16.1 General Equilibrium Analysis - PowerPoint Presentation

1. 16.1 General Equilibrium Analysis16.2 Efficiency in Exchange16.3 Equity and Efficiency16.4 Efficiency in Production16.5 The Gains from Free Trade16.6 An Overview—The Efficiency of Competitive Markets16.7 Why Markets FailC H A P T E R 16Prepared by:Fernando Quijano, IllustratorGeneral Equilibrium andEconomic EfficiencyCHAPTER OUTLINE

2. General Equilibrium Analysis16.1● partial equilibrium analysis Determination of equilibrium prices and quantities in a market independent of effects from other markets.● general equilibrium analysis Simultaneous determination of the prices and quantities in all relevant markets, taking feedback effects into account.A feedback effect is a price or quantity adjustment in one market caused by price and quantity adjustments in related markets.In practice, a complete general equilibrium analysis, which evaluates the effects of a change in one market on all other markets, is not feasible. Instead, we confine ourselves to two or three markets that are closely related. For example, when looking at a tax on oil, we might also look at markets for natural gas, coal, and electricity.

3. TWO INTERDEPENDENT MARKETS: (A) MOVIE TICKETS AND (B) DVD RENTALSFIGURE 16.1 (1 of 2)When markets are interdependent, the prices of all products must be simultaneously determined. Here a tax on movie tickets shifts the supply of movies upward from SM to S*M, as shown in (a). The higher price of movie tickets ($6.35 rather than $6.00) initially shifts the demand for DVDs upward (from DV to D’V ), causing the price of DVDs to rise (from $3.00 to $3.50), as shown in (b).Two Interdependent Markets—Moving to General Equilibrium

4. TWO INTERDEPENDENT MARKETS: (A) MOVIE TICKETS AND (B) DVD RENTALSFIGURE 16.1 (2 of 2)The higher video price feeds back into the movie ticket market, causing demand to shift from DM to D’M and the price of movies to increase from $6.35 to $6.75. This continues until a general equilibrium is reached, as shown at the intersection of D*M and S*M in (a), with a movie ticket of $6.82, and the intersection of D*V and SV in (b), with a DVD price of $3.58.

5. Reaching General EquilibriumIn the end, we must determine the equilibrium prices and quantities ofboth movies and DVDs simultaneously.To find the general equilibrium prices (and quantities) in practice, we must simultaneously find two prices that equate quantity demanded and quantity supplied in all related markets. For our two markets, we need to find the solution to four equations (supply of movie tickets, demand for movie tickets, supply of DVDs, and demand for DVDs).In this example, partial equilibrium analysis would lead us to conclude that the tax will increase the price of movie tickets would increase by less. A general equilibrium analysis, however, shows us that the impact of the tax on the price of movie tickets is greater.Movies and DVDs are substitute goods. If the goods in question were complements, a partial equilibrium analysis would overstate the impact of a tax.

6. EXAMPLE 16.1THE GLOBAL MARKET FOR ETHANOLThe world ethanol market is dominated by Brazil and theUnited States, which accounted for over 90 percent ofworld production in 2005.The U.S. and Brazilian ethanol markets are closely tied toeach other. As a consequence, the U.S. regulation of itsown ethanol market can significantly affect Brazil’smarket.To spur alternatives to gasoline, the U.S. offered a tax credit of $0.51 per gallon of ethanol. Moreover, to prevent foreign ethanol producers from reaping the benefits of this tax credit, the U.S. government imposed a $0.54 per gallon tax on imported ethanol. The policy has been highly effective.While this policy has benefited corn producers, it is not in the interests of U.S. ethanol consumers. Consumers would benefit if the tax and subsidy were removed.

7. EXAMPLE 16.1THE GLOBAL MARKET FOR ETHANOLREMOVING THE ETHANOL TARIFF ON BRAZILIAN EXPORTSFIGURE 16.2If U.S. tariffs on ethanol produced abroad were to be removed, Brazil would export much more ethanol to the United States, displacing much of the more expensive corn-based ethanol produced domestically. As a result, the price of ethanol in the U.S. would fall, benefiting U.S. consumers.

