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Chapter 4
EFFICIENCY IN RESOURCE ALLOCATION: HOW MUCH DO WE
HAVE? HOW MUCH DO WE WANT?
What's in This Chapter and Why
This chapter discusses efficiency in resource allocation through an examination of competitive
markets. 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. Usually, competitive markets will automatically fulfill these conditions,
but there are many instance of inefficiency in the U.S. economy resulting from failure in the market
or government policy.
Several cases of market failure are examined such as monopoly pricing, the presence of
external benefits and costs, public goods, and imperfect markets. The inefficient allocation of
resources caused by market failure is shown for each case. Government regulation designed to
correct the market failures are also discussed.
Several cases of government failure are also examined, such as rent controls, agricultural price
supports, government subsidies for medical care, minimum wage, and taxes. 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 acceptable, 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. The rules for achieving allocative efficiency in competitive markets.
2. How to graphically demonstrate the allocative efficiency in competitive markets.
3. When market failures occur and the resulting allocative inefficiency in the private sector.
Examples include: monopoly, external benefits, public goods, external costs, and imperfect
markets.
4. When government failures occur and the resulting allocative inefficiency in the public sector.
Examples include: rent controls, agricultural price supports, government-subsidized medical
care, minimum wage, taxes.
5. The tradeoffs that exist between efficiency and equity and efficiency and innovation.
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Key Terms
These terms are introduced in this chapter:
Efficiency in resource
allocation (allocative
efficiency)
Static allocative efficiency
Dynamic allocative
efficiency
Marginal benefit curve
(demand curve)
Marginal cost curve
(supply curve)
Total benefit
Total cost
Total net benefit
Market failure
Profit
Total revenue
Allocative efficiency loss
(deadweight loss)
External benefits
Marginal external benefit
(MEB)
Marginal social benefit
(MSB)
Public good
External cost
Marginal external cost
(MEC)
Marginal social cost
(MSC)
Moral hazard
Adverse selection
Government failure
Tax burden
Excess burden of taxation
(deadweight loss)
Capital gain
Welfare loss (deadweight
loss)
Suggestions for Teaching
Following the demand and supply analysis from previous chapters, it is important to analyze the
concept of efficiency with students. Explain the concept of efficiency and discuss the rules for
determining efficient allocation of resources in competitive markets both conceptually, and
graphically. This will provide a strong benchmark from which to carry future discussions about
resource allocation and potential inefficiencies in the marketplace.
Once the concept of efficiency is understood, introduce market failure. Depending upon your
objectives for the course, you can either emphasize the formal monopoly analysis (further
developed in chapter 5) or you can use intuition to argue that a monopoly will charge a higher price
and restrict output. Students will quickly realize that externalities surround them. From cell phones
ringing in the classroom to industrial pollution, and beautiful gardens to immunizations, nonconsenting third parties are continually affected by market transactions. You may wish to discuss
these from a property rights perspective; externalities occur when property rights are not well
enough defined to capture all the potential benefits (public goods) or to internalize all of the costs
(pollution into the air or water).
The correction of market failures is often cited as a basis for government actions that affect the
allocation of resources, such as government expenditures, subsidies, regulations, laws, and policies.
Substituting government actions for private choices, however, is no guarantee of an improvement
in the allocation of resources. In fact, there are many instances where government policy leads to
allocative inefficiency, or government failure.
To encourage critical thinking, the last part of the chapter explains the shortcomings of
efficiency analysis. Economic efficiency is one of many economic goals. The tradeoffs between
efficiency and equity and efficiency and innovation should be realized
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
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Instructor's Manual  51
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.
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: THE MEANING OF EFFICIENCY IN RESOURCE ALLOCATION
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. REQUIREMENTS FOR ACHIEVING EFFICIENCY IN RESOURCE ALLOCATION
A. The objective of economic activity is to satisfy wants, measured by the proxy, benefits.
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.
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.
3. Costs are measured as the largest possible benefits that would have been produced
from other goods and services that have been given up to produce the good or service
of concern.
III. THE COMPETITIVE MARKET: AN EXAMPLE OF EFFICIENCY IN RESOURCE
ALLOCATION
A. Highly competitive markets, in which neither buyers nor sellers can influence market price
by their individual actions, will often automatically achieve allocative efficiency without
other intervention. 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 a good is also a marginal benefit curve; it indicates the benefits
buyers perceive from each additional, or marginal, unit.
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Instructor's Manual  52
2. Economists use the minimum amount that sellers must receive as a measure of what
must be given up, or the (opportunity) cost, to provide each good. Thus, the supply
curve for the good 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. It is the
sum of marginal benefits.
