Chapter 4

1. Chapter 4 Efficiency and Technical Progress

2. Pareto optimality Compensation principle Marginal willingness to pay Consumer surplus Producer surplus Deadweight loss Economies of scale Natural monopoly Monopolistic competition X-inefficiency Rent-seeking behavior Production function Technical progress Key Concepts

3. Defining the Goals • Static efficiency assumes the technology is given • Dynamic efficiency assumes resources are also allocated to developing new technologies

4. Perfect Competition: Recap • All goods are private goods • Consumers are perfectly informed about all goods • No increasing returns to scale and technological change • Consumers maximize their preferences given budget constraints • Producers maximize their profits given their production functions • All agents are price takers • No externalities

5. Welfare Theorem • Under the assumptions of perfect competition the resulting competitive equilibrium is Pareto optimal • In other words, in the competitive equilibrium you cannot improve the society’s welfare without hurting someone • Prices equal marginal costs in all markets

6. Scope for Government Intervention • Government is not necessary under perfect competition • Antitrust policies become necessary when we relax the assumption of price-taking behavior

7. Economic Surplus

8. Maximizing Total Surplus • Maximizing total surplus is equivalent to maximizing the sum of consumer and producer surpluses • Maximizing total surplus is equivalent to choosing the output level where price equals marginal cost • This point is an intersection of supply and demand curves • At this intersection quantity demanded and quantity supplied are equal to each other • Since the supply curve is also the marginal cost curve, at competitive equilibrium prices are equal to marginal costs • At the output levels smaller than the competitive equilibrium marginal willingness to pay exceeds marginal cost (P>MC) so producing and selling an additional output unit will increase total surplus • Equivalently, if output level exceeds the competitive equilibrium level (P<MC) total surplus can be increased by reducing production by one unit • Thus the only stable (equilibrium) point is at the output level where P=MC

9. Deadweight Loss: a Recap • Area FHD in the graph above is called deadweight loss since it represents the potential increases in total surplus that are not realized when output is held at a level different from the competitive equilibrium level • For example, a cartel may agree to keep output levels below the equilibrium level causing a deadweight loss • The loss is deadweight since a transition from the competitive outcome to the cartel output level results in decreases of consumer and producer surpluses that cannot be accounted for by the process of redistribution

10. Deadweight Loss of a Monopoly

11. Example: a Monopoly • A monopolist will produce at a point where its marginal revenues are equal to its marginal costs and the price is above the marginal cost • We assume a perfectly elastic (horizontal) supply curve (marginal cost curve MC) which in that case is equal to the average cost curve AC • Consumer surplus is the area of triangle APmB, producer surplus is the area of rectangle PmBCPc • Competitive equilibrium at point D results in zero producer surplus and consumer surplus equal to APcD • The total surplus now is greater than the total surplus under monopoly, but producers are harmed so that breaking up the monopoly is a desirable policy from the point of view of the compensation principle

12. Natural Monopolies • So far we have assumed that a large firm can be replaced by a number of small firms with no effects on costs • This assumption no longer holds when we face economies of scale • Economies of scale happen when increasing output results in a decrease in average costs • Minimum efficient scale (MES) level of output occurs where average costs are minimized • If the MES is large enough to be comparable to the size of the market, the monopolistic output is more efficient compared to the perfectly competitive one • We call this sort of monopoly a natural monopoly

13. Natural Monopoly

14. When More is Worse • Qm is monopolistic level of output at which price exceeds marginal cost • Splitting the large firm to a number of small firms each one of which produces q units of output will destroy the monopoly, but it will also increase the price to the level of Pc resulting in an even larger difference between price and marginal cost • Examples: • Electric power plants • Sewage facilities • Regulating a natural monopolist • Require pricing so as to receive a fair return on investments • Nationalize the enterprise (Norway oil plants)

15. Monopolistic Competition

16. Monopolistic Competition • Product differentiation refers to a situation where several products are reasonably close substitutes for each other within a product group • Real differences • Perceived differences • In this case we talk about monopolistic competition within a product group • Under monopolistic competition the output level is chosen at a point where demand curve is tangent to the long-run average cost curve • The price is above marginal cost, but is this a problem? • “If heterogeneity is part of the welfare ideal there is no case for doing anything at all…. Unless it can be shown that the loss of satisfaction from a more standardized product is less than the gain from producing more units, there is no “waste” at all, even though every firm is producing to the left of its minimum point.” • The difficult problem is the optimal level of product variety

17. X-Inefficiency • So far we assumed firms are utilizing their resources in an optimal way • However, lack of competition may induce monopolists to be less efficient • We call this inefficiency X-inefficiency • Even if X-inefficiency looks irrational it can occur when ownership is separated from control

18. Rent-Seeking Behavior • Being a monopolist means earning rents in the form of producer surplus • Firms will be willing to pay as much as the size of this producer surplus in order to gain the right to be a monopoly (e.g. under franchising agreement with the government) • This competition will use up real resources that could have been used in real production thus resulting in a real loss to the economy • Firms competing in that way are said to be engaging in the rent seeking behavior

19. Technical Progress • 1909-1949: more than 80% of increase in gross output per worker in the U.S. attributed to technological change • An increase in output between the two years can be decomposed into two parts • Increase due to the technological change (movement of the production function) • Increase due to the increase of capital (movement along the production function) • Technological progress is impossible without research and development (R&D), but it is hard to achieve the desirable level of R&D without granting firms some monopoly power • Patents • Royalties • Competitive pressure may also induce more R&D • Scherer and Ross model of innovation • More rivals are needed to spur R&Dmore innovation • More rivals engaging in R&D mean less individual profitsless innovation

20. Technical Progress