Module 6 – Economic Efficiency Flashcards
A competitive firm will maximize profits by
…producing at that level of output at which Pa = MCa (Price = Marginal Cost).
Adam Smith in the 18th century came up with the following conclusions:
- Utility seeking and profit maximizing behaviors tend to lead to an efficient solution to the problem posed by limited resources and unlimited wants
- Market forces by themselves would not gurantee economic efficiency under all circumstances, collective action and planning would be necessary in certain areas of economic activity
A consumer will maximize utility from a given income when,
…that income is allocated to goods and services so that:
A competitive market economy tends to be economically efficient as well as:
Technically efficient
A fish farm was established and the owner installed the necessary set of tanks and filtration plants to help keep the sea water in and around the fish tanks pure. The expected life of the tanks and filtration plants was 10 years and their purchase price was £500 000; the accountant depreciates the plants (straight line) at £50 000 per year. The annual variable costs associated with the fish farm were also £50 000 per year. Annual fish sales of £120 000 per annum were anticipated. Immediately after the installation of the equipment, which once installed cannot be removed, has no alternative use and no scrap value, the price of fish dropped dramatically, because of the availability of foreign fish. Annual revenues from sales of fish decreased to £80 000 and it is expected the £80 000 annual revenue figure will remain for the foreseeable future. The accountant has advised the fish farm owners to cease operations immediately. He stated, ‘With annual revenues of £80 000 and annual costs of £100 000 it does not need an MBA graduate to tell you that staying in business is throwing good money after bad.’
Should the owner of the fish farm follow the accountant’s advice? Why or why not?
The owner should not follow the advice of the accountant: If the farm is closed down the owner will lose the £500 000 start up cost or £50 000 per annum for 10 years. He will however incur no variable cost. If the farm remains in business for 10 years, the expected life of the equipment, there will be generated each year a surplus of £30 000 over the variable costs, i.e. £80 000 in total revenues minus £50 000 in variable cost, to set against the fixed cost of £50 000. Thus the loss will be only £20 000 instead of £50 000. Thus in the short run i.e. 10 years the farm should remain in business. When it comes time to replace the capital equipment, i.e. at the end of 10 years the marginal benefit for remaining in business i.e. £80 000 is less than the annual marginal cost, i.e. £100 000; thus in the long run the farm should close.
A fish farm was established and the owner installed the necessary set of tanks and filtration plants to help keep the sea water in and around the fish tanks pure. The expected life of the tanks and filtration plants was 10 years and their purchase price was £500 000; the accountant depreciates the plants (straight line) at £50 000 per year. The annual variable costs associated with the fish farm were also £50 000 per year. Annual fish sales of £120 000 per annum were anticipated. Immediately after the installation of the equipment, which once installed cannot be removed, has no alternative use and no scrap value, the price of fish dropped dramatically, because of the availability of foreign fish. Annual revenues from sales of fish decreased to £80 000 and it is expected the £80 000 annual revenue figure will remain for the foreseeable future. The accountant has advised the fish farm owners to cease operations immediately. He stated, ‘With annual revenues of £80 000 and annual costs of £100 000 it does not need an MBA graduate to tell you that staying in business is throwing good money after bad.’
Would you have advised the establishment of a fish farm if there were no fish imports? Why or why not?
The farm was set up on the expectation of an annual return of £20 000, i.e. revenue of £120 000 minus total costs of £100 000, £50 000 for depreciation and £50 000 of variable cost. The £50 000 annual depreciation is the £500 000 initial investment spread evenly over 10 years. But what was the opportunity cost of the £500 000? An interest rate of 4% earns £20 000 in the bank and thus any rate higher than 4% says ‘no fishing’ assuming any working capital faces the same opportunity cost.
As a nation we wish to obtain from our limited resources the maximum benefit at minimum cost. The market mechanism guarantees such economic efficiency. Do you agree with the statement about the efficiency of the market mechanism? Why or why not?
