Lecture Six: Economic Efficiency

1. Lecture Six:Economic Efficiency IPEM Tohoku University Managerial Economics Lecturer: Jack Wu Period 3/ February 16

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. 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

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

16. 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)

17. 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

18. 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?

19. Incidence: Reducing retail prices