Efficiency and Fairness of Markets Chapter 6 CHAPTER IN PERSPECTIVE In Chapter 6 we study the equilibrium quantities of goods, services, and factors of production to determine if markets are efficient. Chapter 6 also studies the main ideas about fairness and determines if competitive markets result in fair outcomes. Distinguish between value and price and define consumer surplus. Value is what buyers get and price is what buyers pay. In economics, the idea of value is called marginal benefit, which is the maximum price that buyers are willing to pay for another unit of the good or service. The demand curve tells us this price. A demand curve is a marginal benefit curve. Consumer surplus is the marginal benefit from a good or service minus the price paid for it, summed over the quantity consumed. Distinguish between cost and price and define producer surplus. Cost is what a seller must give up to produce a good and 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. It is just worth producing one more unit of a good or service if the price for which it can be sold equals marginal cost. The supply curve tells us this price. A supply curve is a marginal cost curve. When the price exceeds marginal cost, the firm obtains a producer surplus. Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity produced. Explain the conditions in which markets are efficient and inefficient. Markets are efficient when resources are used to produce the goods and services people value most highly. When marginal benefit equals the marginal cost, the efficient quantity is produced. The sum of consumer surplus and producer surplus is maximized at a competitive equilibrium. According to Adam Smith, each participant in a competitive market is led by an invisible hand to promote an end [the efficient use of resources] which was no part of his intention. Government imposed price ceilings and floors and production quotas, taxes and subsidies, externalities (costs not borne by the producer or benefits not paid for by the buyer), public goods (everyone can simultaneously consume the good even if they did not pay for it) and common resources, and monopoly (when the market is controlled by a single firm) can lead to inefficiency. Underproduction and overproduction create a deadweight loss. Explain the main ideas about fairness and evaluate claims that competitive markets result in unfair outcomes. The symmetry principle is the requirement that people in similar situations be treated similarly. Two views of fairness are: it s not fair if the result isn t fair and it s not fair if the rules aren t fair. Utilitarianism is a principle that states that we should strive to achieve the greatest happiness for the greatest number. The utilitarian idea of complete equality ignores the cost of making income transfers, which leads to the big tradeoff between efficiency and fairness. When private property and property rights are protected and exchanges are voluntary, competitive markets are fair according to the rules view of fairness.
84 Part 2. A CLOSER LOOK AT MARKETS EXPANDED CHAPTER CHECKLIST When you have completed this chapter, you will be able to: 1 Distinguish between value and price and define consumer surplus. Discuss the difference between value and price. Explain how an economist measures marginal benefit. Explain why the demand curve is a marginal benefit curve. Define consumer surplus and illustrate it in a figure. 2 Distinguish between cost and price and define producer surplus. Discuss the difference between cost and price. Explain why the supply curve is a marginal cost curve. Define producer surplus and illustrate it in a figure. 3 Explain the conditions in which markets are efficient and inefficient. Explain why competitive markets are efficient. Discuss the invisible hand. List the obstacles to achieving an efficient allocation of resources. Define and illustrate the deadweight loss. 4 Explain the main ideas about fairness and evaluate claims that competitive markets result in unfair outcomes. Define the symmetry principle. Discuss the two broad views of fairness. Define utilitarianism and discuss the one big problem with the utilitarian idea of complete equality. Discuss fairness in the face of a natural disaster. KEY TERMS Consumer surplus (page 139) Producer surplus (page 142) Deadweight loss (page 148) Symmetry principle (page 151) Utilitarianism (page 152) Big tradeoff (page 152) CHECKPOINT 6.1 Distinguish between value and price and define consumer surplus. Practice Problem 6.1 1. The figure shows the demand curve for CDs and the market price of a CD. Use the figure to answer the following questions. a. What is the value of the th CD? b. What is the willingness to Price (dollars per CD) Market price 30 40 Quantity (CDs per day) pay for the th CD? c. What is the consumer surplus on the th CD? d. What are the quantity of CDs bought and the consumer surplus? e. What is the amount paid for the CDs in question (d)? f. What is the total benefit from the CDs bought in question (d)? g. If the price of a CD rises to $, what is the change in consumer surplus? Solution to Practice Problem 6.1 This Practice Problem illustrates the relationship between the demand curve and the marginal benefit curve. A demand curve is a marginal benefit curve. Marginal benefit is the maximum price that people are willing to pay for another unit of a good or service. The demand curve tells us this price. 25 15 D
