ProductMix Efficiency
Even if an economy is on its productionpossibilities
frontier, it may not be economically efficient. Not all
points on the productionpossibilities frontier have the
same value. Hence, to be economically efficient, an economy
must find that point on its productionpossibilities
frontier or that mix of products that has the highest value.
This final condition of economically efficiency may be
called productmix efficiency.
For an economy to have productmix efficiency, "trading
with nature" must have the same "price" as trading with
people. If an economy is on the productionpossibilities
frontier, then more of one good, good A, can be
produced only by shifting resources and thus producing less
of something else, good B. The slope of the
productionpossibilities frontier, which economists call the
marginal rate of transformation, shows how much of
good B must be given up to produce more of good A.
When society moves along the productionpossibilities
frontier, it is trading with nature, and the marginal rate
of transformation is the price it pays to get more of good
A.
The amount of good B that must be given to people so they
willingly give up a unit of A must be the same for all
people if the economy is exchange efficient. The ratio at
which people will trade B for A is the marginal rate of
substitution. Only when the marginal rate of
transformation of each product is equal to the marginal rate
of substitution, that is, when "trading with nature" has the
same "price" as trading with people, will the economy be
economically efficient.
A numerical example makes this condition easier to
understand. Suppose that producing one more bushel of corn
requires the sacrifice of three bushels of oats. This
statement tells us how the economy can trade with nature.
Also suppose that people value corn and oats equally, that
is, they will trade a bushel of oats for a bushel of corn.
Even if the economy is production and exchange efficient,
which means that it is on the productionpossibilities
frontier and that given the amounts of corn and oats
produced, all mutually advantageous trades have been made,
there are changes that can increase value. If one less
bushel of corn is produced, three more bushels of oats can
be produced. Because a bushel of corn and a bushel of oats
have the same value in the eyes of consumers, the sacrifice
of one bushel to get three is a desirable sacrifice. Hence
this shift will increase value and thus efficiency.
The graph below illustrates the discussion of the
previous paragraph. Both point a and b are on
the surface of the productionpossibilities frontier. Moving
from a to b means a loss of one unit of corn
and a gain of three units of oats. Points a and
c are on the same budget line. The slope of the
budget line depends only on the relative price of corn and
oats, and all points on a budget line represent equal
expenditures of money. Thus, point a is valued the
same as point c. Because a move from a to c
leaves consumers with the same value (because they
consider a loss of a unit of corn as exactly offset by the
gain in the unit of oats), a move from a to b
would increase value. (You should be able to see that one
can also argue that point b is better than a
by referring to the marginal costs and marginal benefits of
the move.)
A move from a to b in the graph above would
change the marginal rate of transformation (the slope of the
productionpossibilities frontier). It might also change the
marginal rate of substitution (the slope of the budget
line). As the economy slides down the
productionpossibilities frontier, the slope of the
productionpossibilities frontier should get steeper, and
the slope of the budget line flatter (because oats should
get cheaper relative to corn as people get more oats and
less corn). When the two curves have equal slopes, the
budget line will be tangent to the productionpossibilities
frontier. Here, the marginal rate of transformation equals
the marginal rate of substitution and this point is
economically efficient.
An optional
section discussed the possibility of inefficiency from
producing too much or too little bread. This inefficiency is
caused because the marginal rate of transformation does not
equal the marginal rate of substitution. Important cases of
productmix inefficiency occur when markets have monopoly or
externalities.
We finish the unit with some
reservations about economic efficiency.
Copyright
Robert Schenk
