Saturday, 13 November 2010

Competition and efficiency

Efficiency in resource allocation is attained when TSS is maximized (MB=P=MC)
When MB=MC, any reallocation of resource would reduce TSS.
Deadweight loss = Max. TSS – current TSS. At efficient quantity DL=0.
When the quantity is greater than efficient quantity it’ll be overproduction, then output will decrease to avoid loss of TSS.
Oppositely when the quantity is less than the efficient quantity it’ll be under-produced, then output will increase to gain TSS.
In an perfectly competitive market, the quantity transacted is at equilibrium level and efficient level as well, so it achieves efficiency in resource allocation.
Function of prices – used to achieve efficiency in resource allocation
  1. It gives information about market demand and supply conditions. For example higher price implies higher demand for substitute or more demand.
  2. Providing incentives by rewarding/penalizing behavior against price signal. i.e., they earn more CS/PS if they follow the price signal.
  3. Allocating resources and distributing outputs
Government interventions may lead to deadweight loss and loss of efficiency.
  • Price ceiling: P↓, Quantity transacted↓, deadweight loss is enclosed by the line of MB, MC and quantity transacted (i.e., Q = Qt). There’ll be excess demand, i.e., underproduction so that the intervention is inefficient. PS↓, CS unknown, TSS↓ here.
  • Price floor: P↑, Quantity transacted↓, deadweight loss is same as that of price ceiling; excess supply occur, then there’ll be overproduction which is inefficient. In this case, CS↓, PS unknown, TSS↓.
  • Quota: P↑, Quantity transacted↓, deadweight loss is enclosed by the quota curve, MC and MB curve. In this case CS↓, PS unknown, TSS↓. It’s under-produced and inefficient.
  • Taxes: As shown as the figure, the supply curve moved up, price rises and quantity transacted falls. CS is enclosed by Pc and D while PS is enclosed by Pp and S. The tax revenue is (Pc-Pp)(Qt). Note that TSS is equal to CS + PS + Tax revenue.
  • Subsidation: The supply curve moved downwards, amount of subsidy is equal to new quantity transacted * unit subsidy. TSS is equal to CS + PS – amount of subsidy, and deadweight loss occur in the area enclosed by new MC curve, MB curve and the new quantity (Q = Qe’).
I'm trying to avoid the usage of D&S disgram but I failed since the diagram concerning taxes is really complicated orz.

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