8. EXAMPLE 16.2“CONTAGION” ACROSS STOCK MARKETS AROUND THE WORLDStock markets around the world tend to move together, a phenomenon referred to as “contagion.” The reasons why they move together are manifestations of general equilibrium. First, stock (and bond) markets are highly integrated. Any external shocks that affect stock prices in one country will have the same directional effect on prices in other countries.The second reason is that economic conditions around the world tend to be correlated, and economic conditions are an important determinant of stock prices. A recession in the United States can lead to a recession in Europe, and vice versa.

9. EXAMPLE 16.2“CONTAGION” ACROSS STOCK MARKETS AROUND THE WORLDSTOCK PRICES IN THE UNITED STATES AND EUROPEFIGURE 16.3Three stock market indices—the S&P 500 in the United States, the FTSE in the United Kingdom, and the DAX in Germany—are plotted together, scaled so that each starts at 100 in 1984. The indices tend to move together, increasing and decreasing at about the same time.

10. Economic EfficiencyWhen applied to a competitive market, the term economic efficiencyrefers to a market that maximizes aggregate consumer and producer surplus. Fortunately, there is a concept of economic efficiency that applies when there is no market at all.We are now focusing on the interplay of multiple markets with multiple entities competing against each other or trading with each other. Moreover, there are important equity implications that flow from the workings of competitive markets in general equilibrium.We will focus on two, rather than many countries (each represented by a different individual consumer or producer), and two, rather than many, goods and services. We’ll start with a model of exchange in which there is no production, and also initially assume that the two individuals (representing two countries) have some endowment of goods. Trading occurs because it makes both individuals better off. Later, we’ll introduce production, and revisit technical efficiency. Finally, we will move on to the analysis of competitive markets.

11. Efficiency in Exchange16.2● exchange economy Market in which two or more consumers trade two goods among themselves.● Pareto efficient allocation Simultaneous determination of the prices and quantities in all relevant markets, taking feedback effects into account.Pareto efficiency is not the same as economic efficiency as we defined it in Chapter 9. With Pareto efficiency, we know that there is no way to improve the well-being of both individuals (if we improve one, it will be at the expense of the other), but we cannot be assured that this arrangement will maximize the joint welfare of both individuals. Note that there is an equity implication of Pareto efficiency. It may be possible to reallocate the goods in a way that increases the total well-being of the two individuals, but leaves one individual worse off. If we can reallocate goods so that one individual is just slightly worse off but the other individual is much, much better off, wouldn’t that be a good thing to do, even though it is not Pareto efficient?

12. The Advantages of TradeTABLE 16.1THE ADVANTAGE OF TRADEINDIVIDUALINITIAL ALLOCATIONTRADEFINAL ALLOCATIONJames7F, 1C– 1F, + 1C 6F, 2CKaren3F, 5C+ 1F, – 1C 4F, 4CKaren has a lot of clothing and little food, her marginal rate of substitution (MRS) of food for clothing is 3: To get 1 unit of food, she will give up 3 units of clothing.There is room for mutually advantageous trade. To get another unit of food, Karen would be willing to trade up to 3 units of clothing. But James will give up 1 unit of food for 1/2 unit of clothing. The actual terms of the trade depend on the bargaining process. Among the possible outcomes are a trade of 1 unit of food by James for anywhere between 1/2 and 3 units of clothing from Karen.Whenever two consumers’ MRSs are different, there is room for mutually beneficial trade. Conversely, an allocation of goods is efficient only if the goods are distributed so that the marginal rate of substitution between any pair of goods is the same for all consumers.

13. The Edgeworth Box Diagram● Edgeworth box Diagram showing all possible allocations of eithertwo goods between two people or of two inputs between two production processes.EXCHANGE IN AN EDGEWORTH BOXFIGURE 16.4Each point in the Edgeworth box simultaneously represents James’s and Karen’s market baskets of food and clothing. At A, for example, James has 7 units of food and 1 unit of clothing, and Karen 3 units of food and 5 units of clothing.James gives up 1F in exchange for 1C, moving from A to B. Karen gives up 1C and obtains 1F, also moving from A to B. Point B thus represents the market baskets of both James and Karen after the mutually beneficial trade.

