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Chapter 3
Inefficiency: The Pervasive Economic Problem
What's in This Chapter and Why
This chapter continues the development of the function of competitive markets by showing that a
competitive market results in economic efficiency. Efficiency in resource allocation is an important
economic goal. To achieve efficiency, resources must be allocated so that benefits are equal to or
greater than costs and marginal benefits must equal marginal costs. Competitive markets
automatically fulfill these conditions, but there are many instance of inefficiency in the U.S.
economy resulting from market and/or government failure.
Several cases of market failure are examined such as monopoly pricing, the presence of
external benefits and costs, public goods, etc. It is shown in each case that inefficient allocation of
resources result from each market failure and how government regulation aims at correcting the
market failures.
Several cases of government failure are also examined, such as rent controls, agricultural price
supports, government subsidies for medical care, minimum wage, etc. It is shown in each case that
inefficient allocation of resources result from each government failure and how relaxing
government regulation may partly correct the inefficient allocation due to the government failure.
When the various sources of inefficiency are added together, they indicate that inefficiency is a
serious problem for the U.S. economy. Efficiency losses easily exceed a trillion dollars a year. It is
not concluded, however, that eliminating efficiency is a desirable thing to do. There are trade-offs
between efficiency and equity and between efficiency and innovation. These tradeoffs indicate that
some inefficiency is desirable, but they also make it difficult to determine exactly how much this
might be.
Instructional Objectives
After completing this chapter, your students should know:
1. Rules for achieving efficiency in resource allocation in competitive markets.
2. Graphical analysis of efficiency in resource allocation in competitive markets.
3. Market failures and the resulting allocative inefficiency in the private sector. Examples
include: monopoly, external benefits, public goods, external costs, nonexistent markets,
incomplete markets.
4. Government failures and the resulting allocative inefficiency in the public sector. Examples
include: rent controls, agricultural price supports, government-subsidized medical care,
minimum wage, taxes.
5. Tradeoffs between efficiency and equity, and innovation.
27
28  Chapter 3/Inefficiency: The Pervasive Economic Problem
Key Terms
These terms are introduced in this chapter:
Economic efficiency
Static efficiency
Dynamic efficiency
Marginal benefit curve
Marginal cost curve
Total benefit
Total cost
Total net benefit
Market failure
Profit
Total revenue
Efficiency loss
Deadweight loss
External benefits
Marginal external benefits (MEB)
Marginal social benefits (MSB)
Public goods
External costs
Marginal external costs (MEC)
Marginal social costs (MSC)
Nonexistent market
Moral hazard
Adverse selection
Incomplete market
Progressive tax
Regressive tax
Efficiency loss from taxation
Deadweight loss from taxation
Capital gains
Suggestions for Teaching
The approach taken to demand and supply analysis in Chapter 2 makes the discussion of efficiency
easier for students. It is very important to take time to explain the concept of efficiency and the
rules for determining efficient allocation of resources in competitive markets both conceptually,
and graphically. This will save much time in discussion of the topic in the rest of this chapter, and
chapters that follow.
In light of students’ understanding of the concept of efficiency, market failures should be
discussed. Depending upon your objectives for the course, you can either emphasize the formal
monopoly analysis or you can use intuition to argue that a monopoly will charge a higher price and
restrict output. Concepts of external costs and benefits are typically confusing to students. External
costs can best be explained with pollution as an example. External benefits can best be explained
with immunization as an example.
Government failures appears as practical government policy to some students. To encourage
critical thinking, some may choose to spend more time on the last part of the chapter and explain
the shortcomings of efficiency analysis based on premises of rational behavior and perfect
information etc.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. Friedman, Milton, and Rose Friedman. Free to Choose: A Personal Statement. New York:
Harcourt Brace Jovanovich, 1980. An expression of the conservative case for limited
government and the basis of the authors' popular television series.
