Efficiency

ECONOMIC EFFICIENCY

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There are several meanings of this term – but they all relate to how well an economy allocates its scarce resources to meets the needs and wants of consumers over time. Static Efficiency Static efficiency focuses on how much output can be produced now from a given stock of resources, and whether producers are charging a price to consumers that fairly reflects the cost of the factors used to produce a good or a service. There are two main types of static efficiency-allocative and productive efficiency. Allocative Efficiency Allocative efficiency occurs when the value consumers place on a good (reflected in the price people are willing and able to pay) equals the cost of the resources used up in production. The condition required is that price = marginal cost. 

Productive Efficiency Productive efficiency refers to a firm's costs of production and can be applied both to the short and long run. It is achieved when the output is produced at minimum average total cost (AC). For example we might consider whether a business is producing close to the low point of its long run average total cost curve. When this happens the firm is exploiting most of the available economies of scale. Productive efficiency exists when producers minimise the wastage of resources in their production processes. Dynamic Efficiency This is an important concept and focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available. It could be argued that large firms could be dynamically efficient as they can use abnormal profits to undertake research and development of new improved goods and services. However due to a lack of competition it is often argued that they may be dynamically inefficient ot “X-inefficient”

X-Inefficiency (Dynamic inefficiency) Libenstein (1966) pointed to potential cost inefficiencies arising from a lack of effective competition within a market. These are known as X-inefficiencies and are often used as part of the case against pure monopoly. Companies that face little or no real competition often allow their fixed costs of production to rise – for example by running inefficient administration systems and allowing the build up of sizeable expense account systems that bear scant relationship to the output / performance of the company’s employees. X- inefficiencies cause an increase in average total costs at each level of output.

The Spectrum of Competition Market structures can be categorised by the number of suppliers there are in an industry. At one of the end of the spectrum are highly competitive markets, where many firms compete fiercely with each other and have no real control over the price in the market. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">At the other end of the spectrum is pure monopoly where there is just one firm in the market, a sole supplier, who can set prices. There are other types of market structure that lie between these two extremes, with oligopoly being one of the most common. This is a highly concentrated market structure when a few large producers dominate the majority of the industry. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Competitive Markets <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">A perfectly competitive industry is highly unlikely to exist in its entirety given the strong assumptions made about the operation of the market. We do, though, see elements of perfect competition in certain markets such as those for agricultural products and other primary commodities. These are the only markets where there are enough sellers of products that are near perfect substitutes for each other. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">In the diagram above we see both the short run and long run equilibrium of a firm in perfect competition. At P1 Q1 it was making abnormal profits, and therefore more firms enter the industry. This continues until firms are again making normal profits at the LR equilibrium at P2Qx

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<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Perfect Competition and Economic Efficiency <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Perfect competition is used as a yardstick to compare with other market structures because it displays high levels of economic efficiency. In both the short and long run, price is equal to marginal cost (P=MC) and allocative efficiency is achieved. Productive efficiency occurs when average cost are at its minimum point. This is not achieved in the short run, but is attained in the long run. The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">CONCENTRATED MARKETS <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Monopoly

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Price and Output in the Short Run under Monopoly <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can take the market demand curve as its own demand curve. A monopolist therefore faces a downward sloping AR curve with a MR curve with twice the gradient of AR. The firm is a price maker and has some power over the setting of price or output. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">The monopolist cannot, however, charge a price that the consumers in the market will not bear. In this sense, the position and the elasticity of the demand curve acts as a constraint on the pricing behaviour of the monopolist. Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below.

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<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">The profit-maximising level of output is at Q1 and the monopolist will charge price P1. This will generate total revenue equal to OP1aQ1, but the cost of producing this output will be OAC1aQ. As total revenue exceeds total costs the firm will generate abnormal profits (or monopoly profits) equal to P1baAC1. These profits can be earned in both the short and long run because of barriers to entry. No new competition will be able to enter the market and dilute the profit.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Monopoly and Economic Efficiency <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Monopolists earn abnormal profits at the expense of economic efficiency. Price is higher than both marginal and average costs and, as a result, neither allocative nor productive efficiency is achieved. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">The monopolist is extracting a price from consumers that is above the cost of resources used in making the product. Consumers’ needs and wants are not being satisfied, as the product is being under-consumed. The high average cost of production means that the firm is not making optimum use of scarce resources.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">A Comparison between Monopoly and Perfect Competition <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">The conventional view when comparing price and output under both pure monopoly and perfect competition is that a monopolist will produce a lower output at a higher price than a competitive industry. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">The monopolist is also allocatively inefficient as its price is above its marginal cost.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Potential Benefits from Monopoly <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">A monopolist might be better able to exploit economies of scale. In this scenario, consumers actually benefit from a monopoly. Consumers may pay a lower price. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Copy the diagram from Dorton P110 and explain why consumers end up paying a lower price with a monopoly than they would if the industry was perfectly competitive.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Supporters of monopolies argue that consumers can benefits in other ways. As firms are able to earn abnormal profits in the long run there may be a faster rate of technological development that will reduce costs and produce better quality products for consumers. This is because the monopolist will invest profits into research and development to promote dynamic efficiency. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Natural Monopolies –are they in the Public Interest? <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Richard Posner, an economist who studied regulated monopolies such as water, power, telephone and cable television companies in the United States, defined the concept of a “natural monopoly” in 1974. The government tended to tolerate natural monopolies as long as it could regulate them, and justifying them as natural somehow made them acceptable in a free-enterprise system. A natural monopoly is allowed when total market demand is most economically and efficiently satisfied by a single producer and where competition results in duplication and wasted capital investment. <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">X Inefficiencies under Monopoly? <span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">An opposing argument to the case for a monopoly is that the lack of competition gives a monopolist no incentive to invest in new ideas or consider consumer welfare. It can also be argued that even if monopolist benefits from economies of scale they will have little incentive to control costs and 'X' inefficiencies will mean that there will be no real cost savings. Critics also highlight the fact that even if economies of scale lower prices for consumers, the price charged is still above marginal costs and allocative inefficiency exists.

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Plenary Activity on Monopolies

<span style="font-family: 'Trebuchet MS',Helvetica,sans-serif; font-size: 16px;">Monopolies ability to “price discriminate”- see link.