83
Efficiency and equity
Chapter
5 / efficiency and Equity83
Efficiency and equity
EFFICIENCY AND EQUITY 111
Chapter Key Ideas
Self-Interest and the Social Interest
A. Every purchase made by a consumer is an expression of that consumer’s values over what should be produced with our scarce resources. Consumers make these decisions out of self-interest, trying to make themselves the happiest they can with the limited resources they have. Do these choices necessarily promote the social interest—that is, what is best for society?
B. The market economy generates high incomes for some and low incomes for others. What is a fair distribution of goods and services across society?
C. This chapter explains how economists approach questions about the social interest as well as the conditions under which competitive markets can yield efficient outcomes, and it describes the sources of inefficiency and explores different concepts of fairness.
Outline
I. Efficiency and the Social Interest
A. Recall from Chapter Two that an efficient allocation of resources occurs when we cannot produce more of one good without giving up the production of some other good that is valued more highly.
1. This definition implies that it is not possible to make someone better off without making someone worse off.
2. Efficiency is based on values, which are determined by people’s preferences.
B. Marginal benefit is the benefit a person receives from consuming one more unit of a good or service.
1. We can measure the marginal benefit from a good by the dollar value of other goods that a person is willing to give up to get one more unit.
2. The concept of decreasing marginal benefit implies that as more of a good is consumed, its marginal benefit decreases.
3. Figure 5.1 shows the decreasing marginal benefit from each additional slice of pizza, measured in dollars per slice.
C. Marginal cost is the opportunity cost of producing one more unit of a good. The measure of marginal cost is the value of the best alternative forgone to obtain the last unit of the good.
1. 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.
2. The concept of increasing marginal cost implies that as more of a good or service is produced, its marginal cost increases.
3. Figure 5.1 also shows the increasing marginal cost of each additional slice of pizza, measured in dollars per slice.
D. Efficiency and Inefficiency
1. If the marginal benefit from a good exceeds its marginal cost, producing and consuming one more unit of the good uses resources more efficiently.
2. If the marginal cost of a good exceeds its marginal benefit, producing and consuming one less unit of the good uses resources more efficiently.
3. If the marginal benefit from a good equals its marginal cost, producing and consuming one more unit of the good or one less unit of the good uses resources less efficiently.
4. When marginal benefit equals marginal cost, we cannot improve on this allocation of resources. It is efficient. In Figure 5.1, the efficient quantity of pizza is 10,000 pizzas per day.
II. Value, Price, and Consumer Surplus
A. 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.
1. 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.
2. Figure 5.2 shows two ways of interpreting a demand curve.
3. Because a demand curve shows the maximum price that consumers are willing to pay for the last unit of the good at each quantity available, a demand curve is a marginal benefit curve.
B. Consumer surplus is the value of a good minus the price paid for it, summed over the quantity bought.
1. The price paid is the market price, which is the same for each unit bought. The quantity bought is determined by the demand curve.
2. Consumer surplus is measured by the area under the demand curve and above the price paid, up to the quantity bought.
3. Figure 5.3 shows the consumer surplus for pizza for an individual consumer.
III. Cost, Price, and Producer Surplus
A. 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.
1. 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.
2. Figure 5.4 shows two ways of interpreting a supply curve.
3. Because a supply curve shows the minimum price that producers are willing to accept for the last unit of the good at each quantity available, a supply curve is a marginal cost curve.
B. Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity sold.
1. The price of a good is its market price, which is the same for each unit sold.
2. The quantity sold is determined by the supply curve.
3. Producer surplus is measured by the area below the price and above the supply curve, up to the quantity sold.
4. Figure 5.5 shows the producer surplus for pizza for an individual producer.
IV. The Efficiency of a Market Equilibrium
A. Figure 5.6 shows that a competitive market creates an efficient allocation of resources at equilibrium.
1. The demand curve can be thought of as the marginal benefit curve for society, and the supply curve as the marginal cost curve for society.
2. In equilibrium, the quantity demanded equals the quantity supplied, which means the marginal benefit to society of the last unit consumed equals the marginal cost to society of making the last unit available for consumption.
3. The sum of consumer and producer surplus is maximized at this efficient level of output. No other quantity bought and sold will produce as much consumer or producer surplus.
B. Adam Smith’s Invisible Hand idea in his book Wealth of Nations implied that competitive markets motivate consumers and producers to send resources to their highest valued use in society.
1. Consumers and producers make decisions in their own self-interest when they interact in markets.
2. These market transactions can generate an efficient allocation of resources allocated to their highest-valued use in society.