Chapter 6. Efficiency and Fairness of Markets 85 Quick Review Value In economics the idea of value is called marginal benefit, which we measure as the maximum price that people are willing to pay for another unit of a good or service. Consumer surplus Consumer surplus is the marginal benefit from a good or service minus the price paid for it, summed over the quantity consumed. a. What is the value of the th CD? The value of the th CD equals the maximum price a consumer is willing to pay for the th CD. The figure shows that the maximum price for the th CD is $, so the value of the CD equals $. Price (dollars per CD) 25 15 25 15 Market price D 30 40 Quantity (CDs per day) b. What is the willingness to pay for the th CD? The willingness to pay for the th CD is equal to the maximum price the consumer will pay for the th CD, which, from the figure, is $15. c. What is the consumer surplus on the th CD? The consumer surplus is $5, which equals the marginal benefit of the th CD ($) minus the price of the CD ($15). d. What are the quantity of CDs bought and the consumer surplus? The quantity bought Price (dollars per CD) is CDs because the quantity demanded at the price of $15 is CDs. The consumer surplus equals the area of the shaded triangle in the figure. Calculating the area of the consumer Market price D 30 40 Quantity (CDs per day) surplus triangle, which is equal to one half the base of the triangle times the height (the area of the triangle), gives a consumer surplus of $0. e. What is the amount paid for the CDs in question (d)? The price times the quantity purchased equals the amount paid, which is $15 CDs = $300. f. What is the total benefit from the CDs bought in question (d)? The area beneath the marginal benefit curve is the total benefit. This area equals the sum of the consumer surplus plus the total expenditure, so the total benefit is $0 + $300 = $400. g. If the price of a CD rises to $, what is the change in consumer surplus? At $, the quantity demanded decreases to CDs. The new consumer surplus is the area of the triangle beneath the marginal benefit curve and above the $ price per CD, and equals $25. Consumer surplus falls by $75 from the original amount in part (d). Additional Practice Problem 6.1a Your friend paid a lawyer $50 for the hour it took the lawyer to write a letter to settle a rent dispute. Your friend wonders if the concepts of value, marginal benefit, and consumer surplus apply not only to goods but also to services, such as the lawyer s letter. What do you tell your friend? Solution to Additional Practice Problem 6.1a All the concepts of value, marginal benefit, and consumer surplus apply to services as well as to goods. In your friend s case, there was some maximum amount your friend was willing to pay the attorney to write the letter. This maximum amount was the value to your friend of the letter. It is also the marginal benefit of the letter. Presumably your friend got the letter for some amount less than the maximum your friend was willing to pay. The difference between the maximum amount, which is the marginal benefit of the letter, and the price actually paid for the letter, is the consumer surplus your friend enjoyed from the letter.
86 Part 2. A CLOSER LOOK AT MARKETS Self Test 6.1 Fill in the blanks The benefit a person receives from consuming one more unit of a good is its. The opportunity cost of producing one more unit of a good is its. Allocative efficiency is at the quantity where the marginal benefit is (greater than; equal to; less than) marginal cost. The demand curve (is; is not) the marginal benefit curve. The consumer surplus equals the marginal benefit of a good (plus; multiplied by; minus) the price paid for it. True or false 1. In economics, value and price refer to the same thing. 2. A demand curve is a marginal benefit curve. 3. Consumer surplus is the marginal benefit from a good minus the price paid for it. 4. Consumer surplus always equals zero because consumers always must pay for the goods and services they consume. Multiple choice 1. Value is a. the price we pay for a good. b. the cost of resources used to produce a good. c. objective so that it is determined by market forces, not preferences. d. the marginal benefit we get from consuming another unit of a good or service. 2. A marginal benefit curve a. is the same as a demand curve. b. is the same as a supply curve. c. slopes upwards. d. is a vertical line. 3. In general, as the consumption of a good or service increases, the marginal benefit from consuming that good or service a. increases. b. decreases. c. stays the same. d. at first increases and then decreases. 4. The difference between the marginal benefit from a new pair of shoes and the price of the new pair of shoes is a. the consumer surplus from the shoes. b. what we get. c. what we have to pay. d. the price when the marginal benefit is maximized. 5. Suppose the price of a scooter is $199 and Cora Lee is willing to pay $250. Cora Lee s a. consumer surplus from that scooter is $199. b. consumer surplus from that scooter is $51. c. total benefit from that scooter is $199. d. None of the above answers are correct. 6. If the price of a pizza is $ per pizza, the consumer surplus from the first pizza consumed the consumer surplus from the second pizza consumed. a. is greater than b. equals c. is less than d. cannot be compared to Complete the graph FIGURE 6.1 Price (dollars per pair of roller blades) 0 150 0 50 MB 0 30 40 50 60 Quantity (thousands of pairs of roller blades per year) 1. Figure 6.1 shows the demand curve for roller blades. a. What is the marginal benefit of the,000th pair of roller blades? b. What is the marginal benefit of the 40,000th pair of roller blades?.
