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ECONOMICS 5e
Michael Parkin
CHAPTER
6
Efficiency and Equity
Learning Objectives
• Define efficiency
• Distinguish between value and price and
define consumer surplus
• Distinguish between cost and price and
define producer surplus
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Learning Objectives (cont.)
• Explain the conditions in which competitive
markets move resources to their highestvalued uses
• Explain the sources of inefficiency in our
economy
• Explain the main ideas about the fairness
and evaluate claims that competitive
markets result in unfair outcomes
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Learning Objectives
• Define efficiency
• Distinguish between value and price and
define consumer surplus
• Distinguish between cost and price and
define producer surplus
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Efficiency: A Refresher
According to economists, efficiency means
the resources have been used to produce the
goods and services that people value the
most.
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Efficiency: A Refresher
Marginal benefit is the benefit that a person
receives from consuming one more unit of a
good or service.
Measured as the maximum amount that a
person is willing to give up for one additional
unit.
Principle of decreasing marginal benefit:
Marginal benefit decreases as consumption
increases.
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Efficiency: A Refresher
Marginal cost is the opportunity cost of
producing one more unit of a good or
service.
Measured as the value of the best alternative
foregone.
Principle of increasing marginal cost:
Marginal cost increases as the quantity
produced increases.
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Efficiency and Inefficiency
Efficiency depends upon a comparison of
marginal cost and marginal benefit.
Three possibilities:
• Marginal benefit exceeds marginal cost.
• Marginal cost exceeds marginal benefit.
• Marginal benefit equals marginal cost.
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Efficiency and Inefficiency
What is the economically efficient
quantity of pizza?
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Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of Pizza
25
Pizza valued more
highly than it costs:
Increase production
MC
Pizza costs more
than it is valued:
Decrease
production
20
15
10
5
0
Efficient quantity
of pizza
5
10
15
MB
20
Quantity (thousands of pizzas per day)
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Learning Objectives
• Define efficiency
• Distinguish between value and price and
define consumer surplus
• Distinguish between cost and price and
define producer surplus
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Value, Price, and
Consumer Surplus
What is meant by “Value”?
• Value of an item is the same thing as its
marginal benefit.
• Marginal benefit - the maximum price people
are willing to pay for an additional unit.
• Willingness determines demand.
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Price (dollars per pizza)
Demand, Willingness to Pay,
and Marginal Benefit
25
Price determines
quantity demanded
20
15
10
5
Quantity of pizzas
demanded at $15
a pizza
0
5
D
10
15
20
Quantity (thousands of pizzas per day)
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Price (dollars per pizza)
Demand, Willingness to Pay,
and Marginal Benefit
Quantity determines
willingness to pay
25
20
15
5
Maximum price
willingly paid for
the 10,000th
pizza
0
5
10
10
D=MB
15
20
Quantity (thousands of pizzas per day)
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Consumer Surplus
Consumer surplus is the value of a good
minus the price paid for it.
If a person buys something for less than they
are willing to pay for it, a consumer surplus
exists.
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Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
Consumer
surplus
Lisa’s consumer
surplus from the
10th pizza
2.00
Market
price
1.50
1.00
Amount
paid
0.50
0
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10
20
30
D
40
Quantity (slices of pizzas per week)
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Learning Objectives
• Define efficiency
• Distinguish between value and price and
define consumer surplus
• Distinguish between cost and price and
define producer surplus
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Cost, Price, and
Producer Surplus
Cost vs. Price
• Cost is what the producer gives up.
• Price is what the producer receives.
Marginal cost is the cost of producing one more
unit.
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Price (dollars per pizza)
Supply, Minimum Supply-Price,
and Marginal Cost
25
Price determines
quantity supplied
S
20
15
10
Quantity of pizzas
supplied at $15
a pizza
5
0
50
100
150
200
Quantity (thousands of pizzas per day)
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Price (dollars per pizza)
Supply, Minimum Supply-Price,
and Marginal Cost
Quantity determines
minimum supply price
25
20
S=MC
Minimum supplyprice for 10,000th
pizza
15
10
5
0
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50
100
150
200
Quantity (thousands of pizzas per day)
TM 6-‹#›
Learning Objectives
• Distinguish between value and price
• Define consumer surplus
• Distinguish between cost and price
• Define producer surplus
• Explain why consumer surplus and
producer surplus are the gains from trade
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Producer Surplus
Producer surplus is the value of a good
minus the opportunity cost of producing it.
If a firm sells something for more that it costs
to produce, a producer surplus exists
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Price (dollars per pizza)
A Producers Supply
and Producer Surplus
Max’s producer
surplus from the
50th pizza
25
20
S = MC
Market
price
Producer
surplus
15
10
Cost
of Production
5
0
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50
100
150
200
Quantity (pizzas per day)
TM 6-‹#›
Learning Objectives
• Explain the conditions in which competitive
markets move resources to their highestvalued uses
• Explain the sources of inefficiency in our
economy
• Explain the main ideas about the fairness
and evaluate claims that competitive
markets result in unfair outcomes
Copyright © 1998 Addison Wesley Longman, Inc.