4. The area under the supply curve measures total cost, or the sum of marginal costs.
5 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
A. Market failure occurs when markets in the economy do not achieve efficiency.
1. Monopoly: a market in which only one seller exists.
a. If some market participants have market power in the form of the ability to
affect price, such as a monopoly, the market will exhibit inefficiency.
b. 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: benefits in addition to those realized by the consumer.
a. 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.
b. When external benefits exist there is an under-allocation of resources toward
the provision of the good or service where MB=MC.
c. It is not easy to determine the value of external benefits in real-world cases
because they are not included in demand (MB) curves. However, when
marginal external benefits (MEB) are added to the marginal benefits (MB), a
marginal social benefit (MSB) curve can be traced to the right of the MB
curve. Allocative efficiency then occurs where MSB=MC.
3. Public Goods: goods that can be jointly consumed (consumption by one does not
decrease the amount available to others) and for which it is difficult to exclude nonpaying customers.
a. External benefits are most important in the case where, if a good is provided to
one individual, all other individuals benefit from its provision. 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.
b. The determination of a public good is not based on whether the good is
produced by the public or private sector.
4. External Costs: costs in addition to those realized by the producer.
a. 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. Cost of pollution is an
example of external costs.
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Instructor's Manual  53
b. When external costs exist there is an over-allocation of resources to the
provision of that product where MC=MB.
c. When marginal external costs (MEC) are added to marginal costs (MC), the
marginal social cost (MSC) curve can be traced to the left of the MC curve.
Government regulation (such as Clean Air Act) aims at internalizing the
external cost to correct the market failure. Allocative efficiency then occurs
where MSC=MB.
5. Imperfect Insurance Markets: Insuring against the risks of an event in which
individuals have some control may make them less careful about avoiding the event.
a. Moral hazard occurs when individual policyholders can shift the increased
costs associated with their acts to others who are insured. As a result, the cost
of insurance rises for the whole group discouraging some individuals from
buying insurance, especially individuals least in need of it.
b. Adverse selection is a situation that results when an insurance pool includes
predominantly high-risk, and high-cost, individuals. Low risk individuals
consume less because of the high cost that is based on the high risk consumers.
c. The result of imperfect insurance markets is an under-allocation of resources.
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 allocative efficiency.
1. Rent Controls: placing an upper limit on rents that landlords can charge.
a. Controls often keep rents below the market-clearing, or equilibrium, level.
b. 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: keeping the prices of various agricultural commodities
above the market-clearing, or equilibrium, level.
a. Price supports induce farmers to produce more than market-clearing
quantities - too much, in fact, from the perspective of efficiency.
3. Government-Subsidized Medical Care: subsidies to consumers of health care through
the federal Medicare and the federal-state Medicaid programs.
a. These programs are designed to improve medical care access for the elderly
(Medicare) and the poor (Medicaid).
b. The cost-sharing arrangements reduce the perceived price--what the consumer
must pay for a unit of medical care--to 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.
c. Acting solely on the part of the cost that they pay, consumer-patients buy too
much medical care.
4. Minimum Wage: law requiring employers to pay workers in most occupations a
minimum wage ($5.15 an hour according to current U.S. federal law).
a. The intent of the law is to increase the income of low-wage workers.
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Instructor's Manual  54
b. Forced to pay higher wages, employers hire fewer employees. Minimum wage
is a source of inefficiency because it increases unemployment.
5. Taxes: The ways in which governments finance their activities are also sources of
inefficiency. This is especially true of taxes.
a. Sales taxes: A percent of the price of the good or service levied on sellers by
the state. 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.
b. 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. Again, the many exclusions from the tax base
and tax credits can cause too much consumption of some items relative to
others.
c. 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.
VI. HOW MUCH EFFICIENCY DO WE WANT?
A. Efficiency Versus Equity and Tax Trade-Offs: Efficiency losses from taxes must be
balanced with other economic goals such as equity. To reduce the inefficiency from
taxation may lessen equity.
1. Efficiency loss could be reduced 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.
2. Taxing income that is currently excluded from the tax base could enhance economic
efficiency. 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.
3. In theory, reduced efficiency and equity could be balances by assigning weights to the
individuals who will benefit from and pay for the changes that will be made. The
difficulty lies in discovering the appropriate weights.
B. Efficiency vs. Innovation: There are trade-offs between achieving greater efficiency and
more innovation in the economy.
1. Market power reduces allocative efficiency by allowing firms to produce less than the
equilibrium quantity and charge a higher price.
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2. If entrepreneurs perceive a potential reward of profit they are motivated to invest in
research, development, and production even when it requires uncertain start-up costs.
That potential profit comes from market power; the ability to charge prices greater than
the operating, or marginal, costs.
C. Efficiency and Equity: Efforts to achieve greater efficiency do not always create conflicts
with equity.
1. Agricultural Price Supports: Designed to attack farm poverty, 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 (see also chapter 3). 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: Designed to help low income earners, a recent study finds evidence
that the minimum wage largely redistributes income among low-income families (see
also chapter 11). Thus, it seems possible to reduce the application of this measure
without imposing significant additional costs on low-income families as a group.
3. Medicare and Medicaid: Poor families and individuals benefit from these subsidies but
at a social cost (see also chapter 7). A government voucher issued in a smaller amount
than the current subsidy 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.
