# To do today. Efficiency MB and MC Consumer surplus Producer surplus Deadweight loss. Theories of fairness

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1 To do today Efficiency MB and MC Consumer surplus Producer surplus Deadweight loss Theories of fairness

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4 MB and consumer surplus A key concept in defining efficiency Consumer surplus is the MB from a good or service minus the price paid for it, summed over the quantity consumed.

5 Consumer Surplus (CS) and total benefit CS from the 10,000 pizzas = MB P for all the pizzas. CS = \$ The total benefit is expenditure on pizza + consumer surplus = \$

6 From the Production (Supply) Side of the Market Supply and Marginal Cost Sellers distinguish between cost and price. Cost is what a seller must give up to produce the good. Price is what a seller receives when the good is sold. The cost of producing one more unit of a good or service is its marginal cost (MC).

7 Cost, Price and Producer Surplus A supply curve (S) is a MC curve. S tells us the dollars worth of other goods and services that firms must forgo to produce one more pizza. That is, the S shows the seller s cost of producing each unit of pizza.

8 Producer Surplus Producer surplus is the price of a good minus the opportunity cost of producing it, summed over the quantity produced.

9 Cost, Price and Producer Surplus (PS) PS = P - MC P = \$10 PS is the triangle equivalent to CS (upside down)

10 MC (the supply) curve and producer surplus Producer surplus from the 10,000 pizzas sold is \$ a day the area of the blue triangle. Cost equals total revenue of \$ minus the producer surplus of \$ Or, the red area under the marginal cost curve.

11 Benefit, Cost, and Surplus Supply and Marginal Cost Firms are in business to make a profit. To make a profit, firms must sell their output for a price that exceeds the cost of production. Firms distinguish between cost and price.

12 Benefit, Cost, and Surplus Max and Mario are the only producers of pizza. At \$15 a pizza, the quansty supplied by Max is 100 pizzas.

13 The Efficient Market Defined When marginal cost equals marginal benefit, quansty is efficient. Consumer surplus plus producer surplus is maximized.

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15 Inefficiency and Deadweight Loss Deadweight loss: decrease in total surplus and that results from an inefficient underproduction or overproduction. Deadweight loss is borne by the entire society. It is a social loss.

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17 Is the Competitive Market Efficient? When production is: less than the equilibrium quantity, MSB > MSC. greater than the equilibrium quantity, MSC > MSB. equal to the equilibrium quantity, MSC = MSB.

18 Deadweight Loss UnderproducSon case Efficient production at Suppose produce at 5000 Where is deadweight loss?. UnderproducSon is inefficient.

19 Barriers to Efficiency Price and quantity regulations Taxes and subsidies Externalities Public goods and common resources Monopoly High transactions costs

20 Effect of Taxes Taxes and Subsidies Taxes increase the prices paid by buyers and lower the prices received by sellers. So taxes decrease the quantity produced and lead to underproduction.

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22 Effect of Subsidies Subsidies lower the prices paid by buyers and increase the prices received by sellers. So subsidies increase the quantity produced and lead to overproduction. BUT, these effects of subsidies and taxes hold only if there are market failures

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24 How markets fail Externalities An externality is a cost or benefit that affects someone other than the seller or the buyer of a good. An electric utility creates an external cost by burning coal that creates acid rain. The utility doesn t consider this cost when it chooses the quantity of power to produce. Overproduction results.

25 Is the Competitive Market Efficient? Market Failure Markets don t always achieve an efficient outcome. Market failure arises when a market delivers in inefficient outcome. Market failure can occur because Too little of an item is produced (underproduction) or Too much of an item is produced (overproduction).

26 Is the Competitive Market Underproduction The efficient quansty is 10,000 pizzas a day. If producson is restricted to 5,000 pizzas a day, there is underproducson and the quansty is inefficient. A deadweight loss equals the decrease in total surplus the gray triangle. This loss is a social loss. Efficient?

