# Micro Lecture 15: Efficiency and Pareto

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1 Micro Lecture 15: Efficiency and Pareto Review: Perfect Competition, Monopoly, and Profit Maximization Perfect Competition and Monopoly Perfect Competition Monopoly Large number of small independent firms. One large firm. A single firm s production A monopoly produces a quantity decisions cannot significantly and charges a price that lies affect the price. on the market demand curve. MR curve lies beneath demand MR curve is horizontal: curve: MR = Price MR < Price Perfect Competition, Monopoly, and Profit Maximization Perfect Competition Monopoly Large number of small independent firms. One large firm. A single firm s production A monopoly produces a decisions cannot significantly quantity and charges a price that lies affect the price. on the market demand curve. MR curve is horizontal: Profit MR curve lies beneath demand curve: MR = Price Maximization MR < Price or or Price = MR MR = Price > MR é ã é ã Price = MR = Price > MR = Price = Price > Question: Why have I drawn your attention to the relationship between price and marginal cost? Monopoly s Profit Maximizing Quantity To maximize profits, MR = The profit maximizing quantity of output is the quantity of output at which marginal revenue equals marginal cost as shown in figure P M P What price will the monopoly charge? Remember that the monopoly will always operate at a point on the market demand curve. So, once we determine the profit maximizing quantity of output, we look to the market demand curve to determine the price as shown in figure Q M MR Figure 15.1: Profit maximizing monopoly Q

2 2 What is bad about a monopoly and good about perfect competition? It is commonly believed that a monopoly is bad; a monopoly is typically view as a big firm that bullies others. Alternatively, conventional wisdom suggests that an industry composed of a large number of small independent firms is good perhaps even virtuous. Is this view justified on economic grounds? We will consider two economic arguments that are frequently cited about evil of monopolies: Monopolies earn obscenely high profits. Monopolies create inefficiency. Excess Profits - The Popular Notion Most people believe a monopoly is bad because it earns obscenely high profits. While economists recognize that it is possible for a monopoly to earn high positive profits, it need not be true. In other words, the view that the existence of a monopoly guarantees high profits is simply incorrect. To understand why, recall that Profit = (P ATC)q If the price falls short of average total cost when maximizing profits, a monopoly will be incurring losses. Figure 15.2 illustrates this. Consequently, since the existence of a monopoly does not guarantee high profits, high profits cannot the reason that a monopoly is bad. P M P Q M MR Q Figure 15.2: Profit maximizing monopoly ATC Efficiency: Are we getting the most from our economy s finite resources? Pareto s Query: Given the state of affairs in question, is it possible to make at least one Yes No Is state of affairs getting the most Is state of affairs getting the most from the economy s resources? No from the economy s resources? Yes State of affairs is inefficient. State of affairs is efficient.

3 3 Monopoly and Efficiency Consider a rural community in which only a single fast food restaurant operates. The restaurant is owned by Mary. Mary enjoys a monopoly the fast food industry. To maximize her profits, Mary produces the quantity of output at which marginal revenue equals marginal cost: MR = Assume that figure 15.3 accurately depicts the demand curve Mary faces and her marginal revenue and marginal cost curves. To maximize profits Mary will produce 50 hamburgers. What price will Mary charge? Remember that the monopoly will always operate at a point on the market demand curve. So, once we determine the profit maximizing quantity of output, we look to the market demand curve to determine the price. Mary will charge a price of \$1.50 per hamburger. Note that Mary's marginal cost equals \$1.00. Price (\$ per hamburger) MR Quatity (hamburgers) Figure 15.3: Mary s fast food restaurant State of Affairs: Q = 50 P = \$1.50 = \$1.00 Claim: Inefficiency results when the price is \$1.50 and marginal cost is \$1.00; that is, in this situation it is possible to make at least one individual better off without hurting anyone else. To justify this claim, consider a potential customer, call him Joe, who does not buy a hamburger at the present \$1.50 price, but would buy a hamburger if the price were \$1.40. Question: How do we know that a person like Joe exists? Answer: Since the demand curve is downward sloping there must be such an individual.

4 4 Can we devise a special deal between Joe and Mary that will benefit both of them without affecting anyone else? Yes Special eal: Mary sells Joe a hamburger for \$1.30. Is Mary better off? Yes: Mary s total revenues increase by \$1.30 and her total costs by only \$1.00, therefore her profits increase by \$.30. Mary s Profit = TR TC Is Joe better off? Yes: Joe, who is willing to pay \$1.40 for a hamburger, would be overjoyed to buy one at \$1.30. Since we can devise a special deal that makes Mary and Joe better off without affecting others in any way, we have indeed shown that monopoly leads to inefficiency. Efficiency: General Principle Question: What element of this example is crucial in devising the special deal that makes one Answer: The fact that the price does not equal marginal cost. Profit Monopoly Maximization Price > MR = Price > As long as a gap exists between price and marginal cost, we can find an individual like Joe. A potential consumer who: Is not buying a hamburger at the current price, but would buy a hamburger for some amount that exceeds the firm s marginal cost. A special deal can now be devised in which the potential customer will pay a special price which falls between the monopoly price and marginal cost. This special deal would make the potential consumer better off, while allowing the firm to increase its profits. Monopoly results in inefficiency because price does not equal marginal cost. Consumers are basing their consumption decision on a price that does not reflect correct information; that is, the price exceeds the cost of producing an additional unit of output. Too little consumption and production result.

