Chapter18 - Chapter 18 Economic Efficiency The benchmark...

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© Sanjay K. Chugh 227 Spring 2008 Chapter 18 Economic Efficiency The benchmark for any notion of optimal policy, be it optimal monetary policy or optimal fiscal policy, is the economically efficient outcome. Once we know what the efficient outcome is for any economy, we can ask “how good” the optimal policy is (note that optimal policy need not achieve economic efficiency – we will have much more to say about this later). In a representative agent context, there is one essential condition describing economic efficiency: social marginal rates of substitution are equated to their respective social marginal rates of transformation. 145 We already know what a marginal rate of substitution (MRS) is: it is a measure of the maximal willingness of a consumer to trade consumption of one good for consumption of one more unit of another good. Mathematically, the MRS is the ratio of marginal utilities of two distinct goods. 146 The MRS is an aspect of the demand side of the economy. The marginal rate of transformation (MRT) is an analogous concept from the production side (firm side) of the economy: it measures how much production of one good must be given up for production of one more unit of another good. Very simply put, the economy is said to be operating efficiently if and only if the consumers’ MRS between any (and all ) pairs of goods is equal to the MRT between those goods. MRS is a statement about consumers’ preferences: indeed, because it is the ratio of marginal utilities between a pair of goods, clearly it is related to consumer preferences (utility). MRT is a statement about the production technology of the economy. To illustrate further the notion of economic efficiency, we proceed in two simple steps. First, we use the simple one-period consumption-leisure model to understand economic efficiency in a static (non-dynamic) setting. Then, we use the simple two-period consumption-savings model to understand the dynamic analog. Before proceeding in these two steps, we introduce a device that is useful for determining efficient allocations. The Social Planner It is quite easy to characterize, in terms of the solution to an optimization problem, economically-efficient outcomes. To do so, we introduce the concept of a Social Planner. The Social Planner is an all-knowing “individual” or “institution” that is able 145 We qualify this statement with “in a representative agent context” because if we consider heterogeneous agents (both heterogeneous consumers as well as heterogenous firms), there are two additional conditions that are components of the definition of economic efficiency: marginal rates of substitution between any two goods are equated across all consumers; and marginal rates of transformations between any two inputs are equated across all firms. Clearly (and trivially), with a representative (single) consumer, marginal rates of substitution are equated across “all” consumers, and with a representative (single) firm, marginal rates of transformation are equated across “all” firms.
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