The Question Asked
As a nation we wish to obtain from our limited resources the maximum benefit at minimum cost. The market mechanism guarantees such economic efficiency. Do you agree with the statement about the efficiency of the market mechanism? Why or why not?
Suggested Answer
Under certain conditions it is possible, theoretically, for a nation to achieve maximum benefit from its limited resources; to do so goods and services must be produced at minimum cost.
Economic efficiency conditions are captured in the marginal equivalency conditions (MEC).
One necessary condition is that consumers maximise utility from the way they allocate their incomes. This occurs when
MUa/Pa = MUb/Pb= … = MUn/Pn
Another necessary condition is that goods and services are produced using minimum resources. A firm will maximise profit by producing that level of output where MR = MC; under conditions of perfect competition price equals MC of production.
Thus
Pa = MCa, Pb = MCb, Pn = MCn
Substitution the MCs for Ps yields the MEC.
MUa/MCa = MUb/MCb= … = MUn/MCn
In the dynamic real world many forces are at work which prevent MEC being achieved. They include:
- introduction of new goods and services
- changes in factor supplies/prices
- technological change
Second there are areas where competitive market forces will not lead to economic efficiency; they are known as market failures. These areas involve:
- imperfect markets
- externalities
- public goods
- An imperfect market exists if the characteristics of a market are not the same as those for a perfect market:
- Many buyers and sellers
- Perfect information
- Freedom of entry and exit
- Homogeneous product
If all of the above characteristics do not exist then a market is said to be an imperfect market and as a consequence the profit maximising output supplied will be lower than the output at which price is equal to marginal costs, i.e. lower than the optimal output level determined in perfect competition. This means it is not possible to substitute marginal costs for price in the MEC since P > MC.
- Externalities are those costs/benefits that result from an act of production or consumption but are not taken into account by the economic agent making the decision. If externalities exist it implies that either the costs of production or consumption are understated or that the benefits of either or both are understated.
If external benefits exist in the consumption of good A then the value of MUa in the MEC will understate the societal MUa. Similarly if the societal costs of producing goods B exceed a firm’s private cost then will be higher than the rates of other goods.
- Public goods or services have two characteristics, which distinguish them from private goods and services; they are
- non-excludability and
- non-rivalry
The latter characteristic implies that the consumption of the good by one consumer does not preclude the consumption of it by another consumer. This creates a problem as to how to determine the optimum level of supply. However, it is the first characteristic, which implies that consumers can consume a good or service without paying for it, i.e. they can be free riders, that creates the market failure; this is because no firm would be prepared to supply a good or service for which it cannot extract a price.
Division of labour permits
I. specialisation
II. increased total output
III. a larger labour force
Which of the following is correct?
A. I only
B. II only
C. I and II only
D. I, II and III
C
If each member of the labour force specialises in producing those goods/services in which he/she is most skilled there will result a larger total output than the individual performing a multitude of tasks. Thus II is true. If members of a labour force indulge in specialisation they are performing a division of labour. Thus I is true. Division of labour permits a more efficient use of an existing labour force but does not increase the size of the labour force. Thus III is wrong.
A
For the economy to be in long run equilibrium not only will the ratios of MUa/MC(longrun)a be equal but firms will be earning normal returns producing where price = MClongrun; this means the optimally sized firm, i.e. the firm with the lowest average total cost. It follows that price must also equal the MC of this optimally sized firm which is of course MCshortrun. Thus A is true.
In the utility maximising equation it is MUa/Pa which must equal MUb/Pb and not MUa=MUb or Pa=Pb. Thus B and C are wrong. Similarly it is MCa=Paand MCb=Pb which must hold for firms to be in equilibrium, not MCa=MCb. Thus D is wrong.
Which of the following limits how much division of labour can occur in a capitalist society? The size of the
A. labour force
B. capital stock
C. market
D. total output
C
While the size of the labour force, capital stock, market and total output may be highly correlated it is the size of the market which sets a limit on the extent of division of labour. As Adam Smith pointed out if the size of the market for pins is large enough people start to specialise in pin making, e.g. shaping the point, making the head, etc.
