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CHAPTER 5 Efficiency. Efficiency: A Refresher  According to economists, allocative efficiency means the resources have been used to produce the goods.

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Presentation on theme: "CHAPTER 5 Efficiency. Efficiency: A Refresher  According to economists, allocative efficiency means the resources have been used to produce the goods."— Presentation transcript:

1 CHAPTER 5 Efficiency

2 Efficiency: A Refresher  According to economists, allocative efficiency means the resources have been used to produce the goods and services that people value the most.

3 Efficiency: A Refresher  Marginal benefit is the benefit that a person receives from consuming one more unit of a good or service –measured as the maximum amount that a person is willing to give up for one additional unit  Principle of decreasing marginal benefit –marginal benefit decreases as consumption increases

4 Efficiency: A Refresher  Marginal cost is the opportunity cost of producing one more unit of a good or service. –measured as the value of the best alternative foregone  Principle of increasing marginal cost –marginal cost increases as the quantity produced increases

5 Efficiency and Inefficiency  Allocative efficiency depends upon a comparison of marginal cost and marginal benefit.  Three possibilities –marginal benefit exceeds marginal cost –marginal cost exceeds marginal benefit –marginal benefit equals marginal cost

6 Efficiency and Inefficiency What is the economically efficient quantity of pizza?

7 The Efficient Quantity of Pizza MB Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services)

8 The Efficient Quantity of Pizza Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services) MB MC

9 The Efficient Quantity of Pizza Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services) MB MC Pizza valued more highly than it costs: Increase production Pizza costs more than it is valued: Decrease production

10 The Efficient Quantity of Pizza Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services) MB MC Efficient quantity of pizza

11 Value, Price, and Consumer Surplus  What is meant by “Value”? –Value of an item is the same thing as its marginal benefit –Marginal benefit - the maximum price people are willing to pay for an additional unit –Willingness determines demand

12 Consumer Surplus  Consumer surplus is the value of a good minus the price paid for it. –if a person buys something for less than they are willing to pay for it, a consumer surplus exists

13 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) D = MB

14 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) Market price = $1.50 D = MB

15 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) Market price = $1.50 Amount paid = $30 D = MB

16 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) Market price = $1.50 Amount paid = $30 Consumer surplus from 20 pizzas =.5(20x1)=$10 D = MB

17 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) Market price = $1.50 Amount paid = $30 Consumer surplus from 20 pizzas =.5(20x1)=$10 D=MB Consumption Value of 20 slices =$30 + $10 = $40

18 Cost, Price, and Producer Surplus  Cost vs. Price –Cost is what the producer gives up. –Price is what the producer receives.  Marginal cost is the cost of producing one more unit.

19 Quantity (thousands of pizzas per day) Price (dollars per pizza) Price determines minimum supply- price S = MC Quantity of pizzas supplied at $15 a pizza Supply, Minimum Supply- Price, and Marginal Cost

20 Producer Surplus  Producer surplus is the revenue from a good minus the opportunity cost of producing it. –if a firm sells something for more than it costs to produce, a producer surplus exists

21 A Producers Supply and Producer Surplus Quantity (pizzas per day) Price (dollars per pizza) Price determines quantity supplied S=MC

22 Price (dollars per pizza) S=MC Quantity (pizzas per day) Market price = $ A Producers Supply and Producer Surplus

23 Price (dollars per pizza) S=MC Quantity (pizzas per day) Market price Cost of Production =.5(100x10) + (100x5) = $1, A Producers Supply and Producer Surplus

24 Price (dollars per pizza) S=MC Quantity (pizzas per day) Market price Producer surplus =.5(10x100) = $ A Producers Supply and Producer Surplus Cost of Production =.5(100x10) + (100x5) = $1,000

25 Price (dollars per pizza) S=MC Quantity (pizzas per day) Market price Cost of Production = $1,000 Producer surplus of $500 equals profit A Producers Supply and Producer Surplus Production Value of 100 slices =$1000+$500 =$1,500

26 Is the Competitive Market Efficient?  Recall –Supply and demand will force the price toward the equilibrium price Question: Is this the efficient quantity of pizza?

27 An Efficient Market for Pizza Quantity (thousands of pizzas per day) Price (dollars per pizza) S Marginal cost-- opportunity cost --of pizza Marginal benefit-- value--of pizza Efficient quantity of pizzas D

28 Is the Competitive Market Efficient?  At Competitive Equilibrium –Resources are being used efficiently –The sum of consumer surplus and producer surplus is maximized

29 Quantity (thousands of pizzas per day) Price (dollars per pizza) S D An Efficient Market for Pizza

30 Quantity (thousands of pizzas per day) Price (dollars per pizza) S Producer surplus =.5(10x10)= D An Efficient Market for Pizza

31 Quantity (thousands of pizzas per day) Price (dollars per pizza) S Producer surplus =.5(10x10) =50 Consumer surplus =.5(10x10)= D An Efficient Market for Pizza

32 Quantity (thousands of pizzas per day) Price (dollars per pizza) S Producer surplus =.5(10x10) =50 Consumer surplus =.5(10x10)= D An Efficient Market for Pizza Consumer Surplus + Producer Surplus = = 100

33 The Invisible Hand  Adam Smith - Wealth of Nations in 1776 –Participants in a competitive market are “led by an invisible hand to promote an end (the efficient use of resources) which was not part of his intention.”

34 Sources of Inefficiency  Price ceilings and floors  Taxes, subsidies, and quotas  Monopoly  Public goods  External costs and benefits These lead to underproduction or overproduction.

35 Sources of Inefficiency  Deadweight Loss –The decrease in consumer and producer surplus that results from an inefficient allocation of resources

36 Underproduction (Say Monopoly) Quantity (thousands of pizzas per day) Price (dollars per pizza) S D

37 Quantity (thousands of pizzas per day) Price (dollars per pizza) S D Underproduction Consumer Surplus =.5(5x5)=12.5

38 Quantity (thousands of pizzas per day) Price (dollars per pizza) S D Underproduction Consumer Surplus =.5(5x5)=12.5 Producer Surplus = (5x10) +.5(5x5) = = 62.5

39 Quantity (thousands of pizzas per day) Price (dollars per pizza) S D Underproduction Consumer Surplus =.5(5x5)=12.5 Producer Surplus = (5x10) +.5(5x5) = = 62.5 Deadweight loss =.5(10x5) = 25

40 Quantity (thousands of pizzas per day) Price (dollars per pizza) S D Underproduction Consumer Surplus =.5(5x5)=12.5 Producer Surplus = (5x10) +.5(5x5) = = 62.5 Deadweight loss =.5(10x5) = 25 Consumer Surplus + Producer Surplus = = 75

41 Quantity (thousands of pizzas per day) Price (dollars per pizza) S D Overproduction (Say Government Subsidy)

42 Quantity (thousands of pizzas per day) Price (dollars per pizza) D S Overproduction A B C D E Consumer Surplus Gain = B + G Producer Surplus Gain = A + D Government Subsidy = B + G + A + D + F F Deadweight Loss = B + G + A + D - B - G - A - D - F = F G

43 Quantity (thousands of pizzas per day) Price (dollars per pizza) D S Deadweight loss Overproduction A B C D E Consumer Surplus Gain = B + G Producer Surplus Gain = A + D Government Subsidy = B + G + A + D + F F Deadweight Loss = B + G + A + D - B - G - A - D - F = F G


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