Economic Efficiency

1. Economic Efficiency Managerial Economics Jack Wu

2. Econ Efficiency: Conditions • for all users, same marginal benefit • for all suppliers, same marginal cost • marginal benefit = marginal cost

3. Equal Marginal Benefit if not equal • provide more to user with higher marginal benefit • take away from user with lower marginal benefit

4. Equal Marginal Cost if not equal • supplier with lower marginal cost should produce more • supplier with higher marginal cost should produce less

5. Marginal Benefit/Cost • if marginal benefit > marginal cost, produce more of the item • if marginal benefit > marginal cost, produce less of the item

6. Economic efficiency v.s. Technical Efficiency • Contrast economic efficiency vis-à-vis technical efficiency • Technical efficiency • producing at lowest possible cost • doesn’t consider how much benefit the item provides

7. Adam Smith’s Invisible Hand: Price • Competitive market achieves three sufficient condition for economic efficiency: • buyers and sellers in a market system act independently and selfishly, yet the overall outcome is efficient • i) users buy until marginal benefit equals price; • ii) producers supply until marginal cost equals prices; • iii) users and producers face same price.

8. Invisible Hand • Outcome of price competition in market • Marginal benefit = price • Marginal cost = price • Single price in market

9. Example of Invisible Hand • Major policy issue: how to allocate licenses for 3G wireless telecommunications; • “beauty contest” -- France • auction – Germany, UK, US • pioneer: in early 1990s, US Federal Communications Commission showed that spectrum licenses were worth billions; • created pressure on other governments to allocate by auction and not favoritism. • Auction ensures that item goes to user with highest marginal benefit.

10. Invisible Hand • Market system (price system): Economic system in which resources are allocated through the independent decisions of buyers and sellers, guided by freely moving prices. • Successes of market system • West/East Germany • North/South Korea • China after Deng Xiaoping’s reforms

11. De-centralization • create internal market • if there is a competitive market for an item, set transfer price equal to market price • consuming units should be allowed to outsource • Note: • Transfer price: price charged for the sale of an item within an organization; • Outsourcing: purchase of services or supplies from external sources

12. Decentralization • Within organization • For all users, marginal benefit = transfer price • For all producers, marginal cost = transfer price • Marginal benefit = transfer price = marginal cost

13. UCLA Anderson School, 1989 Half an invisible hand is worse than none • priced photocopying paper • free bond paper

14. Price Ceiling Upper limit that sellers can charge and buyers can pay • rent control • regulated price for electricity

15. RENT CONTROL: EQUILIBRIUM 1100 supply b Price ($ per month) 1000 equilibrium 900 excess demand demand 0 290 300 310 Quantity (Thousand units a month)

16. RENT CONTROL: SURPLUSES buyer surplus gain = cfeg buyer surplus loss = dgb seller surplus loss = cfeg + geb d 1100 supply b Price ($ per month) 1000 c g 900 f e demand 0 290 300 310 Quantity (Thousand units a month)

17. Rent Control: Losses • deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur • price elasticities of demand and supply _demand more inelastic --> larger loss _ supply more elastic --> larger loss

18. Price Floor Lower limit that sellers can charge and buyers can pay • minimum wage • agricultural price supports

19. MINIMUM WAGE: EQUILIBRIUM a excess supply supply Wage ($ per hour) 4.20 b 4.00 equilibrium c demand 0 8 10 11 Quantity (Billion worker-hours a week)

20. MINIMUM WAGE: SURPLUSES seller surplus gain = fdge seller surplus loss = ghb buyer surplus loss = fdge + egb a supply f e Wage ($ per hour) 4.20 b 4.00 d g h c demand 0 8 10 11 Quantity (Billion worker-hours a week)

21. Minimum Wage: Losses • deadweight losses -- sellers willing to provide item at price that buyers willing to pay, but provision doesn’t occur • price elasticities of demand and supply _supply more inelastic --> larger loss _demand more elastic --> larger loss

22. Tax: Commodity Tax “the only two sure things in life are death and taxes” • buyer’s price - tax = seller’s price • payment vis-à-vis incidence • US: airlines pay tax • Asia: passengers pay

23. TAX: EQUILIBRIUM $10 804 e supply Price ($ per ticket) 800 b 794 h demand 0 900 920 Quantity (Thousand tickets a year)

24. TAX: SURPLUSES buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg $10 804 f e supply Price ($ per ticket) 800 d g b 794 j h demand 0 900 920 Quantity (Thousand tickets a year)

25. Incidence • incidence and deadweight loss depend on price elasticities of demand and supply • ideal tax (no deadweight loss): inelastic demand/supply • who pays the tax not relevant

26. Retailing: How should manufacturer cut price? • Wholesale price cut: Will retailers pass on the price cut? • Coupons: Will this provide consumers with more effective price cut?

27. Incidence: Reducing retail prices

28. DISCUSSION QUESTION • Consider a company that manages a network of hospitals across several counties in one state. Household incomes and the cost of living are higher in urban than rural areas. The company, however, has set the same prices for pharmaceuticals and services in all of its hospitals. It has also paid the same salaries for doctors, nurses, and other professional staff throughout the state.

29. DISCUSSION QUESTION:CONTINUED • Management has noticed that there are long waiting lists for treatment at its urban hospitals. Can you explain this problem? • The company has had great difficulty in recruiting professional staff for its urban hospitals. Can you explain this problem? • What advice would you give to management?