Chapter 12
Economic
Efficiency and
Public Policy
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In this chapter you will learn to
1. Describe the distinction between productive and
allocative efficiency.
2. Explain why perfect competition is allocatively efficient,
whereas monopoly is allocatively inefficient.
3. List the alternative methods for regulating a natural
monopoly.
4. Describe the goals and results of U.S. antitrust policy.
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Productive and Allocative Efficiency
Full employment of resources does not guarantee
efficiency:
1. firms may not use least-cost methods of production
2. marginal costs may not be equated across firms in an
industry
3. too much of one product and too little of another product
may be produced.
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Table 12.1 Review of Four Market
Structures
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Productive Efficiency
Productive efficiency for a firm requires costs to be minimized
for any given level of output (recall chapter 8).
Productive efficiency for an industry requires the MC to be
the same for every firm.
If all industries are productively efficient, then the economy is
on the production possibilities boundary.
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Figure 12.1 Productive
Efficiency for the Industry
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Figure 12.2 Productive Efficiency and
the Production Possibilities Boundary
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Figure 12.3 Allocative Efficiency and
the Production Possibilities Boundary
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What is the Amount of Steel and
Wheat to Produce?
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Which Market Structures Are
Efficient?
Profit-maximizing, competitive firms are productively efficient.
If they interact in competitive markets, the outcome will be
allocatively efficient (p = MC).
On the other hand, monopoly is productively efficient, but
allocatively inefficient (since p > MC).
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Figure 12.4 Consumer and Producer
Surplus in a Competitive Market
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Figure 12.5 The Allocative
Efficiency of Perfect Competition
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Figure 12.6 The Deadweight
Loss of Monopoly
A monopolist
generates a
deadweight loss
by restricting
output below the
competitive level.
The deadweight
loss is shown by
area = 3 + 5.
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Allocative Efficiency and Market
Failure
Market failures:
• when the free market fails to generate allocative efficiency
• several causes — discussed in Chapter 16
• public policies — discussed in Chapters 17 and 18
Under some circumstances government action can “correct”
the market failure and improve the efficiency of market
outcomes.
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Economic Regulation to Promote
Efficiency
Regulation of Natural Monopolies
Natural monopoly: a situation where costs decline over the
whole range of market output.
 room for only one firm to achieve MES
Two policy responses:
- public ownership
- regulation
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Three Approaches to Regulating
Natural Monopolies
1. Marginal-cost pricing (set p = p1)
p
c1
2
p1
•
ATC
•
•
Q2 Q1
Marginal-cost pricing is
allocatively efficient, but
the firm will incur losses.
MC
D
Output
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Figure 12.7 Pricing Policies for
Natural Monopolies with Falling Costs
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Tariff
2. A two-part tariff can be used to cover costs.
This policy allows customers pay one price to gain access
to the product and a second price for each unit consumed:
For example: Electric bill
– fixed monthly charge
– charge that varies with the actual amount consumed
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Average-Cost Pricing
3. Average-cost pricing (set p = p2)
p
c1
2
p1
•
ATC
•
•
Q2 Q1
Average-cost pricing
results in zero profits, but
it is allocatively inefficient
because p > MC.
MC
D
Output
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Long Run Adjustment
The allocatively efficient pricing system would determine
output by setting prices equal to MC in the short run.
It would also adjust capacity in the long run until the long-run
MC is equal to the price.
(Average-cost pricing generally leads to inefficient long-run
investment decisions.)
In the very long run, technological changes may create or
destroy natural monopolies.
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Regulation of Oligopolies
There is growing skepticism about regulators’ ability to
improve the behaviour of oligopolistic industries.
Advanced industrial countries pushed toward deregulation
and privatization when it was realized that:
• Regulation often reduced competition
• Public ownership was not clearly more efficient
• Globalization led to more international competition
- reduced need for regulation?
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U.S. Antitrust Policy
The Framework of Antitrust Policy
The antitrust law prohibits:
• collusive behavior
• mergers that reduce competition
• Monopolization of an industry
Sherman Act of 1890, Section 1: illegal to restrain trade
Sherman Act of 1980, Section 2: illegal to monopolize
Clayton Act of 1914: prohibited other anticompetitive practices
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Antitrust Policy in the 21th Century
APPLYING ECONOMIC CONCEPTS 12.1
Does Nineteenth Antitrust Policy Still Work
in the Twenty-First Century?
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Evolution of Antitrust Policy and
Recent Developments
Over time, there has been considerable variation in the
aggressiveness of antitrust enforcement and in the
interpretation of exactly what type of behavior is illegal.
• U.S. v. Socony-Vacuum Oil Co. (1940): price fixing was
found illegal regardless of the consequences
• ALCOA (1945): company was ruled an illegal monopoly
despite no evidence of “unreasonable behavior”
• Be the mid-1970s, a more balanced antitrust approach
was adopted, particularly in merger policy.
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Looking Forward
History suggests that U.S. antitrust policy will continue to
change.
Factors that will affect antitrust issues include:
– technological changes
– Globalization
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