105
Efficiency and equity
105
Efficiency and equity
CH5 Efficiency and Equity
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.