Chapter 6. Efficiency and Fairness of Markets 87 FIGURE 6.2 Price (dollars per bag of potato chips) 4 3 2 1 D b. As more MP3 players are purchased, what happens to the consumer surplus of the last unit purchased? Why? 2. What is the relationship between the value of a good, the maximum price a consumer is willing to pay for the good, and the marginal benefit from the good? 3. What is the relationship between the marginal benefit of a slice of pizza, the price paid for the slice, and its consumer surplus? 0 1 2 3 4 5 6 Quantity (millions of bags of potato chips per week) 2. Figure 6.2 shows the demand curve for bags of potato chips. a. What is the maximum price a consumer is willing to pay for the 2 millionth bag of chips? b. What is the marginal benefit from the 2 millionth bag of chips? What is the relationship between your answer to part (a) and your answer to this part? c. If the price of a bag of chips equals $2, in Figure 6.2 shade the area that equals the amount of the consumer surplus. d. If the price of a bag of chips equals $2, what is the amount of the consumer surplus? Short answer and numeric questions 1. The table gives the demand schedule for MP3 players. Price (dollars per MP3 player) Quantity (millions of MP3 players per year) Consumer surplus (dollars) 500 4 400 8 300 12 0 16 0 Suppose the price of an MP3 player is $0. a. Complete the table by calculating the consumer surplus. In the first row, calculate the consumer surplus for the 4 millionth MP3 player; in the second row, calculate the consumer surplus for the 8 millionth MP3 player; and so on. CHECKPOINT 6.2 Distinguish between cost and price and define producer surplus. Practice Problem 6.2 1. The figure shows the supply curve of CDs and the market price of a CD. Use the figure to answer the following questions. a. What is the Price (dollars per CD) 15 Market price marginal cost 30 40 of the th CD? Quantity (CDs per day) b. What is the minimum supply price of the th CD? c. What is the producer surplus on the th CD? d. What are the quantity of CDs sold and the producer surplus? e. What is the total revenue from the CDs sold in question (d)? f. What is the cost of producing the CDs sold in question (d)? g. If the price of a CD falls to $, what is the change in producer surplus? Solution to Practice Problem 6.2 This Practice Problem illustrates the relationship between the supply curve and the marginal cost curve. A supply curve is a marginal cost curve. It is just worth producing one more unit of a good or service if the price for which it 5 S
88 Part 2. A CLOSER LOOK AT MARKETS can be sold equals the marginal cost. The supply curve tells us this price. Quick Review Cost Cost is what the seller must give up to produce a good. Producer surplus The producer surplus of a good equals the price of a good minus the marginal cost of producing it. a. What is the marginal cost of the th CD? The marginal cost of the th CD is equal to the minimum supply price of the th CD. The supply curve tells us this price. In the figure, the supply curve shows that the marginal cost of th CD is $. Price (dollars per CD) 15 5 Market price 30 40 Quantity (CDs per day) b. What is the minimum supply price of the th CD? The minimum supply price of the th CD is read from the supply curve above the th CD and is $15. c. What is the producer surplus on the th CD? The producer surplus on the th CD is equal to its market price minus its marginal cost, which is $15 $ = $5. d. What are the quantity of CDs sold and the producer surplus? At the market price of $15, CDs are sold. The producer surplus equals the area of the blue triangle in the figure. Calculating the area of the triangle as one half the base times the height, the area equals $0. Price (dollars per CD) 15 5 S Market price 30 40 Quantity (CDs per day) S e. What is the total revenue from the CDs sold in question (d)? Because CDs are sold at $15 each, total revenue is $15 = $300. f. What is the cost of producing the CDs sold in question (d)? The area under the supply curve is the cost of producing the CDs. It consists of the rectangle whose size is $5 or $0 plus the triangle whose area is [($15 $5) ]/2 = $0. Thus $0 + $0 equals $0 as the total cost of producing CDs. g. If the price of a CD falls to $, what is the change in producer surplus? The new producer surplus is the smaller triangle above the supply curve and below the $ price. This area equals $25, which is $75 less than the original producer surplus in part (d). Additional Practice Problem 6.2a Why is the minimum price for which a seller will produce a product equal to the product s marginal cost? Solution to Additional Practice Problem 6.2a A seller is willing to produce a good as long as the price the seller receives covers all the costs of producing the good. So the minimum price for which a seller is willing to produce a unit of the good must be the amount that just equals the cost of the producing that unit. But the cost of producing any unit of a good is its marginal cost, so the minimum supply price equals the good s marginal cost. Self Test 6.2 Fill in the blanks (Price; Cost) is what a seller must give up to produce a good and (price; cost) is what a seller receives when the good is sold. A (demand; supply) curve is a marginal cost curve. A firm receives a producer surplus when price is (greater; less) than marginal cost. True or false 1. In economics, cost and price are the same thing.
