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Econ Chapt 12 - Economic Efficiency and Public Policy
Terms in this set (45)
Chapter Outline and Learning Objectives
12.1 Productive and allocative efficiency
- distinguish between productive efficiency and allocative efficiency.
- explain why perfect competition is allocatively efficient, whereas monopoly is allocatively inefficient.
12.2 Economic regulation to promote efficiency
- describe alternative methods for regulating a natural monopoly
12.3 Canadian competition policy
- discuss some details about Canadian competition policy.
12.1 Productive and Allocative Efficiency
- 3 examples of inefficiency in the use of fully employed resources
Efficiency requires that factors of production be
. However, full employment of resources is not enough to prevent the
of resources. Even if factors of production are fully employed, they may be used inefficiently.
3 examples of inefficiency in the use of fully employed resources:
1. If firms do not use the least-cost method of producing their chosen outputs, they are being inefficient.
Ex. Firm that produces 30,000 pairs of shoes at a cost of $400 000 when it could have been done at a cost of only $350,000 - the lower cost method would allow the firm to save money
(this example considers the cost for a single firm producing some level of output)
2. If MC of production is not the same for every firm in the industry, the industry is being inefficient.
- ex. last tonne of steel is higher for some firms than others, industry's overall cost is higher than necessary. Same amount of steel could be produced at a lower total cost if output were distributed differently.
(this example is focusted on the total cost for all firms in an industry)
3. If too much of one product and too little of another product are produced, the economy's resources are being used inefficiently.
- shoes and coats example. Lots many shoes are being produced that the value of shoes to consumers are 0. vs too little of coats are being produced that the value of coats to customers are high. Customers can be made better off if resources are reallocated from shoe production to coat production.
(this example relates to the level of output of one product compared w another)
for the firm
production within each firm.
- When the firm chooses among all available production methods to
produce a given level of output at the lowest possible cost.
- In the SR, w 1 fixed factor, the firm simply uses enough of the variable factors to produce the desired level of output.
- In the LR however, more methods of production are available. Productive efficiency requires that the firm use the least costly method of producing output.
firms are located on, not above, their LRAC curves.
Productive efficiency for the firm requires the firm to be producing its output at the lowest possible cost
- Firms will
be productively efficient if they are producing at a higher cost than is necessary, thus having lower profits than they could have.
- Any profit maximizing firm will seek to be productively efficient no matter what market structure it is - perf competition, monopolistic comp, oligopolies, monopolies.
for the industry
- When the industry is producing a given level of output at the lowest possible cost. This requires MC be equated across all firms in the industry.
- requires that the industry's total output be allocated among its individual firms in such a way that the total cost in the industry is minimized.
- Allocating the industry's output in such a way that it is being productively efficient and minimizing its costs.
- If an industry is
, it is possible to reduce the industry's total cost of producing output by reallocating production among the industries firms.
Productive efficiency for the industry requires that the marginal cost of production be the same for each firm.
- If marginal costs are not equated across firms, then a reallocation of output is necessary in order for the industry to become productively efficient.
Productive Efficiency (for the firm & industry)
and the Production Possibilities Boundary
- If a
is productively efficient, they are minimizing their costs, thus they cannot increase output w out using more resources.
- If an
is productively efficient, the industry as a whole is producing its output at the lowest possible cost; the industry cannot increase output w out using more resources.
Productive efficiency for the industry requires that marginal costs for the production of anyo ne product be equated across all firms.
shows the combinations of output of 2 products that are possible when the economy is using its resources
If firms and industries are productively efficient, the economy will be on, rather than inside, the production possibilities boundary.
- if economy is producing inside the PPB= inefficient. This may be because they are not minimizing their costs, or w in an industry, MC are not equalized across various firms
- A situation in which the output of each good is such that its market price and marginal cost are equal.
- The "ideal" point on the PPB curve.
- When the combo of goods produced is allocatively efficient, the economy is
The economy is allocatively efficient when, for each good produced, its MC of production=P
- then too much of the good is being produced, bc the cost to society exceeds the benefits of consuming it.
