Efficiency and Equity in a
Competitive Market
FSG 16
Outline
Chapter 16.4
Economic Efficiency (pareto efficiency)
Exchange efficiency – edgeworth box
Input efficiency
Substitution efficiency
First fundamental theorem of welfare economics
Second fundamental theorem of welfare
economics
Theory of the second best
Welfare Economics
Concerned with how well an economy
operates in terms of efficiency and
equity/social justice
Efficiency - allocation of resources
Equity - distribution of income
Why Are We Concerned
Efficiency questions in health care sector
arise because costs are high.
Equity questions arise because cost are
high, and many people are uninsured or
under insured.
Why Are We Concerned
To really understand these concerns we
need to:
1. Know the definition of efficiency
2. The assumptions behind efficiency
3. Role of equity
Definition Pareto Efficiency
Definition:
1. An economically efficient (optimal) outcome
in society is one under which it is impossible
to make someone better off without making
someone worse off.
2. An efficient economy is one that has
exhausted all means of mutual gains (trade)
Three Conditions for Efficiency
Exchange (Consumption) Efficiency
“maximum” utility
Input (Production) Efficiency
“maximum” output
Product-Mix (Substitution) Efficiency
optimum mix of commodities
Exchange (Consumption) Efficiency
An allocation of commodities is consumption
efficient if the only way to make one person
better off is to make another person worse
off.
The MRS between each pair of goods must
be equal for all consumers.
Edgeworth Box
Is a graphical tool used to understand what
this definition of efficiency means.
(rest of notes done on chalk board)
Exchange Efficiency Condition
The MRS between the two goods must be
equal for all people
MRS A
M ,F MRS B
M ,F
7
Input (Production) Efficiency
An allocation of inputs is production efficient if
the only way to increase the output of one
commodity is to decrease the output of
another commodity
Production Efficient Allocations
Slope of isoquant: Marginal Rate of Technical
Substitute (MRTS) Food
0'
Production efficient B4
allocations
B3
h
B2 k
Capital
B1
W1
j W2
W3
W4
0
Medicine Labour 6
Production Efficiency Condition
The MRTS between capital and labor must
be equal for all commodities
MRTS Medicine
K ,L MRTS Food
K ,L
7
Production Possibilities Curve
MRT: show the amount of food that the
economy must give up in order to gain an
Food additional unit of medicine.
k'Slope = Marginal Rate
of Transformation
h' (MRT)
Medicine
9
Marginal Rate of Transformation
The MRT is the rate at which the economy
can transform one output into another by
shifting its resources
the (negative of the) slope of the production
possibilities curve
If it equals 2, to have one additional unit of
medicine, we need to give up two units of food
8
Substitution (Allocation) Efficiency
A mix of commodities is allocation efficient if the
MRT between any two goods is equal to
consumers’ common MRS between the two
commodities. (the ratio in which goods are being
produced is the same as people want to
consume).
MRT M ,F MRS Amber , Brent
M ,F
First Fundamental Theorem
of Welfare Economics
This theorem says:
That an competitive equilibrium is Pareto
efficient
Great, so as long as we have a competitive
market, our markets left all to themselves will
be efficient –economists mean Pareto
efficient. The famous “invisible hand solution”
First Fundamental Theorem
of Welfare Economics
But,
1. Is the health care market competitive?
2. Would a competitive market solution be
equitable, or would there be a lot of people
left with no health care?
Lets address point 2 first, then come back to
point 1.
Second Fundamental Theorem
of Welfare Economics
Things are not so bleak
Theorem states that given an appropriate
endowment any Pareto efficient outcome can in
principle be achieved
This means, that for any given endowment, we can
redistribute the endowment to get to the efficient
outcome we want
(Back to chalk board)
How To Redistribute?
Should we subsidize certain services? (health care)
We can but it is not consistent with Pareto efficiency.
Why? well to get to a Pareto efficient point, we had to
find a tangency between both people’s indifference
curve.
When everyone faces the same prices this will happen.
If they face different prices, there will not be a tangency
point, i.e. there will be an inefficient outcome.
Income transfers are a superior way to redistribute
because doesn‘t change prices
How To Redistribute
Some policy makers hesitate to make large-
scale income redistribution because of
incentives.
Transferring wealth away for one group may
provide a disincentive to work, and giving
money to another group may provide a
disincentive to work.
assumes we are only stimulated by money
Theory of the Second Best
Q1: So should we try to adhere to as many of
the assumptions as possible for competitive
markets?
Q2: Does removing a distortion of
competitive markets make competitive
markets work better?
Answer: Not necessarily
Theory of the Second Best tell us why
Competitive Model Assumptions
1. Fragmentation: lots of buyers and sellers out
there so firms and consumers are price takers
(perfect competition)
No one has market power
2. A homogenous product or undifferentiated
product
3. Perfect information
E.g. know the prices and quality in the market.
4. Equal Access to Resources OR Free entry
and exit of firms
No barriers to entry
Competitive Model Assumptions
5. Consumers maximize their utility
6. Firms maximize profits
7. There are no significant externalities.
Externality occurs if we receive benefits or are
harmed by the actions of others.
e.g. vaccinations
Theory of the Second Best
Say we have more than one departure from
competitive market (more than one assumption
does not hold).
Call this departure a distortion
Now there is a policy that tries to correct on of these
distortions.
Theory of the Second Best says: that such a
correction may not improve welfare i.e. we can’t
assume welfare will be improved or that we get any
closer to a competitive market.
Theory of the Second Best
Classic Example
Classic Example: Polluting Monopolist
Suppose we have a monopolist who is in an industry where they
make a lot of pollution due to the process of how the good is made.
Monopolist is a departure from perfect competition assumption.
Only one firm in the market not many.
First distortion
Polluter – pollution is a negative externality.
Second distortion
Monopoly prices are higher than under perfect competition and
monopolists produce less than would be produced under perfect
competition.
They can set prices because have market power
Theory of the Second Best
Classic Example
Now, suppose we introduce more firms so the
market is not a monopolistic anymore, but
competitive (price takers).
Well if we do that, output will increase and prices go
down, but the amount of pollution will also increase
which could be a big problem.
So we made one problem better (prices) but another
problem worse (pollution)
Theory of the Second Best
Health Example
Health example: licensure laws
Create a monopoly
At same time there is imperfect information in the market
about quality of doctors.
If get rid of licensure laws, more doctors can practice, we
may solve the monopoly problem.
But, there may be unqualified doctors and you may
receive poor quality if not dangerous health care.
Problem in developing countries
Theory of the Second Best
Can’t assume that making the health care market look
more like a competitive market will be a good thing.
Each policy and all the implications must be considered
first and one should not implement a policy just because
it promotes competition.
MANY policy makers fail to really realize this and don’t
examine ALL implications.
One of the reasons economists don’t like politicians, they
use our vocabulary as proof (i.e. competitive markets are
efficient), but don’t use the theory correctly.