Chapter 6. Efficiency and Fairness of Markets 89 2. The minimum price for which Bobby will grow another pound of rice is, so the marginal cost of an additional pound of rice is. 3. A supply curve is a marginal benefit curve. 4. Producer surplus equals the marginal benefit of a good minus the cost of producing it. Multiple choice 1. Cost is a. what the buyer pays to get the good. b. always equal to the marginal benefit for every unit of a good produced. c. what the seller must give up to produce the good. d. greater than market price, which results in a profit for firms. 2. If a firm is willing to supply the 1,000th unit of a good at a price of $23 or more, we know that $23 is the a. highest price the seller hopes to realize for this output. b. minimum price the seller must receive to produce this unit. c. average price of all the prices the seller could charge. d. price that sets the marginal benefit equal to the marginal cost. 3. A supply curve shows the of producing one more unit of a good or service. a. producer surplus b. consumer surplus c. total benefit d. marginal cost 4. Producer surplus is a. equal to the marginal benefit from a good minus its price. b. equal to the price of a good minus the marginal cost of producing it. c. always equal to consumer surplus. d. Both answers (a) and (c) are correct. 5. Suppose you re willing to tutor another student for $ an hour. The student pays you $15 an hour. What is your producer surplus? a. $5 an hour b. $ an hour c. $15 an hour d. $25 an hour 6. In a figure that shows a supply curve and a demand curve, producer surplus is the area a. below the demand curve and above the market price. b. below the supply curve and above the market price. c. above the demand curve and below the market price. d. above the supply curve and below the market price. Complete the graph FIGURE 6.3 Price (dollars per bag of potato chips) 4 3 2 1 0 1 2 3 4 5 6 Quantity (millions of bags of potato chips per week) 1. Figure 6.3 shows the supply curve for bags of potato chips. a. What is the minimum price for which a supplier is willing to produce the 2 millionth bag of chips? b. What is the marginal cost of the 2 millionth bag of chips? What is the relationship between your answer to part (a) and your answer to this part? S
90 Part 2. A CLOSER LOOK AT MARKETS c. If the price of a bag of chips equals $2, in Figure 6.3 shade the area that equals the amount of the producer surplus. d. If the price of a bag of chips equals $2, calculate the producer surplus. Short answer and numeric questions 1. What is the relationship between the minimum price a supplier must receive to produce a slice of pizza and the marginal cost of the slice of pizza? What is the relationship between the marginal cost curve and the supply curve? 2. What is producer surplus? As the price of a good or service rises and the supply curve does not shift, what happens to the amount of the producer surplus? CHECKPOINT 6.3 Explain the conditions in which markets are efficient and inefficient. Practice Problem 6.3 1. The figure shows the Price (dollars per ton) market for paper. Use the figure to answer 9 the following 7 questions. 5 a. What are the S equilibrium price and the equilibrium quantity of paper? b. In market equilibrium, 3 1 D 30 40 50 60 70 Quantity (tons per day) what is the consumer surplus? c. In market equilibrium, what is the producer surplus? d. Is the market for paper efficient? Why or why not? e. If a news magazine lobby group persuaded the government to pass a law requiring paper producers to sell 50 tons of paper a day, would the market be efficient? Why or why not? f. In the situation described in part (e), shade the deadweight loss on the figure. g. If an environmental lobby group persuaded the government to pass a law restricting producers of paper to sell only tons of paper a day, would the market for paper be efficient? Why or why not? h. In the situation described in part (g), shade the deadweight loss on the figure. Solution to Practice Problem 6.3 The efficient use of resources occurs when marginal benefit equals marginal cost. When production in a market occurs at an inefficient level, a deadweight loss occurs. Quick Review Efficiency of competitive equilibrium The condition that marginal benefit equals marginal cost delivers an efficient use of resources. It allocates resources to the activities that create the greatest possible value. Marginal benefit equals marginal cost at a competitive equilibrium, so a competitive equilibrium is efficient. Deadweight loss The decrease in consumer surplus and producer surplus that results from an inefficient level of production. a. What are the equilibrium price and the equilibrium quantity of paper? The equilibrium is shown in the figure and is where the supply and demand curves intersect. The equilibrium price is $3 a ton and the equilibrium quantity is 40 tons a day. b. In market equilibrium, what is the consumer surplus? The consumer surplus is illustrated in Price (dollars per ton) the figure as the area 9 of the top, shaded 7 triangle. The consumer surplus equals 5 S the area of the triangle, or 1/2 (40 3 tons) ($6 per ton) = 1 D $1, where $6 a ton 30 40 50 60 70 is the height of the Quantity (tons per day) triangle, $9 a ton $3