- then too little of the good is being produced, bc the cost to society of is less than the benefit gained from consuming it.
- When the combo of goods produced is allocatively efficient, the economy is
Allocative Efficiency and the PPB
- MC(to producers) = MV(to consumers)
- Allocative efficiency requires that all goods be produced to the point where the marginal cost to producers equals the marginal value to consumers.
What is required for productive efficiency?
For productive efficiency
firms must be minimizing their costs and marginal cost should be the same for all firms in any one industry.
face the same market price, and equate their own
, so marginal cost is equated across all firms.
2. when each
in LR equilibrium is producing at the
lowest point on its LRAC curve
3. When the market structure for the whole economy;
4. While specific industries may be productively and allocatively efficient,
entire economies are neither perfectly competitive nor allocatively efficient
1. profits will be maximized when it adopts the
lowest-cost production method
- which means it operates on its LRAC curve.
- since the firm is the only one in the industry, the industry is also productively efficient.
; thus the marginal value to consumers(P) exceeds the marginal cost of production, so a monopoly is
not allocatively efficient.
monopolistic and oligopoly
1. profits will be maximized when they adopt the
lowest-cost production method
- which means the firms in both market structures operate on their LRAC curves.
2. It is not possible to say whether the
in either market structure will be productively efficient. Since each firm sells differentiated products, there is no single industry-wide price. Therefore,
it is impossible to conclude that marginal costs will be equated across all firms.
1. For both monopolistic competition and oligopolies, P>MC, therefore they will not be allocatively efficient.
- For oligopoly however, there are are some situations where rivalry between firms drives price toward marginal cost, improving efficiency.
Allocative efficiency and total surplus
- another way of thinking about allocative efficiency, is to use the concepts of consumer and producer surplus.
- diff between the value consumers place on a product and what they actually pay.
- the price of a good minus the marginal cost of producing it, summed over the quantity produced.
- diff between the actual price that the producer receives and the lowest price that the producer is willing to accept.
For each unit sold, producer surplus is the difference between price and marginal cost
- By producing 1 more unit, the producers costs increase by the marginal cost - this is the lowest amount the producer is willing to accept - anything less than the MC would reduce the firm's profits.
- For a producer
selling many units
of the product, total producer surplus is the diff between P and MC summed over all the units sold.
- For an individual producer, total producer surplus = area above MC and below P.
- For the whole industry, we need to know the industry supply curve to compute overall producer surplus. Since in perf comp supply curve is the horizontal sum of all firms' MC curves (S=MC), producer surplus = area above S and below P.
The Allocative Efficiency of Perfect Competition Revisited
allocative efficiency exists in a market if total economic surplus is maximized.
Allocative efficiency occurs at the level of output where the sum of consumer and producer surplus is maximized.
- where demand and supply curves intersect (equilibrium)
What does it tell us when demand curve lies above the supply curve in perf comp?
1. consumer value an extra unit of product
than it costs to produce it.
2. society is better off if less of that product is produced.
What does it tell us when demand curve lies below the supply curve in perf comp?
- at any level of output above equilibrium, total surplus is negative.
- producers would earn negative producer surplus because the MC(supply curve) on those units exceeds P.
- consumers would also earn negative consumer surplus because their marginal value (represented by the demand curve) is below price.
For a perfectly competitive market, when is producer and consumer surplus maximized? What is the level of output that is allocatively efficient? Why is this level of output allocatively efficient?
The sum of producer and consumer surplus is maximized only at the perfectly competitive level of output. (equilibrium; when
(MC) or MV=MC) This is the only level of output that is allocatively efficient.
- Competitive equilibrium is allocatively efficient because it maximizes the sum of consumer surplus and producer surplus.
The allocative inefficiency of monopoly revisited
- the lower monopoly output reduces consumer and producer surplus.
- the monopoly equilibrium is not the voluntary agreement between producer and consumers. It is imposed by the monopolist by the power it has over the market.
