ECONOMIC EFFICIENCYManagerial EconomicsJack Wu

ECON EFFICIENCY: CONDITIONS

for all users, same marginal benefit for all suppliers, same marginal cost marginal benefit = marginal cost

EQUAL MARGINAL BENEFITif not equal provide more to user with higher marginal

benefit take away from user with lower marginal

benefit

EQUAL MARGINAL COSTif 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

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

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.

INVISIBLE HANDOutcome of price

competition in market Marginal benefit =

price Marginal cost = price Single price in market

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.

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

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

DECENTRALIZATION Within organization

For all users, marginal benefit = transfer price For all producers, marginal cost = transfer price Marginal benefit = transfer price = marginal cost

UCLA ANDERSON SCHOOL, 1989

Half an invisible hand is worse than none priced photocopying paper free bond paper

PRICE CEILINGUpper limit that sellers can charge and buyers can pay rent control regulated price for electricity

0

1100

290 300 310

supply

demand

b

equilibriumexcess demand

Quantity (Thousand units a month)

Price

($ p

er

mon

th)

RENT CONTROL: EQUILIBRIUM

1000 900

0

1100

290 300 310

supply

demand

b

Quantity (Thousand units a month)

Price

($ p

er

mon

th)

RENT CONTROL: SURPLUSES

1000 900

d

g

e

buyer surplus gain = cfeg buyer surplus loss = dgbseller surplus loss = cfeg + geb

c

f

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 FLOORLower limit that sellers can charge and buyers can pay minimum wage agricultural price supports

0

4.20

8 10 11

supply

demand

a

b

c

equilibrium

excess supply

Quantity (Billion worker-hours a week)

Wag

e ($

per

hou

r)

MINIMUM WAGE: EQUILIBRIUM

4.00

0

4.20

8 10 11

supply

demand

a

b

c

Quantity (Billion worker-hours a week)

Wag

e ($

per

hou

r)

MINIMUM WAGE: SURPLUSES

4.00

f

d

e

g

seller surplus gain = fdgeseller surplus loss = ghb buyer surplus loss = fdge + egb

h

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

0

800

900

e

Quantity (Thousand tickets a year)

Price

($ p

er ti

cket

)

supply

demand

$10

TAX: EQUILIBRIUM

b

h

804

794

920

0

800

900

e

Quantity (Thousand tickets a year)

Price

($ p

er ti

cket

)

supply

demand

$10

TAX: SURPLUSES

b

h

804

794

920

f

d

j

buyer surplus loss = fdge + egb seller surplus loss = djhg + ghb revenue gain = fdge + djhg

g

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

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?

INCIDENCE: REDUCING RETAIL PRICES

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.

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?