Chapter 6. Efficiency and Fairness of Markets 91 a ton. c. In market equilibrium, what is the producer surplus? The producer surplus equals the area of the lower, lighter triangle and is $40. d. Is the market for paper efficient? Why or why not? The market equilibrium is efficient because the marginal benefit of a ton of paper equals its marginal cost. The sum of the consumer surplus and producer surplus is at its maximum at the efficient level of production. e. If a news magazine lobby group persuaded the government to pass a law requiring paper producers to sell 50 tons of paper a day, would the market be efficient? Why or why not? Selling 50 tons is inefficient because the marginal cost of the 50th ton exceeds the marginal benefit of the 50th ton. f. In the situation described in part (e), shade the deadweight loss on the figure. The deadweight loss created by this law is the triangle to the right of 40 tons of paper. Each ton of paper in this triangle has a marginal cost that exceeds its marginal benefit and hence contributes to the deadweight loss. Price (dollars per ton) 9 7 5 3 1 D 30 40 50 60 70 Quantity (tons per day) g. If an environmental lobby group persuaded the government to pass a law restricting producers of paper to sell only tons of paper a day, would the market for paper be efficient? Why or why not? Selling tons is inefficient because the marginal benefit from the th ton exceeds the marginal cost of the th ton. h. In the situation described in part (g), shade the deadweight loss on the figure. The deadweight loss created by this law is the triangle to the left of 40 tons of paper. S Additional Practice Problem 6.3a Who benefits from a deadweight loss? Solution to Additional Practice Problem 6.3a No one gains from a deadweight loss. Deadweight loss is a decrease in consumer surplus and producer surplus that results from an inefficient level of production. The deadweight loss is borne by the entire society. It is not a loss for the consumers and a gain for the producer. It is a social loss. Self Test 6.3 Fill in the blanks Equilibrium in a competitive market (is; is not) efficient. Adam Smith believed that each participant in a competitive market is led by (an invisible hand; government actions). A price (ceiling; floor) is a regulation that makes it illegal to charge a price higher than a specified level. (An externality; A public good) is a good or service that is consumed simultaneously by everyone, even if they don t pay for it. Deadweight loss is the decrease in (only consumer surplus; consumer surplus and producer surplus; only producer surplus) that results from an inefficient level of production. True or false 1. When the demand curve is the marginal benefit curve and the supply curve is the marginal cost curve, the competitive equilibrium is efficient. 2. When the efficient quantity of a good is produced, the consumer surplus is always zero. 3. According to Adam Smith, the invisible hand suggests that competitive markets require government action to ensure that resources are allocated efficiently. 4. Producing less than the efficient quantity of a good results in a deadweight loss but producing more than the efficient quantity does not result in a deadweight loss.
92 Part 2. A CLOSER LOOK AT MARKETS Multiple choice 1. When a market is efficient the a. sum of consumer surplus plus producer surplus is maximized. b. deadweight gain is maximized. c. quantity produced is maximized. d. marginal benefit of the last unit produced exceeds the marginal cost by as much as possible. 2. Which of the following occurs when a market is efficient? a. producers earn the highest income possible b. production costs equal total benefit c. consumer surplus equals producer surplus d. scarce resources are used to produce the goods and services that people value most highly 3. The concept of the invisible hand suggests that markets a. do not produce the efficient quantity. b. are always fair. c. produce the efficient quantity. d. are unfair. 4. What can cause a market to produce an inefficient quantity of a good? a. a monopoly b. an external cost or an external benefit c. a public good that is consumed by everyone simultaneously d. All of the above answers can result in inefficiency. 5. When underproduction occurs, a. producers gain more surplus at the expense of consumers. b. marginal cost is greater than marginal benefit. c. consumer surplus increases to a harmful amount. d. there is a deadweight loss that is borne by the entire society. 6. When production moves from the efficient quantity to a point of overproduction, a. consumer surplus definitely increases. b. the sum of producer surplus and consumer surplus increases. c. there is a deadweight loss. d. consumers definitely lose and producers definitely gain. Complete the graph 1. In Figure 6.4, what is the equilibrium quantity of automobiles? What is the efficient quantity of automobiles? Shade the consumer surplus and the producer surplus. FIGURE 6.4 Price (thousands of dollars per automobile) 40 30 0 S=MC D=MB 40 60 80 0 1 Quantity (thousands of automobiles per week) 2. Figure 6.5 is identical to Figure 6.4. Now suppose that 80,000 automobiles are produced. If there is a deadweight loss, shade it light gray. Next suppose that 40,000 automobiles are produced. If there is a deadweight loss, shade it.