14. Efficient AllocationsEFFICIENCY IN EXCHANGEFIGURE 16.5The Edgeworth box illustrates the possibilities for both consumers to increase their satisfaction by trading goods. If A gives the initial allocation of resources, the shaded area describes all mutually beneficial trades.Even if a trade from an inefficient allocation makes both people better off, the new allocation is not necessarily efficient.When the indifference curves are tangent, one person cannot be made better off without making the other person worse off. C and D are both efficient allocations, although James prefers D to C and Karen C to D. In general, the allocation that will be reached in a bargain depends on the bargaining abilities of the people involved.

15. The Contract CurveTHE CONTRACT CURVEFIGURE 16.6The contract curve contains all allocations for which consumers’ indifference curves are tangent. Every point on the curve is efficient because one person cannot be made better off without making the other person worse off.● contract curve Curve showing all efficient allocations of goodsbetween two consumers, or of two inputs between two production functions.

16. Consumer Equilibrium in a Competitive MarketCOMPETITIVE EQUILIBRIUMFIGURE 16.7In a competitive market the prices of the two goods determine the terms of exchange among consumers. If A is the initial allocation of goods and the price line PP′ represents the ratio of prices,the competitive market will lead to an equilibrium at C, the point of tangency of both indifference curves. As a result, the competitive equilibrium is efficient.An equilibrium is a set of prices at which the quantity demanded equals the quantity supplied in every market. This is also a competitive equilibrium because all suppliers and demanders are price takers.

17. The market is in disequilibrium when the quantities of food andclothing demanded are not equal to the quantities supplied. This disequilibrium should be only temporary.● excess demand When the quantity demanded of a good exceeds the quantity supplied.● excess supply When the quantity supplied of a good exceeds the quantity demanded.In our example, each Karen’s quantity demanded for food is greater than each James’s willingness to sell it, whereas each Karen’s willingness to trade clothing is greater than each James’s quantity demanded. As a result of this excess quantity demanded for food and excess quantity supplied of clothing, we can expect the price of food to increase relative to the price of clothing. As the price changes, so will the quantities demanded by all those in the market. Eventually, the prices will adjust until an equilibrium is reached.

18. The Economic Efficiency of Competitive MarketsWe can now understand one of the fundamental results ofmicroeconomic analysis. We can see from point C in Figure 16.6 that the allocation in a competitive equilibrium is Pareto efficient. The key reason why this is so is that C must occur at the tangency of two indifference curves. If it does not, one of the Jameses or one of the Karens will not be achieving maximum satisfaction; he or she will be willing to trade to achieve a higher level of utility.This result holds in an exchange framework and in a general equilibrium setting in which all markets are perfectly competitive. It is the most direct way of illustrating the workings of Adam Smith’s famous invisible hand, because it tells us that the economy will automatically allocate resources in a Pareto efficient manner without the need for regulatory control.The result that a competitive equilibrium is Pareto efficient is often described as the first theorem of welfare economics.If everyone trades in the competitive marketplace, all mutually beneficial trades will be completed and the resulting equilibrium allocation of resources will be economically efficient.● welfare economics Normative evaluation of markets and economic policy

19. Let’s summarize what we know about a competitive equilibrium from the consumer’s perspective:1. Because the indifference curves are tangent, all marginal rates of substitution between consumers are equal.2. Because each indifference curve is tangent to the price line, each person’s MRS of clothing for food is equal to the ratio of the prices of the two goods.(16.1) 

20. Equity and Efficiency16.3UTILITY POSSIBILITIES FRONTIERFIGURE 16.8The Utility Possibilities Frontier● utility possibilities frontier Curve showing all efficient allocations of resources measured in terms of the utility levels of two individuals.The utility possibilities frontier shows the levels of satisfaction that each of two people achieve when they have traded to an efficient outcome on the contract curve. Points E, F, and G correspond to points on the contract curve and are efficient. Point H is inefficient because any trade within the shaded area will make one or both people better off.

