Lecture-3

Economic Efficiency
The central idea of economic efficiency is that there should be a balance between the
marginal benefits and marginal costs of production.
Efficiency must also have a reference point. What is efficient for one person, in the sense of
balancing his or her own costs and benefits, may not be efficient for somebody else.
How do we identify the rate of output that is socially efficient?

The socially efficient equilibrium can be found algebraically:

At this point

here

is an equilibrium point . So,

and
OR

Which

So,

Another name of

is a net benefits or the social surplus

Figure 4-1: Determining the Socially Efficient Level of Output

Numerical computation of the net social value

Markets
The key question to address in this section is how much to produce? And how much will be price
of good?
Economists worry about this question. Because buyers want to pay a low price, while sellers
want to receive high prices. If you can find the equilibrium point for these questions, it means
that it is benefitable for you and also affected positively to the environment.
When supply is equal to demand, we get equilibrium point for buyers and sellers. In our case

At this intersection, the equilibrium price and quantity produced is determined. This is illustrated
in Figure 4-2.

Figure 4-2: Determining Equilibrium in a Competitive Market

Markets and Social Efficiency

When environmental values are concerned, there are likely to be very substantial differences
between market values and social values. Market failures cause the divergence. Market failure is
a situation in which the allocation of goods and services is not efficient. Market failures can
affect both the supply and demand sides of the market.
On the supply side, market failures can drive a wedge between normal market supply curves and
true or social marginal cost curves. On the demand side, market failures can create a divergence
between market demands and social marginal willingness to pay. On the supply side the problem
is external costs, while on the demand side the problem is external benefits.
In this section we will learn one type of market failure: externalities.

Social Values drive what people feel, think, believe, desire, consume and so on.

Externality
Externality means that when one persons action imposes a cost or benefit on the well-being of a
bystander. Economists say that externalities usually result in market failure and cause markets to
allocate resources inefficiently.
Market Failure: a market falure exists whenever the free market equilibrium quantity of output is
greater or less than the socially optimal level of output. The free market will produce either too
much of a good or too little.
There are four types of externalities:
1) Negative externality of Production (an external cost)
2) Positive externality of Production (an external benefit)
3) Negative externality of Consumption (an external cost)
4) Positive externality of Consumption (an external benefit)

Negative externality of Production (an external cost)

In this case the social cost is larger than the private cost (
cost (from point to point )
Mathematically:

Negative Externality

), because of the external

Area of triangle is a welfare loss.

-is the cost to society of producing one extra unit of output
Example: Suppose there is a paper industry into the river. This industry is affected negatively to
trees, waste materials, decreases the quality of water, reduce the number of fish in the river, and
so on.
Why it is loss? Because, now cost is high for the society (

Possible government solutions to negative externalities of production

Tax

Positive externality of Production (an external benefit)

In this case the social cost is less than the private cost (

External cost is negative

External Benefit

).

P2

P1

Q1

Q2

Why it is gain? Because now cost is less for the society (

Example: The construction and operation of an airport, to lay out new parks and so on. This will
beneficial for society.

Possible government solutions to positive externalities of production

Subsidize (for example, the government finances education {

})

Negative externality of Consumption (an external cost)

When the private benefits of consumers of a product are greater than the social benefits of its
consumption, it is negative externality of consumption.

MPC=MSC

P2
P1
MPB
MSB

Q1

If you smoke, you will get benefits, but society NO

Possible government solutions to negative externalities of consumption

Ban. The government could ban smoking

MSC=MPC
P2
P3
P1

MPB1
MPB2
MSB
Q1

Q3

Q2

Q2

Indirect tax
MSC+tax

P3

MSC

P2
MPB

P1

MPC

Q1

Q2

Positive externality of Consumption (an external benefit)

In this case the marginal social benefit is greater than the marginal private benefit.

For example:
Education
Vaccinations
and so on

For example: when you consume education you get a private benefit. But there are also benefits
to the rest of society (teacher and students)

Possible government solutions to positive externalities of consumption

Subsidy (the government could subsidize the education)

MSC

MSC+subsidy
P2

P1

P3

MSB

MPB

Q1

Q2