Principles of Microeconomics – Mr. Lilly

Topic 6 Skills

1. Know the meaning of the expressions “allocative efficiency” and “productive efficiency”. (Lecture only: slide 6-4.)

(Slide 4) Two Different Kinds of Efficiency

Allocative efficiency: “Producing the right things.” Allocative efficiency occurs when we’re producing the right MIX of goods. The one that produces the most collective happiness.

Productive efficiency: “Producing the things right.” Productive efficiency occurs when you’re producing ON the production possibilities curve instead of INSIDE it.

(slide 4) When we’re making the RIGHT STUFF – the mix of goods and services that, among all combinations that are technologically feasible – MAXIMIZES the collective happiness of the members of society – then we say we have ALLOCATIVE EFFICIENCY.

2. Know the meaning of the expression “Pareto Efficient.”

(Slide 3) We also show how to measure the economic loss from producing more or less than the Pareto efficient quantity.

(165)Pareto efficient = a situation in which it is not possible to make someone better off without making someone else worse off.

(slide 6) A Specific Measure of Allocative Efficiency

Pareto Efficient: An allocation of resources so nearly perfect that is is not possible to make someone better off without making someone else worse off.

An example of a Pareto Inefficient Allocation of Resources:

•An coal-burning electric generating plant with no air pollution control equipment.

3. Know the First Theorem of Welfare Economics.

(Slide 3) The main goal of this chapter is to state clearly and prove intuitively the “first theorem of welfare economics,” also know as “the invisible hand theorem.”

(Slide 9) Assumptions Required to Prove The First Theorem of Welfare Economics

(167) first theorem of welfare economics = the conclusion that a competitive market results in an efficient outcome; sometimes called the “invisible hand theorem”; the definition of efficiency used in the theorem is Pareto efficiency.

(165)Pareto efficient = a situation in which it is not possible to make someone better off without making someone else worse off.

•(Slide 8) The First Theorem of Welfare Economics

•“Under certain assumptions, competitive markets will produce a Pareto optimal allocation of society’s resources.”

•The perfect number of hamburgers will be cooked, and the perfect number of vegetarian meals!

•The perfect number of pairs of tennis shoes will be manufactured, in the perfect sizes and colors!

•No “Pareto superior” reallocation will be possible!

(slide 9) Assumptions Required to Prove The First Theorem of Welfare Economics

•Consumers are rational and have perfect information about all available products, and transaction costs are zero.

•All products are homogenous within each market and all markets are perfectly competitive.

•There are no externalities or public goods.

•Firms have perfect information about the skills and contributions of current and available workers, are rational, and are not prejudiced against any persons.

•Consumers are rational and have perfect information about all available products, and transaction costs are zero.

•All products are homogenous within each market and all markets are perfectly competitive.

•There are no externalities or public goods.

•Firms have perfect information about the skills and contributions of current and available workers, are rational, and are not prejudiced against any persons.

4. Know the meaning of the expression “total economic surplus”. (Lecture only: slide 6-11.)

Measuring the Economic Cost of Market Disequilibrium

Consumer Surplus: The difference between the maximum consumers would have been willing to pay for their purchases and the amount they actually had to pay.

Producer Surplus: The difference between the price firms received for their output and the variable cost of producing that output.

Total Economic Surplus: The sum of consumer surplus and producer surplus.

5. Be able to identify the area of negative consumer surplus and the area of negative producer surplus that would be earned if more than the equilibrium quantity were manufactured and sold. (See the bottom third of figure 7.7 or slide 6-13.)

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6. Know the meaning of the expressions “price ceiling” and “price floor.” Know whether a price ceiling will cause a shortage or a surplus. Know whether a price floor will cause a shortage or a surplus. Know whether a minimum wage law is a price ceiling or a price floor. Know whether rent control is a price ceiling or a price floor. Know whether farm price supports are a price ceiling or a price floor. (See slides 6-15 to 6-21.)

(72) price ceiling = a government price control that sets the maximum allowable price for a good.

(72) price floor = a government price control that sets the minimum allowable price for a good.

Price floor -> surplus, minimum wage, Many farm products have minimum prices set.

Price ceiling -> shortage, rent control

(21) Price Ceiling

•A law or regulation that prevents sellers from charging more than a specified amount

•It keeps price low

•It reduces total economic surplus

•It would allow some poor families to buy some of the good at the reduced price

•But it results in an allocation of resources that is not Pareto Efficient

•Let us construct a mutually-beneficial trade to show that the allocation of resources is not Pareto Efficient.

7. Be able to calculate the following items for a per-unit tax, given simple linear demand and supply curves: the consumer surplus before and after the tax, the producer surplus before and after the tax, the tax revenue collected by the government, and the deadweight loss. Be able to identify the graphical area that quantifies the deadweight loss. (See slides 6-24 to 6-26.)

8. Understand Key Element of Economics #10; and in particular, know both the noble intentions behind and some of the unintended effects of: a. rent controls, and b. tariffs on imported products such as automobiles. (See slide 6-27 and Gwartney and Stroup pages 27-29.)

Key Element of Economics #10

“Ignoring secondary effects and long-term consequences is the most common source of error in economics.”

•The unintended effects of rent controls are reduced investments in housing stock, poorly maintained apartments, reduced supply, shortages, and illegal payments.

•A tariff on imported Japanese automobiles functions exactly like a per-unit tax. The unintended effects include reduced consumer surplus for U.S. consumers, lower spending on other items (because of the income effect of a price increase,) and lower levels of U.S. exports to other countries.

(172) deadweight loss = the loss in producer and consumer surplus due to an inefficient level of production

(171) consumer surplus + producer surplus = marginal benefit – marginal cost.

(148) producer surplus = the difference between the price received by a firm for an additional item sold and the marginal cost of the item’s production; for the market as a whole, it is the sum of all the individual firms’ producer surpluses, or the area above the market supply curve and below the market price.

Firm’s Profit = producer surplus – fixed costs

(155) invisible hand = the idea that the free interaction of people in a market economy leads to a desirable social outcome; the term was coined by Adam Smith

(155) competitive equilibrium model = a model that assumes utility maximization on the part of consumers and profit maximization on the part of firms, along with competitive markets and freely determined prices.

(159) equilibrium price = the price at which quantity supplied equals quantity demand.

(160) surplus (excess supply) = the situation in which quantity supplied is greater than quantity demanded.

(160) shortage (excess demand) = the situation in which quantity supplied is lower than quantity demanded.

(168) income inequality = disparity in levels of income among individuals in the economy.

(72) price control = a government law or regulation that sets or limits the price to be charged for a particular good.

(72) rent control = a government price control that sets the maximum allowable rent on a house or apartment.

(72) minimum wage = a wage per hour below which it is illegal to pay workers.