1 Chapt er 5 EFFICIENCY AND EQUITY Key Concepts Resource Allocation Methods Resources are scarce so they must be allocated to producing different goods. Some methods of resource allocation include: Market price people who are willing and able to pay the price get the resource. Command a command system allocates resources by the order of (command) someone in authority. Majority rule the majority vote decides how resources are allocated, for example, what will be the tax rates on income. Contest winners receive the resource. Sports are an example, but more generally contests occur when many people are competing to win one big prize, such as being named CEO of a company. First-come, first-served people first in line get the resource, be it a table at a restaurant or a space on a highway. Lottery the randomly selected winners receive the resource. Personal characteristics people with the right characteristics get the resource. Force the stronger person or group gets the resource. Force includes wars but it also includes the ability of the state to protect voluntary exchange. Benefit, Cost, and Surplus Resources are allocated efficiently and in the social interest when they are used in the ways that are most highly valued by people. This outcome occurs when the marginal benefit, the benefit a person receives from consuming one more unit of a good or service, equals the marginal cost, the opportunity cost of producing one more unit of a good or service. The value of one more unit of a good is its marginal benefit. Marginal benefit is measured as the maximum that someone is willing to pay for another unit of the good. The demand curve shows the maximum someone is willing to pay for each unit of a good, so the demand curve for a good is its marginal benefit curve. The relationship between the price and the quantity demanded by one person is the individual demand. The market demand curve is the horizontal summation of all the individual demand curves. The value of a good can be different than the good s price. Consumer surplus is the excess of the benefit received from a good over the amount paid for it. Consumer surplus equals the marginal benefit of a good minus its price, summed over the quantity bought. Because the demand curve shows the marginal benefit, consumer surplus is the area under the demand curve (the benefit) and above the market price. Figure 5.1 shows the consumer surplus for the good. It is the darkened triangle under the market demand curve and above the market price. The cost of producing a good is what the producer pays to produce it; the price of a good is what the producer receives when it is sold. The marginal cost of a good is
2 78 CHAPTER 5 equal to the minimum price a producer must receive to produce the unit of the good because this amount just covers all the costs of producing it. A supply curve shows the minimum price a producer must receive to produce another unit of a good, so the supply curve of a good is its marginal cost curve. The relationship between the price and the quantity supplied by one producer is the individual supply. The market supply curve is the horizontal summation of all the individual supply curves. If a firm sells a good for more than it costs to produce it, the firm receives a producer surplus. Producer surplus is the excess of the amount received from the sale of a good over the cost of producing it. Because the supply curve is the marginal cost curve, producer surplus equals the area below the market price of the good and above the market supply curve. Figure 5.2 shows a producer surplus. The allocatively efficient amount of a good is produced when the marginal social benefit equals its marginal social cost. If the marginal social benefit exceeds the marginal social cost, then the benefit of another unit exceeds the cost to produce it, so it is in the social interest to produce the unit. If the marginal social cost exceeds the marginal social benefit, the benefit of the last unit being produced is less than the cost of producing it, so it is in the social interest that the unit not be produced. Is the Competitive Market Efficient? If the entire benefit from a good is enjoyed by the buyers, then the marginal benefit to the society, MSB, equals the marginal benefit to the consumers and the demand curve is the MSB curve. If the entire cost of producing a good is paid by the producers, then the marginal cost to the society, MSC, equals the marginal cost to the producers and the supply curve is the MSC curve. In a competitive market, the quantity produced is the equilibrium quantity. In Figure 5.3, the equilibrium quantity is 30 units, determined by the D and S curves. The efficient quantity sets the marginal social benefit equal to the marginal social cost, MSB = MSC. In Figure 5.3, the efficient quantity is 30 units, determined by the MSB and MSC curves. A competitive market is efficient because the quantity produced is the same as the efficient quantity. When the market is using resources efficiently, the total surplus the sum of consumer surplus plus producer surplus is as large as possible, as illustrated in Figure 5.3. Adam Smith s idea of the invisible hand concludes that competitive markets send resources to their highest-valued use, that is, competitive markets are efficient.