In small villages in some countries the only medical doctor is also the local dentist and the village general store serves also as the post office. Which of the following explains the dual nature of these suppliers?
A. The demand for dental services is price elastic
B. The demand for postal services is price inelastic
C. Specialisation is determined by the size of markets
D. People have healthier diets outside of cities and require fewer dentists and villagers do not write many letters
C
Division of labour is limited by the extent of the market. In major cities there may be enough business to attract a heart surgeon – in a small village the services of a heart surgeon may be sought only once in fifty years. Specialisation is determined by demand which in turn is determined by the size of the market; the bigger the market the greater the degree of specialisation.
For an economy to be economically efficient
I. it must produce that bundle of goods and services where no individual could be made better off
II. each firm must produce the maximum amount of output it possibly could
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
D
Economic efficiency requires that the bundle of goods and services produced must be produced using the minimum amount of resources and the bundle produced must satisfy society’s wants as fully as possible. It is always possible however to make one individual better off by transferring goods and services from other members of society. Thus I is wrong. No profit maximising firm producing in an engineering efficient fashion will produce beyond that point at which marginal revenue equals marginal cost; it would cost more than the firm would receive in revenue for any production beyond that point; thus to be efficient firms will not produce the maximum amount of output possible. Thus II is wrong.
A consumer is maximising utility by allocating income so that
MUa/Pa = MUb/Pb = … = MUn/Pn
Which of the following gives the correct explanation of why the consumer would be worse off if income were reallocated among the goods a, b …n? A reallocation
A. would mean a smaller quantity of goods and services would be purchased
B. would cause the gain in utility of at least one good to be more than offset by the loss in utility of at least one other good
C. would cause a misallocation of resources used in the production of the goods for which expenditure had changed
D. would cause the terms on which existing goods might be exchanged to alter
The correct answer is B.
Consider two goods only and a consumer not in equilibrium. Suppose MUa/Pa = 4/1 and MUb/Pb = 3/1. A dollar reallocated from the purchase of good b to good a yield a net utility gain of +1, i.e. +4 − 3. Such reallocation of $1.00 however will cause MUa to decrease and MUb to increase (Law of Diminishing Utility). No utility gain can be realised when they are equal. Consequently if equilibrium were reached and a reallocation were then to occur the above process would be reversed; there would be a net loss in utility. Thus B is true. All aspects of supply are unaffected; thus A and C are wrong. The terms of exchange may be altered because the consumer in question may have different endowments of goods to trade but that is not the reason for being worse off. Thus D is wrong.
Suppose after an economy had achieved long run equilibrium the market demand for the product in the figure shifted to the right. What would happen in the short run? The price would rise and
A. the market supply curve shift to the right
B. the firm would move up its LMC
C. the firm would move up its MC
D. new firms would enter the industry
C
In the ‘market’ diagram the supply curve is the summation of all the firms’ (in this market) short run marginal cost curves. The rightward shift in demand curve, given S, will cause the price to rise which in turn will cause the firms, given profit maximising behaviour to move up their MC curves as they equate price with MC. Thus C is correct. In the short run the supply curve is given and no ‘fixed’ resources move into the industry. Thus A, B and D are wrong.
Suppose after an economy had achieved long run equilibrium the market demand for the product in the figure shifted to the right. What would happen in the long run?
A. Price of the product and firms’ profit would increase
B. New firms would enter the market; what would happen to the price of the product is unknown
C. New firms would enter the market; the price of the product would remain constant
D. Each firm would move up its long run marginal cost curve
B
The shift in demand to the right would cause firms to move up their short run marginal cost curves to achieve equilibrium; this would result in above normal profits which in turn would attract new firms into the industry, shifting the short run supply curve to the right. If the entry of new firms did not cause factor input prices to increase the long run supply curve would be a horizontal line and the price of the product would return to its original equilibrium level. If however the entry of new firms caused factor input prices to increase the long run supply curve would be positively inclined, i.e. upward sloping and the new equilibrium price of the product would be higher than it was before.
