ACTIVIDADES DESCRIPCIÓN RECURSOS RESULTADO

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UNIT 3: ECONOMIC EFFICIENCY AND EQUITY; SOCIAL AND PRIVATE

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The relationship between efficiency and Pareto Optimality can be demonstrated as follows:

In Figure 3.34, line AB represents the production possibility frontier in a given economy denoting the combination of goods 1 and 2 that could be produced if all resources are fully employed X1 and X2 indicate aggregate consumption levels of goods 1 and 2. The Slope = MRS Pareto efficient consumption levels will lie along the Pareto set (the Edgeworth Contract line) – the line of mutual tangencies of the indifference curves as illustrated in the figure (1). These are the allocations in which each consumer’s marginal rate of substitution – the rate at which he or she is just willing to trade – equals that of the other.

These allocations are Pareto efficient as far as the consumption decisions are concerned.

If people can simply trade one good for another, the Pareto set describes the set of boundless that exhausts the gains from trade. But in an economy with production, there is another way to “exchange” one good for another – namely to produce less of one good and more of another - that is at another point on the production possibility frontier.

The Pareto set in the above example describes the set of Pareto efficient boundless given the amounts of goods 1 and 2 available. In other words, in an economy with production those amounts can themselves be chosen out of the production possibilities set.

3.2 Efficiency and Equity

Decisions made on the grounds of efficiency may clash with those made on considerations of equity or fairness. For example, efficiency suggests that it is not rational to tax other consumer goods but exempt food, while equity suggests exempting food from tax as the poor spend relatively more of their incomes on food.

Let us use Figure 2 for an illustration.

Fig 3.34:

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In the figure, AA represents the degree of social satisfaction or utility frontier. The dotted area therefore represents the social opportunity set. If the society is made up of only two individuals, Karl and John, their respective utilities are shown on the vertical and horizontal axes

The overall social welfare maximum is at point B where the highest attainable social welfare function is tangent to the total utility frontier. Suppose that a social choice is to be made between alternative allocations D and C. D is in the Pareto-efficient set and C is not. But the distribution between the two parties concerned (Karl and John) is such that D is not Pareto preferred to C, Karl is better off at D but John is worse off.

Decision on the basis of efficiency would dictate allocation at B. What then are the factors responsible for the choice of D or C? The answers to this question may be:

(b) The desirable social outcomes such as the goals of policies such as the reduction in income inequality.

(c) The satisfaction of desirable wants of individuals.

(d) Societal values which do not accord with efficiency criterion, such as what is fair, just, equitable, etc, in the eyes of the society.

3.3 Private Versus Social Costs

Private cost is the cost of providing goods or services as it appears to the persons or firm supplying them. This includes the cost of any factor services or inputs bought by the supplier, the value of the work done, and the use of land, buildings, and equipment owned by the supplier. Private cost excludes any external harm caused to other people or the environment, such as noise or pollution, unless the supplier is legally obliged to pay for it.

Social cost, on the other hand, is the total cost of any activity. This includes not only private costs which fall directly on the person or firm conducting the activity, but also external costs which fall on other people who are not able to exact any compensation for them.

3.4 Externalities

Let us illustrate the relationship between private and social costs from the point of view of production externalities. Suppose that firms produce some amount of steels, and also produces a certain amount of pollution, x, which it dumps into a river. Firm F, a fishery,

Fig 3.35:

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is located downstream and is adversely affected by S’s pollution. Suppose that firm S’s cost function is given by

𝐶_𝑠(𝑆, 𝑥 ), … … … (3.4.1)

Where s is the amount of steel produced and x is the amount of pollution produced Firm F’s cost function is given by 𝐶_𝑓(𝑓, 𝑥 ); f indicates the production of fish and x the amount of pollution. (Note that F’s costs of producing a given amount of fish depend on the amount of pollution produced by the steel firm). We will suppose that pollution increases the cost of providing fish that is ^𝑑𝐶𝑓

𝑑𝑥 > 0 and that pollution decreases the cost of steel production, ^𝑑𝐶𝑠

𝑑𝑥 > 0. This last assumption says that increasing the amount of pollution will decrease the cost of steel production and that reducing pollution will increase the cost of steel production, at least over some range. The steel firm profit-maximization problem is to maximise:

𝑃𝑥_𝑠 – 𝐶_𝑠 (𝑠, 𝑥 ) … … … . (3.4.2) and the fishery’s profit-maximization problem is to maximise:

𝑃_𝑓𝐹 – 𝑐_𝑓(𝑓, 𝑥 ) … … … (3.4.3)

Note that the steel mill gets to choose the amount of pollution that it generates, but the fishery firm must take the level of pollution as outside its control.

The conditions characterizing profit maximization will be 𝑃_𝑠 =𝑑𝑐_𝑠(𝑠^∗, 𝑥^∗)

𝑑𝑠 … … … (3.4.4) 0 =𝑑𝑐_𝑠(𝑠^∗, 𝑥^∗)

𝑑𝑠 … … … (3.4.5) for the steel firm and 𝑃_𝑓 =^{𝑑𝑐𝑓(𝑓}

∗,𝑥^∗)

𝑑𝑓 … … … (3.4.6)

for the fishery. Those conditions say that at the profit-maximizing point, the price of each good – steel and pollution – should equal its marginal cost. In the case of steel firm, one of its products is pollution, which by assumption, has a zero price. So the condition determining the profit maximizing supply of pollution says to produce pollution unit the cost of an extra unit is zero.

It is not hard to see the externality here: the fishery cares about the production of pollution but has no control over it. The steel firm looks only at the cost of producing steel when it makes its profit-maximizing calculations. It does not consider the cost it imposes on the fishery. The increase in the cost of fishing associated with an increase in pollution is part of the social cost of steel production, and it is being ignored by the steel firm. In general, we expect, that the steel firm will produce too much pollution from a social point of view since it ignores the impact of that pollution on the fishery.

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The steel firm produces pollution up to the point where the marginal cost of extra pollution equals zero. But the Pareto efficient production of pollution is at the point where price equals marginal social cost, which includes the cost of pollution borne by the fishery.

4.0 CONCLUSION

From our discussion so far, we can infer that Economic efficiency is a more general concept that occurs when any change that benefits someone would result in harm for someone else. Note that technical efficiency is a necessary condition for economic efficiency since a movement toward the production possibilities curve would benefit one or more individuals and we also illustrated the relationship between private and social costs from the point of view of production externalities.

5.0 SUMMARY

We saw that efficiency is also referred to as Pareto optimality and private cost excludes any external harm caused to other people or the environment, such as noise or pollution, unless the supplier is legally obliged to pay for it while Social cost, on the other hand, is the total cost of any activity.

6.0 TUTOR-MARKED ASSIGNMENT

What determines economic efficiency as described by Vilfredo Pareto.

7.0 REFERENCES/FURTHER READING

Koutsoyiannis, A. (2001). Modern Microeconomics (2nd ed.). Hampshire: Macmillan Press Ltd.

Krugman, P. & Robin, W. (2012). Economics. (3rd ed.). New York: Worth Publishers.

Lipsey, et al. (2008). Economics. (13th ed.). Upper Saddle River, NJ: Pearson.

Robert, S. P. & Daniel, L. R. (2009). Microeconomics. (7th ed.). New Jersey: Pearson Education International.

Fig 3.36:

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UNIT 4: LINEAR PROGRAMMING