Chapter 6. Efficiency and Fairness of Markets 93 FIGURE 6.5 Price (thousands of dollars per automobile) 40 30 0 S=MC D=MB 40 60 80 0 1 Quantity (thousands of automobiles per week) Short answer and numeric questions 1. What is the relationship between a competitive market, efficiency, and the invisible hand? 2. Suppose the demand for cotton clothing increases. What effect does the increase in demand have on the equilibrium quantity and on the efficient quantity? 3. What factors might lead a market to produce an inefficient amount of a product? CHECKPOINT 6.4 Explain the main ideas about fairness and evaluate claims that competitive markets result in unfair outcomes. Practice Problem 6.4 A winter storm cuts the power supply and isolates a small town in the mountains. The people rush to buy candles from the town store, which is the only source of supply of candles. The store owner decides to ration the candles to one per family but keep the price of a candle unchanged. a. Who gets to consume the candles? b. Who receives the consumer surplus on candles? c. Who receives the producer surplus on candles? d. Is the outcome efficient? e. Is the outcome fair according to the utilitarian principle? f. Is the process fair according to the symmetry principle? g. If the town government declares a state of emergency and gives every family $0 to cope with the crisis, does this produce a more efficient and fairer outcome? Solution to Practice Problem 6.4 This problem challenges you to use what you learned about fairness and think carefully about what is fair and what is unfair. Quick Review Utilitarianism A principle that states that we should strive to achieve the greatest happiness for the greatest number. Symmetry principle The requirement that people in similar circumstances be treated similarly. a. Who gets to consume the candles? At first blush, the answer might seem to be that each family gets to consume one candle. But that answer is incorrect because candles can be resold. Families for whom the marginal benefit of the candle is higher will purchase candles from families for whom the marginal benefit is lower. So the families that most highly value the candles buy them and then consume them. b. Who receives the consumer surplus on candles? The consumer surplus is received by the families that ultimately buy and consume the candles. If a family buys and then sells a candle, it does not receive any consumer surplus because it does not consume the candle. c. Who receives the producer surplus on candles? Some producer surplus is received by the store owner. In addition, the families who initially purchased the candles to resell them to other families also receive some producer surplus. d. Is the outcome efficient? The outcome is efficient because those families that most highly value the candles are the families that consume the candles.
94 Part 2. A CLOSER LOOK AT MARKETS e. Is the outcome fair according to the utilitarian principle? The outcome is not fair according to the utilitarian principle. Utilitarians would have the candles shared equally, so that every family gets the same number of candles. But the outcome has the candles shared unequally because some families sell their candles. f. Is the process fair according to the symmetry principle? The process is fair according to the symmetry principle because all the exchanges are voluntary. Families that want to sell their candles are free to do so and families that want to buy candles also are free to do so. g. If the town government declares a state of emergency and gives every family $0 to cope with the crisis, does this produce a more efficient and fairer outcome? The government s action has no effect on who consumes the candles. The candles will still go to the families who most highly value the candles, so the outcome remains efficient. According to the utilitarian principle, the outcome remains unfair; according to the symmetry principle, the outcome remains fair. However, the $0 given to each family must be raised through taxes, which raises the possibility that the taxes will be unfair. In this case, the government s action might create unfairness by the symmetry principle. Additional Practice Problem 6.4a If Bill Gates gives $1,000 to a homeless person, would the transaction be fair? If Mr. Gates is taxed $1,000 by the government and the government gives the $1,000 to the same homeless person, would the transaction be fair? Comment on your answers. Solution to Additional Practice Problem 6.4a If Mr. Gates gives $1,000 to a homeless person, the action is considered fair. The exchange is fair according to the symmetry principle because the exchange is voluntary. And the outcome is fair according to the utilitarian principle because there is more equality of income. If Mr. Gates is taxed by the government, the outcome is fair according to the utilitarian principle because there is more equality of income. But the transaction is not fair according to the symmetry principle because the exchange does not occur voluntarily; pages 147-148. Self Test 6.4 Fill in the blanks Two views of fairness are that it s not fair if the (result; income distribution) isn t fair; and it s not fair if the (rules; tradeoffs) aren t fair. (Symmetry; Utilitarianism) is a principle that states that we should strive to achieve the greatest happiness for the greatest number. The requirement that people in similar circumstances be treated similarly is (utilitarianism; the symmetry principle). According to Robert Nozick, fair-rules ideas require (government intervention; property rights and voluntary exchange). True or false 1. The symmetry principle is the idea that all people should receive symmetric incomes. 2. The goal of utilitarianism is to achieve the greatest happiness for the greatest number of people. 3. The big tradeoff is the tradeoff between efficiency and happiness. 4. According to the fair-rules view of fairness, in times of natural disasters it is fair to force people to make available necessary goods and services at lower than usual prices. Multiple choice 1. The requirement that people in similar situations be treated similarly is the principle. a. equity b. symmetry c. market d. fairness
