Economics 001 Definitions of Efficiency Principles of Microeconomics • Engineering efficiency Professor Arik Levinson – output per unit of input – example: miles per gallon •Lecture 4 • Production efficiency –Efficiency –Pareto efficiency – cannot produce more of one good without –Consumer and producer surplus • producing less of another good –Deadweight loss • using more inputs – points on the PPF

Definitions of Efficiency The textbook definition

• Economic efficiency (or Pareto efficiency) –An efficient allocation of resources occurs – cannot make any one person better off without when we produce the goods and services that making another person worse off people value most highly. – Resources are allocated efficiently when it is not possible to produce more of a good or • Note that this is not the textbook definition. service without giving up some other good or service that is valued more highly. – Efficiency is based on value, and people’s preferences determine value.

Efficiency: underlying concepts

• Marginal benefit is the benefit that a person • Marginal cost is the opportunity cost of producing receives from consuming one more unit of a good one more unit of a good or service. or service – measured as the value of the best alternative foregone – measured as the maximum amount that a person is willing to give up for one additional unit • Principle of (eventually) increasing marginal cost – marginal cost increases as the quantity produced • Principle of (eventually) decreasing marginal increases benefit – marginal benefit decreases as consumption increases

1 Another way of thinking about Efficiency and Inefficiency Demand

• Efficiency depends upon a comparison of P marginal cost and marginal benefit. Consumer Surplus

• Three possibilities Willingness – marginal benefit exceeds marginal cost to pay – marginal cost exceeds marginal benefit D – marginal benefit equals marginal cost Q Q

Another way of thinking about Another way of thinking about Supply Market Equilibria

P The market P equilibrium Consumer Surplus S maximizes the sum of CS+PS S

Willingness Willingness to provide to provide Producer Surplus Producer Surplus D

Q Q Q Q

The Efficient Quantity of Pizza The Efficient Quantity of Pizza

25 25

20 20

15 15

10 10

Marginal cost and marginal benefit marginal and cost Marginal (dollars worth of goods and services) 5 benefit marginal and cost Marginal (dollars worth of goods and services) 5 MB

0 5 10 15 20 0 5 10 15 20 Quantity (thousands of pizzas per day) Quantity (thousands of pizzas per day)

2 The Efficient Quantity of Pizza The Efficient Quantity of Pizza Pizza valued more highly than it costs: 25 MC 25 Increase production MC

20 20 Pizza costs more than it is valued: 15 15 Decrease production 10 10

Marginal cost and marginal benefit marginal and cost Marginal (dollars worth of goods and services) 5 MB benefit marginal and cost Marginal (dollars worth of goods and services) 5 MB

0 5 10 15 20 0 5 10 15 20 Quantity (thousands of pizzas per day) Quantity (thousands of pizzas per day)

Another way of seeing the efficient The Efficient Quantity of Pizza quantity of pizza

25 Efficient quantity MC 25 Efficient quantity MC of pizza of pizza 20 20

CSCS + + -CS - 15 15 PSPS PS 10 10

Marginal cost and marginal benefit marginal and cost Marginal (dollars worth of goods and services) 5 MB benefit marginal and cost Marginal (dollars worth of goods and services) 5 MB Low Quantity High Quantity 0 5 10 15 20 0 5 10 15 20 Quantity (thousands of pizzas per day) Quantity (thousands of pizzas per day)

Deadweight Loss and Rent Control At the market equilibrium S (MC) P

•QS=QD CS

•MC = MB Rent ceiling • Welfare (the sum of CS+PS) is maximized. D (MB)

Q* Q

3 Deadweight Loss and Rent Control Deadweight Loss

S (MC) P Deadweight Loss (DWL) DN: Deadweight Loss = The decrease in consumer and producer CS surplus resulting from an inefficient level Rent of production. ceiling

D (MB)

Q* Q

4