5 5 Price, Marginal Cost, and Efficiency Suppose that the local government regulates the price charged by Mary, the owner of the only fast food restaurant in the area. Furthermore, the government insists that Mary sell hamburgers to all those consumers who wish to purchase them at the regulated price. To summarize: The government regulates the price of hamburgers (the government sets the price of hamburgers). Mary is required to produce a hamburger for all consumers that wish to purchase one at the regulated price. To determine whether a state of affairs is efficient, we pose Pareto s query: Claim: Efficiency requires Mary to charge a price of \$1.25 and produce 75 hamburgers. As illustrated in figure Preview: To justify this claim we will consider two cases: Case 1: When the price is greater than \$1.25, the price exceeds marginal cost; consequently, the production of more hamburgers would allow us to make at least one individual better off without hurting anyone else. Case 2: When the price is less Price (\$ per hamburger) than \$1.25, the price is less than marginal cost; consequently, the production of fewer hamburgers would allow us to make at least one individual better off without hurting anyone else. Therefore, to be efficient the price must equal \$1.25 and the price will equal marginal cost Quatity (hamburgers) Figure 15.4: Mary s fast food restaurant

6 6 Case 1: Price is greater than \$1.25; that is, the price is greater than marginal cost. For example, suppose that the regulated price is \$1.50. When the price is \$1.50 consumers would purchase 50 hamburgers; hence, Mary would produce 50 hamburgers and her marginal cost would equal \$1.00: State of Affairs: Q = 50 P = \$1.50 = \$1.00 Now, recall our friend Joe. Joe does not purchase a hamburger at the \$1.50 price, but would purchase a hamburger if the price were \$1.40. We know that a person like Joe exists because the demand curve is downward sloping; when the price falls from \$1.50 to \$1.40, more people buy hamburgers. Joe is one of these individuals. Next consider the following special deal. Special eal: Mary produces one more hamburger and gives it to Joe in exchange for \$1.30. How would this special deal affect Mary? Mary s Profit = TR TC Mary s total revenue would rise by \$1.30, the amount that Joe gives her for the hamburger. Since Mary s marginal cost equals \$1.00, her total cost would rise by \$1.00. Mary s profits would rise by \$.30. the special deal would make Mary better off. How would this special deal affect Joe? Joe would be willing to pay \$1.40 for a hamburger, but he only has to pay \$1.30. The special deal would make Joe better off. The special deal makes both Mary and Joe better off without affecting anyone else. Now, reconsider Pareto s query: Pareto s Query: Given the state of affairs in question, is it possible to make at least one Yes No Is the state of affairs getting the most Is the state of affairs getting the most from the economy s resources? No. from the economy s resources? Yes. State of affairs is inefficient. State of affairs is efficient. The answer is yes. When the price is greater than marginal cost it is possible to make at least one individual better off without hurting anyone else. We are not getting the most from the economy s resources and hence, the state of affairs is inefficient. From an efficiency standpoint more hamburgers should be produced and consumed when the price is greater than marginal cost. This occurs because consumers are basing their consumption decisions on misleading information. Marginal cost equals the change in total cost resulting from a one unit change in production; consequently, marginal cost equals the cost of producing one more hamburger. Since the price exceeds marginal cost, consumers base their consumption decisions on a price that overstates the production costs. Hence, consumers demand too few hamburgers and too few are produced.

7 7 Case 2: Price is less than \$1.25; that is, the price is less than marginal cost. For example, suppose that the regulated price is \$.75. When the price is \$.75 consumers would purchase 125 hamburgers; hence, Mary would produce 125 hamburgers and her marginal cost would equal \$1.75: State of Affairs: Q = 125 P = \$.75 = \$1.75 Consider a consumer, call her Joan, who does purchase a hamburger at the \$.75 price, but would not purchase a hamburger if the price were \$1.00. We know that a person like Joan exists because the demand curve is downward sloping; when the price rises from \$.75 to \$1.00, fewer people buy hamburgers. Joan is one of these individuals. Next consider the following special deal: Special deal: Mary produces one less hamburger and gives Joan \$.50 on the condition that she will not purchase a hamburger. How would this special deal affect Mary? Mary s Profit = TR TC Mary s total revenue would fall by \$.75. Since Mary s marginal cost equals \$1.75, her total cost would fall by \$1.75. It looks like her profits will rise by \$1.00. But now remember that she paid Joan \$.50 on the condition that Joan does not buy a hamburger. In net, Mary is \$.50 better off. How would this special deal affect Joan? Joan will have a total of \$1.25 to spend on other goods: Since Joan has agreed not buy a hamburger, she will now have the \$.75 available that she used to spend on the hamburger. Mary is giving \$.50 to Joan for agreeing not to buy a hamburger. What do we know about Joan? Since Joan did not buy a hamburger when its price was \$1.00, we know that she prefers \$1.00 worth of other goods to a hamburger. Joan now has \$1.25 available to spend on other goods. The special deal makes Joan better off. The special deal makes both Mary and Joan better off without affecting anyone else. Now, reconsider Pareto s query: Pareto s Query: Given the state of affairs in question, is it possible to make at least one Yes No Is the state of affairs getting the most Is the state of affairs getting the most from the economy s resources? No. from the economy s resources? Yes. State of affairs is inefficient. State of affairs is efficient. The answer is yes. When the price is less than marginal cost it is possible to make at least one individual better off without hurting anyone else. We are not getting the most from the economy s resources and hence, the state of affairs is inefficient. From an efficiency standpoint fewer hamburgers should be produced and consumed when the price is less than marginal cost. This occurs because consumers are basing their consumption decisions on incorrect information. Marginal cost equals the change in total cost resulting from a one unit change in production; consequently, marginal cost equals the costs that are saved when one fewer hamburger is produced. Since the price is less than marginal cost, consumers are basing their consumption decisions on a price that understates the production costs. Hence, consumers demand too many hamburgers and too many are produced.