3 EFFICIENCY AND EQUITY 79 Contrary to the invisible hand idea, markets are not always efficient. Market failure occurs when a market delivers an inefficient outcome. When a market underproduces or overproduces a good, a deadweight loss is created. Deadweight loss is decrease in the total surplus that results from an inefficient level of production. The deadweight loss is inflicted on the entire society; it is not something that the producer gains at the expense of the consumer or vice versa. Figure 5.4 illustrates the deadweight loss triangles from overproduction (producing 4 units rather than 3) and underproduction (producing 2 units rather than 3). The major obstacles that can lead to market failure and inefficiency are: Price and quantity regulations price regulations that set the highest legal price or the lowest legal price sometimes block price adjustments and prevent the market from reaching its (efficient) equilibrium. Quantity regulations also can prevent the market from reaching its unregulated equilibrium. Taxes and subsidies taxes increase the price paid by buyers and lower the price received by sellers; subsidies decrease the price paid by buyers and raise the price received by sellers. Taxes lead to underproduction; subsidies lead to overproduction. Externalities an externality is a cost or benefit that affects someone other than the seller or buyer of the good. In these cases the participants do not consider all the costs or benefits to others of their actions. External costs lead to overproduction; external benefits lead to underproduction. Public goods and common resources a public good is a good or service that is consumed simultaneously by everyone regardless of whether they paid for it. Public goods create a free rider problem, in which people are unwilling to pay for the good. A common resource is a resource that no one owns but everyone can use, such as fish in the ocean. Common resources are over-used. Monopoly a monopoly is a single firm that controls the entire market. A monopoly underproduces because it decreases its production in order to raise the price and increase its profit. High transactions costs the opportunity cost of bringing buyers and sellers together in a market are transactions costs. Transactions costs can make some markets too costly to operate. Competitive markets can be efficient. When a market is inefficient, one of the alternative non-market methods described in the first section might do a better job of allocating resources. Is the Competitive Market Fair? While there is general agreement about what constitutes efficiency, there is not the same general agreement about fairness. The two approaches to fairness are It s not fair if the result isn t fair and It s not fair if the rules aren t fair. Utilitarianism aims for the greatest happiness for the greatest number of people. Utilitarianism looks at the results of the process so redistribution of income can lead to fairness. Redistribution to achieve equality in incomes (the fair outcome) leads to the big tradeoff, the tradeoff between efficiency and fairness. Redistribution weakens the incentive to work so that a more equal income distribution leads to inefficiency. Symmetry Principle the requirement that similar people should be treated similarly. The symmetry principle looks at the rules of the process and judges fairness on the basis of rules. If a market is efficient (there are no price and quantity regulations, taxes or subsidies, externalities, public goods and common resources, monopolies, and transactions costs are not too high), then a competitive market is fair according to the symmetry principle.
4 80 CHAPTER 5 Helpful Hints 1. MARGINAL BENEFIT AND MARGINAL COST : In casual conversation we talk about how much a good cost us or how much a firm benefited by selling us the good. But be careful not to confuse conversation with the precise language of economic science. In particular, the marginal benefit from a good is received by the consumer and the marginal cost is paid by the producer. It is that the consumer of the good who benefits from the good. You, when you drive your car, benefit from your car. It is the producer of the good who pays for the production. The firm that manufactured your car paid the steel mill for the steel used to produce it. 2. WHY MSB = MSC IS EFFICIENT : Why does producing where MSB = MSC lead to efficiency? If MSB > MSC, society s total surplus increases if the unit is produced. For instance, in Figure 5.5 the first unit has a large difference between MSB and MSC, shown by the long arrow. The second unit also has MSB greater than MSC but by less than the first unit. However, producing this unit still adds to society s total net surplus; it just adds less than the first unit. As long as MSB exceeds MSC total surplus increases if the unit is produced. By producing at the point where MSB = MSC, all the units that have a total surplus to society are produced and none of the units that impose a loss on society, units for which MSB < MSC, are produced. Questions True/False and Explain Resource Allocation Methods 11. When market prices are used to allocate resources, only the people who are able and willing to pay get the resources. 12. A boss telling a worker what to do is an example of a command system of allocating resources. 13. In the U.S. economy, resources are never allocated according to random chance. 14. Force is used as an allocation method force only for illegal activities, such as theft or robbery. Benefit, Cost, and Surplus 15. Allocative efficiency occurs when resources are used to produce the goods and services that people value most highly. 16. The price of a good or service always equals its value. 17. The market demand curve for tacos shows the maximum price a consumer is willing to pay for the ten millionth taco. 18. As more of a good or service is consumed, its marginal benefit decreases. 19. Consumer surplus equals the area above the market demand curve and below the market price. 10. Cost and price are the same thing. 11. The marginal cost of the one millionth pizza is another name for the total cost of producing all one million pizzas. 12. The market supply curve and the marginal social benefit curve are the same. 13. Producer surplus equals the price of a good minus the cost of producing it summed over the quantity sold. Is the Competitive Market Efficient? 14. If the marginal social benefit from a good exceeds its marginal social cost, resources are used more efficiently if less of the good is produced. 15. Allocative efficiency requires that the marginal social benefit of a good equal its marginal social cost. 16. A competitive market is always efficient.
