Chapter 5Efficiency & EquityFigures from the text Copyright 2014 Pearson Addison Wesley

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.Prices in markets coordinate your choices with those of everyone else. Do markets do a good job? Do they enable our self-interested choices to also be in the social interest?You can afford to buy a pizza, but it might be an unaffordable luxury for a very poor person. Is this situation fair?How do other resource allocation methods compare?

Resource Allocation MethodsScare resources might be allocated by

Market price ---> allocative efficiencyCommand (inside firms)Majority rule (elections)Contest (sporting events, promotions)First-come, first-served (restaurants)Lottery (income reallocation)Personal characteristics (friends, discrimination)Force (war, theft)

EfficiencyAllocative efficiency means resources are used to produce the goods and services that people value the most. (Efficient use of resources.)Impossible to produce more of a good or service without giving up some other good or service that is more highly valued.Efficiency is partly based on value, and peoples preferences determine value.

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.Can be measured in other goods or as the dollar value of those other goods.Principle of decreasing marginal benefit: marginal benefit decreases as consumption increases.A demand curve is a marginal benefit curve.

Individual Demand & Market DemandThe relationship between the price of a good and the quantity demanded by one person is called individual demand.The relationship between the price of a good and the quantity demanded by all buyers in the market is called market demand.We horizontally sum the individual demands to get the market demand (for each price, add each persons quantity demanded).The market demand curve is a marginal social benefit (MSB) curve. It reflects the total benefits to society of producing each unit.

Horizontally summing two consumers demands.

Value v. PricePrice of an item is the amount a buyer actually pays for an additional unit.Value of an item is the same thing as its marginal benefit the maximum price people are willing to pay for an additional unit.

Consumer SurplusConsumer surplus is the value of something minus the price paid for it. Consumer surplus = Value Price If a person buys something for less than s/he is willing to pay for it, s/he enjoys a 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.

Application: If the price of a slice of pizza is $1.00, what is Lisas total consumer surplus? What is Lisas consumer surplus on just the 10th slice? What is the total market consumer surplus?

Opportunity cost: the value of the next best alternative foregone. Marginal cost is the opportunity cost of producing one more unit of a good or service.The minimum amount that a person must receive to be willing to produce one additional unit.Can be measured in other goods or as the dollar value of those other goods.Principle of increasing marginal cost: marginal cost increases as the quantity produced increases.A supply curve is a marginal cost curve.

Individual Supply & Market SupplyThe relationship between the price of a good and the quantity supplied by one producer is called individual supply.The relationship between the price of a good and the quantity supplied by all producers in the market is called market supply.We horizontally sum the individual supplies to get the market supply (for each price, add each firms quantity supplied).The market supply curve is a marginal social cost (MSC) curve. It reflects the total costs to society of producing each unit.

Horizontally summing two producers supplies.

Cost v. PricePrice of an item is the amount a seller actually receives for an additional unit.Cost of an item is the same as its opportunity cost or marginal cost:what the seller must give up in order to produce an additional unit; the minimum supply price for an additional unit.

Producer Surplus Producer surplus is the price received for something minus the opportunity cost of producing it.Producer surplus = Price Cost If a firm sells something for more than it costs to produce, a producer surplus exists.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.Producer surplus is a component of profit.

Application: If the price of a pizza is $15.00, what is Marias total producer surplus? What is Marias producer surplus on just the 50th pizza? What is the total market producer surplus?Marias producer surplusMaxs S = MCMarias producer surplusMaxs producer surplusMarias producer surplus from the 50th pizzaMaxs producer surplusMarias S = MCMarket producer surplus

Social v. Private Costs and BenefitsIf the only people who bear the cost of producing pizza are the people who actually produce the pizza, then the marginal cost of pizza (MC) also equals the marginal social cost of pizza (MSC).If the only people who reap the benefit of pizza are the people who actually buy it, then the marginal benefit of pizza (MB) also equals the marginal social benefit of pizza (MSB).We will assume this unless you are told otherwise.

Efficient Use of ResourcesOur Rules of Marginal Analysis become:If MSB > MSC, we should increase production of that good.If MSC > MSB, we should decrease production of that good.When MSB = MSC, resources are being used efficiently.

The Efficient Quantity of Pizza0 5101520510152025Quantity (thousands of pizzas per day)Marginal social cost and marginal social benefit(dollars worth of goods and services)

Application:Starting at the efficient level of pizza production, think about producing one more unit of pizza.What is given up and what is gained?Which is larger?

Application:Starting at the efficient level of pizza production, think about producing one less unit of pizza.What is given up and what is gained?Which is larger?

At the efficient level of pizza production:If we produce more pizza, we give up goods and services (MSC) we value even more highly than the additional pizza (MSB).If we produce less pizza, the pizza we give up (MSB) is more valuable than the goods and services we get instead of the pizza (MSC).

