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 Pizza25 20
(dollars worth of goods and services)
Marginal cost and marginal benefit 15 10 5 MB
Quantity (thousands of pizzas per day)

8. The Efficient Quantity of Pizza25 MC 20
(dollars worth of goods and services)
Marginal cost and marginal benefit 15 10 5 MB
Quantity (thousands of pizzas per day)

9. The Efficient Quantity of Pizza
Pizza valued more
highly than it costs:
Increase production 25 MC 20
Pizza costs more
than it is valued:
Decrease
production
(dollars worth of goods and services)
Marginal cost and marginal benefit 15 10 5 MB
Quantity (thousands of pizzas per day)

10. The Efficient Quantity of Pizza25 MC 20
(dollars worth of goods and services)
Marginal cost and marginal benefit 15 10 5 MB
Quantity (thousands of pizzas per day)

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
2.50
Price (dollars per slice)
2.00
1.50
1.00
0.50
D = MB
Quantity (slices of pizzas per week)

14. A Consumer’s Demand and Consumer Surplus
2.50
Market
price = $1.50
Price (dollars per slice)
2.00
1.50
1.00
0.50
D = MB
Quantity (slices of pizzas per week)

15. A Consumer’s Demand and Consumer Surplus
2.50
Market
price = $1.50
Price (dollars per slice)
2.00
1.50
1.00
Amount
paid = $30
0.50
D = MB
Quantity (slices of pizzas per week)

16. A Consumer’s Demand and Consumer Surplus
Consumer surplus from 20 pizzas
= .5(20x1)=$10
2.50
Market
price = $1.50
Price (dollars per slice)
2.00
1.50
1.00
Amount
paid = $30
0.50
D = MB
Quantity (slices of pizzas per week)

17. A Consumer’s Demand and Consumer Surplus
Consumer surplus from 20 pizzas
= .5(20x1)=$10
2.50
Market
price = $1.50
Price (dollars per slice)
2.00
1.50
Consumption
Value of 20 slices
=$30 + $10 = $40
1.00
Amount
paid = $30
0.50
D=MB
Quantity (slices of pizzas per week)

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. Supply, Minimum Supply-Price, and Marginal Cost
S = MC 25
Price determines
minimum supply-
price
Price (dollars per pizza) 20 15 10
Quantity of pizzas
supplied at $15
a pizza 5
Quantity (thousands of pizzas per day)

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
S=MC 25
Price (dollars per pizza) 20
Price determines
quantity supplied 15 10 5
Quantity (pizzas per day)

22. A Producers Supply and Producer Surplus
S=MC 25
Market
price = $15
Price (dollars per pizza) 20 15 10 5
Quantity (pizzas per day)

23. A Producers Supply and Producer Surplus
S=MC 25
Market
price
Price (dollars per pizza) 20 15 10
Cost of Production
= .5(100x10) + (100x5) = $1,000 5
Quantity (pizzas per day)

24. A Producers Supply and Producer Surplus
S=MC 25
Market
price
Price (dollars per pizza) 20
Producer surplus
= .5(10x100) = $500 15 10
Cost of Production
= .5(100x10) + (100x5) = $1,000 5
Quantity (pizzas per day)

25. A Producers Supply and Producer Surplus
S=MC 25
Producer surplus
of $500 equals profit
Market
price
Price (dollars per pizza) 20 15 10
Production
Value of 100
slices
=$1000+$500
=$1,500
Cost of Production
= $1,000 5
Quantity (pizzas per day)

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 PizzaS
Marginal cost--
opportunity cost
--of pizza 25
Price (dollars per pizza) 20 15
Marginal benefit--
value--of pizza 10 5
Efficient quantity
of pizzas D
Quantity (thousands of pizzas per day)

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. An Efficient Market for PizzaS 25
Price (dollars per pizza) 20 15 10 5 D
Quantity (thousands of pizzas per day)

30. An Efficient Market for PizzaS 25
Price (dollars per pizza) 20 15 10
Producer
surplus
= .5(10x10)=50 5 D
Quantity (thousands of pizzas per day)

31. An Efficient Market for Pizza
Consumer
surplus
= .5(10x10)=50 S 25
Price (dollars per pizza) 20 15 10
Producer
surplus
= .5(10x10) =50 5 D
Quantity (thousands of pizzas per day)

32. An Efficient Market for Pizza
Consumer
surplus
= .5(10x10)=50 S 25
Consumer Surplus +
Producer Surplus
= = 100
Price (dollars per pizza) 20 15 10
Producer
surplus
= .5(10x10) =50 5 D
Quantity (thousands of pizzas per day)

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)25
Price (dollars per pizza) 20 15 10 5 D
Quantity (thousands of pizzas per day)

37. Underproduction S 25 20 15 10 5 D 0 5 10 15 20 Consumer Surplus
= .5(5x5)=12.5 S 25
Price (dollars per pizza) 20 15 10 5 D
Quantity (thousands of pizzas per day)

38. Underproduction S 25 20 15 10 5 D 0 5 10 15 20 Consumer Surplus
= .5(5x5)=12.5 S 25
Price (dollars per pizza) 20 15 10
Producer Surplus
= (5x10) + .5(5x5)
= = 62.5 5 D
Quantity (thousands of pizzas per day)

39. Underproduction S 25 20 15 10 5 D 0 5 10 15 20 Consumer Surplus
= .5(5x5)=12.5 S 25
Price (dollars per pizza) 20
Deadweight
loss = .5(10x5) = 25 15 10
Producer Surplus
= (5x10) + .5(5x5)
= = 62.5 5 D
Quantity (thousands of pizzas per day)

40. Underproduction S 25 20 15 10 5 D 0 5 10 15 20 Consumer Surplus+
Producer Surplus
= = 75
Consumer Surplus
= .5(5x5)=12.5 S 25
Price (dollars per pizza) 20
Deadweight
loss = .5(10x5) = 25 15 10
Producer Surplus
= (5x10) + .5(5x5)
= = 62.5 5 D
Quantity (thousands of pizzas per day)

41. Overproduction (Say Government Subsidy)25
Price (dollars per pizza) 20 15 10 5 D
Quantity (thousands of pizzas per day)

42. Overproduction S 25 C 20 D A 15 F G B 10 E 5 D 0 5 10 15 20
Consumer Surplus
Gain = B + G S
Producer Surplus
Gain = A + D 25 C
Price (dollars per pizza) 20 D
Government Subsidy
= B + G + A + D + F A 15 F G B
Deadweight Loss
= B + G + A + D
- B - G - A - D - F
= F 10 E 5 D
Quantity (thousands of pizzas per day)

43. Overproduction S 25 C 20 D A 15 F G B 10 E 5 D 0 5 10 15 20 Deadweight
Consumer Surplus
Gain = B + G S
Producer Surplus
Gain = A + D 25 C
Price (dollars per pizza) 20 D
Government Subsidy
= B + G + A + D + F
Deadweight
loss A 15 F G B
Deadweight Loss
= B + G + A + D
- B - G - A - D - F
= F 10 E 5 D
Quantity (thousands of pizzas per day)