Instructor's Manual  29
2. Galbraith, John Kenneth. Age of Uncertainty. Boston: Houghton Mifflin, 1977. The liberal case
for an expansive role for government in the U.S. economy.
3. Gordon, David M. Fat and Mean: The Corporate Squeeze of Working Americans and the Myth
of Managerial "Downsizing" New York, NY: Free Press, 1996.
4. Wolf, Charles, Jr. Markets or Governments: Choosing Between Imperfect Alternatives.
Cambridge, MA: MIT Press, 1989.
Outline
I. INTRODUCTION
A. The fundamental premise of Economics is that resources are scarce. Economists recognize
that scarcity cannot be eliminated, but they also believe that its effects can be minimized.
This can be accomplished by allocating resources so that wants are satisfied as fully as
possible. An economy that does this has achieved economic efficiency.
B. An economy that allocates resources efficiently in the short-run achieves static efficiency.
An economy that allocates resources efficiently in the long-run achieves dynamic
efficiency. Only a small percentage of the economy's resources, however - primarily
nonrenewable resources like minerals, fossil fuels and timber, pose a long-run allocation
problem. Accordingly, we will concentrate on the problem of achieving static efficiency.
II. RULES FOR ACHIEVING EFFICIENCY IN RESOURCE ALLOCATION
A. Assuming that benefits can be measured (much more on this below), there is a two-part
rule for determining the efficient amount of a good or service. The first part is that the
benefits provided by a good or service must be equal to or greater than the costs of
providing it. The second part is that the difference between the benefits and costs must be
as large as possible, or maximized.
III. THE COMPETITIVE MARKET: AN EXAMPLE OF EFFICIENCY IN RESOURCE
ALLOCATION
A. The first case is one in which the amount produced and sold is determined solely by
demand and supply.
1. Economists use the maximum amount that buyers are willing to pay for a unit of
something as a measure of the benefit they perceive from buying that unit. Thus, the
demand curve for apartments is also a marginal benefit curve; it indicates the benefits
buyers perceive from each additional, or marginal, unit.
2. Economists use the minimum amount that sellers must receive as a measure of what
must be given up, or the cost, to provide each apartment. Thus, the supply curve for
apartments is also a marginal cost curve; it indicates the costs sellers must pay to
provide each additional, or marginal, unit.
3. The area under the demand curve is a measure of the total benefit to buyers. The area
under the supply curve measures total cost, or the sum of marginal costs.
4. An alternative way to approach this proof is to realize that the difference between total
benefits and total costs is equal to the area between the MB and MC curves. This area,
also known as the total net benefit, is maximized when MB=MC.
IV. MARKET FAILURE: INEFFICIENCY IN THE PRIVATE SECTOR
30  Chapter 3/Inefficiency: The Pervasive Economic Problem
A. There are markets in the economy, however, that do not achieve efficiency. When they do
not, they are said to exhibit market failure.
1. Monopoly: If some market participants have market power in the form of the ability to
affect price, the market will exhibit inefficiency. A good example is that of a
monopoly, a market in which only one seller exists. The monopolist will set the price
at a level that maximizes the profits. The respective quantity will be less than the
efficient level, resulting in efficiency loss (or a deadweight loss) due to monopoly
pricing.
2. External Benefits: In the competitive model we assumed that the demand or marginal
benefit curve provides an accurate measure of all of the benefits realized from
consumption. If third parties benefit from a transaction, external benefits exist–they are
external to the transaction between buyers and sellers. It is not easy to determine the
value of external benefits in real-world cases because they are not included in demand
curves. However, when marginal external benefits (MEB) are added to the marginal
benefits (MB) curves, marginal social benefits (MSB) results as a shift upward in the
MB curve.
3. Public Goods: External benefits are most important in the case where, if a good is
provided to one individual, all other individuals benefit from its provision. Economists
call such goods public goods. National defense is the classic example of a public good.
