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CHAPTER 6 BASIC ECONOMIC PROBLEM & RESOURCE ALLOCATION

Productive efficiency

Price = minimum average cost


Production of each unit of output uses least possible resources.
E.g. When a car manufacturing plant is using most up-to-date technology in production process
Productive efficient is production is along PPC boundary
Competition leads to productive efficiency because firms want to maximise profits, and keep
their price low compared to rivals.
Perfectly competitive market structure constrains firms to produce at minimum AC.

Allocative efficiency

Price = marginal cost


Price paid by consumer represents true economic cost of producing the last unit of the product
=> right amount is produced
Production of the combination of products that will yield greatest possible level of satisfaction of
consumer wants.
Price represents value which the consumer places on the product. If P<MC, less should be
produced. If P>MC, more should be produced.
Competition leads to allocative efficiency because firms want to maximise profits, and prevent
bankruptcy, by producing those goods that consumers most demand.

Pareto Optimality

A situation where it is impossible to make someone better off without making someone else
worse off, implying that resources are being used in the most efficient way.
Any point on PPF boundary is Pareto efficient.
Pareto improvement = any action where at least one person is made better off without making
anyone else worse off
o At Pareto optimality, no more Pareto improvements can be made.
In practice, virtually no action can be taken that will make nobody else worse off. Those made
worse off must be paid compensation in order to minimise welfare loss in the face of efficiency
gain.

Dynamic efficiency

A form of productive efficiency that benefits a firm over time.


Resources are allocated such that output increases relative to the increase in resources.
LRAC curve shifts downward.
Monopolies and oligopolies seek to protect their market share through this.
E.g. ploughing excess profits to R&D, product innovation, etc.; employing production processes
with higher technology
E.g. motor vehicle manufacturing industry Henry Ford invested in innovation and automated
production plants
Market failure

Where the free market, left to its own devices, with no government intervention, fails to make
the optimum use of scarce resources
Externalities, underproduction of merit goods, overproduction of demerit goods, public goods
not provided, information failure, adverse selection/moral hazard, abuse of monopoly power in
market

Externalities

A situation where a third party, that was not directly involved in an economic decision, is
affected (positively or negatively) by that decision.
Transaction between a particular supplier and consumer for a product should not affect anyone
else other than the supplier and consumer.
Negative externality: where an economic decision has negative side effects on third parties, and
which impose costs on third parties
Positive externality: where an economic decision has positive side effects on third parties, and
which provide benefits to third parties
Distinguish negative/positive, production/consumption, externalities
Social cost = private cost + external cost
o Negative externality = divergence between private costs and social costs
Social benefit = private benefit + external benefit
o Positive externality = divergence between private benefits and social benefits
With negative externality, there is overproduction because if even external costs were taken into
account, supply curve should be further inside. (draw diagram to illustrate)
With positive externality, there is underproduction because if even external benefits were taken
into account, demand curve should be further outward. (draw diagram to illustrate)

Cost-benefit analysis (CBA)

A method for assessing the desirability of an economic decision by taking into account the costs
and benefits involved.
Used by public sector because a long and wide view must be given.
Long view = public sector investment needs to have long-term costs and benefits analysed
because of the large sum involved. A public sector project is appraised over many years.
Wide view = considers full social costs & social benefits
CBA allows justification of projects involving large sums of money by showing overarching wide
impacts on society and on the economy over a given period.
CBA differs from private sector appraisal methods because it seeks to take into account both
private & external costs and benefits; CBA also has to impute shadow price on costs/benefits
which do not have a market price (e.g. pollution).
Difficulties in CBA: not easy to define all costs and benefits in discrete way; hard to define
physical & geographical cut-off points
1. Identification of relevant costs and benefits.
2. Placing monetary value on costs and benefits. Placing shadow price where market price is
unavailable.
3. Forecasting future costs and benefits, for long-term projects. Involves statistical forecasting
techniques.
4. Decision is made social costs and benefits are presented clearly. If social benefit > social
cost, decision is YES.
But: CBA is only a guide; ultimate decision depends on availability of funding and competing
options.
Projects with highest benefit:cost ratio is prioritised to be accepted.
CBA is often dismissed as reliable method of decision making, and is shoved aside because of
political agenda.
CBA often does not satisfactorily reflect the distributional consequences of an economic
decision.

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