Question

Explain how, in the absence of market failures, efficiency as part of allocative efficiency in consumption is achieved.

Explain, in the absence of market failures, efficiency in production (as part of allocative efficiency) is achieved

Explain, and support graphically, the Coase theorem and specify the conditions necessary for it to hold

Answer 1

Let us start by defining pareto efficiency.

Pareto efficiency is said to be achieved if there is no way to make one person better off without making another person worse-off.

1) Efficiency in consumption:

Condition: MB_a = MB_b    [D_a = D_b]

i.e. The marginal benefit of X (the benefit of consuming an additional unit of X) for consumer A is equal to that of consumer B.

From the figures above, Consumer A decreases his/her consumption and consumer B increases his/her consumption until D_A (MB_A) = D_B (MB_B).The marginal benefits of individuals approach each other will equal out. Consider that when consumers A and B consume 10 units of X, they value each unit at $10 and $18, respectively. Therefore, a middleman could buy several units of X from consumer B at $11 (or any price greater than $10 and less than $18), and sell them to consumer A for $17 (or any price less than $18 and greater than $11). The middleman would earn a profit from the transaction. And the terms of trade are favorable to both consumers—everyone benefits. The system achieves efficiency in consumption and moves closer to Pareto efficiency.

2) EFFICIENCY IN PRODUCTION:

  One can't produce more of one good (X, for example) without producing less of another good (Y).

Condition: production bundle must be on the PPC

From the following diagram,we can see the production possibility curve for goods X and Y. All points on the PPC itself (such as B and C) are efficient in production because they satisfy the above condition. Starting from point C (11Y and 9X), one cannot produce more X without producing less Y—moving to point B (9 to 12 units of X) entails a gain of 3 X, but it comes                with the loss of 4 Y (11 to 7). This reasoning works regardless of whether you move up or down the PPC.

Looking at diagram, Point A is not efficient in production because one can produce more of either one or both goods (X and Y) without producing less of the other. (A→B = +7 X, no decrease in Y output; A→C = +4 X, +4 Y). Thus, moving from A to B or C enables to make one person better off without making anyone else worse off (rise in Pareto efficiency). You can hand out 4 X and 4 Y to someone (and increase that person's benefit) by moving from A to C, without taking any X or Y from others (reducing their benefit).

All producers face the same marginal cost of production

                Condition: MC_a = MC_b [S_a =S_b]

—The marginal cost of X (cost of producing an additional unit of X) faced by firm A is equal to that faced by firm B.

Firm A will decrease its production (from 15 to XA) and Firm B will increase its production (from 15 to XB) until MC_A = MC_B ($36, in this example). At these altered outputs, productive efficiency is attained.

3) COASE THEOREM

Coase Theorem is an economic theory developed by economist Ronald Coase that says that where there are complete competitive markets with no transactions costs, an efficient set of inputs and outputs, production-optimal distribution will be selected, regardless of how property rights are divided. Further, the Coase Theorem asserts that if conflict arises over property rights under these assumptions, then parties will tend to settle on the efficient set of inputs and output.

Thus conditions for coase theorem to hold are:

1) Trade in externality should be possible

2) Transaction cost = 0