Competitive Markets are Efficient Market forces will pull the pizza market to an equilibrium price of $15 and an equilibrium quantity of 10,000 pizzas. (More about this when we go back to Chapter 3.)Q: Is the resulting equilibrium quantity the efficient quantity of pizza?A: At Competitive EquilibriumResources are used efficiently (MSB=MSC).The sum of consumer surplus and producer surplus (the total surplus to society) is maximized.

= MSC= MSB

This is a very nice property of competitive markets:In a competitive market, the forces of supply and demand allocate resources to their highest valued use and maximize the gains from trade.The competitive equilibrium quantity is the allocative-efficient quantity.No one plans this, no one intends for this to happen, no one even thinks about it. It just happens and the market mechanism is self correcting and maintenance free!

Famous quote:Adam Smith The Wealth of Nations (1776)Each participant in a competitive market is led by an invisible hand to promote an end [the efficient use of resources] which was not part of his intention.

Note that all these nice properties apply only to a competitive market.There are several situations where markets fail to deliver efficient outcomes

Sources of InefficiencyPrice ceilings and price floorsTaxes, subsidies, and quotasMonopoly (and monopsony)Public goods and common resourcesExternal costs and external benefits (externalities)High Transactions Costs and/or Incomplete information

These situations lead to either underproduction or overproduction of the good. The amount of resources allocated to production of the good is either greater or less than the efficient amount.This means that economic welfare could be increased by allocating resources differently; however, the market fails to do this.

Deadweight Loss is the decrease in consumer and producer surplus that results from an inefficient allocation of resources.Called deadweight loss because it is surplus that is not captured by anyone it is a social loss. (It is not the case that it is a loss for consumers but a gain for producers, or vice versa. Nobody captures the lost surplus.)

Inefficiency Due To Underproduction

Application:What is the value of the deadweight loss in the previous slide?If the equilibrium price were $15 but the quantity bought and sold was restricted to 5 thousand pizzas for some reason, what would be the consumer surplus? What would be the producer surplus?

Inefficiency Due To Overproduction

Application:What is the value of the deadweight loss in the previous slide?

Efficiency is a very important concept in economics and we will return to it many times. Economists agree about efficiencyit makes sense to make the economic pie as large as possible and to produce it at the lowest possible cost.However, efficiency implies absolutely nothing about equity or fairness.Economists do not agree about equity, though they have thought about it.

Is the Competitive Market Fair?Ideas about equity or fairness can be divided into two groups:Its not fair if the result isnt fair.Its not fair if the rules arent fair.

Its Not Fair If The Result Isnt FairUtilitarianism is the principle that states that we should strive to achieve the greatest happiness for the greatest number. (Jeremy Bentham, John Stuart Mill) Utilitarians believed only income equality brings efficiency.If everyone gets the same satisfaction 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 to society. Only when income is equally distributed has the greatest total social happiness been achieved.

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.

Utilitarianism ignores the cost of making income transfers.Recognizing these costs leads to the big tradeoff between efficiency and fairness.Taxing individuals incomes reduces their incentive to be productiveAdministrative costs may mean that $1 taken from a rich results in less than $1 given to a poor person.In the following slide, notice that even though the pie is divided equally (2,2) after redistribution, Tom is worse off than before because the pie has shrunken so dramatically in the Actual? scenario.

IdealActual?If too much pizza is taken away from Jerry, his incentive to produce is reduced. Less pizza to divide between the two.The Big Tradeoff: a 10oz pizza

Because of the big tradeoff, John Rawls proposed that, taking all the costs of income transfers into account, the fair distribution of the economic pie is the one that makes the poorest person as well off as possible.Tax the incomes of the richPay the costs of the tax/transfer systemGive what is left to the poorBe sure what poor gets is better than what theyd get without the redistribution.

This may not result in an equal distribution.

RawlsRawlss Modified Utilitarianism

Its Not Fair If The Rules Arent FairThe idea that its not fair if the rules arent fair is based on the symmetry principle.The symmetry principle is the requirement that people in similar situations be treated similarly. 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.(everything valuable must be owned and theft is prevented)Private property may be transferred from one person to another only by voluntary exchange.(to acquire property a person buys it in exchange for something s/he owns.)If these rules, which are the only fair rules, are followed, then the result is fair.This means the efficient allocation is a fair oneeven if the pie is unequally shared.

Case Study: Hurricane Katrina shut down electricity supplies over a wide area and increased demand for portable generators. Only a few people initially possess portable generators.Compare methods of allocating the generators. Are they efficient? Are they fair? By what standardfair results or fair rules?How to Allocate Generators?

How to Allocate Generators?Market Price:Efficient - Yes, Fair Rules - Yes, Fair Results Not likelyAlternative methods (command, majority rule, contest, first-come-first-served, lottery, personal characteristics, and force)Efficient Only by chance, Fair Rules No (distribution involves involuntary transfers)Fair Results Not likely (poor arent made as well off as possible)

5556**1621*7**2834producer surplus = total revenue minus total variable cost; economic profit = total revenue minus total cost.so producer surplus = economic profit plus total fixed cost*146684141484150505116168***