EFFICIENCY AND EQUITY

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EFFICIENCY AND EQUITY
CHAPTER
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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

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More for Less

• People are constantly striving to get more for
  less.
• Could we get more out of our scarce resources if
  we used them differently or is our use efficient?
• Are market outcomes fair outcomes?
• This chapter explains the conditions under which
  competitive markets achieve an efficient outcome.
• It describes the sources of inefficiency.
• It explores the concept of fairness.

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Efficiency A Refresher

• 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, which is determined
  by peoples preferences.

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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.

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Efficiency A Refresher

• Figure 5.1 shows the decreasing marginal benefit
  from each additional slice of pizza, measured in
  dollars per slice.

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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.

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Efficiency A Refresher

• Figure 5.1 shows the increasing marginal cost of
  each additional slice of pizza, measured in
  dollars per slice.

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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.

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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.

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Efficiency A Refresher

• If the marginal cost of a good equals its
  marginal benefit, resources are being used
  efficiently.

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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
  the 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.

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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.

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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.
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Value, Price, and Consumer Surplus

• 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.

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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.
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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.
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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 the
  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.

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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.

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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.
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Cost, Price, and Producer Surplus

• 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.

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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.
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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.
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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.

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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.
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Is the Competitive Market Efficient?

• The Invisible Hand
• Adam Smiths 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 efficienthighest
  valueduse of resources.

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Is the Competitive Market Efficient?

• The Invisible Hand at Work Today
• The invisible hand 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.

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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
• Public goods
• External costs and external benefits.

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Is the Competitive Market Efficient?

• Underproduction and Overproduction
• Obstacles to efficiency lead to underproduction
  or overproduction and create a deadweight lossa
  decrease in consumer and producer surplus.

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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 deadweight loss arises from
underproduction.
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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 deadweight loss arises from overproduction.
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Is the Competitive Market Fair?

• Ideas about fairness can be divided into two
  groups
• Its not fair if the result isnt fair
• Its not fair if the rules arent fair

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Is the Competitive Market Fair?

• Its Not Fair if the Result Isnt Fair
• The idea that its not fair if the result isnt
  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 giving
  it to a poorer person increases the total
  benefit. Only when income is equally distributed
  has the greatest happiness been achieved.

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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.
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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.

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Is the Competitive Market Fair?

• Its Not Fair If the Rules Arent Fair
• The idea that its not fair if the rules arent
  fair is based on the symmetry principle, which
  is the requirement that people in similar
  situations be treated similarly.

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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 114115 present an extended illustration of
  two proposals for achieving a fair and efficient
  use of resources.

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EFFICIENCY AND EQUITY
CHAPTER
THE END