It is "public" in the sense that if it is provided at all it bestows benefits on the public in
general.
4. External Costs: In the competitive model we assumed that the supply or marginal cost
curve provides an accurate measure of all of the costs of production. If costs are
incurred by third parties from a transaction, external costs exist–they are external to the
transaction between buyers and sellers. When marginal external costs (MEC) are added
to the marginal cost (MC) curve, marginal social benefits (MSC) results as a shift
upward in the MC curve. Cost of pollution is an example of external costs. In presence
of external costs, society over-allocates resources to production of that product,
resulting in inefficiencies. Government regulation (such as Clean Air Act) aims at
internalizing the external cost to correct the market failure.
5. Nonexistent Markets: The situations discussed above-external benefits, public goods,
and external costs-are cases in which the probability that markets could develop and
provide an efficient allocation of resources is small. These are cases of nonexistent
markets. Nonexistent markets characterize two other important events: unemployment
and poverty. In these cases Government steps in and provides unemployment
insurance, and poverty insurance in the form of income support programs. It exacts
"premiums" in the form of taxes.
6. Incomplete Markets: The markets where moral hazard and adverse selection exists are
called incomplete markets. Here, the good or service is available but only to part of the
population of potential consumers. Government intervenes and by regulation adjusts
demand to the efficient quantity.
V. GOVERNMENT FAILURE: INEFFICIENCY IN THE PUBLIC SECTOR
A. To develop a balanced view of the U.S. economy's defects, in addition to examining
market failure, government failures must also be considered. In a manner parallel to the
concept of market failure, government failure occurs whenever government activity is
inconsistent with achieving one of the nation's economic goals. The analysis is confined to
the goal of efficiency.
Instructor's Manual  31
1. Rent Controls: Several local governments in the United States have adopted rent
controls, placing an upper limit on rents that landlords can charge. These limits
commonly keep rents below the market-clearing, or equilibrium, level. When this
happens, landlords supply fewer units than the equilibrium quantity - too few from the
perspective of efficiency - resulting in less than maximum net benefits.
2. Agricultural Price Supports: The U.S. government has a series of programs designed to
keep the prices of various agricultural commodities above the market-clearing, or
equilibrium, level. Such prices induce farmers to produce more than market-clearing
quantities - too much, in fact, from the perspective of efficiency.
3. Government-Subsidized Medical Care: Government provides large subsidies to
consumers of health care through the federal Medicare and the federal-state Medicaid
programs. These programs are designed to improve medical care access for the elderly
(Medicare) and the poor (Medicaid). The cost-sharing arrangements drastically reduce
the perceived price--what the consumer must pay for a unit of medical
care--significantly less than the marginal social cost of medical care--the amount the
consumer and the government together must pay to ensure the production of a unit of
medical care. Acting solely on the part of cost that they pay, consumer-patients buy too
much medical care.
4. Minimum Wage: The United States has a federal law requiring employers to pay
workers in most occupations a minimum wage of $5.15 an hour. The intent of the law
is to increase the income of low-wage workers. Whatever its merits, theoretically it is a
source of inefficiency as it gives rise unemployment.
5. Taxes: How governments spend their money or require private sector participants to
use their resources is not the only source of inefficiency. The ways in which
governments finance their activities are also sources of inefficiency. This is especially
true of taxes.
a. Income Taxes: Taxes collected are the product of the tax rate and the tax base.
Efficiency can be affected by both the size of the tax rate and the design of the tax
base. If individuals’ decision to work is directly dependent on the wage rate,
income taxes would reduce their net income and reduce work hours resulting in
efficiency losses.
b. Sales taxes: A similar tale can be told for the general sales taxes levied at the state
level. The rates associated with these taxes induce taxpayers to spend too little,
creating efficiency losses. There are many exclusions from the tax base, especially
for services, and these exclusions lower the cost of the exempted items relative to
the cost of items subject to taxation. This produces a pattern of too much
consumption of some items and too little of others. The net result is a system of
sales taxation that is characterized by many instances of inefficiency.
c. Excise taxes: Are sales taxes applied to narrow classes of items. They are also
sources of inefficiency. Excise tax rates increase the price of taxed items relative to
non-taxed items, inducing taxpayers to buy too little of the taxed items.
d. The Individual Income Tax and Personal Saving: The overall division of
disposable income into consumption and saving may also be affected by taxes.
