# EFFICIENCY EQUITY. Chapt er. Key Concepts

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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.

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.

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-