5 EFFICIENCY AND EQUITY When producing the efficient quantity of a good, the sum of consumer surplus plus producer surplus is as large as possible. 18. Deadweight loss is comprised of a loss of consumer surplus and/or producer surplus. Is the Competitive Market Fair? 19. Utilitarianism says that a competitive market producing the efficient quantity is always fair. 20. The idea of making the poorest as well off as possible uses the results to judge fairness. 21. The symmetry principle states that people should have identical incomes, that is, symmetric incomes. Multiple Choice Resource Allocation Methods 11. Allocating resources by the order of someone in authority is a allocation method. a. first-come, first-served b. market price c. majority rule d. command 12. Often people trying to withdraw money from their bank must wait in line, which reflects a allocation method. a. first-come, first-served b. market price c. contest d. command 13. If a person will rent an apartment only to married couples over 30 years old, that person is allocating resources using a allocation method. a. first-come, first-served b. market price c. personal characteristics d. command Benefit, Cost, and Surplus 14. Allocative efficiency occurs when a. the MSB of the good is zero. b. the MSB from a good exceeds its MSC by as much as possible. c. resources are used in the ways that people value most highly. d. the MSC of a good is set equal to zero. 15. Which of the following statements is TRUE? a. The value of one more unit of a good is not the same as the good s marginal benefit. b. A good s marginal benefit is the maximum price someone is willing to pay for another unit. c. The maximum price someone is willing to pay for one more unit of a good equals its consumer surplus. d. None of the above are correct because all the statements are false. 16. The marginal social benefit curve for a good is the same as the good s a. marginal social cost curve. b. market supply curve. c. market demand curve. d. consumer surplus curve. 17. Susan is willing to pay $5.00 for the second slice of pizza she eats. The price she actually pays is $4.00. Susan s consumer surplus for this slice of pizza is a. $5.00. b. $4.00. c. $2.00. d. $ Because of decreasing marginal benefit, the consumer surplus from the first unit of a good is the consumer surplus from the second unit. a. greater than b. equal to c. less than d. not comparable to 19. The cost of producing one more unit of a good is that good s a. price. b. marginal benefit. c. marginal cost. d. producer surplus. 10. The market supply curve shows the a. minimum price suppliers must receive in order to produce another unit of the good. b. maximum price suppliers must receive in order to produce another unit of the good. c. amount of producer surplus suppliers receive. d. profit that suppliers receive from producing another unit of the good.
