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EFFICIENCY AND
EQUITY
5
CHAPTER
Objectives
After studying this chapter, you will able to
 Define efficiency
 Distinguish between value and price and define
consumer surplus
 Distinguish between cost and price and define producer
surplus
 Explain the conditions under which markets move
resources to their highest-valued uses and the sources
of inefficiency in our economy
 Explain the main ideas about fairness and evaluate
claims that markets result in unfair outcomes
More for Less
People are constantly striving to get more for less.
Could we get more out of our scarce resources if we used
them differently or is our use efficient?
Are market outcomes fair outcomes?
This chapter explains the conditions under which
competitive markets achieve an efficient outcome.
It describes the sources of inefficiency.
It explores the concept of fairness.
Efficiency: A Refresher
An efficient allocation of resources occurs when we
produce the goods and services that people value most
highly.
Resources are allocated efficiently when it is not possible
to produce more of a good or service without giving up
some other good or service that is valued more highly.
Efficiency is based on value, which is determined by
people’s preferences.
Efficiency: A Refresher
Marginal Benefit
Marginal benefit is the benefit a person receives from
consuming one more unit of a good or service.
We can measure the marginal benefit from a good or
service by the dollar value of other goods and services
that a person is willing to give up to get one more unit of it.
The concept of decreasing marginal benefit implies that as
more of a good or service is consumed, its marginal
benefit decreases.
Efficiency: A Refresher
Figure 5.1 shows the
decreasing marginal
benefit from each
additional slice of pizza,
measured in dollars per
slice.
Efficiency: A Refresher
Marginal Cost
Marginal cost is the opportunity cost of producing one
more unit of a good or service. The measure of marginal
cost is the value of the best alternative forgone to obtain
the last unit of the good.
We can measure the marginal cost of a good or service by
the dollar value of other goods and services that a person
is must give up to get one more unit of it.
The concept of increasing marginal cost implies that as
more of a good or service is produced, its marginal cost
increases.
Efficiency: A Refresher
Figure 5.1 shows the
increasing marginal cost
of each additional slice
of pizza, measured in
dollars per slice.
Efficiency: A Refresher
Efficiency and
Inefficiency
If the marginal benefit
from a good exceeds its
marginal cost, producing
and consuming more of
the good uses resources
more efficiently.
Efficiency: A Refresher
If the marginal cost of a
good exceeds its
marginal benefit,
producing and
consuming less of the
good uses resources
more efficiently.
Efficiency: A Refresher
If the marginal cost of a
good equals its marginal
benefit, resources are
being used efficiently.
Value, Price, and Consumer Surplus
Value, Willingness to Pay, and Demand
The value of one more unit of a good or service is its
marginal benefit, which we can measure as the maximum
price that a person is willing to pay.
A demand curve for a good or service shows the quantity
demanded at each price.
A demand curve also shows the maximum price that
consumers are willing to pay at each quantity.
Value, Price, and Consumer Surplus
Figure 5.2 shows these
two ways of interpreting a
demand curve.
In part a, shown here, the
demand curve tells us the
quantity that consumers
plan to buy at a given
price.
Value, Price, and Consumer Surplus
In part b, shown here, the
demand curve tells us the
maximum price that
consumers are willing to
pay for a given quantity.
This price measures the
marginal benefit of the
good at that given quantity.
Value, Price, and Consumer Surplus
Consumer Surplus
Consumer surplus is the value of a good minus the price
paid for it, summed over the quantity bought.
It is measured by the area under the demand curve and
above the price paid, up to the quantity bought.
Figure 5.3 on the next slide shows the consumer surplus
for pizza for an individual consumer.
Value, Price, and Consumer Surplus
The price paid is the
market price, which is the
same for each unit bought.
The quantity bought is
determined by the demand
curve, and the blue
rectangle shows the
amount paid for pizza.
The green triangle shows
the consumer surplus from
pizza.
Value, Price, and Consumer Surplus
The consumer surplus on
the 10th slice is the $2 that
the consumer is willing to
pay minus the $1.50 that
she does pay, which is 50
cents a slice.
Cost, Price, and Producer Surplus
Cost, Minimum Supply-Price, and Supply
The cost of one more unit of a good or service is its
marginal cost, which we can measure as the minimum
price that a firm is willing to accept.
