Economics 10 1 2017 September Lecture 7 Chapter 5 Efficiency & Equity 2017 Economics 101 CCC

Content Describe the alternative methods for allocating scarce resources Explain the connection between demand and marginal benefit and define consumer surplus; Explain the connection between supply and marginal cost and define producer surplus Describe and calculate producer, consumer and economic surplus and dead weight loss Describe markets that are efficient and inefficient Explain market failure and sources Explain the main ideas about fairness and evaluate claims that markets result in unfair outcomes

Resource Allocation Methods Chapter 5 pages 106/108

Resource Allocation Methods Scare resources might be allocated by Market price Command Majority rule Contest First-come, first-served Lottery Personal characteristics Force How does each method work?

Resource Allocation Methods Market Price Market & Market Price allocates a scarce resource People who get the resource are those who are willing to pay the market price. Works well but difficult to differentiate people who: Cannot afford Can pay don’t want the good Does it matter? Example Education Health care

Resource Allocation Methods Command Allocates resources by the order (command) of someone in authority. Works well in organizations with clear lines of authority but poorly in an entire economy. Why? Large, circumvent, corruption Example: North Korea

http://time.com/4274666/arduous-march-north-korea-famine/

Resource Allocation Methods Majority Rule Majority rule allocates resources in the way the majority of voters choose. Societies use majority rule for some of their biggest decisions. Example : Tax rates that allocate resources between private and public use and tax dollars between competing uses such as defense and health care. Majority rule works well when the decision affects lots of people and self-interest must be suppressed to use resources efficiently.

Resource Allocation Methods Contest A contest allocates resources to a winner (or group of winners). Everyone motivated to work hard to win – one person wins Example: Oscars, Grammys Sauder access to classes – grade me in! Works well when the efforts of the “players” are hard to monitor and reward directly.

Resource Allocation Methods First-Come, First-Served First-come, first-served allocates resources to those who are first in line. Casual restaurants Supermarkets Airplane Tix First-come, first-served works best when scarce resources can serve just one person at a time in a sequence.

Resource Allocation Methods Lottery Allocate resources to those with the winning number - gaming system. Example: State lotteries and casinos reallocate millions of dollars Marathon TREK program, French Immersion Work well when there is no effective way to distinguish among potential users of a scarce resource.

Resource Allocation Methods Personal Characteristics Allocate resources to those with the “right” characteristics. Example: business & marriage partners unacceptable ways – higher paying jobs to white males and discriminating against minorities and women.

Resource Allocation Methods Force Force plays a role in allocating resources. Example: Theft, War, Robin Hood? State transfer wealth from the rich to the poor and establish the legal framework in which voluntary exchange can take place in markets.

Market demand curve – individual & horizontal Chapter 5 108-109

Getting Market Demand from Individual Demand curves individual demand - relationship between the price of a good and the quantity demanded by one person market demand - relationship between the price of a good and the quantity demanded by all buyers in the market.

Individual Demand and Market Demand Lisa and Nick are the only buyers in the market for pizza. At $1 a slice, the quantity demanded by Lisa is 30 slices.

Individual Demand and Market Demand At $1 a slice, the quantity demanded by Nick is 10 slices.

Individual Demand and Market Demand At $1 a slice, the quantity demanded by Lisa is 30 slices and by Nick is 10 slices. The quantity demanded by all buyers is 40 slices.

Individual Demand and Market Demand How do we obtain market demand curves? horizontal sum of the individual demand curves.

Benefit & Consumer Surplus Chapter 5 pages 108-109

Demand, Willingness to Pay, and Value We want “value for our money” Demand curve Price and quantity demanded relationship Relationship is derived from consumers' willingness to pay for a product or service Remember: Willingness to pay reflects the benefit a consumer gets from each unit. Thus the demand curve can also be considered the marginal benefit curve. The demand curve is NOT what we paid for the good !

Demand, Willingness to Pay, and Value We want “value for our money” Example: Price of one pizza slice = $2.00 Willingness to Pay: : $2.00 Marginal Benefit (MB) of the Pizza: Benefit derived from being no longer hungry $2.00 MB = willingness to pay What if willingness to pay was 5$

Consumer Surplus difference between what consumers would have been willing to pay and what they actually did pay Equation: calculate as marginal benefit (or value) of a good minus its price Graphically: measured by area under the demand curve and above the price paid, up to the quantity bought.

Consumer Surplus Consumer Surplus – graphically S D How do you find the area of this triangle?

Marginal benefit Social Private ???

Individual to Market Supply curves Chapter 5 pages 110-111

Individual Supply and Market Supply individual supply - market supply. Same as demand – horizontal summation Check Textbook pages 110 - 113

Individual Supply and Market Supply At $15 a pizza, the quantity supplied by Maria is 100 pizzas and by Max is 50 pizzas. The quantity supplied by all producers is 150 pizzas.