21. In Figure 16.8, point H represents an inefficient allocation because any trade within the shaded area makes one or both parties better off. At L, both people would be better off, but L is not attainable because there is not enough of both goods to generate the levels of utility that the point represents.It might seem reasonable to conclude that an allocation must be Pareto efficient to be equitable. Compare point H with F and E. Both F and E are efficient, and (relative to H) each makes one person better off without making the other worse off. We might agree, therefore, that it is inequitable to James or Karen or both for an economy to yield allocation H as opposed to F or E.But suppose H and G are the only possible allocations. Is G more equitable than H? Not necessarily. Compared with H, G yields more utility for James and less for Karen. Some people may feel that G is more equitable than H; others may feel the opposite. We can conclude, therefore, that one Pareto inefficient allocation of resources may be more equitable than another Pareto efficient allocation.The problem is how to define an equitable allocation. Even if we restrict ourselves to all points on the utility possibilities frontier, we can still ask which of these points is the most equitable. The answer depends on what one thinks equity entails and, therefore, on the interpersonal comparisons of utility that one is willing to make.

22. SOCIAL WELFARE FUNCTIONS● social welfare function Measure describing the well-being ofsociety as a whole in terms of the utilities of individual members.A social welfare function is useful when we want to evaluate policies that affect some members of society differently than others. One such function, the utilitarian, weights everyone’s utility equally and consequently maximizes the total utility of all members of society. Each social welfare function can be associated with a particular view about equity. But some views do not explicitly weight individual utilities and cannot therefore be represented by a social welfare function. For example, a market-oriented view argues that the outcome of the competitive market process is equitable because it rewards those who are most able and who work the hardest. If E is the competitive equilibrium allocation, for example, E would be deemed to be more equitable than F, even though goods are less equally allocated.

23. When more than two people are involved, the meaning of the wordequity becomes even more complex. The Rawlsian view considers a world in which individuals do not know what their individual endowments will be. Rawls argues that, faced with a world in which you do not know your own “fate,” you would opt for a system assuring that the least well-off person in society will be treated reasonably well. Specifically, according to Rawls, the most equitable allocation maximizes the utility of the least-well-off person in society. The Rawlsian perspective could be egalitarian—involving an equal allocation of goods among all members of society. But it need not be. Suppose that by rewarding more productive people more highly than less productive people, we can get the most productive people to work harder. This policy could produce more goods and services, some of which could then be reallocated to make the poorest members of society better off.

24. TABLE 16.2FOUR VIEWS OF EQUITY1. Egalitarian—all members of society receive equal amounts of goods2. Rawlsian—maximize the utility of the least-well-off person3. Utilitarian—maximize the total utility of all members of society4. Market-oriented—the market outcome is the most equitableThe four views of equity in Table 16.2 move roughly from most to leastegalitarian. While the egalitarian view explicitly requires equal allocations, theRawlsian puts a heavy weight on equality (otherwise, some people would bemuch worse off than others). The utilitarian is likely to require some differencebetween the best- and worst-off members of society. Finally, the market-orientedview may lead to substantial inequality in the allocations of goods and services.

25. Equity and Perfect CompetitionThe result that a competitive equilibrium can sustain every point on thecontract curve is a fundamental result in microeconomics. It is important because it suggests an answer to a basic normative question: Is there a trade-off between equity and efficiency? In other words, must a society that wishes to achieve a more equitable allocation of resources necessarily operate in a manner that is Pareto efficient? The answer, which is given by the second theorem of welfare economics, tells us that redistribution need not conflict with economic efficiency. Formally, the second theorem states the following:If individual preferences are convex, then every Pareto efficient allocation(every point on the contract curve) is a competitive equilibrium for some initialallocation of goods.Literally, this theorem tells us that any equilibrium deemed to be equitable can be achieved by a suitable distribution of resources among individuals and that such a distribution need not in itself generate inefficiencies. Unfortunately, all programs that redistribute income in our society are economically costly. Taxes may encourage individuals to work less or cause firms to devote resources to avoiding taxes rather than to producing output. So, in effect, there is a trade-off between the goals of equity and efficiency, and hard choices must be made.

26. Efficiency in Production16.4Input Efficiency● technical efficiency Condition under which firms combine inputs to produce a given output as inexpensively as possible.A particular allocation of inputs into the production process is technically efficient if the output of one good cannot be increased without decreasing the output of another good. Because technical efficiency requires the appropriate combination of inputs, we will also call it input efficiency.If input markets are competitive, a point of efficient production will be achieved. Let’s see why. If the labor and capital markets are perfectly competitive, then the wage rate w will be the same in all industries. Likewise, the rental rate of capital r will be the same whether capital is used in the food or clothing industry.From chapter 7 we know that to minimize production costs, producers will use combinations of labor and capital so that:and, (16.2)Because the MRTS is the slope of the firm’s isoquant, the competitive equilibrium is efficient in production. 