6 82 CHAPTER The producer surplus from computers is equal to the a. maximum amount a consumer is willing to pay for the computer minus the price that actually must be paid summed over the quantity sold. b. actual price of the computer minus the maximum amount a consumer is willing to pay for it. c. cost of producing the computer minus the its price summed over the quantity sold. d. computer s price minus the cost of producing it summed over the quantity sold.. Use Figure 5.7, and the areas illustrated in it, for the next four questions. Is the Competitive Market Efficient? Figure 5.6 illustrates the perfectly competitive market for shirts. There are no externalities, taxes, subsidies, price or quantity regulations, or high transactions costs. Use Figure 5.6 for the next two questions. 14. When production is 150 units with a price of $3, consumer surplus in the market illustrated in Figure 5.7 equals a. area a. b. area b. c. area a + b. d. area a + d. 15. When production is 150 units with a price of $3, producer surplus in this market equals a. area a + b. b. area c. c. area c + d. d. area a + c. 12. The equilibrium quantity of shirts equals per day. a. 0 shirts b. 300,000 shirts c. 600,000 shirts d. None of the above. 13. The efficient quantity of shirts equals per day. a. 0 shirts b. 300,000 shirts c. 600,000 shirts d. None of the above. 16. If the quantity is restricted to 100 units, then the deadweight loss equals a. area c. b. area c +d. c. area a +b. d. area b + c. 17. The total surplus when 150 units are produced the total surplus when 100 units are produced? a. is larger than b. the same as c. is less than d. cannot be compared to
7 EFFICIENCY AND EQUITY If a market results market failure, then a. it is impossible to achieve efficiency. b. the market must be supplied by a monopoly. c. there can be no consumer surplus in the market. d. some other allocation scheme might be more efficient. Is the Competitive Market Fair? 23. Susan thinks the only fair outcome is one in which she receives three slices of pizza a week. Susan is using a concept of fairness. a. it s not fair if the result isn t fair b. it s not fair if the rules aren t fair c. big tradeoff d. symmetry principle 18. In Figure 5.8, when 20 units are produced, what is the dollar value of the deadweight loss? a. $0 b. $20 c. $30 d. $ A deadweight loss a. is possible only if the good is underproduced but is not possible if the good is overproduced. b. subtracts only from producer surplus. c. is a loss to consumers and a gain to producers. d. is a loss inflicted on the entire society. 20. Which of the following is NOT a potential source of inefficiency? a. External costs b. Decreasing marginal benefit c. Monopoly d. A tax 21. Suppose consumers decide they value a good more highly than before. Then the efficient quantity to produce of that good. a. increases. b. does not change. c. decreases. d. perhaps changes, but without more information the direction of the change cannot be told. 24. The assertion that if resources are allocated efficiently, they also are allocated fairly is made by a. all utilitarians. b. John Rawls, who proposed making the poorest as well off as possible. c. Robert Nozick, who believes that equality of opportunity is fair. d. all economists who understand the big tradeoff. Short Answer Problems 1. Why must resources be allocated? 2. a. Table 5.1 presents the marginal benefit and marginal cost schedules for video games. There are no externalities, so the marginal benefit to the consumer is the same as the marginal social benefit and the marginal cost paid by the producer is the same as the marginal social cost. Based on Table 5.1, complete Table 5.2 (on the next page). TABLE 5.1 Marginal Benefit and Marginal Cost of Video Games Quantity (millions of video games) Marginal benefit (dollars per game) Marginal cost (dollars per game)
8 84 CHAPTER 5 TABLE 5.2 Short Answer Problem 2 (a) Quantity (millions of video games) Marginal social benefit minus marginal social cost a. Figure 5.10 shows the market demand curve for jeans. In the figure, indicate consumer surplus if the market price is $40 for a pair of jeans. What dollar amount does the consumer surplus equal? b. In Figure 5.10, indicate the consumer surplus if the market price is $30 for a pair of jeans. What does the consumer surplus now equal? c. When is the consumer surplus larger? b. In Figure 5.9 draw the marginal social benefit and marginal social cost curves from Table 5.1. c. What is the efficient number of video games to produce? 3. a. Using the data in Table 5.1, in Figure 5.9 now draw the demand curve for video games and the supply curve for video games. b. There are no price or quantity regulations, no taxes, and no subsidies in this market. The market is competitive so it is not a monopoly. What quantity of video games will be produced? c. Compare your answer to part (c) of problem 2 with your answer to part (c) of problem What is the relationship between the marginal benefit of a good, its value, and the maximum amount that a consumer is willing to pay for the good? 6. a. Figure 5.11 shows the market supply curve for jeans. In the figure, indicate the producer surplus if the market price is $40 for a pair of jeans.