C. Markets are not always efficient. Some obstacles to efficiency include:
1. Price ceilings and floors: Artificial constraints on price.
2. Taxes, subsidies, and quotas: Place a wedge between price received by sellers and price offered by sellers.
3. Monopoly: A lack of competitive pressure places a wedge between marginal cost and selling price.
4. Public goods and Common Resources: Marginal benefits (costs) no longer equal social marginal benefits (costs)
5. External costs and external benefits: The full benefits (costs) do not accrue to the consumer (producer)
D. Underproduction and Overproduction
1. Obstacles to efficiency lead to underproduction or overproduction and create a deadweight loss—a decrease in consumer and producer surplus.
2. Figure 5.7 shows the dead weight loss from underproduction and overproduction.
V. Is the Competitive Market Fair?
A. Economists agree about efficiency, but disagree about equity. To help understand why, Ideas about fairness can be divided into two groups:
1. It’s not fair if the result isn’t fair
2. It’s not fair if the rules aren’t fair
B. It’s Not Fair if the Result Isn’t Fair
1. 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.”
2. 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. In this way, only when income is equally distributed has the greatest happiness been achieved.
3. Utilitarianism ignores the cost of making income transfers. Recognizing these costs leads to the big tradeoff between efficiency and fairness.
4. 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.
C. It’s Not Fair If the Rules Aren’t Fair
1. 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.
2. In economics, this principle means equality of opportunity, not equality of income. Robert Nozick suggested that fairness is based on two rules:
a) The state must create and enforce laws that establish and protect private property.
b) Private property may be transferred from one person to another only by voluntary exchange.
Reading Between the Lines
A news article discusses inefficiency in water use. The analysis points out that in some places, such as Ethiopia, less than the efficient quantity of water is used from the Nile whereas in other places, such as Egypt, more than the efficient quantity of water is used from the Nile. In both circumstances, a deadweight loss results.
New in the Seventh Edition
The discussion of how consumer choices made in self-interest influence the social interest is expanded.
Teaching Suggestions
1. Efficiency: A Refresher
The substance of this section is identical to Chapter 2, pp. 35–37. Explain that this section in Chapter 5 provides an alternative example of the same ideas as those in Chapter 2 and serves as a springboard for going forward and seeing the connection between what they’ve learned about demand, supply, market price, and quantity in Chapter 3 and what they learned about efficiency in Chapter 2. Emphasize that learning economics isn’t memorizing facts, but understanding principles and ideas, and that one idea builds on another.
2. Value, Price, and Consumer Surplus
One thing that students sometimes get hung up on is the exact shape of the consumer surplus area—steps versus the complete triangle. The point isn’t worth laboring, but if students raise the matter and are curious, you might explain that we’re assuming that the good (pizza in the example) is finely divisible so that the whole triangle is (approximately) the consumer surplus. (Note: You will look at consumer surplus again if you cover marginal utility theory.)
3. Cost, Price, and Producer Surplus
A similar issue about the shapes of the areas arises here too. You might want to emphasize that the total revenue of the producer is the rectangle whose corners are (0, 0) and (P, Q). This total revenue divides into cost and producer surplus and the supply curve (the marginal cost curve) marks the boundary for the division.
The issue is not likely to arise at this point in the course, but you might like to keep this up your sleeve for later when explaining the relationship between producer surplus and economic profit. The textbook doesn’t spend any time on this relationship because for most students, it is too esoteric. But a few thoughtful students want to know. You can explain that producer surplus equals total revenue minus total variable cost; economic profit equals total revenue minus total cost; so producer surplus equals economic profit plus total fixed cost. Don’t try to explain this point now. Wait until you get a question when you’re in Chapter 9, 10, 11, or 12.
4. The Efficiency of the Competitive Market
a) The Astonishing Market Machine: Although done just with words and a graph, this section explains the so-called “first fundamental theorem of welfare economics” that under appropriate conditions, competitive equilibrium is Pareto efficient (what this textbook calls an efficient allocation). You might want to provide your students with more background to this astonishing result. It begins with Adam Smith’s invisible hand conjecture. Some progress was made by Vilfredo Pareto (1848–1923), an Italian economist (see http://cepa.newschool.edu/het/profiles/pareto.htm), who defined an efficient allocation as one in which it is not possible to rearrange the use of resources an make someone better off without making someone else worse off. But Adam Smith’s conjecture did not receive formal proof until the 1950s. John Hick, Kenneth Arrow, and Gerard Debreu are credited with the major contributions to welfare economics and received the Nobel Prize in Economic Sciences for their work (see http://www.nobel.se/economics/laureates/1972/index.html, http://www.nobel.se/economics/laureates/1983/index.html). Lionel McKenzie (University of Rochester) is also credited with a major independent statement of the theorem and some economists refer to it as the Arrow-Debreu-McKenzie theorem.
The A-D-M proof is deeper and more restricted that the arm waving words and diagrams of a principles text. But we do not mislead our students by being enthusiastic and amazed at the astonishing proposition. Selfish people all pursuing their own ends and making themselves as well off as possible end up allocating resources in such a way that no one can be made better off (qualified by the exceptions that we quickly note in the chapter.)