27. The Production Possibilities Frontier● production possibilities frontier Curve showing the combinationsof two goods that can be produced with fixed quantities of inputs.PRODUCTION POSSIBILITIES FRONTIERFIGURE 16.9The production possibilities frontier shows all efficient combinations of outputs. The production possibilities frontier is concave because its slope (the marginal rate of transformation) increases as the level of production of food increases.

28. ● marginal rate of transformation Amount of one good that must be given up to produce one additional unit of a second good.Note that as we increase the production of food by moving along the production possibilities frontier, the MRT increases.When the MRT is low, so is the ratio of the marginal cost of producing food MCF to the marginal cost of producing clothing MCC. In fact, the slope of the production possibilities frontier measures the marginal cost of producing one good relative to the marginal cost of producing the other.At every point along the frontier, the following condition holds:MARGINAL RATE OF TRANSFORMATION (16.3)

29. Output EfficiencyFor an economy to be efficient, goods must not only be produced at minimum cost; goods must also be produced in combinations that match people’s willingness to pay for them.The marginal rate of transformation measures the cost of an additional unit of food in terms of producing less clothing. An economy produces output efficiently only if, for each consumer, (16.4)To see why this condition is necessary for efficiency, suppose the MRT equals 1, while the MRS equals 2. In that case, consumers are willing to give up 2 units of clothing to get 1 unit of food, but the cost of getting the additional food is only 1 unit of lost clothing. Clearly, too little food is being produced. To achieve efficiency, food production must be increased until the MRS falls and the MRT increases and the two are equal. The outcome is output efficient only when MRS = MRT for all pairs of goods.

30. OUTPUT EFFICIENCYFIGURE 16.10The efficient combination of outputs is produced when the marginal rate of transformation between the two goods (which measures the cost of producing one good relative to the other) is equal to the consumer’s marginal rate of substitution (which measures the marginal benefit of consuming one good relative to the other).

31. Efficiency in Output MarketsWhen output markets are perfectly competitive, all consumers allocate their budgets so that their marginal rates of substitution between two goods are equal to the price ratio. For our two goods, food and clothing, (16.5)At the same time, each profit-maximizing firm will produce its output up to thepoint at which price is equal to marginal cost. Again, for our two goods, Because the marginal rate of transformation is equal to the ratio of the marginalcosts of production, it follows that 

32. COMPETITION AND OUTPUT EFFICIENCYFIGURE 16.11In a competitive output market, people consume to the point where their marginal rate of substitution is equal to the price ratio. Producers choose outputs so that the marginal rate of transformation is equal to the price ratio. Because the MRS equals the MRT, the competitive output market is efficient. Any other price ratio will lead to an excess demand for one good and an excess supply of the other.

33. The Gains from Free Trade16.5Comparative Advantage● comparative advantage Situation in which Country 1 has an advantage over Country 2 in producing a good because the cost of producing the good in 1, relative to the cost of producing other goods in 1, is lower than the cost of producing the good in 2, relative to the cost of producing other goods in 2.● absolute advantage Situation in which Country 1 has an advantage over Country 2 in producing a good because the cost of producing the goodin 1 is lower than the cost of producing it in 2.TABLE 16.3HOURS OF LABOR REQUIRED TO PRODUCE CHEESE AND WINECHEESE (1 LB)WINE (1 GAL)Holland12Italy63

34. WHAT HAPPENS WHEN NATIONS TRADEThe comparative advantage of each country determines what happens when they trade. The outcome will depend on the price of each good relative to the other when trade occurs. Suppose that with trade, one gallon of wine sells for the same price as one pound of cheese in both Holland and Italy. Suppose also that because there is full employment in both countries, the only way to increase production of wine is to take labor out of the production of cheese, and vice versa. Both countries have 24 hours of labor input available.It is in Holland’s interest to specialize in the production of cheese, which it will export to Italy in exchange for wine. If, for example, Holland produced 24 pounds of cheese and traded 6, it would be able to consume 18 pounds of cheese and 6 gallons of wine—a definite improvement over the 18 pounds of cheese and 3 gallons of wine available in the absence of trade.Specialization in wine production is advantageous for Italy. Suppose that Italy produced 8 gallons of wine and traded 6; in that case, it would be able to consume 6 pounds of cheese and 2 gallons of wine—likewise an improvement over the 3 pounds of cheese and 2 gallons of wine available without trade.