9 EFFICIENCY AND EQUITY 85 What is the dollar amount of the producer surplus? b. In Figure 5.11, indicate the producer surplus if the market price is $30 for a pair of jeans. What does the producer surplus now equal? c. When is the producer surplus larger? 7. a. Using the demand curve from Figure 5.10 and the supply curve from Figure 5.11, in Figure 5.12 determine the equilibrium price and quantity of jeans. b. In Figure 5.12 illustrate the consumer surplus and the producer surplus. What are the dollar amounts of consumer surplus and producer surplus? What amount does the sum of consumer surplus and producer surplus equal? c. Suppose that output is restricted to 2 million pairs of jeans. In a figure similar to Figure 5.12, show the deadweight loss. What does the deadweight loss equal? What now is the sum of consumer surplus and producer surplus? d. Suppose that output is equal to 4 million pairs of jeans. In another figure similar to Figure 5.12, show the deadweight loss. What does the deadweight loss equal? What now is the sum of consumer surplus and producer surplus? e. When is the total surplus the largest: When 2 million jeans are produced? When 4 million jeans are produced? Or when the efficient quantity of jeans is produced? 8. What is a deadweight loss? 9. a. Igor has a job as Minister of Agriculture. He is interested in the market for mushrooms because he has a fondness for mushrooms. Igor realizes that this market is competitive. He also knows that there are no external benefits or external costs and that there are no government policies, such as taxes or subsidies, affecting the market. Mushrooms are not a common resource. The equilibrium quantity of mushrooms is 10 million pounds a year. Igor wants to know what would be the quantity produced if resources are being used efficiently. Based on the information given, what is the efficient quantity of mushrooms? b. Igor can t believe that the efficient quantity is as low as you answered. (He really likes mushrooms!) Igor asks: What would be the loss if 11 million pounds of mushrooms are grown? In a diagram, show Igor the loss. c. Igor now claims that the efficient quantity isn t fair because it is too small. What concept of fairness is Igor using? d. Given Igor s view in the previous question, is Igor likely to agree that it isn t fair if the rules aren t fair? Why or why not? You re the Teacher 1. You know, there s one point about this chapter that bugs me. I can t understand how it s possible to have too much of a good. After all, in Chapter 2 we talked a lot about scarcity and about how there aren t enough resources available to produce enough stuff so that everyone s wants are met. Now here s this chapter that says we can produce too much of a good. What is going on? Explain to your friend why it is possible to overproduce a good and, if you feel ambitious, further explain how the fact that resources are scarce implies that such overproduction harms society.
10 86 CHAPTER 5 True/False Answers Answers Resource Allocation Methods 11. T Market prices allocate goods to consumers who both want the good and are able to pay for it. 12. T The boss is commanding the worker to use his or her time doing a specific task. 13. F Lotteries are one of the resource allocation methods occasionally used in the U.S. economy. 14. F The government also uses force to insure that property rights are protected. Benefit, Cost, and Surplus 15. T Allocative efficiency occurs when marginal benefit equals marginal cost. 16. F The value of a good equals the maximum that someone is willing to pay for it, which often exceeds the price. 17. T Because the demand curve shows the maximum someone is willing to pay for each unit, the demand curve is the same as the marginal benefit curve. 18. T The download slope of the demand (and marginal benefit) curve shows that as more of a good is consumed, its marginal benefit decreases. 19. F Consumer surplus equals the area under the market demand curve and above the price. 10. F Cost is what a producer pays to produce a good; price is what a producer receives when the good is sold. 11. F The marginal cost of the one millionth pizza is the cost of producing only the one millionth pizza. 12. F The market supply curve is the same as the marginal cost curve. 13. T The statement defines producer surplus. Is the Competitive Market Efficient? 14. F If the marginal benefit exceeds the marginal cost, resources are used more efficiently if production of the good is increased. 15. T The equality between marginal social benefit and marginal social cost signals that resources are being used efficiently. 16. F Government imposed taxes, subsidies, and price or quantity regulations can lead a competitive market to produce inefficiently. In addition, if there are externalities, the good is a public good or common resource, the good is sold by a monopoly, or there are high transactions costs, then the market will not necessarily be efficient. 17. T The fact that the sum of consumer surplus and producer surplus is as large as possible indicates that the gains from trade are as large as possible. 18. T A deadweight loss is a total loss to society; no one benefits from a deadweight loss. Is the Competitive Market Fair? 19. F Utilitarianism argues that income should be taken from the rich and given to the poor. It does not claim that efficiency is fair. 20. T Making the poorest as well off as possible changes the economic game s results after the game is over. 21. F The symmetry principle is the assertion that people in similar circumstances should be treated similarly. Multiple Choice Answers Resource Allocation Methods 11. d Command is used because the person in charge is issuing orders ( commands ) telling how resources will be allocated. 12. a The earlier someone arrives, the closer to the start of the line and the sooner the person is served. 13. c The person is using the personal characteristics of the potential tenants to determine to whom the apartment will be rented. Benefit, Cost, and Surplus 14. c Efficiency occurs when the goods people value most highly are the goods being produced. 15. b The marginal benefit of the good equals the maximum price consumers are willing to pay for another unit of the good. The value of the good also equals its marginal benefit. 16. c Because the marginal benefit is the maximum amount someone is willing to pay for another unit of the good, the demand curve, which shows this maximum price, is the same as the marginal benefit curve.
