Lecture 9 Monday Sept 28 1 Midterm two weeks from today In class Monday Oct 12 2 Posted midterms from Fall 2007 at course home page The class is a bit different There is some overlap and this gives you something for you to look at 3 If convenient bring a laptop to class on Wed Will run a quick experiment in class Lecture 1 More about Pareto Efficiency 2 Link between efficiency and the market allocation Adam Smith Theorem 3 Taxes Last class An allocation is Pareto Efficient if it is feasible and there is no way to make someone better off without making someone worse off or The Pie is big as it can be If someone is to get a bigger slice it can only come from someone else getting a smaller slice Concept is easy to understand if cookies are the only thing in the economy Like when we had 6 cookies in the example from last class In this case efficient allocations are those with no cookies in the trash 3 for me 3 for student efficient 6 for me 0 for student efficient 3 for me 1 for student 2 in trash not efficient Things are more complicated in Econland where there are two goods dollars and widgets How many widgets should be produced Who should produce Who should consume Reservation Prices and Costs for Widgets Name Res Cost Name Price D1 9 1 S1 D2 8 2 S2 D3 7 3 S3 D4 6 4 S4 D5 5 5 S5 D6 4 6 S6 D7 3 7 S7 D8 2 8 S8 D9 1 9 S9 D10 0 10 S10 Last class we showed the following General Principle 1 Efficient Allocation of Consumption An allocation where D8 consumes a widget but D2 does not can not be Pareto efficient In any efficient allocation consumers with highest willingness to pay consume Because D8 gives widget D2 D2 gives 6 to D8 D8 better off get 6 for widget values at 2 D2 better off pays 6 dollars for widget he values at 8 Reservation Prices and Costs for Widgets Name Res Cost Name Price D1 9 1 S1 D2 8 2 S2 D3 7 3 S3 D4 6 4 S4 D5 5 5 S5 D6 4 6 S6 D7 3 7 S7 D8 2 8 S8 D9 1 9 S9 D10 0 10 S10 Next consider an allocation where S7 produces a widget but S3 does not Is this Pareto efficient No Consider this alternative deal S3 makes widget and gives it to S7 S7 doesn t make widget and gives 5 cash to S3 S7 is outsourcing S3 better off because gets 5 to make widget that costs her 3 to make S7 pays 5 to get widget rather than incur costs of 7 to make it herself General Principle 2 Efficient Allocation of Production In any efficient allocation producers with the lowest cost produce What about quantity Let s see what we can learn from the next two examples Next consider an allocation where 3 widgets are produced by S1 S2 S3 and 3 widgets are consumed by D1 D2 and D3 Pareto efficient No Consider alternative deal suggested by student at 10 10 Lec S4 makes widget gives it to D4 D4 pays 5 to S4 and 50 cents to student arranging deal S4 gets 5 for widget that cost her 4 to make She is ahead D4 pays 5 50 for widget he values at 6 So ahead And student gets 50 Next consider an allocation where 8 widgets are produced by S1 through S8 and 8 widgets are consumed by D1 through D8 Let s say S8 is supposed to deliver a widget to D8 Pareto efficient No Relative to the initial allocation S8 can give 5 instead of a widget Paying 5 is cheaper for S8 than making a widget D8 would rather have 5 than a widget So both better off no one worse off So what do we learn from these last two examples When Q 3 there is someone out there D4 not consuming who is willing to pay more than it will cost someone S4 to produce So raise quantity When Q 8 there is someone out there consuming D8 who is willing to pay less than what it is costing someone S8 to produce So lower quantity From this we get a general principle General Principle 3 Efficient Quantity 10 9 8 6 Dollars In any efficient allocation the quantity is where the marginal valuation of the last unit consumed equals the marginal cost of the last unit produced Marginal Cost 7 5 4 Marginal reservation price 3 2 1 0 Principles 1 2 and 3 imply that in an efficient allocation for the widget industry in Econ land Q 5 S1 S2 S3 S4 S5 produce D1 D2 D3 D4 D5 consume 0 1 2 3 4 5 6 7 8 9 10 efficient QQefficient Quantity Qefficient 5 Social Surplus equals 8 6 4 2 0 20 All of this should look familiar Let s link this to the market Dollars Market Allocation Q P 1 Big Idea 10 9 8 7 6 5 4 3 2 1 0 S D 0 1 2 3 4 5 6 7 8 Quantity Qmarket Q 5 S1 S2 S3 S4 S5 produce D1 D2 D3 D4 D5 consume Market Allocation is Pareto Efficient 9 10 Assume 1 Market structure is perfectly competitive not monopoly or oligopoly 2 No externalities my action hurts or benefits others but I don t take into account Like pollution Then the unregulated market laissez faire allocation is Pareto efficient It maximizes the size of the social pie First Welfare Theorem Adam Smith was on to this Wealth of Nations 1776 Every individual neither intends to promote the public interest nor knows how much he is promoting it but by directing that industry to its greatest value he is led by an invisible hand to promote an end which was no part of his intention The First Welfare Theorem also sometimes called Adam Smith Theorem or Invisible Hand Theorem Now while the market maximizes the size of the pie under the assumptions given above you might not like the way it is divided up Market delivers on efficiency Not necessarily on equity And something else Update in light of the recent banking crisis An unregulated banking sector has the potential for collapse and get take the whole economy down with it Now can argue that there are externalities in the banking industry and in that way fits into the theorem So on account of these externalities the government can potentially make the social pie bigger by regulation While this may be true let s be clear that the banking industry is very different from the widget industry in Econland Econland is useful for looking at many industries corn oil apartments etc But banking is special Finally it should be said that it is not an unregulated banking industry that failed It was a badly regulated industry with policies like too big to fail that contributed to the behavior that led …