35. An Expanded Production Possibilities FrontierTHE GAINS FROM TRADEFIGURE 16.12Without trade, production and consumption are at point A, where the price of wine is twice the price of cheese. With trade at a relative price of 1 cheese to 1 wine, domestic production is now at B, while domestic consumption is at D. Free trade has allowed utility to increase from U1 to U2.

36. EXAMPLE 16.3TRADING TASKS AND IPOD PRODUCTIONA typical product embodies a sequence of tasks, each of which can also be traded. Where and how those tasks are performed is an important part of efficient production and trade. iPod manufacturing is a truly global undertaking.TABLE 16.4DIFFERENT TASKS IN IPOD PRODUCTIONCOMPONENTCOMPANYMANUFACTURING LOCATIONPRICE ($)% OF RETAIL PRICEProduct Design/ ConceptApple (U.S)U.S.79.8526.7Hard Drive (30GB)Toshiba (Japan)China73.3924.6DisplayMatsushita & ToshibaJapan20.396.8Video ProcessorBroadcom (U.S)Taiwan or Singapore8.362.8Central ProcessorPortaPlayer (U.S.)U.S. or Taiwan4.941.7Unit AssemblyInventec (Taiwan)China3.701.2All other parts (about 450)--33.6211.2Total parts--144.4048.3Distribution and Retail-U.S.74.7525.0Retail Price299.00100.0

37. EXAMPLE 16.4THE COSTS AND BENEFITS OF SPECIAL PROTECTIONThe demands for protectionist policies increased steadily during the 1980s and into the 1990s. They remain a subject of debate today, whether out of concern for trade with various Asian countries or in relation to the North American Free Trade Agreement (NAFTA). Protectionism can take many forms, including tariffs and quotas of the kind that we analyzed in Chapter 9, regulatory hurdles, subsidies to domestic producers, and controls on the use of foreign exchange.TABLE 16.5QUANTIFYING THE COSTS OF PROTECTIONINDUSTRYPRODUCER GAINSa ($ MILLIONS)CONSUMER LOSSESb ($ MILLIONS)EFFICIENCY LOSSESc ($ MILLIONS)Book manufacturing6221,02059Orange juice7961,071265Textiles and apparel44,88355,0849,895Carbon steel7,75313,873673Color televisions38885714Dairy products10,20111,2212,795Meat3,2643,672296Sugar1,4312,882614aProducer gains in the tariff case are defined as the area of trapezoid A in Figure 9.15.bConsumer losses are the sum of areas A, B, C, and D in Figure 9.15.cThese are given by triangles B and C in Figure 9.15.

38. An Overview—The Efficiency ofCompetitive Markets16.6During our analysis of general equilibrium and economic efficiency we obtained two remarkable results:First, for any initial allocation of resources, a competitive process of exchange in input or output markets will lead to a Pareto efficient outcome. We referred to this outcome as the first theorem of welfare economics.The second theorem of welfare economics tells us that under certain (admittedly ideal) conditions, issues of equity and efficiency can be treated distinctly from one another. If we are willing to put equity issues aside, then we know that there is a competitive equilibrium that maximizes consumer and producer surplus, i.e., is economically efficient.Unfortunately, neither of these results necessarily holds when, for some reason, markets are no longer competitive.

39. Below we list the conditions required for economic efficiency inexchange, in input markets, and in output markets.1. Efficiency in exchange. All allocations must lie on the exchange contract curve so that: For consumers, the tangency of the budget line and the highest attainable indifference curve ensure that: 2. Efficiency in the use of inputs in production: Each producer maximizes profit by choosing labor and capital inputs so that: 

40. 3. Efficiency in the output market. The mix of outputs must be chosenso that: Profit-maximizing producers increase their output to the point at which: But consumers maximize their satisfaction in competitive markets only if: As a result,  Therefore,and the output efficiency conditions are satisfied. Thus efficiency requires that goods be produced in combinations and at costs that match people’s willingness to pay for them.