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Is the Competitive
Market Efficient?
Recall:
Supply and demand will force the price
toward the equilibrium price.
Question: Is this the efficient quantity of
pizza?
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Price (dollars per pizza)
An Efficient Market for Pizza
25
Consumer
surplus
S
Marginal cost-(opportunity cost)
--of pizza
20
15
Marginal benefit-(value)--of pizza
10
Producer
surplus
0
5
Efficient quantity
of pizzas
10
15
D
20
Quantity (thousands of pizzas per day)
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Is the Competitive
Market Efficient?
At Competitive Equilibrium
• Resources are being used efficiently.
• The sum of consumer surplus and producer
surplus is maximized.
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The Invisible Hand
Adam Smith - Wealth of Nations in 1776
Participants in a competitive market is “led by
an invisible hand to promote an end (the
efficient use of resources) which was not part of
his intention.”
Copyright © 1998 Addison Wesley Longman, Inc.
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Learning Objectives (cont.)
• Explain the conditions in which competitive
markets move resources to their highestvalued uses
• Explain the sources of inefficiency in our
economy
• Explain the main ideas about the fairness
and evaluate claims that competitive
markets result in unfair outcomes
Copyright © 1998 Addison Wesley Longman, Inc.
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Sources of Inefficiency
• Price ceilings and floors
• Taxes, subsidies, and quotas
• Monopoly
• Public goods
• External costs and benefits
These lead to underproduction or
overproduction.
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Sources of Inefficiency
Deadweight Loss
The decrease in consumer and producer
surplus that results from an inefficient
allocation of resources.
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Price (dollars per pizza)
Underproduction and
Overproduction
Underproduction
25
S
Deadweight
loss
20
15
10
5
D
0
5
10
15
20
Quantity (thousands of pizzas per day)
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Price (dollars per pizza)
Underproduction and
Overproduction
Overproduction
25
20
S
Deadweight
loss
15
10
5
D
0
5
10
15
20
Quantity (thousands of pizzas per day)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 6-‹#›
Learning Objectives (cont.)
• Explain the conditions in which competitive
markets move resources to their highestvalued uses
• Explain the sources of inefficiency in our
economy
• Explain the main ideas about the fairness
and evaluate claims that competitive
markets result in unfair outcomes
Copyright © 1998 Addison Wesley Longman, Inc.
TM 6-‹#›
Is the Competitive Market Fair?
Economists agree about efficiency but they
do not agree about fairness.
It’s not fair if the result isn’t fair.
• Utilitarianism
• The Big Tradeoff
• Make the Poorest as Well off as Possible
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Utilitarianism
• Utilitarianism (also: utilism) is the idea that the
moral worth of an action is determined solely by
its usefulness in maximizing utility and
minimizing negative utility (utility can be defined
as pleasure, preference satisfaction, knowledge or
other things) as summed among all sentient
beings. It is thus a form of consequetialism,
meaning that the moral worth of an action is
determined by its outcome. The most influential
contributors to this theory are considered to be
Jeremy Bentham and John Stuart Mill (18061873).
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Is the Competitive Market Fair?
Economists agree about efficiency but they
do not agree about fairness.
It’s not fair if the rules aren’t fair
• Fairness and Efficiency
• A Price Hike in a Natural Disaster
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Is the Competitive Market Fair?
Utilitarianism
A principle that states that we should
strive to achieve “the greatest happiness
for the greatest number.”
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Marginal benefit (units)
Is the Competitive Market Fair?
Tom
a
3
c
2
Maximum
total
benefit
Jerry
b
1
MB
0
5
25
45
Income (thousands of dollars)
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Is the Competitive Market Fair?
The Big Tradeoff
Recognizing the cost of making income
transfers leads to what is called “the big
tradeoff,” which is a tradeoff between
efficiency and fairness.
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Is the Competitive Market Fair?
Make the Poorest as Well Off as Possible
Harvard philosopher, John Rawls, proposed
a modified version of utilitarianism in a
classic book entitled A Theory of Justice,
published in 1971. Rawls says that, taking
all the costs of income transfers into
account, the fair distribution of the economic
pie is the one that makes the poorest person
as well off as possible.
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Is the Competitive Market Fair?
The Symmetry Principle
The requirement that people in similar
situations be treated similarly.
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Is the Competitive Market Fair?
Fairness and Efficiency
If private property rights are enforced and
if voluntary exchange takes place in
competitive markets, and if there are no:
• Price ceilings and floors
• Taxes, subsidies, and quotas
• Monopoly
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Is the Competitive Market Fair?
Fairness and Efficiency (cont.)
• Public goods
• External costs and benefits
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Is the Competitive Market Fair?
A Price Hike in a Natural Disaster
• Shop offers water for $4.
• Government buys water.
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The End
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