Efficiency in Exchange

We begin with an exchange economy, analyzing the behavior of two consum- ers who can trade either of two goods between themselves. (The analysis also applies to trade between two countries.) Suppose the two goods are initially allocated so that both consumers can make themselves better off by trading with each other. In this

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Equity and Efficiency

We have shown that different efficient allocations of goods are possible, and we have seen how a perfectly competitive economy generates a Pareto efficient allocation. But there are many Pareto efficient allocations, and some are likely to be more fair than others. How do we decide what is the most equitable alloca- tion? That

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Efficiency in Production

Having described the conditions required to achieve an efficient allocation in the exchange of two goods, we now consider the efficient use of inputs in the production process. We assume that there are fixed total supplies of two inputs, labor and capital, which are needed to produce the same two products, food and clothing.

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The Gains from Free Trade

Clearly there are gains from international trade in an exchange economy. We have seen that two persons or two countries can benefit by trading to reach a point on the contract curve. However, there are additional gains from trade when the economies of two countries differ so that one country has a comparative advantage

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An Overview—The Efficiency of Competitive Markets

Our analysis of general equilibrium and economic efficiency is now complete. In the process, we have obtained two remarkable results. First, we have shown that for any initial allocation of resources, a competitive process of exchange among individuals, whether through exchange, input markets, or output markets, will lead to a Pareto efficient outcome. The

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Why Markets Fail?

We can give two different interpretations of the conditions required for effi­ciency. The first stresses that competitive markets work. It also tells us that we ought to ensure that the prerequisites for competition hold, so that resources can be efficiently allocated. The second stresses that the prerequisites for competi­tion are unlikely to hold. It

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Quality Uncertainty and the Market for Lemons

Suppose you bought a new car for $20,000, drove it 100 miles, and then decided you really didn’t want it. There was nothing wrong with the car—it performed beautifully and met all your expectations. You simply felt that you could do just as well without it and would be better off saving the money

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Market Signaling

We have seen that asymmetric information can sometimes lead to a lemons prob- lem: Because sellers know more about the quality of a good than buyers do, buy- ers may assume that quality is low, causing price to fall and only low-quality goods to be sold. We also saw how government intervention (in the

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Moral Hazard

When one party is fully insured and cannot be accurately monitored by an insurance company with limited information, the insured party may take an action that increases the likelihood that an accident or an injury will occur. For example, if my home is fully insured against theft, I may be less diligent about locking

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The Principal–Agent Problem

If monitoring the productivity of workers were costless, the owners of a busi­ness would ensure that their managers and workers were working effectively. In most firms, however, owners can’t monitor everything that employees do—employees are better informed than owners. This information asymmetry creates a principal-agent problem. An agency relationship exists whenever there is an

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Managerial Incentives in an Integrated Firm

We have seen that owners and managers of firms can have asymmetric informa­tion about demand, cost, and other variables. We’ve also seen how owners can design reward structures to encourage managers to make appropriate efforts. Now we focus our attention on firms that are integrated—that consist of several divisions, each with its own managers.

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Asymmetric Information in Labor Markets: Efficiency Wage Theory

When the labor market is competitive, all who wish to work will find jobs for wages equal to their marginal products. Yet most countries have substantial unemployment even though many people are aggressively seeking work. Many of the unemployed would presumably work for an even lower wage rate than that being received by employed

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Externalities

Externalities can arise between producers, between customers, or between consumers and producers. They can be negative—when the action of one party imposes costs on another party—or positive—when the action of one party benefits another party. A negative externality occurs, for example, when a steel plant dumps its waste in a river that fishermen downstream

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Ways of Correcting Market Failure

How can the inefficiency resulting from an externality be remedied? If the firm that generates the externality has a fixed-proportions production technology, the externality can be reduced only by encouraging the firm to produce less. As we saw in Chapter 8, this goal can be achieved through an output tax. Fortunately, most firms can

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Stock Externalities

We have studied the negative externalities that result directly from flows of harm­ful pollution. For example, we saw how sulfur dioxide emissions from power plants can adversely affect the air that people breathe, so that government intervention in the form of emissions fees or standards might be warranted. Recall that we compared the marginal

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Externalities and Property Rights

We have seen how government regulation can deal with the inefficiencies that arise from externalities. Emissions fees and transferable emissions permits work because they change a firm’s incentives, forcing it to take into account the exter- nal costs that it imposes. But government regulation is not the only way to deal with externalities. In

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Common Property Resources

Occasionally externalities arise when resources can be used without payment. Common property resources are those to which anyone has free access. As a result, they are likely to be overutilized. Air and water are the two most com- mon examples. Others include fish, animal populations, mineral exploration, and extraction. Let’s look at some of

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Public Goods

We have seen that externalities, including common-property resources, create mar- ket inefficiencies that sometimes warrant government regulation. When, if ever, should governments replace private firms as a producer of goods and services? In this section we describe a set of conditions under which the private market either may not provide a good at all

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Private Preferences for Public Goods

Government production of a public good is advantageous because the govern­ment can assess taxes or fees to pay for it. But how can government determine how much of a public good to provide when the free rider problem gives peo­ple an incentive to misrepresent their preferences? In this section we discuss one mechanism for

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