Individuals have the choice of spending all of their income during the period in
which it is received or saving it for future consumption. Savings is influenced, in
part, by the interest rate. Thus, the individual income tax applies to interest income
distorts the choice between current consumption and saving. This distortion is the
source of additional efficiency losses from taxation.
32  Chapter 3/Inefficiency: The Pervasive Economic Problem
VI. HOW MUCH EFFICIENCY DO WE WANT?
A. Efficiency Vs. Equity: Tax Trade-offs: We have so far ignored the possibility of desirable
economic goals other than efficiency. Many people are concerned, however, about who
reaps the benefits from and who pays the costs of alternative allocations of resources, or
about who pays the tax bill. They want an allocation of resources or a distribution of the
tax burden treats particular individuals or groups equitably or fairly.
Since the tax system is a source of inefficiency there is interest in redesigning it to reduce
the efficiency costs of taxation. This could be done, for example, by reducing marginal
income tax rates or by eliminating some of the exclusions, deductions, and credits
pertaining to this tax. The largest increase in efficiency via rate reductions could be
achieved by reducing the higher bracket rates more than the lower bracket rates. This
would tend to shift a greater portion of the tax burden, however, to lower income taxpayers
and many people would consider this to be a less equitable distribution of the tax burden.
Alternatively, efficiency could be enhanced by taxing income that is currently excluded
from the tax base. This could be done, for example, by eliminating the child-care tax credit,
but many people would object to this on the grounds that the costs of this change would
fall primarily on lower-income households. Many trade-offs between efficiency and equity
such as these would be involved in any attempts to reduce the efficiency costs of taxation.
B. Efficiency vs. Innovation: There are trade-offs, as well, between achieving greater
efficiency and more innovation in the economy.
C. Efficiency and Equity: Efforts to achieve greater efficiency do not always create conflicts
of the type noted above. There are cases where we could increase efficiency and equity at
the same time - or at least be unlikely to reduce equity significantly as efficiency increases.
1. Agricultural Price Supports: Although federal farm programs supposedly are designed
to attack farm poverty, however, the evidence indicates that price-support and
target-price programs give the biggest benefits to farmers who produce the most and
surely have the most wealth. Given this result, it seems possible to reduce some of the
inefficiency created by these programs without seriously violating notions of equity.
2. Minimum Wage: A similar verdict seems in order for the federal minimum wage. A
recent study finds evidence that the minimum wage largely redistributes income among
low-income families. Thus, it seems possible to reduce the application of this measure
without imposing significant additional costs on low-income families as a group. That
is, most of the gainers and losers from such a measure would be in the same income
category.
3. Medicare and Medicaid: Government-subsidized medical care is a source of
inefficiency. Poor families and individuals benefit significantly, however, from these
subsidies through the Medicare and (especially) Medicaid programs. One potential
solution to the problem of reducing inefficiency without great harm to the welfare of
these groups is to provide them with vouchers that they could use to pay for medical
care directly. The vouchers could be issued in a smaller amount than the current
subsidy because the existence of too much medical care is evidence that the care is
worth less to consumers than the cost of providing it. The vouchers, themselves, would
provide consumers of medical care with the incentive and the means to be more careful
shoppers.