Chapter 6. Efficiency and Fairness of Markets 95 2. The principle that states that we should strive to achieve the greatest happiness for the greatest number is a. equity. b. fairness. c. market equilibrium. d. utilitarianism. 3. Which of the following is an example in which the big tradeoff can occur? a. the government redistributes income from the rich to the poor b. Ford increases the price of a pickup truck c. a basketball player signs a $5 million contract d. a college lowers tuition 4. The fair-rules view of fairness is based on a. income transfers from the rich to the poor. b. property rights and voluntary exchange. c. utilitarianism. d. the big tradeoff. 5. An unequal distribution of income is considered fair according to Robert Nozick if a. marginal cost equals marginal benefit. b. the cost of administering a welfare system is minimized. c. property rights are enforced and voluntary exchange occurs. d. the economy is producing its maximum total output. 6. Suppose a hurricane is poised to strike Miami and the price of plywood jumps from $15 a board to $28. If the government buys all the plywood at $28 and offers it to consumers for $15, which of the following is true? a. There will be enough plywood for everyone at the $15 government price. b. There will be a surplus of plywood at the $15 government price. c. Some people who buy plywood at the $15 government price will resell the plywood to consumers who are willing to pay $28, earning a producer surplus of $13. d. Because the government is both buying and selling the plywood, there is no need to impose a tax to pay for the government intervention. Short answer and numeric questions 1. In the United States, richer people generally pay a larger fraction of their income as taxes than do poorer people. Is this arrangement fair? Answer from a fairresults view and from a fair-rules view. 2. Suppose that during their working lifetimes, Matt and Pat have earned identical incomes as computer programmers. The only difference between the two is that Matt spent all of his income while Pat saved a large portion of hers. Now that they are retired, Pat s income is substantially higher than Matt s because of Pat s saving. Is it fair for Pat s income to be higher than Matt s? Answer from a fair results and from a fair rules perspective. 3. What is the effect of the big tradeoff in transferring income from people with high incomes to people with low incomes? 4. Is it fair for the government to limit the prices sellers charge for bottled water after a flood destroys a town s water supply? Why or why not?
96 Part 2. A CLOSER LOOK AT MARKETS SELF TEST ANSWERS CHECKPOINT 6.1 Fill in the blanks The benefit a person receives from consuming one more unit of a good is its marginal benefit. The opportunity cost of producing one more unit of a good is its marginal cost. Allocative efficiency is at the quantity where the marginal benefit is equal to marginal cost. The demand curve is the marginal benefit curve. The consumer surplus equals the marginal benefit of a good minus the price paid for it. True or false 1. False; page 138 2. True; page 138 3. True; page 139 4. False; page 139 Multiple choice 1. d; page 138 2. a; page 138 3. b; page 138 4. a; page 139 5. b; page 139 6. a; page 139 Complete the graph 1. a. The marginal benefit of the,000th pair of roller blades is the maximum price a consumer is willing to pay for that pair, which is $150; page 138. b. The marginal benefit of the 40,000th pair of roller blades is the maximum price a consumer is willing to pay for that pair, which is $0; page 138. 2. a. The maximum price is $3; page 138. b. The marginal benefit is $3. The marginal benefit is the maximum price a consumer is willing to pay for another bag of potato chips; page 138. c. Figure 6.6 shades the area of the consumer surplus; page 139. FIGURE 6.6 Price (dollars per bag of potato chips) 4 3 2 1 0 Consumer surplus 1 2 3 4 5 6 Quantity (millions of bags of potato chips per week) d. The consumer surplus equals the area of the shaded triangle in Figure 6.6, which is ½ ($4 $2) 4 million = $4 million; page 139. Short answer and numeric questions 1. a. The table contains the consumer surpluses. The consumer surplus is zero for the millionth MP3 player because when the price of an MP3 player is $0, the millionth MP3 player is not purchased. For the remaining quantities, the consumer surplus is the marginal benefit, which equals the maximum price consumers are willing to pay minus the price; page 139. Price (dollars per MP3 player) Quantity (millions of MP3 players per year) D Consumer surplus (dollars) 500 4 300 400 8 0 300 12 0 0 16 0 0 0 b. The consumer surplus decreases as more MP3 players are purchased because the value of an additional MP3 player decreases as more are purchased; page 139. 2. The value of a good is equal to the maximum price a buyer is willing to pay, which also equals the marginal benefit; page 138.