27 Is the Competitive Market Overproduction Again, the efficient quansty is 10,000 pizzas a day. If producson is expanded to 15,000 pizzas a day, a deadweight loss arises from overproducson. This loss is a social loss. Efficient?

28 Sources of Market Failure In competitive markets, underproduction or overproduction arise when there are Price and quantity regulations Taxes and subsidies Externalities Public goods and common resources Monopoly Is the Competitive Market High transactions costs Efficient?

29 How markets fail A common resource is owned by no one but used by everyone. It is in everyone s self interest to ignore the costs of their own use of a common resource that fall on others (called tragedy of the commons). This leads to overproduction.

30 Are Markets Fair? Two broad and generally conflicting views of fairness are: It s not fair if the rules aren t fair It s not fair if the result isn t fair.

31 Is the Competitive Market Efficient? Price and Quantity Regulations Price regulations sometimes put a block of the price adjustments and lead to underproduction. Quantity regulations that limit the amount that a farm is permitted to produce also leads to underproduction.

32 Is the Competitive Market Taxes and Subsidies Efficient? Taxes increase the prices paid by buyers and lower the prices received by sellers. So taxes decrease the quantity produced and lead to underproduction. Subsidies lower the prices paid by buyers and increase the prices received by sellers. So subsidies increase the quantity produced and lead to overproduction.

33 Is the Competitive Market Externalities Efficient? An externality is a cost or benefit that affects someone other than the seller or the buyer of a good. An electric utility creates an external cost by burning coal that creates acid rain. The utility doesn t consider this cost when it chooses the quantity of power to produce. Overproduction results.

34 Is the Competitive Market Efficient? An apartment owner would provide an external benefit if she installed an smoke detector. But she doesn t consider her neighbor s marginal benefit and decides not to install the smoke detector. The result is underproduction.

35 Is the Competitive Market Efficient? Public Goods and Common Resources A public good benefits everyone and no one can be excluded from its benefits. It is in everyone s self-interest to avoid paying for a public good (called the free-rider problem), which leads to underproduction.

36 Is the Competitive Market Efficient? A common resource is owned by no one but can be used by everyone. It is in everyone s self interest to ignore the costs of their own use of a common resource that fall on others (called tragedy of the commons). The tragedy of the commons leads to overproduction.

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38 EYE on PRICE GOUGING Should Price Gouging be Illegal? Following a hurricane, the demand for camp stoves increases to D 1. With no price gouging law, the price jumps to \$ and the quansty increases to stoves per day. This outcome is efficient because the marginal cost of a stove equals the marginal benefit from a stove.

39 EYE on PRICE GOUGING Should Price Gouging be Illegal? If a strict price gouging law requires the price a^er the hurricane to be \$20. At this price, the quansty of stoves supplied remains at 5 per day. Where is the deadweight loss? The price gouging law is inefficient, but is it fair?

40 Is the Competitive Market Fair? It s Not Fair if the Result Isn t Fair The idea that only equality brings efficiency is called utilitarianism. Utilitarianism is the principle that states that we should strive to achieve the greatest happiness for the greatest number.

41 Is the Competitive Market Fair? If everyone gets the same marginal utility 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. Only when income is equally distributed has the greatest happiness been achieved.

42 Is the Competitive Market Fair? Figure 5.7 shows how redistribution increases efficiency. 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 unsl they have equal incomes increases total benefit.

43 Is the Competitive Market Fair? The Big Tradeoff Utilitarianism ignores the cost of making income transfers. Recognizing these costs leads to the big tradeoff between efficiency and fairness. 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.

44 Is the Competitive Market Fair? It s Not Fair If the Rules Aren t Fair The idea that it s not fair if the rules aren t fair is based on the symmetry principle. Symmetry principle is the requirement that people in similar situations be treated similarly.

45 Is the Competitive Market Fair? In economics, this principle means equality of opportunity, not equality of income. Robert Nozick suggested that fairness is based on two rules: 1. The state must create and enforce laws that establish and protect private property. 2. Private property may be transferred from one person to another only by voluntary exchange. This means that if resources are allocated efficiently, they may also be allocated fairly.

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