11 EFFICIENCY AND EQUITY d Susan s consumer surplus equals the benefit from the slice, which is maximum she is willing to pay for the slice, $5, minus what she actually pays, $ a With decreasing marginal benefit, the marginal benefit a consumer receives from the first unit of the good exceeds the marginal benefit the consumer receives from the second unit of the good. 19. c The question gives the definition of marginal cost. 10. a For any unit of output, the market supply curve shows the minimum price for which that unit will be produced and sold. Because the minimum price is the marginal social cost of the unit, the market supply curve is the same as the marginal cost curve. 11. d Producer surplus accrues to suppliers, and answer d is the definition of producer surplus. Is the Competitive Market Efficient? 12. b The quantity produced is determined by the intersection of supply and demand curves. 13. b The efficient quantity is determined by the intersection of the marginal social benefit and marginal social cost curves. In comparison with the last answer, when demand equals the marginal benefit and supply equals the marginal cost, the equilibrium quantity is the efficient quantity. 14. c Consumer surplus equals the area under the demand curve and above the price. 15. c Producer surplus is the area above the supply curve and below the price. 16. d The deadweight loss is the sum of the lost consumer surplus (area b) plus the lost producer surplus (area c). 17. a When 150 units are produced, the total surplus is the area a + b + c + d; when 100 units are produced, the total surplus is only the area a + d. 18. c The deadweight loss is the area of the darkened triangle in Figure The area of a triangle equals (½) (base) (height). The base equals 40 units minus 20 units, or 20. The height equals $4 per unit minus $1 per unit, or $3. So the deadweight loss is (½) (20) ($3) = $ d No one benefits from a deadweight loss. 20. b Decreasing marginal benefit simply implies that the value of the initial units consumed exceeds the value of last units consumed. 21. a When a good is valued more highly, the marginal benefit increases and so efficiency requires that more of the good be produced. 22. d If a market allocation of resources results in market failure, then perhaps one of the other resource allocation methods might lead to allocative efficiency. Is the Competitive Market Fair? 23. a Susan is judging fairness by looking at the outcome she must have three slices of pizza a week so she is using a it s not fair if the result isn t fair approach. 24. c Robert Nozick asserts that the government must establish and protect private property and that all exchanges must be voluntary, in which case the resulting outcome is efficient and fair. Answers to Short Answer Problems 1. Resources must be allocated because they are scarce. Because of the scarcity of resources, not everyone s wants can be met. The resource allocation method used will determine whose wants are fulfilled and whose wants are left unfulfilled.
12 88 CHAPTER 5 TABLE 5.3 Short Answer Problem 2 (a) Quantity (millions of video games) Marginal social benefit minus marginal social cost a. See the completed Table 5.3. For each quantity, the answer in the table is obtained by subtracting the marginal benefit from the marginal cost. b. Figure 5.14 shows the marginal social benefit and marginal social cost schedules. c. Both the table and the figure demonstrate that the efficient number of video games is 3 million because this quantity sets the marginal social benefit from an additional game equal to the game s marginal social cost. 3. a. Figure 5.15 shows the demand and supply curves for video games. The key point in drawing Figure 5.15 is the fact that the demand curve, D, is the same as the marginal social benefit curve, MSB, and the supply curve, S, is the same as the marginal social cost curve, MSC. These equivalencies are noted in the figure. b. The quantity produced is 3 million video games, determined by where the supply and demand curves cross. c. The two answers are identical, 3 million video games. In other words, the efficient quantity of video games is the same as the quantity actually produced. 4. All three concepts are the same. In other words, the marginal benefit of a good is defined as the good s value. And the value of a good is the maximum price that someone is willing to pay for it. Hence all three terms are interchangeable. 5. a. Figure 5.16 (on the next page) shows the consumer surplus as the area of the shaded triangle. The amount of consumer surplus is equal to the area of the triangle. Use the formula for the area of a triangle, (½) (base) (height). The base equals 2 million pairs of jeans, the quantity demanded. The height is $20 per jean. Thus consumer surplus is (½) (2 million jeans) ($20 per jean) or $20 million. b. Figure 5.17 (on the next page) shows the consumer surplus when the price of jeans is $30 a pair. The consumer surplus in this case is $45 million, from (½) (3 million jeans) ($30 per jean). As the price falls, the consumer surplus rises.