A supply curve of a good or service shows the quantity
supplied at each price. A supply curve also shows the
minimum price that producers are willing to accept at each
quantity.
Cost, Price, and Producer Surplus
Figure 5.4 shows these
two ways of interpreting a
supply curve.
In part a, shown here, the
supply curve tells us the
quantity that producers
plan to sell at a given
price.
Cost, Price, and Producer Surplus
In part b, shown here, the
supply curve tells us the
minimum price that
producers are willing to
accept for a given quantity.
This price measures the
marginal cost of producing
that given quantity of the
good.
Cost, Price, and Producer Surplus
Producer Surplus
Producer surplus is the price of a good minus the
marginal cost of producing it, summed over the quantity
sold.
Producer surplus is measured by the area below the price
and above the supply curve, up to the quantity sold.
Figure 5.5 on the next slide shows the producer surplus
for pizza for an individual producer.
Cost, Price, and Producer Surplus
The price is the market
price, which is the same
for each unit sold.
The quantity sold is
determined by the supply
curve and the red area
shows the total cost of
producing pizza.
The blue triangle shows
the producer surplus from
pizza.
Cost, Price, and Producer Surplus
The producer surplus on
the 50th pizza is the $15
that the producer receives
minus the $10 that it cost
to produce, which is $5 a
pizza.
Is the Competitive Market Efficient?
Efficiency of Competitive
Equilibrium
Figure 5.6 shows that a
competitive market creates
an efficient allocation of
resources at equilibrium.
In equilibrium, the quantity
demanded equals the
quantity supplied.
Is the Competitive Market Efficient?
At the equilibrium quantity,
marginal benefit equals
marginal cost, so the
quantity is the efficient
quantity.
The sum of consumer and
producer surplus is
maximized at this efficient
level of output.
Is the Competitive Market Efficient?
The Invisible Hand
Adam Smith’s “invisible hand” idea in the Wealth of
Nations implied that competitive markets send resources
to their highest-valued use in society.
Consumers and producers pursue their own self-interest
and interact in markets.
Market transactions generate an efficient—highest
valued—use of resources.
Is the Competitive Market Efficient?
The Invisible Hand at Work Today
The invisible hand works in our economy today.
It coordinates the self-interest of producers and
consumers of computers, oranges, and just about every
good or service that you can think of.
The cartoon on page 109 shows how the invisible hand
sometimes works in surprising ways.
Is the Competitive Market Efficient?
Obstacles to Efficiency
Markets are not always efficient and the obstacles to
efficiency are:
 Price ceilings and floors
 Taxes, subsidies, and quotas.
 Monopoly
 Public goods
 External costs and external benefits.
Is the Competitive Market Efficient?
Underproduction and
Overproduction
Obstacles to efficiency
lead to underproduction or
overproduction and create
a deadweight loss—a
decrease in consumer and
producer surplus.
Is the Competitive Market Efficient?
Figure 5.7a shows the
effects of underproduction.
The efficient quantity is
10,000 pizzas a day.
If production is restricted to
5,000 pizzas a day, a
deadweight loss arises
from underproduction.
Is the Competitive Market Efficient?
Figure 5.7b shows the
effects of overproduction.
Again, the efficient quantity
is 10,000 pizzas a day.
If production is expanded
to 15,000 pizzas a day, a
deadweight loss arises
from overproduction.
Is the Competitive Market Fair?
Ideas about fairness can be divided into two groups:
 It’s not fair if the result isn’t fair
 It’s not fair if the rules aren’t fair
Is the Competitive Market Fair?
It’s Not Fair if the Result Isn’t Fair
The idea that “it’s not fair if the result isn’t fair” began with
utilitarianism, which is the principle that states that we
should strive to achieve “the greatest happiness for the
greatest number.”
If everyone gets the same marginal utility from a given
amount of income, and if the marginal benefit of income
decreases as income increases, 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.
Is the Competitive Market Fair?
Figure 5.8 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 until
they have equal incomes
increases total benefit.
Is the Competitive Market Fair?
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.
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, which is the requirement that
people in similar situations be treated similarly.
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:
 The state must create and enforce laws that establish
and protect private property.
 Private property may be transferred from one person to
another only by voluntary exchange.
Pages 114–115 present an extended illustration of two
proposals for achieving a fair and efficient use of
resources.
EFFICIENCY AND
EQUITY
THE END
5
CHAPTER