Efficiency IMBA Managerial Economics Jack Wu
Econ Efficiency: Conditions • for all users, same marginal benefit • for all suppliers, same marginal cost • marginal benefit = marginal cost
Equal Marginal Benefit if not equal • provide more to user with higher marginal benefit • take away from user with lower marginal benefit
Equal Marginal Cost if not equal • supplier with lower marginal cost should produce more • supplier with higher marginal cost should produce less
Marginal Benefit/Cost • if marginal benefit > marginal cost, produce more of the item • if marginal benefit > marginal cost, produce less of the item
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.
Example of Invisible Hand • Major policy issue: how to allocate licenses for 3G wireless telecommunications; • 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.
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
UCLA Anderson School, 1989 Half an invisible hand is worse than none • priced photocopying paper • free bond paper
Price Ceiling Upper limit that sellers can charge and buyers can pay • rent control • regulated price for electricity
Rent Control: Equilibrium 1100 supply b Price ($ per month) 1000 equilibrium 900 excess demand demand 0 290 300 310 Quantity (Thousand units a month)
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)
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
Price Floor Lower limit that sellers can charge and buyers can pay • minimum wage • agricultural price supports
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)
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)
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
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
Tax: Equilibrium $10 804 e supply Price ($ per ticket) 800 b 794 h demand 0 900 920 Quantity (Thousand tickets a year)
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)
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
Discussion Question 1 • 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.
Discussion Question 1: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?
Discussion Question 2 • E-commerce is predicted to reduce the cost of intermediary services such as those of travel agencies, real-estate brokers, and investment advisors. Consider the market for air travel. Suppose that, with conventional travel agencies, the market equilibrium price is $300 per ticket, including a $15 intermediation cost. The quantity bought is 2 million tickets a year. With e-commerce, however, the intermediation cost falls to $2 per ticket.
Discussion Question 2:continued • Using suitable demand and supply curves, illustrate the original equilibrium with conventional travel agencies. Represent the intermediation cost by shifting the supply curve. • Illustrate the new equilibrium with e-commerce. • What factors determine the extent to which consumers will benefit from e-commerce? Explain your answer with demand and supply curves.
Discussion Question 3 • Typical real-estate broker: "In California, the seller always pays the broker's commission, so, buyers get brokerage services free." • MBA: "If the custom were for the buyer to pay the commission, then would sellers get brokerage services free?" • Real-estate broker, clearly losing patience: "That is a purely hypothetical scenario, but if that situation were to arise, yes, I guess you're right."
Discussion Question 3:continued • Assume that each seller pays a brokers' commission of $18,000. Then, the supply of houses includes the cost of brokerage. Illustrate the market equilibrium with a price of $310,000 per house and sale of 200,000 houses a year. • Now suppose that buyers rather than sellers pay the $18,000 commission. Using your figure, illustrate the following: (i) shift the supply curve down by $18,000 since sellers do not pay the commission, and (ii) shift the demand curve down by $18,000 since buyers now pay the commission.
