective of society. The loss to society is thus
only the loss of Consumer Surplus and Producer Surplus from the goods no longer produced (QC
– QM). These two triangles constitute the efficiency loss of society. You don’t need to know this
derivation but it helps a general understanding and is useful in examining particular issues, such
as free trade]
P, MC, MR ($s) P, MC, MR ($s)
1000 1000
800 800
PM 612 PM 612
600 600
Consumer Surplus Loss MC MC
P* 420 P* 420 Producer Surplus Gain
400 400 Producer Surplus Loss
324
D 324
D
200 200
MR
MR
0 144 240 0
0 50 100 150 200 250 300 144 240
QM Q*
0 50 100 150 200 250 300
QM
Thousands Q*
Thousands
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Principles of Microeconomics: Efficiency
TARIFFS AND EFFICIENCY LOSS
The issue of free trade (no barriers to trade between countries) versus tariffs (taxes on
imports) in international trade is one of the most important theoretical and practical issues in
economics. One side insists on tariffs to protect jobs and investment from international
competition while the other side emphasizes the gains to consumers from lower price. The
equivalence of efficiency loss to net Consumer Surplus and Producer Surplus loss is useful in
determining the net social benefit of free trade or tariffs in international trade. The following
diagrams constitute the standard economics defense of free trade.
Free Trade in Imports versus a Tariff = Po – P*
We examine first the case of a country where the international price (P*) is less than the
equilibrium domestic price (P* < PHome). The diagram below shows the domestic Demand and
Supply functions for the commodity as well as equilibrium (QHome, PHome) given no international
trade. P* is the international price of the commodity. P* determines the domestic price provided
that there are no barriers to trade (including no significant transportation costs). Free trade
results in an increase in Quantity Demanded to Qd as consumers buy more at the lower price and
a decrease in domestically produced Quantity Supplied to Qs as fewer domestic firms produce
the commodity profitably. Imports provide the shortfall of goods equal to Qd – Qs.
P
SHome
P*+Tariff PHome
1 2 3
P*
Imports DHome
Qs QHome Qd Q
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Principles of Microeconomics: Efficiency
Suppose that a specific tariff ‘T’ is imposed on imports such that P*+T = Po. Since all
goods sell at the Domestic Price, there are no imports and revenue from the tariff on imports.
=> Consumer Surplus loss = areas 1 + 2 + 3
and Producers’ Surplus gain = area 1 (due to the sale at the higher price)
=> Efficiency Loss = Area 1 + 2 +3 – 1 = Area 2 + Area 3
Free trade results in a net Social Gain for society because the Consumer Surplus Gain is
greater than the Producer Surplus loss. Free trade is therefore preferable to a tariff. (Less output
would imply less jobs and possibly closure of factories but the usual analysis ignore these
effects, except perhaps in the short-run, due to the assumption that workers and capital will find
other employments through the tendency of markets to full employment)
E.g. Refrigerators: Domestic Demand: P = 1500 – 6Q Domestic Supply: P = 300 + 4Q
Domestic Equilibrium: => Q = 120 and P = $780
Suppose that the International Price (P*) = $600
=> Qs = 75 and Qd = 150 => Imports = 150 – 75 = 75
Efficiency Gain from Trade = (780 – 600)(150 – 75)/2 = $6,750
Free Trade in Exports
Suppose that a country produces a commodity which would sell at Po without international
trade or could sell at P*> Po with international trade. Should a country limit exports to retain the
low domestic price for consumers or allow free trade in exports that would increase output and
prices for producers. An example of such an issue occurred in the 1970s when Pierre Trudeau
passed the National Energy Policy (NEP) to force Alberta to sell oil to Ontario at a price lower
than the international price. His rationale was that the gain to the large number of consumers in
Ontario was greater than the lost profit of producers.
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Principles of Microeconomics: Efficiency
P
SHome
Exports
P*
1 2 3
PHome
DHome
Qd QHome Qs Q
Net Social (Efficiency) Gain
= Producers’ Surplus Gain (1 + 2 + 3) – Consumers Surplus Loss (1 + 2)
= Net Producers Surplus Gain (3)
Trudeau was wrong according to this analysis since the gain to the country (producer
surplus gain) from the exports is greater is greater than the loss to the country (consumer surplus
loss)
EXTERNALITIES
Definition: Externalities are costs of a commodity other than the costs of the firms producing the
commodity or benefits of a commodity other than the benefits of the households purchasing
the commodity.
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Principles of Microeconomics: Efficiency
The Atomistic or ‘Micro Foundations’ approach of Microeconomics means that market Demand
is the sum of the demands of individual households and that market Supply is the sum
of the supplies of individual firms. This may in fact properly depict market Demand
and Supply but market Demand and Supply are not equivalent to social Demand and
Supply if there are benefits of the commodity not received by households or costs of
the commodity not incurred by firms. If there are such externalities, the sum of
private benefits and costs in market Demand and Supply does not equal the sum of
social benefits and costs. Since the concept of allocative efficiency refers to the
optimal allocation of resources for society, the marginal benefits (Price) and marginal
costs of market Demand and Supply encompass only part of the social benefits and
costs of a commodity. The existence of externalities means that competitive market
equilibrium does not give the optimal allocation of resources.
1. Cost (or Negative) Externalities
Pollution and Health Costs are typical externalities for a commodity. The diagram below
shows the market Demand and Supply functions for automobiles and the Supply function for
society that includes not only the cost of car manufacturers but also the pollution and accident
costs of cars as a per unit cost per vehicle. Optimal Allocation occurs where Price equals the
Marginal Cost for society (MCSocial) at P* and Q* not where Price equals only the Marginal Cost
of the firms (MCMarket). Competitive equilibrium results in an efficiency loss for society since the
cost of output beyond optimal social allocation is greater than society’s willingness to pay.
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Principles of Microeconomics: Efficiency
Cost Externalities and Optimal Allocation
P MC
Social
MCMarket
P* Efficiency Loss
PComp
at Competitive Equilibrium
DMarket
Q* QComp
The problem with externalities is that they are not internal to the market so they do not
factor into market equilibrium. There are two ways to make firms incorporate externalities in
their costs (besides government regulation of output)
a) Taxation equivalent to the externalities such as a per unit tax
b) Litigation by individuals to force firms to include externality costs as part of firm costs
2. Benefit (or Positive) Externalities
Benefit externalities occur when there are benefits from commodities for individuals other
than those purchasing the good or service. These externalities typically occur with public goods.
Definition: A Public Good is not depleted by an additional user nor is it exclusive to a user
Visual art or public spaces are typical public goods. The diagram below shows the Demand
and Supply functions for sculpture and the benefits received by non-purchasers as a per unit
amount of each commodity. Optimal allocation occurs at a greater output and price than
competitive equilibrium resulting in an efficiency loss at competitive equilibrium. Economists
call the existence of individuals who benefit from but do not pay for a good the ‘Free Rider
Problem” because their lack of payment results in non-optimal market allocation.
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Principles of Microeconomics: Efficiency
Benefit Externalities and Optimal Allocation
P
Efficiency Loss MCMarket
at Competitive Equilibrium
P*
PComp
DSocial
DMarket
QComp Q*
A solution to benefit externalities is government subsidization of output to attain the optimal
output and price for producers. The diagram below shows a per unit subsidy that results in
optimal output at Q* and a market price at PSubsidy. Producers get P* though because they get the
market price plus the subsidy.
Benefit Externalities and Optimal Allocation
P
Efficiency Loss MCMarket
at Competitive Equilibrium
MCSubsidy
P*
PComp
PSubsidy
DSocial
DMarket
QComp Q*
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