Econ 2113: Principles of
Microeconomics
Spring 2009
ECU
Chapter 5
Efficiency and Equity
Resource Allocation Methods

You’re on a bus filled to capacity going up to
snowboard at Mammoth and the bus breaks
down 2 miles away from your lodge.

A replacement bus comes but it only holds half
the number of people as the old bus and it can
only make one trip up tonight (the road down is
blocked by snow).

Who gets to ride up on the replacement bus?
Resource Allocation Methods
Scarce resources might be allocated by using
any or some combination of the following
methods:
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Market price
Command
Majority rule
Contest
First-come, first-served
Sharing equally
Lottery
Personal characteristics
Force
Demand and Marginal Benefit

Demand, Willingness to Pay, and Value
  Value
is what we get, price is what we pay.
  The value of one more unit of a good or
service is its marginal benefit.
  We measure value as the maximum price
that a person is willing to pay.
  Willingness to pay determines demand.
  A demand curve is a marginal benefit
curve.
Demand and Marginal Benefit

Individual Demand and Market Demand
  The
relationship between the price of a
good and the quantity demanded by one
person is called individual demand.
  The relationship between the price of a
good and the quantity demanded by all
buyers in the market is called market
demand.
Demand and Marginal Benefit

The market demand curve is the
horizontal sum of the individual demand
curves.
Market Demand
P
11
6
Market
demand
D2
5
7
D1
12
Q
Demand and Marginal Benefit

Consumer Surplus (Buyers’ 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.
  Example: What is the market consumer
surplus of consuming 5 million sodas?
Demand and Marginal Benefit
If the price of a soda is $6 per can, then:
P
11
CS
6
Total Paid
5
Q (mill.)
Demand and Marginal Benefit

Notice that total value is the area under the demand
curve (green plus grey). The total shaded area is equal
to $42.5 mill.

The grey area is called “consumer surplus”, and it is
equal to $12.5 mill. in the example

CS measures the benefit for the consumers beyond
what they pay, and therefore it is a gain to the
consumers from buying the good
Supply and Marginal Cost

Supply, Cost, and Minimum Supply-Price
Cost is what the producer gives up, price is what
the producer receives.
  The cost of one more unit of a good or service is
its marginal cost.
  Marginal cost is the minimum price that a firm is
willing to accept.
  The minimum supply-price determines supply.
  A supply curve is a marginal cost curve.

Supply and Marginal Cost

Individual Supply and Market Supply

The relationship between the price of a good and the
quantity supplied by one producer is called individual supply.

The relationship between the price of a good and the
quantity supplied by all producers in the market is called
market supply.
Supply and Marginal Cost

The market supply curve is the
horizontal sum of the individual supply
curves.

Blackboard
Supply and Marginal Cost

Producer Surplus (Sellers’ Surplus)
  Producer
surplus is the price received for a
good minus the minimum-supply price
(marginal cost), summed over the quantity
sold.
  It is measured by the area below the market
price and above the supply curve, summed
over the quantity sold.
  Question: What is the producer surplus of
producing 5 mill. sodas?
Supply and Marginal Cost
If the price of a soda is $6 per can, then:
S
P
6
PS
1
TC
5
Q (mill.)
Supply and Marginal Cost

Total cost is the area under the supply curve, equal to
$17.5 mill.

The red area is called “producer surplus”, and equals
$12.5 mill.

PS measures the benefit for producers beyond what
they spend to produce the good, and therefore it is a
gain to producers from selling the good
Total surplus

Total surplus is the sum of CS and PS

TS = PS + CS
Total Surplus
S
P
11
CS
6
PS
1
D
5
Q (mill.)
Total Surplus

If the market clears (i.e. it is in equilibrium), then
demand must equal supply

In this case there are 5 mill. sodas sold at a price of
$6 each

Total surplus is the sum of consumer and producer
surplus. That is the net benefit for all market
participants combined

In this case total surplus equals $25 mill. (gray plus
red)
The Market and Efficiency
•  At the equilibrium quantity marginal benefit equals
marginal cost. This is the efficient quantity.
•  When the efficient quantity is produced, total
surplus (the sum of consumer surplus and producer
surplus) is maximized
The Market and Efficiency

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.
Deadweight loss from underproduction
  Underproduction
The efficient quantity is 10,000
pizzas a day.
If production is restricted to
5,000 pizzas a day, there is
underproduction and the
quantity is inefficient.
A deadweight loss equals the
decrease in total surplus—the
gray triangle.
This loss is a social loss.
Deadweight loss from overproduction
  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.
This loss is a social loss.
Obstacles to Efficiency
In competitive markets, underproduction or
overproduction arise when there are
Price and quantity regulations
  Taxes and subsidies
  Monopoly

Price and Quantity Regulations
  Price
regulations sometimes put a block on
price adjustments and lead to underproduction.
  Quantity
regulations limit the amount that a
firm is permitted to produce also leads to
underproduction.
Taxes and Subsidies
  Taxes
increase the prices paid by buyers
and lower the prices received by sellers.
  So taxes decrease the quantity produced
and lead to underproduction.
 Subsidies
lower the prices paid by buyers
and increase the prices received by sellers.
 So subsidies increase the quantity produced
and lead to overproduction.
Monopoly
  A
monopoly is a firm that has sole provider
of a good or service.
  The self-interest of a monopoly is to
maximize its profit. To do so, a monopoly
sets a price to achieve its self-interested
goal.
  As a result, a monopoly produces too little
and underproduction results.
Markets and Fairness
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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
It’s Not Fair if the Result Isn’t Fair

Utilitarianism: 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.

Big Tradeoff
Utilitarianism ignores the cost of making income
transfers.
  Recognizing these costs leads to the big tradeoff
between efficiency and fairness.


You’re at an oasis in a desert. You have ice
cream in an unmovable fridge. Some people at the
next oasis are starving. Ice cream is the only food
available. If you try to transport your ice cream to
them some of the ice cream will melt along the
way. How much of the ice cream would have to
make it to be worth transporting it?
Big Tradeoff
Similarly to the example, usually income is lost
when redistribution takes place
  Redistribution diminishes the incentives to work
  Higher taxes encourage people to work less
  Higher transfers encourage receivers to work less

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.
Equality of Opportunity
In economics, this principle means equality of
opportunity, not equality of income.
Robert Nozick suggested that fairness must be 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.
This means that if resources are allocated efficiently, they may
also be allocated fairly.