D. Efficiency Offsets to Inefficiency: There are cases in which one source of inefficiency is
offset to some degree by other sources of efficiency. Some examples of taxes illustrate this
point clearly. Excise taxes on cigarettes are a case in point. Cigarette smoking is a source
of external costs in the form of second-hand smoke. Without excise taxes on cigarettes,
Instructor's Manual  33
there will be too many cigarettes consumed from an efficiency perspective. Application of
the excise tax will reduce cigarette consumption, creating efficiency losses from taxation
but reducing efficiency losses from second-hand smoke. The two effects may or may not
offset each other, but the excise tax certainly works in this instance as a corrective
measure.
Answers to Review Questions
1. What do we mean by market failure? By government failure?
When markets in the economy do not achieve efficiency, they are said to exhibit market failure.
When market failures occur the society either over-allocates or under-allocates resources to
production of goods. Market failures occur, for example, in presence of monopolies, external
benefits, or external costs. Government failure occurs when governments spend their money or
require private sector participants to use their resources becomes a source of inefficiency. The
ways in which governments finance their activities can also be a source of inefficiency. This is
especially true of taxes.
2. What conditions must be fulfilled to achieve economic efficiency?
The objective of economic activity is to satisfy wants, but economists have no direct measure
of the "want-satisfying power" of goods and services. They are forced to work, instead, with
proxy measures of the "benefits" that individuals derive from goods and services. Assuming
that benefits can be measured, there is a two-part rule for determining the efficient amount of a
good or service.
1. The benefits provided by a good or service must be equal to or greater than the costs of
providing it.
2. The difference between the benefits and costs must be as large as possible, or maximized.
The rule for efficiency in resource allocation is nothing more than the common sense notion
that you're not doing the best you can until you maximize the difference between what you get
and what you give up to get it. It takes something more than common sense, however, to
determine benefits and costs. For goods and services that are produced and sold in markets, the
demand curve provides the information needed to determine benefits and the supply curve
provides the information needed to determine costs.
3. Explain how a competitive market achieves economic efficiency automatically.
In a competitive market the amount produced and sold is determined solely by demand and
supply. As an example, take the demand (D) for, and supply (S) of, apartments for rent in
Kansas City shown in the following figure.
34  Chapter 3/Inefficiency: The Pervasive Economic Problem
The height of the demand curve for each apartment indicates the maximum monthly rent that
buyers are willing to pay for that apartment. The above figure indicates that buyers are willing
to pay $800 for the 100,000th apartment, slightly less for the next apartment, $700 for the
200,000th apartment, and so on. Economists use the maximum amount that buyers are willing
to pay for a unit of something as a measure of the benefit they perceive from buying that unit.
Thus, the demand curve for apartments is also a marginal benefit curve; it indicates the benefits
buyers perceive from each additional, or marginal, unit.
The height of the supply curve for apartments indicates the minimum monthly rent that sellers
must receive for each apartment. For example, above figure indicates that sellers must receive
at least $100 for the 100,000th apartment, slightly more for the next one, $200 for the 200,000th
apartment, and so on. Economists use the minimum amount that sellers must receive as a
measure of what must be given up, or the cost, to provide each apartment. Thus, the supply
curve for apartments is also a marginal cost curve; it indicates the costs sellers must pay to
provide each additional, or marginal, unit.
The area under the demand curve is a measure of the total benefit to buyers. Thus, the total
benefit from the first 100,000 units is $85,000,000 - calculated as the sum of two areas under
the demand curve: the rectangle bounded by the points $800, A, 100,000 units and 0, and the
triangle bounded by the points $900, A and $800. The total benefit of all 900,000 units, or the
area under the entire demand curve, is $405,000,000 - the area of the triangle bounded by the
points $900, 900,000 units, and 0.
Instructor's Manual  35
The area under the supply curve measures total cost, or the sum of marginal costs. Thus, the
total cost of the first 100,000 apartments is $5,000,000 (the triangle bounded by the points, 0,
100,000 units, and B. And the total cost of the first 500,000 units is $125,000,000 - the value of
a triangle with a height of $500 and base of 500,000 units.