41. Why Markets Fail16.7Market PowerCompetitive markets fail for four basic reasons: market power, incomplete information, externalities, and public goods. We will discuss each in turn.Suppose, for example, that the producer of food in our Edgeworth box diagram has monopoly power. It therefore chooses the output quantity at which marginal revenue (rather than price) is equal to marginal cost and sells less output at a price higher than it would charge in a competitive market.The lower output will mean a lower marginal cost of food production, thus an increase in the marginal cost of clothing production. Then, the marginal rate of transformation will decrease because MRTFC = MCF/MCC. We might end up, for example, at A on the production possibilities frontier in Figure 16.9. Producing too little food and too much clothing is an output inefficiency because firms with market power use different prices in their output decisions than consumers use in their consumption decisions.

42. A similar argument would apply to market power in an input market. Suppose that unions gave workers market power over the supply oftheir labor in the production of food. Too little labor would then be supplied to the food industry at too high a wage (wF) and too much labor to the clothing industry at too low a wage (wC). In the clothing industry, the input efficiency conditions would be satisfied because MRTSLKC = wC/r. But in the food industry, the wage paid would be greater than the wage paid in the clothing industry. Therefore, MRTSLKF = wF/r > wC /r = MRTSLKC. The result is input inefficiency because efficiency requires that the marginal rates of technical substitution be equal in the production of all goods.Incomplete InformationLack of information may give producers an incentive to supply too much of some products and too little of others. In other cases, while some consumers may not buy a product even though they would benefit from doing so, others buy products that leave them worse off. Lack of information may also prevent some markets from ever developing. These informational problems can lead to competitive market inefficiency.

43. ExternalitiesSometimes, however, market prices do not reflect the activities of either producers or consumers. There is an externality when a consumption or production activity has an indirect effect on other consumption or production activities that is not reflected directly in market prices.As we explained in Section 9.2, the word externality is used because the effects on others (whether benefits or costs) are external to the market. An externality causes both input and output inefficiencies.Public GoodsA market may fail to supply goods that many consumers value. For example, suppose a firm is considering whether to undertake research on a new technology for which it cannot obtain a patent. Once the invention is made public, others can duplicate it. As long as it is difficult to exclude other firms from selling the product, the research will be unprofitable.● public good Nonexclusive, nonrival good that can be made available cheaply but which, once available, is difficult to prevent others from consuming.

44. EXAMPLE 16.5INEFFICIENCY IN THE HEALTH CARE SYSTEMThe United States spends a larger fraction of its GDP on health care than do most other countries. Is the U.S. health care system less “efficient” than other health care systems? The system may be technically efficient in production, in the sense of utilizing the best combination of such inputs as hospital beds, physicians, nurses, and drugs to obtain better health outcomes? Second, being output efficient would mean that the benefits from the marginal dollar spent on health care are greater than the opportunity cost of other goods and services that might be provided instead.There is reason to believe that the health care industry is operating below its production possibilities frontier, so that if inputs were used more efficiently, better health outcomes could be achieved with little or no increase in resources. It appears that substantially more time and expense is devoted to claim reporting, verification, and billing requirements relative to other developed countries. In addition, a number of low cost, highly effective treatments seem to be under-prescribed in the United States.

45. EXAMPLE 16.5INEFFICIENCY IN THE HEALTH CARE SYSTEMWhat about output efficiency? It has been suggested that the increasing fraction of income being devoted to health expenditures in the United States is evidence of inefficiency. But, as we saw in Example 3.4, this could simply reflect a strong preference for health care on the part of the U.S. population, whose incomes have generally been increasing. The study underlying that example calculated the marginal rate of substitution between health related and nonhealth related goods and found that as consumption increases, the marginal utility of consumption for non-health related goods falls quickly. As we explained, this should not be surprising; as individuals age and their incomes increase, an extra year of life expectancy becomes much more valuable than a new car or a second home. Thus an increasing share of income devoted to health is entirely consistent with output efficiency.