1. Excise taxes on cigarettes reduce cigarette consumption, creating efficiency losses
from taxation but reducing efficiency losses from second-hand smoke (an externality).
2. Gasoline taxes may be offset somewhat by reduced efficiency losses from the air
pollution associated with oil refining or automobile travel.
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. Even so, substituting government actions for private choices is no
guarantee of an improvement in the allocation of resources.
Government failure occurs when government expenditures, policy, or actions, leave markets at
less than the efficient outcome. Price controls and subsidies alter resource allocation, again
encouraging society to over-allocate or under-allocate resources in the production of goods and
services. 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 efficiency in resource allocation?
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
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Instructor's Manual  56
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 allocative 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.
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
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Instructor's Manual  57
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, the 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.
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 allocation of resources.
Explain why.
In a monopoly, where there is only one seller, the seller has the market power, and the ability
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.
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5. Describe and explain two cases in which markets produce an inefficiently large allocation of
resources. Explain why.
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. External costs exist, however, if third parties
incur costs (are harmed) from transaction between buyers and sellers. In the presence of
external costs, the marginal social cost would be greater than the marginal cost by the amount
of the marginal external costs, implying that society over-allocates resources and produces an
inefficiently large amount at level where MB=MC.
The best example for external costs is pollution. Coal that is burned to heat an apartment
produces harmful byproducts, pollutants, in the form of coal combustion that escapes from the
apartments and drifts 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 can
internalize 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.
6. 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.
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Rent per bushel ($)
Instructor's Manual  59
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 the 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.
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Price per unit ($)
Instructor's Manual  60
S, MC
S
Government’s
Pe
E
Share
Pc
M
Consumer’s Share
D, MB
0
Qe
Qc
Units of Medical Care
Quantity (Q)
7. Draw a diagram in which you indicate the effect of a general sales tax levied on the
seller. Identify the burden of the tax and the excess burden of the tax. What does
your diagram imply about the common claim that the general sales tax is paid by
the buyer?
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Price($)
1000
900
S+T
800
S
700
600
Pb
500
450
400
B
Pp
A P
Ps
S
300
200
100
D
Quantity
0
10
0
20
0
0
30
0
40
0
45
0
50
0
60
0
70
0
80
0
90
Qa Qp
00
10
The effect of a sales tax is illustrated above. The supply curve before the tax is S. Though
the seller is liable for the tax, they attempt to shift the tax to consumers in the form of
higher prices by increasing supply price (the price they require in order to supply a good or
service) by the amount of the tax. The supply curve will rotate leftward to S + T. The
vertical distance between S and S + T is the tax. As illustrated, the tax is a constant
percentage of the supply price before the tax is imposed. The pretax equilibrium is at P, the
intersection of the demand curve and the supply curve before the tax is imposed. The
pretax price and quantity are Pp and Qp, respectively.
The tax raises the price to the buyer to Pb and lowers the price to the seller to Ps.
The difference between the two prices (Pb – Ps or B – S) is the tax per unit. Total tax
revenue, also known as the burden of the tax, is equal to the rectangle bounded by Pb, Ps, S,
and B. Even though the tax is levied on the seller, the seller and buyer share the burden.
The buyer is paying $50 more per unit with the tax. The total tax burden on consumers is
the area Pb, B, A and Pp. The seller receives $50 less per unit after taxes are paid to tax
authorities or a total tax burden of the area Pp, A, S, and Ps.
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The tax also lowers the quantity sold from Qp (the pretax quantity) to Qa (the
after-tax quantity). Assuming that the supply curve before taxes is a marginal cost
curve and the demand curve is a marginal benefit curve, the tax results in an
inefficiently small quantity of goods and services sold. The allocative efficiency loss
attributable to the tax is equal to the net benefits not realized because of the tax, or the
area bounded by B, P, and S. This area is the excess burden of the tax. The excess
burden is also called the deadweight loss from taxation.
8. 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
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. The perceived costs would also increase,
however. It is possible that the desire for equity outweighs the benefits of efficiency.
Efficiency is not the only economic goal.
c. The tradeoff between efficiency and equity. At the core of the problem is that benefits
cannot be measured well since they are subjective.
9. 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.
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Instructor's Manual  63
Price per Unit
S1, MC1
S2, MC2
P1
P2
D, MB
0
Q3
Q1
Q2
Quantity per Month
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. If the price of water was held at P2, consumers would still desire Q2 of water
but producers would provide only Q3. There is an under-allocation of resources at price P2.
10. 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
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Instructor's Manual  64
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 $1,400. How large is
the efficiency loss from monopoly pricing?
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Instructor's Manual  65
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 (3,000 x .5 x $600).
11. 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 left, 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 8,000 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 $3,600,000 (the area LIB0). Thus, the competitive market solution is
marked by inefficiency, characterized by an allocation of too many resources to apartments.
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Instructor's Manual  66
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