Suppose after an economy had reached long run equilibrium the market demand for the product in the figure shifted to the left. What would happen in the short run?
A. The market supply curve would shift to the left
B. Firms would move down their short run marginal cost curves
C. Profits would decrease and firms would leave the industry
D. Profits would remain unaltered as firms would leave the industry
B
To maximise profit firms move up/down their marginal cost curves in response to price changes. Thus B is correct. In the short run the number of firms in the industry by definition, is fixed thus A, C and D are wrong.
Suppose after an economy had reached long run equilibrium the market demand for the product in the figure shifted to the left. What would happen in the long run?
A. The minimum point on the long run average cost curve would decrease
B. The market supply curve would shift to the left
C. Firms would experience a decline in profits
D. The firm’s long run supply curve would shift to the left
B
To minimise losses firms in the short run would move down their marginal cost curves, the price of the product would fall and firms would earn less than normal returns. This in the long run would force some firms out of the industry causing the market supply curve to shift to the left. Thus B is true. Unless factor input prices were affected, the long run cost curves would remain unaltered; in the long run equilibrium normal profits/returns would exist. Thus A, C and D are wrong.
If the firm’s average variable cost curve were to be drawn in the figure
I. its minimum point would equal the distance from the origin to where the market supply curve cuts the vertical axis
II. LMC would pass through its minimum point
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
A
Where the market supply curve begins indicates the price below which no firm will supply any output because average variable costs (AVC) will not be covered and as a consequence a firm would lose less by closing down. Thus where the S curve touches the vertical axis indicates the minimum point of the firm’s AVC. Thus I is true. The MC curve must go through the minimum points of both the ATC and AVC and as a consequence the LMC curve must intersect the AVC above its minimum point. Thus II is wrong.
Family A, golf enthusiasts, owns 3 weeks per annum of time share in the Algarve, Portugal. Family B owns an apartment in St Andrews, Scotland, home of golf. The next year the Open Golf Championship is being played in St Andrews B is going to exchange the St Andrew’s apartment for the one week of the Championship for the 3 weeks of family A’s time share in Portugal. Which of the following can be concluded from this transac-tion?
A. B gains more than A since 3 weeks are greater than 1 week
B. A gains more than B since A gains the Golf Championship as well
C. Both A and B gain from the exchange; relative gains cannot be assessed
D. The family who first proposed the exchange, suggested the terms and concluded the exchange benefits more
C
Exchange permits individuals to become better off without an increase in the amount of goods and services available. The goal in an exchange is to find someone with a good, which for you, has high marginal utility (low for the exchanger) who wishes a good in your possession which is yielding you a relatively low marginal utility (high utility for the exchanger). Both benefit from exchange but comparison of interpersonal utilities is not possible no matter who initiated the exchange process or who proposed the terms. Thus A, B and D are wrong.
For an economy to be economically efficient it must
I. be technologically efficient
II. ensure all wants are satisfied
Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II
A
For economic efficiency to prevail the goods and services produced must be produced using the minimum amount of resources (technological efficiency) and must be those which satisfy society’s wants as fully as possible, i.e. given the resource constraint. This does not imply all wants are satisfied. Thus I is true and II is wrong.
Which of the following is correct?
I. The LAC is derived from ATCs
II. The LMC is derived from AVCs
A. I only
B. II only
C. Both I and II
D. Neither I nor II
A
The LAC curve is an envelope curve indicating the optimally sized plant for any given level of output; i.e. it traces out the lowest average total cost for each output level. Given its ‘saucer shape’ there will be one plant at which ATC is a minimum and this will be the optimally sized plant and reflect minimum LAC. Thus I is true.
The LMC curve traces out the marginal cost of producing an additional unit of output when all factor inputs are variable. The MC curve reflects the cost of an additional unit of output in the presence of fixed factor inputs. There is no connection therefore between the LMC and AVCs. Thus II is wrong.