Total benefits are greater than total costs all the way up to the last, or 900,000th apartment (the
reader should verify this by calculating the areas under the MB and MC curves). However,
efficiency requires provision of the number of apartments where the difference between total
benefit and total cost is maximized. This occurs at 450,000 units. This can be confirmed by
noting that MB>MC for all apartments up to 450,000 units and that MB<MC for all apartment
units beyond 450,000. Thus, each apartment rented up to 450,000 units adds to the difference
between benefits and costs. Beyond 450,000 units, however, each apartment yields benefits
less than costs, so each additional apartment reduces the total difference between benefits and
costs. It follows that the total difference between benefits and costs must be the largest at
450,000 units.
4. Describe two cases in which the market produces an inefficiently small quantity. Explain why.
In a monopoly, where there is only one seller, the seller has the market power, and the able to
set the market price. The monopolist will set the price at the level where its profits are
maximized. The profit-maximizing price is normally higher than the price determined by the
forces of demand and supply. This makes the monopoly inefficient in the sense that too little is
produced and too few resources are allocated to the monopolized market.
In the competitive model it is assumed that the demand or marginal benefit curve provides an
accurate measure of all of the benefits realized from consumption. However, external benefits
would exist, if third parties benefit from transaction between buyers and sellers. In presence of
external benefits, the marginal social benefit would be greater than the marginal benefit,
implying that society under-allocates resources and produces an inefficiently small amount, if
society produced at the apparently efficient level where MB=MC.
5. Describe and explain two cases in which markets produce too much from the perspective
of economic efficiency.
In the competitive model it is assumed that the supply or marginal cost curve provides an
accurate measure of all of the costs of production. However, external costs would exist, if third
parties incur costs (are harmed) from transaction between buyers and sellers. In presence of
external costs, the marginal social cost would be greater than the marginal cost by the amount
of marginal external costs, implying that society over-allocates resources and produces an
inefficiently large amount, if society produced at the apparently efficient level where MB=MC.
The best example for external costs is pollution. If coal is burned to heat an apartment, and that
harmful byproducts - pollutants - of coal combustion escape from the apartments and drift
across the city. People who are particularly sensitive to these pollutants suffer physically. Some
become ill and miss work. Many see the doctor more frequently. Some curtail their outdoor
activities. Some buy filtration systems for their homes. The income they forgo, the money they
spend at the doctor, the value to them of the activities they give up, and their outlays for
filtration systems all are examples of external costs imposed by apartment dwellers. These
costs are not reflected in the rent. Through regulation, government internalized these external
costs, for example with pollution taxes, and imposing maximum pollution levels. This
increases the rent and reduces the equilibrium quantity of the apartments that are demanded.
36  Chapter 3/Inefficiency: The Pervasive Economic Problem
6. Explain why the resolution of the problems of unemployment and poverty cannot be left
up to the market.
Life is full of risks-risks that might lead to accidents, fire, inflation, disability, natural disasters,
and unemployment and poverty. The market system responds to these risks by offering
insurance. However, it cannot insure against unemployment and poverty. Why? Suppose
people want to purchase insurance against the possibility of becoming unemployed or poor.
Would a private insurance firm find it profitable to supply unemployment or poverty
insurance? No, because if individuals purchased such insurance, they might decide not to work
so hard. To discourage such behavior, insurers would have to monitor behavior to determine if
an individual's low income sprang from circumstances beyond his or her control or from
shirking. Such monitoring would be difficult, if not impossible, and certainly expensive.
Hence, no market exists for unemployment and poverty insurance. Government steps in and
provides unemployment insurance, and poverty insurance in the form of income support
programs. It exacts "premiums" in the form of taxes.
7. Describe and explain two cases in which government policies cause too many resources to
be allocated to an activity.