13 EFFICIENCY AND EQUITY 89 c. Consumer surplus is larger when the price is lower. This result reflects the conclusion that consumers are better off when the prices of the goods they buy are lower. 6. a. Figure 5.18 shows the producer surplus as the area of the grey triangle. The amount of the producer surplus can be determined by using the formula for the area of a triangle, specifically (½) (base) (height). The base equals 4 million pairs of jeans, the quantity supplied. The height equals $40 per jean. Producer surplus is (½) (4 million jeans) ($40 per jean) or $80 million. b. Figure 5.19 shows the producer surplus when the price of a pair of jeans is $30. Producer surplus equals (½) (base) (height), which is equal to (½) (3 million jeans) ($30 per jean), or $45 million. c. Producer surplus is larger when the price is higher. This result illustrates the fact that producers are better off when the price of the good they sell is higher.
14 90 CHAPTER 5 7. a. Figure 5.20 demonstrates that the quantity is 3 million jeans and the price is $30 a pair. b. Consumer surplus and producer surplus are illustrated in Figure The price of a pair of jeans is $30. From Problem 5 (b), the consumer surplus is $45 million. From Problem 6 (b), producer surplus is $45 million. (The result that the consumer surplus equals the producer surplus is a coincidence; in general there is no particular relationship between the amount of consumer surplus and the amount of producer surplus.) The sum of consumer surplus plus producer surplus is $90 million. c. Figure 5.21 illustrates the case when production of jeans is limited to 2 million pairs. The deadweight loss is the dark triangle in the figure. Use (½)(base)(height), the formula for the area of a triangle, to calculate it. The base is 1 million pairs of jeans. The height is $20 per jean, the difference between what consumers are willing to pay for another pair of jeans, $40, and the amount suppliers need to receive to produce an additional pair, $20. The deadweight loss equals (½) (1 million jeans) ($20 per jean) or $10 million. The sum of consumer surplus and producer surplus is most easily calculated by subtracting the deadweight loss from the sum when the market produces the efficient quantity. From part (b) of this problem, the sum when the market is efficient is $90 million. So when the market underproduces by producing only 2 million pairs of jeans, the sum of consumer surplus and producer surplus equals $90 million minus $10 million or $80 million. d. Figure 5.22 shows the situation when 4 million pairs of jeans are produced. The deadweight loss is again illustrated by the dark triangle. The amount of deadweight loss equals the area of the triangle, or (½) (base) (height). The base is 1 million pairs of jeans, the amount of overproduction. The height is $20, the difference between the marginal social cost of another pair of jeans and the marginal social benefit from an-
15 EFFICIENCY AND EQUITY 91 other pair. The deadweight loss is equal to (½) (1 million jeans) ($20 per jean) = $10 million. The result that the deadweight loss in part (d) from overproducing 1 million pairs of jeans equals the deadweight loss from underproducing 1 million pairs of jeans, in part (c), is a coincidence. In general these amounts are not equal. The sum of consumer surplus and producer surplus equals the sum when the efficient quantity is produced, $90 million, minus the deadweight loss, $10 million. So with this overproduction, the sum of consumer surplus and producer surplus is $80 million. e. The total surplus equals the sum of consumer surplus and producer surplus. It is largest when the efficient quantity of jeans is produced, when 3 million pairs of jeans are produced. 8. A deadweight loss is the loss to society when resources are used inefficiently. When resources are used efficiently, the sum of the consumer surplus plus the producer surplus is as large as possible. Any sort of inefficiency decreases the total sum, and the decrease is the deadweight loss. It is important to note that a deadweight loss is a loss to society as a whole. In other words, no one benefits from a deadweight loss. 9. a. Based on the data in the question, the efficient quantity of mushrooms to produce is 10 million pounds a year. Why? The mushroom market meets all the criteria to be efficient: It is a competitive market, there are no externalities, and there are no government policies (such as price controls or taxes) that lead the amount produced to differ from the equilibrium quantity. So the amount produced, the equilibrium quantity, is the efficient amount. b. Figure 5.23 shows the deadweight loss from producing 11 million pounds of mushrooms. The deadweight loss exists because past 10 million pounds of mushrooms, the value people place on an additional pound of mushrooms their marginal benefit is less than the cost to produce an additional pound the marginal cost. Hence all the pounds past 10 million subtract from the gains from trade, and the amount subtracted is equal to the deadweight loss. c. Igor thinks that too