Which of the diagrams represents the Law of Diminishing Marginal Utility?
A. A only
B. B only
C. C only
D. D only
B
The Law of Diminishing Marginal Utility states that as an individual consumes more of a good in a given time period total utility increases but at a decreasing rate. The only diagram to exhibit such characteristics is B.
In which of the diagrams are average and marginal utility equal?
A. A only
B. B only
C. C only
D. D only
The correct answer is D.
Average utility is total utility divided by quantity, i.e. U/Q. Marginal utility is additional utility gained by consumption of one additional unit of output, i.e. △U/△Q. The only diagram in which U/Q = △U/△Q is D; it must be linear.
If in a 3 good economy MUa/MCa > MUb/MCb > MUc/MCcto achieve economic efficiency which of the following will have to occur?
A. More of a will have to be produced
B. More of b will have to be produced
C. The marginal cost of c will have to increase
D. The marginal cost of a will have to decrease
A
For economic efficiency to prevail the marginal equivalency conditions must hold, i.e. MUa/MCa > MUb/MCb > MUc/MCc . If resources were transferred from industry c to industry a MUa/MCa would decrease and MUc/MCc would increase. It is theoretically possible that both could equal; MUb/MCb without any resources moving into industry b. Thus A is true and B is wrong. If all three industries are competitive and average costs are unaffected by marginal movements of resources the prices of which are determined also in competitive markets marginal cost need not change.
The reasons a modern economy never reaches long run equilibrium are
I. consumers’ tastes and preferences are constantly changing
II. rapid technological changes alter resources and product prices continuously
III. the relationship between productivity curves and cost curves are not constant
Which of the following is correct?
A. I and II only
B. II only
C. II and III only
D. I, II and III
A
For the Marginal Equivalency Conditions (MEC) to exist in the long run:
Once firms make decisions, however, and make investments, they are back in the short run where changes in tastes and preferences, and changes in factor prices to name but two will prevent MEC being established. Thus I and II are true. Average and marginal productivities always determine average and marginal costs. Thus III is wrong.
For an economy to be in long run equilibrium:
If then resources…
…will move from the production B to A.
The law of diminishing marginal utility will cause MUb to increase and MUa to decrease as more of A and less of B are produced. So equilibrium is achieved over time.
In a two good world composed of profit maximizing producers and utility maximizing consumers, the following must hold:
In the short run, a firm is in equilibrium (P=MC=MR) with the following curves:
(Draw curve)
The correct answer is B. At a price of $2, excess demand exists; to clear the market,
price must rise. At $3, however, excess supply exists. Thus the equilibrium price
must lie between $2 and $3. At a price of $4, excess supply exists and those suppli-
ers willing to offer services at lower prices will do so to obtain sales, i.e. there will be
a movement along the supply curve. The demand curve given by the first two
columns will not change as prices change.
In order to make the most efficient use of a city’s trains and buses, how should train and bus fares vary during the day?
A. They should be relatively low during rush hour to reduce cost for the maxi-mum number of people.
B. They should be relatively low during rush hour to transport as many people as possible at that time.
C. They should be relatively high during rush hour to allocate the limited space to the rush hour travellers who value it most highly.
D. They should be the same at all times to avoid travellers altering their schedules because of price differences.
The correct answer is C. In order for resources to be used efficiently, it is necessary that the prices of goods and services produced by those resources be equal to marginal cost. Clearly, the marginal cost of transportation services is higher during rush hour if trains and buses are filled to capacity since each traveller prevents some
other potential traveller from consuming the services. The price should be set
during rush hour so that there is no excess demand. This will ensure that the people
who travel during rush hour are the people who value it most, i.e. the people who
are willing to pay that high price. During the off-peak hours, the price should just
cover the cost in terms of resources used up associated with carrying an additional passenger. Looked at from another point of view, such a pricing scheme would
serve to spread the use of transportation facilities over the day, thereby reducing the
amount of equipment required to handle the peak load.