Agricultural price supports refer to the U.S. government programs designed to keep the prices
of various agricultural commodities above the market-clearing, or equilibrium, level. Such
prices induce farmers to produce more than market-clearing quantities - too much, in fact, from
the perspective of efficiency.
These points are illustrated in the following figure, which depicts the market for wheat. The
equilibrium price and quantity are Pe and Qe, respectively. If the government supports the price
at Ps, farmers will produce Qs bushels, a quantity resulting in efficiency losses equal to area
E,S,M.
Rent per bushel ($)
Instructor's Manual  37
S, MC
Ps
S
Pe
E
M
D, MB
0
Qe
Qs
Number of bushels
Government also provides large subsidies to consumers of health care through the federal
Medicare and the federal-state Medicaid programs. These programs are designed to improve
medical care access for the elderly and the poor by lowering the cost of each unit of medical
care received or consumed by Medicare and Medicaid patients. These cost-sharing
arrangements reduce the perceived price of a hospital stay below the marginal social cost of
medical care. Acting solely on the part of cost that they pay, consumer-patients buy too much
medical care.
These points are illustrated in the following figure, which represents the market for medical
care. MC is the minimum amount that suppliers must receive to pay the costs of providing each
unit. The line Pc represents the amount that consumers pay for each unit. The difference
between MC and Pc per unit is the share of costs paid by the government. Consumers will want
to buy all units for which the perceived benefit per unit - the marginal benefit - is greater than
or equal to Pc. Thus, consumers will choose to buy Qc, resulting in efficiency losses equal to
area ESM.
Price per unit ($)
38  Chapter 3/Inefficiency: The Pervasive Economic Problem
S, MC
S
Government’s
Pe
E
Share
Pc
M
Consumer’s Share
D, MB
0
Qe
Qc
Units of Medical Care
Quantity (Q)
8. In determining the effect of income taxes on individual work effort, the key is the highest
marginal tax rate faced by an individual. Explain.
The individual income tax is an example of a progressive tax, one for which the tax rate
increases as taxable income increases. The payroll tax is an example of a regressive tax, one for
which the tax rate decreases as taxable income increases. The 2001 marginal income tax rate
for income over $297,351 was 39.1 percent, while it was 15 percent for income up to $45,200.
It has been argued that income taxes collected are the product of the tax rate and the tax base,
hence, efficiency can be affected by both the size of the tax rate and the design of the tax base.
If individuals’ decision to work is directly related to the wage rate, income taxes would reduce
their net income and reduce work hours resulting in efficiency losses. Due to the progressive
nature of the income tax system, at higher incomes percent taxes increase and net income
becomes relatively smaller, creating a disincentive to work and greater efficiency losses from
taxation.
9. A study has been done of a government program that provides the following benefits to,
and imposes the following costs on, two groups of individuals:
a. From the perspective of efficiency alone, should the program be undertaken? Why or
why not?
b. Suppose that group A consists of rich people and that group B consists of poor people,
and that it has been determined that a dollar to a poor person is worth three times as
much as a dollar to a rich person. Should the program be undertaken? Why or why
not?
c. What trade-off is illustrated by part b of this question? Explain.
a. The two-part rule for determining the efficient amount of a good or service requires that:
1. The benefits provided by a good or service must be equal to or greater than the costs of
providing it, and
2. The difference between the benefits and costs must be as large as possible, or
Instructor's Manual  39
maximized.
The information provided above, satisfies the first condition for group A but not group b
considered by themselves. However, as a whole the total benefit is $150 million for both
groups and total cost is $125 million. Thus, the first condition is satisfied. But the second
condition for efficiency is not met since marginal benefit is not equal to marginal cost. No,
this is not an efficient program.
b. If the dollar to a poor person is worth three times as much as a dollar to a rich person, the
benefits to group be would be $150 million. Therefore, the total benefit $250 million is
greater than total cost $125 million, and the marginal benefit is equal to marginal cost. So
this program is efficient.
c. The tradeoff between efficiency and equity. At the core of the problem is that benefits
cannot be measured well since they are subjective.
