5 EFFICIENCY AND EQUITY CHAPTER

Objectives After studying this chapter, you will able to Define efficiency Distinguish between value and price and define consumer surplus Distinguish between cost and price and define producer surplus Explain the conditions under which markets move resources to their highest-valued uses and the sources of inefficiency in our economy Explain the main ideas about fairness and evaluate claims that markets result in unfair outcomes

Self-Interest and the Social Interest When you buy a pair of shoes or a textbook or fill your gas tank, or even just take a shower, you express your view about how scarce resources should be used. You make choices that are in your self-interest. Markets coordinate your choices with those of everyone else. Do markets do a good job? Do they enable our self-interest choices to be in the social interest? And do markets produce a fair outcome?

Efficiency and the Social Interest Allocative efficiency is one aspect of the social interest and the aspect about which economists have most to say. An efficient allocation of resources occurs when we produce the goods and services that people value most highly. Resources are allocated efficiently when it is not possible to produce more of a good or service without giving up some other good or service that is valued more highly. Efficiency is based on value, and people’s preferences determine value.

Efficiency: A Refresher Marginal Benefit Marginal benefit is the benefit a person receives from consuming one more unit of a good or service. We can measure the marginal benefit from a good or service by the dollar value of other goods and services that a person is willing to give up to get one more unit of it. The concept of decreasing marginal benefit implies that as more of a good or service is consumed, its marginal benefit decreases.

Efficiency: A Refresher Figure 5.1 shows the decreasing marginal benefit from each additional slice of pizza, measured in dollars per slice.

Efficiency: A Refresher Marginal Cost Marginal cost is the opportunity cost of producing one more unit of a good or service. The measure of marginal cost is the value of the best alternative forgone to obtain the last unit of the good. We can measure the marginal cost of a good or service by the dollar value of other goods and services that a person is must give up to get one more unit of it. The concept of increasing marginal cost implies that as more of a good or service is produced, its marginal cost increases.

Efficiency: A Refresher Figure 5.1 shows the increasing marginal cost of each additional slice of pizza, measured in dollars per slice.

Efficiency: A Refresher Efficiency and Inefficiency If the marginal benefit from a good exceeds its marginal cost, producing and consuming more of the good uses resources more efficiently.

Efficiency: A Refresher If the marginal cost of a good exceeds its marginal benefit, producing and consuming less of the good uses resources more efficiently.

Efficiency: A Refresher If the marginal cost of a good equals its marginal benefit, resources are being use efficiently.

Value, Price, and Consumer Surplus Value, Willingness to Pay, and Demand The value of one more unit of a good or service is its marginal benefit, which we can measure as maximum price that a person is willing to pay. A demand curve for a good or service shows the quantity demanded at each price. A demand curve also shows the maximum price that consumers are willing to pay at each quantity.

Value, Price, and Consumer Surplus Figure 5.2 shows these two ways of interpreting a demand curve. In part a, shown here, the demand curve tells us the quantity that consumers plan to buy at a given price.

Value, Price, and Consumer Surplus In part b, shown here, the demand curve tells us the maximum price that consumers are willing to pay for a given quantity. This price measures the marginal benefit of the good at that given quantity.

Value, Price, and Consumer Surplus Consumer surplus is the value of a good minus the price paid for it, summed over the quantity bought. It is measured by the area under the demand curve and above the price paid, up to the quantity bought. Figure 5.3 on the next slide shows the consumer surplus for pizza for an individual consumer.

Value, Price, and Consumer Surplus The price paid is the market price, which is the same for each unit bought. The quantity bought is determined by the demand curve and the blue rectangle shows the amount paid for pizza. The green triangle shows the consumer surplus from pizza.

Value, Price, and Consumer Surplus The consumer surplus on the 10th slice is the $2 that the consumer is willing to pay minus the $1.50 that she does pay, which is 50 cents a slice.

Cost, Price, and Producer Surplus Cost, Minimum Supply-Price, and Supply The cost of one more unit of a good or service is its marginal cost, which we can measure as minimum price that a firm is willing to accept. A supply curve of a good or service shows the quantity supplied at each price. A supply curve also shows the minimum price that producers are willing to accept at each quantity.

Cost, Price, and Producer Surplus Figure 5.4 shows these two ways of interpreting a supply curve. In part a, shown here, the supply curve tells us the quantity that producers plan to sell at a given price.

Cost, Price, and Producer Surplus In part b, shown here, the supply curve tells us the minimum price that producers are willing to accept for a given quantity. This price measures the marginal cost of producing that given quantity of the good.

Cost, Price, and Producer Surplus Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity sold. Producer surplus is measured by the area below the price and above the supply curve, up to the quantity sold. Figure 5.5 on the next slide shows the producer surplus for pizza for an individual producer.

Cost, Price, and Producer Surplus The price is the market price, which is the same for each unit sold. The quantity sold is determined by the supply curve and the red area shows the total cost of producing pizza. The blue triangle shows the producer surplus from pizza.

Cost, Price, and Producer Surplus The producer surplus on the 50th pizza is the $15 that the producer receives minus the $10 that it cost to produce, which is $5 a pizza.

Is the Competitive Market Efficient? Efficiency of Competitive Equilibrium Figure 5.6 shows that a competitive market creates an efficient allocation of resources at equilibrium. In equilibrium, the quantity demanded equals the quantity supplied.

Is the Competitive Market Efficient? At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity. The sum of consumer and producer surplus is maximized at this efficient level of output.

Is the Competitive Market Efficient? The Invisible Hand Adam Smith’s “invisible hand” idea in the Wealth of Nations implied that competitive markets send resources to their highest valued use in society. Consumers and producers pursue their own self-interest and interact in markets. Market transactions generate an efficient—highest valued—use of resources.

Is the Competitive Market Efficient? The Invisible Hand at Work Today The invisible works in our economy today. It coordinates the self interest of producers and consumers of computers, oranges, and just about every good or service that you can think of. The cartoon on page 109 shows how the invisible hand sometimes works in surprising ways.

Is the Competitive Market Efficient? Obstacles to Efficiency Markets are not always efficient and the obstacles to efficiency are: Price ceilings and floors Taxes, subsidies, and quotas. Monopoly External costs and external benefits. Public goods and common resources

Is the Competitive Market Efficient? Underproduction and Overproduction Obstacles to efficiency lead to underproduction or overproduction and create a deadweight loss—a decrease in consumer and producer surplus.

Is the Competitive Market Efficient? Figure 5.7a shows the effects of underproduction. The efficient quantity is 10,000 pizzas a day. If production is restricted to 5,000 pizzas a day, a dead weight loss arises from underproduction.

Is the Competitive Market Efficient? Figure 5.7b shows the effects of overproduction. Again, the efficient quantity is 10,000 pizzas a day. If production is expanded to 15,000 pizzas a day, a dead weight loss arises from overproduction.

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 “it’s not fair if the result isn’t fair” began with utilitarianism, which is the principle that states that we should strive to achieve “the greatest happiness for the greatest number.” If everyone gets the same marginal utility from a given amount of income, and if the marginal benefit of income decreases as income increases, taking a dollar from a richer person and given 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 5.8 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? 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 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, which 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. Pages 114–115 present an extended illustration of two proposals for achieving a fair and efficient use of resources.

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