Chapter 6. Efficiency and Fairness of Markets 97 3. The marginal benefit of the slice of pizza equals the price paid plus the consumer surplus on that slice; page 139. CHECKPOINT 6.2 Fill in the blanks Cost is what a seller must give up to produce a good and price is what a seller receives when the good is sold. A supply curve is a marginal cost curve. A firm receives a producer surplus when price is greater than marginal cost. True or false 1. False; page 141 2. True; page 141 3. False; page 141 4. False; page 142 Multiple choice 1. c; page 141 2. b; page 141 3. d; page 141 4. b; page 142 5. a; page 142 6. d; page 142 Complete the graph 1. a. The minimum price is $1; page 141. b. The marginal cost is $1. The marginal cost of the 2 millionth bag is the minimum price for which a supplier is willing to produce that bag of chips; page 141. c. Figure 6.7 shades the area of the producer surplus; page 142. d. The producer surplus equals the area of the shaded triangle in Figure 6.7, so producer surplus is ½ ($2 $0) 4 million, which equals $4 million; page 142. Short answer and numeric questions 1. The minimum price for which a firm will produce a slice of pizza equals the marginal FIGURE 6.7 Price (dollars per bag of potato chips) 4 3 2 1 0 Producer surplus 1 2 3 4 5 6 Quantity (millions of bags of potato chips per week) cost of producing that slice. It is just worth producing one more slice of pizza if the price for which it can be sold equals its marginal cost. The supply curve tells us this price. So the supply curve is the same as the marginal cost curve; page 141. 2. Producer surplus equals the price of a good or service minus the marginal cost of producing it. As the price of a good or service rises and the supply curve does not shift, the producer surplus increases; page 142. CHECKPOINT 6.3 Fill in the blanks Equilibrium in a competitive market is efficient. Adam Smith believed that each participant in a competitive market is led by an invisible hand. A price ceiling is a regulation that makes it illegal to charge a price higher than a specified level. A public good is a good or service that is consumed simultaneously by everyone, even if they don t pay for it. Deadweight loss is the decrease in consumer surplus and producer surplus that results from an inefficient level of production. True or false 1. True; page 144 2. False; page 145 3. False; page 145 4. False; page 148 S
98 Part 2. A CLOSER LOOK AT MARKETS Multiple choice 1. a; page 145 2. d; page 145 3. c; page 145 4. d; page 147 5. d; page 148 6. c; page 148 Complete the graph FIGURE 6.8 Price (thousands of dollars per automobile) 40 30 0 Consumer surplus Producer surplus S=MC D=MB 40 60 80 0 1 Quantity (thousands of automobiles per week) 1. In Figure 6.8 the equilibrium quantity of automobiles is 60,000 a week. The efficient quantity of automobiles is also 60,000 a week because that is the quantity at which the marginal benefit equals the marginal cost. The consumer surplus and producer surplus are the shown in the figure; pages 144. FIGURE 6.9 Price (thousands of dollars per automobile) 40 30 0 Deadweight loss S=MC Deadweight loss D=MB 40 60 80 0 1 Quantity (thousands of automobiles per week) 2. When 80,000 automobiles are produced, there is a deadweight loss from overproduction because for the last,000 automobiles, the marginal cost exceeds the marginal benefit. The deadweight loss is the area of the light gray triangle in Figure 6.9. If 40,000 automobiles are produced, there again is a deadweight loss, this time from underproduction, because automobiles for which the marginal benefit exceeds the marginal cost are not produced. The amount of the deadweight loss is the area of dark gray triangle in Figure 6.9; page 148. Short answer and numeric questions 1. Adam Smith was the first to suggest that competitive markets send resources to the uses in which they have the highest value. Smith believed that each participant in a competitive market is led by an invisible hand to promote an end [the efficient use of resources] which is no part of his intention; page 145. 2. If the demand for cotton clothing increases, the demand curve for cotton clothing shifts rightward and the equilibrium quantity increases. The demand curve is the marginal benefit curve, so when the demand curve shifts rightward, the marginal benefit curve also shifts rightward. The efficient quantity also increases; page 145. 3. Governments influence markets by setting price ceilings and floors, production quotas, and taxes and subsidies, all of which can create inefficiency. Other obstacles to achieving an efficient allocation of resources involve externalities, public goods and common resources, and monopoly; pages 147-148. CHECKPOINT 6.4 Fill in the blanks Two views of fairness are that it s not fair if the result isn t fair; and it s not fair if the rules aren t fair. Utilitarianism is a principle that states that we should strive to achieve the greatest happiness for the greatest number. The requirement that people in similar circumstances be treated similarly is the symmetry principle. According to Robert Nozick, fairrules ideas require property rights and voluntary exchange.
Chapter 6. Efficiency and Fairness of Markets 99 True or false 1. False; page 151 2. True; page 152 3. False; page 152 4. False; page 154 Multiple choice 1. b; page 151 2. d; page 152 3. a; page 152 4. b; page 153 5. c; page 153 6. c; page 154 Short answer and numeric questions 1. The tax arrangement is fair from a fairresults view because it leads to a greater equality of income. The tax arrangement is not fair from a fair-results view because the tax is not a voluntary exchange; pages 152-153. 2. From a fair-results view, it is not fair for Pat s income to be substantially higher than Matt s. From a fair-rules view, it is fair because Pat and Matt had the same opportunities; pages 152-153. 3. Income can be transferred from people with high incomes to people with low incomes only by taxing incomes, which discourages work. This tax results in the quantity of labor being less than the efficient quantity. Similarly, taxing income from capital discourages saving, which results in the quantity of capital being less than the efficient quantity. So the greater the amount of income redistribution through income taxes, the greater is the inefficiency and the smaller is the economic pie; page 152. 4. Limiting the price that can be charged is unfair because it compels the seller to help and such compulsion is unfair; page 154.
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