S1, MC1
Price per Unit
S2, MC2
B
E
C
P1
L
P2
M
F
H
G
D, MB
A
I
0
Q1
J
Q2
K
Q3
Quantity per Month
10. Many communities in the United States experience droughts each year.
a. Use a supply-demand diagram to illustrate the effects of a drought on the equilibrium
price and quantity of water in such a community.
b. Suppose the city authorities do not allow the price of water to change as indicated in
your diagram. Use your diagram to illustrate the effect of such a pricing policy on
efficiency.
a. The above diagram shows the demand and supply for water. In absence of a drought, the
market price and quantity would be P2 and Q2 respectively. A drought would reduce the
supply and the new equilibrium price and quantity would be would be P1 and Q1
respectively. The price of water would naturally rise.
b. During a drought the equilibrium price and quantity would be would be P1 and Q1
respectively. The total benefit is represented by the area under the MB curve, which is
40  Chapter 3/Inefficiency: The Pervasive Economic Problem
0BCQ1 and the total cost is represented by the area under the MC curve, which is 0LCQ1.
Thus, the net benefit is LBC. If the city authorities keep the price low at P2, since the
quantity of water cannot increase, the net benefits would increase by area P2LCM,
however, the second condition for efficiency (MB=MC) would not be satisfied.
11. Suppose that the market for apartments for rent in your community is described by the
following data:
Determine the following
a. The equilibrium quantity of apartments
b.
c.
d.
e.
f.
Rent Per
Apartments
Apartments
Month
Demanded
Supplied
$2,000
0
20,000
$1,800
2,000
18,000
$1,600
4,000
16,000
$1,400
6,000
14,000
$1,200
8,000
12,000
$1,000
10,000
10,000
$800
12,000
8,000
$600
14,000
6,000
$400
16,000
4,000
$200
18,000
2,000
$0
20,000
0
Total benefits at equilibrium
Total costs at equilibrium
Total net benefits at equilibrium
Total revenue at equilibrium
Suppose that Bill Gateway buys all the apartments in your community and engages in
monopoly pricing. As a result, the number of units rented falls to 7,000 (you might
want to prove this as an advanced exercise) and the price rises to $14,000. How large
is the efficiency loss from monopoly pricing?
Instructor's Manual  41
a.
b.
c.
d.
The equilibrium quantity of apartments is 10,000
The total benefit at equilibrium is $15,000,000 or the area 0ABC
The total cost at equilibrium is $5,000,000 or the area 0BC
Total net benefits at equilibrium is total benefits minus total costs, $15,000,000 $5,000,000 = $10,000,000 or the area 0AB.
e. Total revenues at equilibrium is the product of equilibrium price and quantity, $1,000 x
10,000 = $10,000,000 or the area 0EBC.
f. Under the described conditions, the efficiency or deadweight losses resulting from
monopoly pricing would be $900,000 or the area GHB.
12. Use the diagram you have constructed for your answer to question 11 (without Bill
Gateway) to illustrate the efficiency losses from air pollution. Suppose that each
apartment produces smoke that impairs health in the community by an average of $400
per apartment per month.
The marginal external cost (MEC) for each apartment per month would be $400. Adding that
to the marginal cost (MC) or the supply curve, shifts it up, and the result is the marginal social
curve (MSC) as shown in the following figure.
Given this change, the difference between total benefits (the area under the demand or MB
curve) and total costs, or total net benefit, is maximized at 800,000 units. Total net benefit at
this level is $6,400,000 (area ALI). If 10,000 units are rented, as in a competitive market, total
net benefits will decrease by $400,000 (the triangle IKB). Thus, the competitive market
solution is marked by inefficiency, characterized by an allocation of too many resources to
apartments.
42  Chapter 3/Inefficiency: The Pervasive Economic Problem