- Monopolists choose output below the competitive level, which makes market price higher than it would be under perf comp. Results in a loss of surplus for consumers and and an increase in surplus for producers. -
monopolists gains at the expense of others
- When output is below the competitive level, there is always a
of total surplus - most, but not all of the lost consumer surplus is gained from producers- some is DWSL. This is because output between the monopolistic and the competitive levels is not produced - this loss is called the
deadweight loss of monopoly
When is Government intervention needed in Monopolistic markets?
- DWSL created by monopolies leads to conflict between the interest of the monopolist and society as a whole (nation's consumers).
- This creates grounds for government intervention - to prevent monopolies or regulate their behaviour.
Allocative efficiency and market behaviour
- when is gov intervention appropriate
- Perfect competition is an ideal that exists in a small number of industries, is only approximated in others, and not even close in most. Therefore, to say that perf comp is allocatively efficient is not to say that real-world market economies are ever allocatively efficient.
One of the most important issues in public policy is determining the circumstances in which government action can increase the allocative efficiency of market outcomes.
- when market transactions - production or consumption or both - impose costs or confer benefits on economic agents who are not involved in the transaction.
- involves economic costs or benefits for parties that are
to the transaction
- generally raise the possibility that market outcomes will be allocatively inefficient.
- ex. technology of agricultural production uses extensive fertilizers that cause pollution. - effects ppl who drink from the water and aquatic life - these are externalities and are costs that are not considered in the market for the agricultural products (they are thus external to transactions in these markets)
Economic regulation to promote efficiency
-Monopoly practices, and
- Competition policy / economic regualtions
- Monopolies, cartels, and price-fixing agreements among oligopolists, whether explicit or tacit, have met w public suspicion and official hostility. - These and other non-competitive practices are referred to as
- laws, regulations etc that are used to encourage competitive behaviour and discourage monopoly practices make up
- Canadian competition policy has sought to create more competitive behaviour where market structures cannot be established.
- Governments also employ
which state the rules under which firms can do business and sometimes determine the prices that businesses can charge for their output.
- Ex. Canadian Radio-television and Telecommunications Commission (CRTC) - regulates many aspects of radio, TV, price you pay for cellphone and internet etc; or OSFI (oversees regulations of banks and insurance companies)
- Gov regulates the extraction of fossil fuels and the harvesting of forests w in their provincial boundaries. (and charge royalties)
- regulate the zoning of land, and operation of restaurants, taxicabs, and issue licences for retail businesses.
Competition policies to promote allocative efficiency
- Competition policies are used to promote allocative efficiency by increasing competition in the market place.
Economic regulations to promote allocative efficiency
- When competitive behaviour is not possible - as in the case of natural monopolies, like gas or electricity distribution companies - public ownership or economic regulation of privately owned firms can be used as a substitute for competition.
- Consumers can be protected from high prices and reduced output that would likely result from unregulated use of monopoly power.
An industry characterized by economies of scale sufficiently large that one firm can most efficiently supply the entire market demand.
- An industry in which economies of scale are so dominant that there is room for
one firm to operate at the minimum efficient scale. (the firm's LRAC curve is declining over the entire range of the market demand curve)
- found mostly in public utilities - ex electricity transmission and natural gas distribution. - these types of industries require large and expensive distribution networks (ex pipelines, transmission lines) and the size of the market is such that only a single firm can achieve MES while still covering its costs.
Government regulation of Natural Monopolies
- Most common case for public intervention is with natural monopolies.
- One response to natural monopoly is for government to assume ownership of the single firm -
(businesses/corporations owned and operated by the government) - supposed to set prices in public interest.
Ex. Canada Post, Ontario hydro
- Another response is to allow private ownership but regulate the monopolist's behaviour.
Ex. cable tv and local internet service providers
- when gov regulates the monopolist's behaviour, it's pricing policy is determined by the government. Industry is required to follow some pricing policy that conflicts w the goal of profit maximization for monopolies.