few mushrooms are produced. Hence, Igor is using the result (not enough mushrooms) to judge fairness. Thus Igor is using the concept of it s not fair if the result isn t fair. d. Igor is unlikely to agree that it isn t fair if the rules aren t fair because when the rules are fair, that is, when there is no government interference in the market, Igor does not like the outcome. Basically, Igor wants to bend the rules so that more mushrooms are grown, perhaps by giving growers a subsidy to encourage more production. You re the Teacher 1. Yeah, I know what you mean that there seems to be a contradiction between the idea that resources are limited and therefore not everyone can have everything they want and a lesson in this chapter that it is possible to produce too much of a good. But, once you think about it a bit, the two ideas actually fit together okay. Think about sodas. We both drink a lot of them, but you know we d both like to drink more. The fact that we d like more shows us that sodas are scarce, that is, some of our wants for more sodas won t be satisfied. But now suppose that 100 times more sodas were produced. We d have soda coming out of our ears! We d have plenty to drink, but we d have to brush our teeth in it and use it in the shower. I like soda as much as anybody, but taking a bath in soda sounds gross! In this situation obvious-
16 92 CHAPTER 5 ly too much soda is being produced. We d be a lot better off if production was cut back. In fact, in some sense it s precisely because resources are limited that we can overproduce a good. Look, if society produced 100 times the amount of soda we produce now, the fact that our resources are limited means that we d have to give up a bunch of other things: We d have no cars because all the metal was being used to make soda cans; we d have no books or magazines because all the paper was being used to make six-pack holders; we d lose a lot of stuff because the resources were devoted to making soda. If we had unlimited resources, we would not lose anything and so in this case, we really couldn t overproduce a good. But, because our resources are limited, we want to use them the best we can, which means we want to produce the efficient amount of each good!
17 EFFICIENCY AND EQUITY 93 Chapter Quiz 11. If the marginal social cost of the sixth slice of pizza is greater than the marginal social benefit, then the output level is a. efficient and more pizza should be produced. b. efficient and less pizza should be produced. c. inefficient and more pizza should be produced. d. inefficient and less pizza should be produced. 12. When the city of Fresno holds a referendum to determine if taxes will be raised to pay for road repairs, the city is using a allocation method. a. majority rule b. market price c. contest d. personal characteristics 13. If the only people who benefit from a pizza are those who buy the pizza, the demand curve for pizza a. lies above the marginal social benefit curve for pizza. b. lies below the marginal social benefit curve for pizza. c. is the same as the marginal social benefit curve for pizza. d. has one point in common with the marginal social benefit curve for pizza. 14. The value of a good minus the price paid for it is the a. producer surplus from the good. b. consumer surplus from the good. c. total surplus from the good. d. exchange surplus from the good. 15. Which of the following can be a source of inefficiency? a. Competition b. Taxes c. Markets d. None of the above are sources of economic inefficiency. 16. Competitive markets will generally a. produce too much of a public good. b. produce too little of a public good. c. produce the efficient amount of a public good. d. produce too much, too little, or the efficient amount of a public good depending on whether the market demand curve accurately reflects the marginal social benefit. 17. Which of the following statements about a deadweight loss is correct? a. The deadweight loss is largest in a perfectly competitive market producing a good with no external costs or benefits. b. A deadweight loss is a loss to consumers and a gain to producers. c. A deadweight loss is a loss to producers and a gain to consumers. d. None of the above are correct. 18. If the marginal social cost of the last unit of a good produced is less than the marginal social benefit, a. the amount produced is efficient. b. less than the efficient amount is being produced. c. more than the efficient amount is being produced. d. as time passes, consumers will increase their benefit from the good. 19. Deadweight loss can be the result of a. overproduction but not underproduction. b. underproduction but not overproduction. c. both overproduction and underproduction. d. neither overproduction nor underproduction. 10. The Big Tradeoff points out that a. the symmetry principle is not fair. b. taking income from rich people and giving it to poor people can create inefficiency. c. making the poorest as well off as possible is not compatible with fairness. d. utilitarianism is fair. The answers for this Chapter Quiz are on page 343