Supply, Cost and producer surplus Chapter 5 pages 109-111

Supply, Cost, and Minimum Supply-Price Cost is what the producer gives up Price is what the producer receives. Make a product only if Price > Cost Marginal cost cost of one more unit of a good or service minimum price that a firm is willing to accept. Remember what this includes! Ex: Cost of Production ..opportunity cost ..other costs

Supply, Cost, and Minimum Supply-Price Example: Cost of producing one more pizza for firm $1.50 MC = 1.50 Min Price they will take then is 1.50 If minimum supply-price determines supply. Thus - supply curve is also called a marginal cost curve.

Producer Surplus Producer Surplus Difference between what price producers receives for good and the price they would have been willing to accept Equation: Calculate as Price received for a good minus the marginal cost of good Graphically: area below the market price and above the supply curve

Producer Surplus S D Producer surplus.

Economic surplus Consumer surplus the difference between the price a consumer would be willing to pay and price they actually pay for a good. willingness to pay or reservation price also used as terms Producer surplus the difference between the amount a producer is willing to accept for their product and price the really receive. Economic surplus measure of the net benefit gained from a market transaction. sum of consumer and product surplus way to measure a policy or a market efficiency Maximization of economic surplus is an economic goal!! Economic efficiency and scarcity .. use of resources Makes these triangles as large as possible

Demand Curve P = 2000 –50Q Supply Curve P = 500 + 10Q Find the equilibrium ad graph curve and equilibrium P = 750 $ Q = 25 units

Use 1/2 bh = area of a triangle To calc CS =½ (25) (2000-750) 15,625

1/2 bh = area of a triangle To calc PS =½ (25) (750 - 500) 3,125

Total Surplus .. Add together 3125 + 15625 = 18,750 Economic surplus is a measure of the net benefit gained from a market transaction. sum of consumer and product surplus As long as all the costs and benefits are included in these curve.. Then this is economic efficiency.. The best use of the scarce resources.

Economic surplus is max at 18750 Anything that changes this to a lower economic surplus is not a good thing, Can you see why this is a way to measure a policy or a market. ? What happens if… Government action to decrease or increase price? What happens to the size of the triangles?

Efficiency in the Market Chapter 5 pages 112-113

Is the Competitive Market Efficient? free market invisible hand The Invisible Hand

Is the Competitive Market Efficient? Invisible Hand: unintended social benefits of individual actions Also called Free market or Capitalism or Laissez-faire economics Buyers focus on: max utility using cost benefit Supplier focus on: max profit using cost benefit Result: something that was not really part of the individuals original goals Each use the cost benefit model and when all the costs and benefits are included society’s collective interest (allocation of resources and goods) efficient allocation

Is the Competitive Market Efficient? Efficiency of Competitive Equilibrium A competitive market creates an efficient allocation of resources at equilibrium. Where is it max efficiency? Market equilibrium Qd=Qs

Is the Competitive Market Efficient? Producing Less or More than the Equilibrium Q When production is … less than the equilibrium quantity, MSB > MSC. greater than the equilibrium quantity, MSC > MSB. equal to the equilibrium quantity, MSC = MSB.

At quantity Q1 & price P1, consumer surplus is the purple area & producer surplus is the green area.

As we increase the quantity & reduce the price, the total area of the consumer & producer surpluses increases, P S P2 D Q Q2

and increases, P S P3 D Q3 Q

until we reach the perfectly competitive equilibrium. S P* D Q* Q

Implications Shows that economic surplus (which equals total consumer & producer surplus) is maximized at the competitive equilibrium. Size Of Triangles and Consumer & Producer Surpluses max a equilibrium Q & P

the supply and demand curves shown, the equilibrium price of milk is $2/litre and the equilibrium quantity is 4000 litres/day. How much of the total economic surplus do producers and consumer reap?

Consumer surplus S D Producer surplus.

$2000 consumer surplus $4000 producer surplus Economic surplus = ? THUS WE CAN USE TOTAL ECONOMIC SURPLUS AS A TEST FOR ECONOMIC POLICY OR INTERVENTION

MARKET FAILURE

Market Failure & Competitive Market Efficiency Scenario where allocation of goods and services is not efficient. another conceivable outcome exist where an individual may be made better-off without making someone else worse-off. Market failure can occur because Too little of an item is produced (underproduction) or Too much of an item is produced (overproduction). .

Is the Competitive Market Efficient? Underproduction The efficient quantity is 10,000 pizzas a day. If production is restricted to 5,000 pizzas a day, there is underproduction and the quantity is inefficient. A deadweight loss equals the decrease in total surplus— the gray triangle. This loss is a social loss.