3 general types of pricing policies for regulated natural monopolies:
1. Marginal-Cost Pricing
2. Two-Part Tariff
3. Average-Cost Pricing
- sometimes gov enforces that the natural monopoly must set a price where the market demand curve and the firm's marginal cost curve intersect. (Marginal-Cost Pricing)
This leads to the allocatively efficient level of output- however, this is NOT profit-maximizing output -where MC=MR.
-This sets up tension between the regulators desire to achieve the allocatively efficient level of output, and the firm's goal to maximize profits.
- Natural monopolies LRAC curve declines over the rage of the market demand curve- thus MC is less than LRAC, and when Price(demand)=MC, price will be less than av cost. Therefore, marginal cost pricing will lead to losses.
When a natural monopoly w falling av costs sets a price equal to marginal cost, it will suffer losses.
- firm incurs economic losses, which means this situation cannot be sustained for long. There is a motivation for 2 alternative pricing policies (av-cost pricing and two-part tariff)
- Pricing policy that permits the natural monopoly to cover its costs by allowing it to charge a two-part tariff in which customers pay one price to gain access to the product and a second price for each unit consumed.
- Ex. Regulated cable TV company or Internet service provider. The hookup fee includes fixed costs, and then each unit of output can be priced at marginal cost.
- Hook up fee is considerably high, however since fee includes that household's share of the firm's fixed costs, then the large fee is more understandable.
- A way to regulate a natural monopoly is to set prices just high enough to cover total costs, thus generating neither profits nor losses.
- Firm produces at a level of output which the demand curve cuts the LRAC curve. This pricing policy requires producing at less than the allocatively efficient output.
- The firm's losses that would occur under marginal cost pricing are avoided by producing less output (and having higher prices) than what is socially optimal.
For a natural monopoly w falling average costs, a policy of average-cost pricing will not result in allocative efficiency because price exceeds marginal cost
Average or Marginal-Cost pricing?
- regulators may choose average-cost pricing over marginal-cost pricing....
Marginal-cost pricing generates allocative efficiency, but firm incurs losses. The firm will eventually go out of business unless someone is prepared to cover the firm's losses. If the government has no incentive to do so, then the average-cost pricing may be preferable.
Average-cost pricing provides the lowest price that can be charged and the largest output that can be produced, given that revenue must cover the total cost of producing the product.
What is the implications of choosing average-cost pricing in the long-run?
- since MC is below AC,
average-cost pricing will generally lead to inefficient long-run investment decisions.
- A natural monopoly will be required to set P=AC. and the firm be just breaking even. If it expanded its capacity (moved down LRAC curve) the regulated price would fall and firm would still be breaking even, so it has no incentive to do so. P must exceed MC in this case (because MC must be below AC and AC is falling). Society would benefit by having a larger amount of fixed capital allocated to producing this good.
A gov-owned natural monopoly may make such an investment, however a regulated but privately owned firm has little or no incentive to do so if it will just break even.
a socially desirable investment will not likely occur when a firm is required to use av-cost pricing.
Very Long-Run Innovation
Industries that once used to be natural monopolies are now more competitive industries due to innovation and technological change.
Ex. airlines, courier services, long-distance telephone services, the generation of electricity.
Problems with regulations designed to prevent natural monopolies from charging profit-maximizing prices:
- regulators usually do not have enough info to determine demand and cost curves precisely. Without accurate data, regulators judge prices according to the firm's profits.
Regulators tend to permit price increases only when profits fall below 'fair' levels and require price reductions if profits exceed such levels.
What started as price regulation ends up becoming profit regulation- which is referred to as
- If average-cost regulation is successful, only normal rate of return will be earned (economic profits will be zero).
Unfortunately the reverse is not necessarily true. Profits can be zero for a number of reasons: inefficient operation, excessive salaries or employee benefits, and misleading accounting.
- Regulatory commissions that rely on rate or return as their guide to pricing must monitor a number of other aspects of the regulated firm's behaviour in order to limit the possibility of wasting resources. This monitoring itself requires considerable expenditure of resources.
