Prepared by Dr Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 6: Exchange, Efficiency, and Prices By Edgar K Browning & Mark A Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives Understand why voluntary exchange is mutually beneficial Explain what economists mean by efficiency in exchange and the benefits associated with the promotion of such efficiency Discuss how competitive markets promote efficient distribution of goods between consumers Explore the extent to which price and nonprice mechanisms for rationing goods across consumers serve to promote efficiency Explain the mathematics behind efficiency in exchange Copyright © 2015 John Wiley & Sons, Inc All rights reserved Economic Efficiency With regard to exchange, economic efficiency represents a distribution of goods across consumers in which no one consumer can be made better off without hurting another consumer Copyright © 2015 John Wiley & Sons, Inc All rights reserved Understand why voluntary exchange is mutually beneficial 6.1 TWO-PERSON EXCHANGE Copyright © 2015 John Wiley & Sons, Inc All rights reserved Two-Person Exchange People engage in exchanges (or trades) because they expect to benefit Voluntary exchange is mutually beneficial, assuming that Fraud has not taken place Benefit: expectations at the time of the transaction Copyright © 2015 John Wiley & Sons, Inc All rights reserved Table 6.1 Copyright © 2015 John Wiley & Sons, Inc All rights reserved The Edgeworth Exchange Box Diagram Edgeworth exchange box: a diagram for examining the allocation of fixed total quantities of two goods between two consumers Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 6.1 - Edgeworth Exchange Box Copyright © 2015 John Wiley & Sons, Inc All rights reserved The Edgeworth Exchange Box with Indifference Curves Indifference curves: Negatively sloped Convex Curves farther from the origin are preferred to those closer to the origin Indifference map – shows entire preference mapping Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 6.2 – Gains from Trade Copyright © 2015 John Wiley & Sons, Inc All rights reserved 10 Efficiency in the Distribution of Goods Pareto optimality – another term for economic efficiency: an efficient distribution of fixed total quantities of goods such that it is not possible, through any change in the distribution, to benefit one person without making some other person worse off Contract curve – in an Edgeworth exchange box, a line drawn through all the efficient distributions Inefficiency – an allocation of goods in which it is possible, through a change in the distribution, to benefit one party without harming the other Equity – the concept of fairness Copyright © 2015 John Wiley & Sons, Inc All rights reserved 13 Figure 6.3 - Efficient Distributions and the Contract Curve Copyright © 2015 John Wiley & Sons, Inc All rights reserved 14 Efficiency and Equity Initial Endowment: determines which efficient points on the contract curve at attainable though voluntary exchange Fairness requires normative considerations which are subjective judgments Pareto optimality cannot help make normative judgments Copyright © 2015 John Wiley & Sons, Inc All rights reserved 15 Discuss how competitive markets promote efficient distribution of goods between consumers 6.3 COMPETITIVE EQUILIBRIUM AND EFFICIENT DISTRIBUTION Copyright © 2015 John Wiley & Sons, Inc All rights reserved 16 Competitive Equilibrium and Efficient Distribution Price taker – firms or consumers who cannot affect the prevailing price through their respective production and consumption decisions Adam Smith’s “invisible hand”: each trader, concerned only with furthering his or her own interest, is led to exchange to a socially efficient result Competitive market: Final equilibrium point is an efficient allocation All potential gains are realized from voluntary exchange Copyright © 2015 John Wiley & Sons, Inc All rights reserved 17 Figure 6.4 - Competitive Exchange Copyright © 2015 John Wiley & Sons, Inc All rights reserved 18 Competitive Equilibrium and Efficient Allocation Copyright © 2015 John Wiley & Sons, Inc All rights reserved 19 Figure 6.5 - A Market-Determined Distribution is Efficient Copyright © 2015 John Wiley & Sons, Inc All rights reserved 20 Explore the extent to which price and nonprice mechanisms for rationing goods across consumers serve to promote efficiency 6.4 PRICE AND NONPRICE RATIONING AND EFFICIENCY Copyright © 2015 John Wiley & Sons, Inc All rights reserved 21 Price and Nonprice Rationing and Efficiency Demand curve treatment of rationing problems In an open market, prices serve as rationing function Result: efficient distribution of goods Alternative to the Edgeworth box approach Copyright © 2015 John Wiley & Sons, Inc All rights reserved 22 Figure 6.6 – Gasoline Rationing Copyright © 2015 John Wiley & Sons, Inc All rights reserved 23 Explain the mathematics behind efficiency in exchange 6.5 SOME OF THE MATHEMATICS BEHIND EFFICIENCY IN EXCHANGE* *Denotes digital-only content Copyright © 2015 John Wiley & Sons, Inc All rights reserved 24 Some of the Mathematics behind Efficiency in Exchange “Efficient distribution” (interpretations) One that makes one consumer as well off as possible for a given level of well-being for the other consumer One that maximizes the utility of one consumer subject to the constraint that the utility of the other is held fixed at some level Efficient distribution is attained when: Consumers’ indifference curves in the Edgeworth diagram are tangent The consumers’ MRSs are equal Copyright © 2015 John Wiley & Sons, Inc All rights reserved 25 Some of the Mathematics behind Efficiency in Exchange (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved 26 Some of the Mathematics behind Efficiency in Exchange (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved 27 ...Learning Objectives Understand why voluntary exchange is mutually beneficial Explain what economists mean by efficiency in exchange and the benefits associated with the promotion... Explore the extent to which price and nonprice mechanisms for rationing goods across consumers serve to promote efficiency 6.4 PRICE AND NONPRICE RATIONING AND EFFICIENCY Copyright © 2015 John... John Wiley & Sons, Inc All rights reserved 21 Price and Nonprice Rationing and Efficiency Demand curve treatment of rationing problems In an open market, prices serve as rationing function