MicroEconomics theory and application 12th by browning an zupan chapter 06

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MICROECONOMICS: Theory & Applications

By Edgar K Browning & Mark A Zupan

John Wiley & Sons, Inc.

Chapter 6: Exchange, Efficiency, and Prices

Prepared by Dr Della Lee Sue, Marist College

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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

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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

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6.1 TWO-PERSON EXCHANGE

Understand why voluntary exchange is mutually beneficial.

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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

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Table 6.1

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The Edgeworth Exchange Box Diagram

 Edgeworth exchange box: a diagram for examining the allocation of fixed total quantities of two goods between two consumers

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Figure 6.1 - Edgeworth Exchange Box

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The Edgeworth Exchange Box with

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Figure 6.2 – Gains from Trade

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Gains from Trade

 Every point inside the shaded area: a market basket for each consumer that is preferred to Basket A (Figure 6.2)

 Where the marginal rates of substitution differ: mutually

beneficial trade between the parties is possible

 Final outcome is not uniquely determined

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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

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Figure 6.3 - Efficient Distributions and the Contract Curve

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Efficiency and Equity

the contract curve at attainable though voluntary exchange

 Fairness requires normative considerations which are

subjective judgments

 Pareto optimality cannot help make normative judgments

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6.3 COMPETITIVE EQUILIBRIUM AND EFFICIENT DISTRIBUTION

Discuss how competitive markets promote efficient distribution of goods between consumers.

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Competitive Equilibrium and Efficient

Distribution

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

 Final equilibrium point is an efficient allocation

 All potential gains are realized from voluntary exchange

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Figure 6.4 - Competitive Exchange

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Competitive Equilibrium and Efficient Allocation

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Figure 6.5 - A Market-Determined

Distribution is Efficient

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6.4 PRICE AND NONPRICE

RATIONING AND EFFICIENCY

Explore the extent to which price and nonprice mechanisms for rationing goods across consumers serve to promote efficiency.

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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

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Figure 6.6 – Gasoline Rationing

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6.5 SOME OF THE MATHEMATICS

BEHIND EFFICIENCY IN EXCHANGE*

Explain the mathematics behind efficiency in exchange.

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*Denotes digital-only content

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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

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Some of the Mathematics behind

Efficiency in Exchange

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(continued)

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Some of the Mathematics behind

Efficiency in Exchange (continued)

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