Is the Competitive Market Efficient? Overproduction Again, the efficient quantity is 10,000 pizzas a day. If production is expanded to 15,000 pizzas a day, a deadweight loss arises from overproduction. This loss is a social loss.

Sources of Market Failure In competitive markets, underproduction or overproduction arise when there are Price and quantity regulations Taxes and subsidies Externalities Public goods and common resources Monopoly High transactions costs

Sources of Market Failure Price and Quantity Regulations Price regulations sometimes put a block on the price adjustments and lead to underproduction. Quantity regulations that limit the amount that a firm is permitted to produce also lead to underproduction.

Examples?

Sources of Market Failure Taxes and Subsidies Taxes increase the prices paid by buyers and lower the prices received by sellers. So taxes decrease the quantity produced and lead to underproduction. Subsidies lower the prices paid by buyers and increase the prices received by sellers. So subsidies increase the quantity produced and lead to overproduction.

Examples?

Sources of Market Failure Externalities An externality is a cost or benefit that affects someone other than the seller or the buyer of a good. An electric utility creates an external cost by burning coal that creates acid rain. The utility doesn’t consider this cost when it chooses the quantity of power to produce. Overproduction results.

Examples?

Sources of Market Failure An apartment owner would provide an external benefit if she installed an smoke detector. But she doesn’t consider her neighbor’s marginal benefit and decides not to install a smoke detector. The result is underproduction.

Examples?

Sources of Market Failure Public Goods and Common Resources A public good benefits everyone and no one can be excluded from its benefits. It is in everyone’s self-interest to avoid paying for a public good (called the free-rider problem), which leads to underproduction.

Sources of Market Failure A common resource is owned by no one but can be used by everyone. It is in everyone’s self interest to ignore the costs of their own use of a common resource that fall on others (called tragedy of the commons). The tragedy of the commons leads to overproduction.

Examples?

Sources of Market Failure Monopoly A monopoly is a firm that is the sole provider of a good or service. The self-interest of a monopoly is to maximize its profit. To do so, a monopoly sets a price to achieve its self-interested goal. As a result, a monopoly produces too little and underproduction results.

Examples?

Sources of Market Failure High Transactions Costs Transactions costs are the opportunity cost of making trades in a market. To use the market price as the allocator of scarce resources, it must be worth bearing the opportunity cost of establishing a market. Some markets are just too costly to operate. When transactions costs are high, the market might underproduce.

Examples?

Is the Competitive Market Efficient? Alternatives to the Market When a market is inefficient, can one of the non-market methods of allocation do a better job? Often, majority rule might be used. But majority rule has its own shortcomings. A group that pursues the self-interest of its members can become the majority. Also, with majority rule, votes must be translated into actions by bureaucrats who have their own agendas.

Is the Competitive Market Efficient? There is no one efficient mechanism for allocating resources efficiently. But supplemented majority rule, bypassed inside firms by command systems, and occasionally using first-come, first- served, markets do an amazingly good job.

FAIRNESS VS EFFICIENCY CHAPTER 5 P 116-119

Is the Competitive Market Fair? Ideas about fairness can be divided into two groups: It’s not fair if the result isn’t fair. It’s not fair if the rules aren’t fair.

Is the Competitive Market Fair? It’s Not Fair if the Result Isn’t Fair The idea that only equality brings efficiency is called utilitarianism. Utilitarianism is the principle that states that we should strive to achieve “the greatest happiness for the greatest number.”

Is the Competitive Market Fair? If everyone gets the same marginal utility from a given amount of income, and if the marginal benefit of income decreases as income increases, then taking a dollar from a richer person and giving it to a poorer person increases the total benefit. Only when income is equally distributed has the greatest happiness been achieved.

Is the Competitive Market Fair? Figure 5.7 shows how redistribution increases efficiency. Tom is poor and has a high marginal benefit of income. Jerry is rich and has a low marginal benefit of income. Taking dollars from Jerry and giving them to Tom until they have equal incomes increases total benefit.

Is the Competitive Market Fair? The Big Tradeoff Utilitarianism ignores the cost of making income transfers. Recognizing these costs leads to the big tradeoff between efficiency and fairness. Because of the big tradeoff, John Rawls proposed that income should be redistributed to the point at which the poorest person is as well off as possible.

Is the Competitive Market Fair? It’s Not Fair If the Rules Aren’t Fair The idea that “it’s not fair if the rules aren’t fair” is based on the symmetry principle. The symmetry principle is the requirement that people in similar situations be treated similarly.

Is the Competitive Market Fair? In economics, this principle means equality of opportunity, not equality of income. Robert Nozick suggested that fairness is based on two rules: The state must create and enforce laws that establish and protect private property. Private property may be transferred from one person to another only by voluntary exchange. This means that if resources are allocated efficiently, they may also be allocated fairly.

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