Regulation of Oligopolies
- Governments have also intervened in industries that were oligopolies, seeking to enforce the type of price and entry behaviour that was thought to be in the public interest. Either by government owned oligopolies or government regulated oligopolies.
Skepticism about government direction: 2 main experiences that are important in developing this skepticism:
1. Oligopolies and Innovation
- oligopolies have led to new products and production methods that have led to higher living standards and higher productivity. As long as oligopolists continue to compete, rather than cooperate to produce monopoly profits, economist see no need for government regulations - for gov to regulate prices at which oligopolists sell their products and the conditions of entry into oligopolistic industries.
2. Protection from Competition
- Postwar gov intervention in regulated industries did not prove to be very successful. In many industries the regulatory bodies get "captured" by the very firms that they're supposed to be regulating. Regulating agencies tend to hire former employees of the regulated firm in attempt to hire 'knowledgeable' people; which leads to these employees being sympathetic to the firms in the industry, and as a result, instead of ensuring competition often act to enforce monopoly practices that would be illegal if instituted by the firms themselves.
- The process of regulation, rather than protecting its consumers from anti-competitive behaviour by the firms, often ends up protecting firms from competition.
-creates monopoly practices and discourages competition.
Deregulation and Privatization
- 3 negative consequences of gov intervention
- Many industrialized economies began to reduce the level of gov control over industry; because:
1. realization that regulatory actions led to reduced competition instead of increased competition.
2. wrongly thought that publicly owned firms would work better than privately owned firms.
3. falling costs for things like transportation, communications, data processing actually exposed local industries to more international competition than they had experienced domestically beforehand.
Deregulation and Privatization
- 2 policies that were put in place as a result of failed gov intervention
- After experiencing these negative results from government regulation, two policies were put in place as a result:
1. Deregulation - intended to leave prices and entry to be determined by private decisions.
2. Privatization of publicly owned firms.
- Resulting in many government owned crown corporations to be privatized and the deregulation of government regulated corporations. Prices were freed to be set by the firms in the industries and entry was no longer restricted by government policies.
A return to government control?
The global financial crisis in 2008 followed by a severe global recession, government intervention was seen to be necessary to prevent the collapse of big industries such as General Motors and Chrysler. They were a support to these firms in attempt to dampen the reduction in output and rise in unemployment. However, government support was only meant to be temporary, and not design to be a return to the government control of private firms, rather temporary gov support response to unusual problems in an rare circumstance.
- least stringent form of government is designed not to force firms to sell at particular prices or regulate conditions of entry or exit; but rather to create conditions of competition by preventing firms from merging unnecessarily or from engaging in anticompetitive practices, such as coming together to set monopoly prices. (form monopolies/oligopolies)
- policy designed to prohibit the acquisition and exercise of monopoly power by business firms.
The evolution of Canadian policy
By the 1950's the following 3 classes of activity were illegal:
By the 1950's the following 3 classes of activity were illegal:
1. price-fixing agreements that lessen competition
2. merers or monopolies that operate not in the public interest
3. "unfair" trade practices
-Regulated by the competition Bureau
The Competition Act was recently amended (updated) to:
1. increase penalties for deceptive marketing
2. create more effective mechanism for criminal prosecution of cartel agreements
3. introduce 2-stage merger review to improve efficiency and effectiveness
4. allow the Competition Tribunal to assign penalties to companies who abuse a dominant position in the marketplace.
- The ongoing process of globalization poses 2 challenges for canadian competition policy
1. As the flow of goods and services across national boundaries increases, it becomes more important to define markets on an international rather than national basis.
Ex. Canadian banking industry - w continuing development of the internet, it becomes possible for foreign banks to sell some financial services to Canadians w out establishing a costly physical presence in Canada.
2. Desirability of standardizing competition policy across countries. Firms that are mobile have considerable market power and may locate their firms where competition policy is most lax, exporting to other countries.