Advanced Economic Efficiency - Essay Example

The efficiency of exchange requires that all allocations lie on the contract curve such that the marginal rate of substitution between each pair of goods (x and y) is identical for all consumers. Recall that each consumer maximizes utility by attaining the point of tangency between the indifference curve and the budget line for goods x and y. Production efficiency requires that each producer’s Marginal Rate of Technical Transformation between capital and labor is identical in the production of all goods and is achieved analogously to the efficiency of exchange.

The requirement is that the Marginal rates of transformation between any two pairs of inputs be the same for all producers. This is ensured through profit maximization which ascertains equality between the MRTS and input price ratio. Efficiency in the Output market requires that the output mix be chosen such that the marginal rate of transformation between any two pairs of goods is equal to every consumer’s marginal rate of substitution for the two goods. . assuming that in the sugar market initially the price and quantity are at their equilibrium or market clearing levels P* and Q* as shown in the diagram below (figure 1).

Figure 1: The market clearing price and quantity of sugar two cases need to be looked at: 1) the government intends to restrict the price above P* and 2) the government intends to restrict the price below P*. Consider the first case. At any price above P*, there will be excess supply and this excess supply will exert downward pressure on the price to move back to the market clearing level of P*. Suppose the government wants to restrict the price at P’>P*. The government has two main options.

First, it can impose regulation or a price control that does not allow producers to charge below P’. Alternatively, it can buy off the necessary excess supply so that the price settles at P’. This is shown in the diagram below (figure 2). Figure 2: The government buys off the excess supply at price P' so that it now becomes the market clearing price Essentially, the government creates additional demand to sweep up the excess supply and thereby mitigates the downward pressure on prices. Apart from this, the options available to the government are those of putting a quota on the sugar producers and/or providing them monetary incentives to produce within the quota.

Now, consider case 2) where the government intends to restrict the price at a level below P*. There will be excess demand at this price and thus prices will tend to rise upward. The first option the government has is to legally forbid producers from charging more. Suppose the government wants to restrict the price at a maximum of P’’. It can legally prohibit higher prices.