V. General equilibrium with competitive markets

    B. Input efficiency (IE)
            (Frank: production efficiency)

    1. The Edgeworth box for inputs

    This concerns firms and their use of inputs.

    Consider:
    2 firms: i and j in 2 different industries
    2 inputs: K and L

    Each firm's initial endowment:
    i: (Li, Ki)
    j: (Lj, Kj)

    Li + Lj = Lt
    Ki + Kj = Kt

    Do "Achieving input efficiency" worksheet

    Lesson: if MRTSi <> MRTSj, input efficiency can be improved.

    The firm with the higher MRTS values L more highly relative to K. Exchange should give that firm more L and less K.

    2. Input efficiency and competitive markets

    In practice, firms don't bargain much; they just go to the market and buy.

    Unrestricted competitive markets promote input efficincy since producers face equal market-clearing prices for equivalent inputs

    MRTSi = PL/PK = MRTSj

    Main exceptions: input price differentials due to factors such as
    --trade unions
    --resource immobility
    --minimum wage laws with exempt sectors

    Ex: International differences in PL/PK ratios, such as PLus > PKmex

    As long as PLus > PLmex for unskilled labor, both coutnries can produce more by exchange

    Restricted in practice: Note resistance:
    US labor: wage will fall
    Mex capitalists: return to K will fall

    C. Output efficiency (OE)

    We've now addressed the how to produce and for whom to produce questions.
    All that is left is output efficiency

    Output efficiency is the one efficiency we are used to seeing in supply and demand diagrams

    Anytime
        (1) P not = MC
        (2) Qd not = Qs
    we have some output inefficiency.

    Problem with partial equilibrium: with a tax on DVDs, you might be looking at the market for regular  videos. Nothing seems wrong. But maybe people rent more videos because they are discouraged from the DVD market.
    Through general equilibrium analysis, you don't miss see this spillover effect.

    1. Achieving output efficiency

    Concepts regarding PPFs

? What is the economic interpretation of the slope of a PPF?       Size of slope = the opportunity cost of X in terms of Y.     Called the marginal rate of transformation (MRT): rate you have sacrifice Y to get another X.     How is good y transformed into good x?     Down y releases inputs. These inputs then get used to produce x.     A PPF assumes this transformation takes place in the most efficient manner: i.e., DX with as little DY as possible.

    MRT reflects MC of each good

    Example: MCx=$20, MCy=$10
    ? O/Cx = ?

    See handout

    Key result: MRT = MCx/MCy

    (1) Input efficiency and the PPF

    Input efficiency => we are on the PPF
    --can't get more X without giving up Y.

    MRTSx not = MRTSy => we are inside PPF.

    Plot a lens and points at ends of lens, point inside lens.

    (2) Exchange efficiency and the PPF

    Example: a Robinson Crusoe economy (1 person)
    Crusoe is both a consumer and producer
    Instead of a budget line his trade-off is his PPF

GoodX = Coconuts     GoodY = Firewood     MRS = MUc/MUf = 6     MRT = MCc/MCf = 2     U=Ua ? Advice?     Moving to b: MRS falls and MRT rises:     At b: MRS = MRT = 4.

    Does the preceding analysis carry over to an economy with lots of people?
    Yes: consider this:

    With many consumers:

    Can bring any single consumer out to PPF.
    Each one becomes analogous to Robinson Crusoe:
        Compare value to cost and make bargains.

    For every consumer:
    Optimal Q = Q* => MRS = MRT
    Underproduction: Q<Q* => MRS > MRT => raise Q
    Overproduction: Q>Q* => MRS < MRT => lower Q

    2. Output efficiency and competitive markets

    Again, in practice we have prices.

    Unrestricted competitive markets promote output efficincy by ensuring that consumer prices reflect producer costs.

    End result: MRS = MRT

    Counterexamples: Any situation which --> output where value <> cost:
    --taxes, subsidies
    --monopolies

    Example: VAT in Norway

    See: Summary of efficiency conditions handout

    Conclusion:
    See "Testing for economic efficiency" worksheet

    Competition is a powerful force for efficiency. But:
    (1) sometimes we have market situations which keep us from getting to the competitive output level
    (2) sometimes the competitive output level is not the best place to be.

    These are the situations we turn to next

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