CHAPTER
5
Efficiency
Efficiency: A Refresher
 According to economists, allocative
efficiency means the resources have
been used to produce the goods and
services that people value the most.
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
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
Efficiency and Inefficiency
 Allocative 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
Efficiency and Inefficiency
What is the economically efficient
quantity of pizza?
Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of
Pizza
25
20
15
10
5
0
MB
5
10
15
20
Quantity (thousands of pizzas per day)
Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of
Pizza
25
MC
20
15
10
5
0
MB
5
10
15
20
Quantity (thousands of pizzas per day)
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
MB
5
10
15
20
Quantity (thousands of pizzas per day)
Marginal cost and marginal benefit
(dollars worth of goods and services)
The Efficient Quantity of
Pizza
25
Efficient quantity
of pizza
MC
20
15
10
5
0
MB
5
10
15
20
Quantity (thousands of pizzas per day)
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
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
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
2.00
1.50
1.00
0.50
0
D = MB
10
20
30
40
Quantity (slices of pizzas per week)
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
Market
price = $1.50
2.00
1.50
1.00
0.50
0
D = MB
10
20
30
40
Quantity (slices of pizzas per week)
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
Market
price = $1.50
2.00
1.50
1.00
Amount
paid = $30
0.50
0
10
20
30
D = MB
40
Quantity (slices of pizzas per week)
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
Consumer surplus from 20 pizzas
= .5(20x1)=$10
Market
price = $1.50
2.00
1.50
1.00
Amount
paid = $30
0.50
0
10
20
30
D = MB
40
Quantity (slices of pizzas per week)
Price (dollars per slice)
A Consumer’s Demand and
Consumer Surplus
2.50
Consumer surplus from 20 pizzas
= .5(20x1)=$10
Market
price = $1.50
2.00
1.50
Consumption
Value of 20 slices
=$30 + $10 = $40
1.00
Amount
paid = $30
0.50
0
10
20
30
D=MB
40
Quantity (slices of pizzas per week)
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.
Producer Surplus
 Producer surplus is the revenue from
a good minus the opportunity cost of
producing it.
– if a firm sells something for more than it costs
to produce, a producer surplus exists
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
S=MC
25
20
Price determines
quantity supplied
15
10
5
0
50
100
150
200
Quantity (pizzas per day)
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
S=MC
25
Market
price = $15
20
15
10
5
0
50
100
150
200
Quantity (pizzas per day)
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
S=MC
25
Market
price
20
15
10
Cost of Production
= .5(100x10) + (100x5) = $1,000
5
0
50
100
150
200
Quantity (pizzas per day)
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
S=MC
25
20
Market
price
Producer surplus
= .5(10x100) = $500
15
10
Cost of Production
= .5(100x10) + (100x5) = $1,000
5
0
50
100
150
200
Quantity (pizzas per day)
Price (dollars per pizza)
A Producers Supply
and Producer Surplus
25
S=MC
Producer surplus
of $500 equals profit
Market
price
20
15
10
Cost of Production
= $1,000
5
0
50
100
150
200
Quantity (pizzas per day)
Production
Value of 100
slices
=$1000+$500
=$1,500
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?
Price (dollars per pizza)
An Efficient Market for Pizza
S Marginal cost--
25
opportunity cost
--of pizza
20
15
Marginal benefit-value--of pizza
10
5
0
Efficient quantity
of pizzas
5
10
D
15
20
Quantity (thousands of pizzas per day)
Is the Competitive
Market Efficient?
 At Competitive Equilibrium
– Resources are being used efficiently
– The sum of consumer surplus and producer
surplus is maximized
Price (dollars per pizza)
An Efficient Market for Pizza
S
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
An Efficient Market for Pizza
S
25
20
15
10
5
0
Producer
surplus
= .5(10x10)=50
5
10
D
15
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
An Efficient Market for Pizza
25
Consumer
surplus
= .5(10x10)=50
S
20
15
10
5
0
Producer
surplus
= .5(10x10) =50
5
10
D
15
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
An Efficient Market for Pizza
25
Consumer
surplus
= .5(10x10)=50
S
Consumer Surplus
+
Producer Surplus
=50 +50 = 100
20
15
10
5
0
Producer
surplus
= .5(10x10) =50
5
10
D
15
20
Quantity (thousands of pizzas per day)
The Invisible Hand
 Adam Smith - Wealth of Nations in
1776
– Participants in a competitive market are “led by
an invisible hand to promote an end (the
efficient use of resources) which was not part
of his intention.”
Sources of Inefficiency
 Price ceilings and floors
 Taxes, subsidies, and quotas
 Monopoly
 Public goods
 External costs and benefits
These lead to underproduction or
overproduction.
Sources of Inefficiency
 Deadweight Loss
– The decrease in consumer and producer surplus
that results from an inefficient allocation of
resources
Price (dollars per pizza)
Underproduction (Say
Monopoly)
S
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
Underproduction
Consumer Surplus
= .5(5x5)=12.5
S
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
Underproduction
Consumer Surplus
= .5(5x5)=12.5
S
25
20
15
10
Producer Surplus
= (5x10) + .5(5x5)
= 50 + 12.5 = 62.5
5
0
5
10
15
D
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
Underproduction
Consumer Surplus
= .5(5x5)=12.5
S
25
20
Deadweight
loss = .5(10x5) = 25
15
10
Producer Surplus
= (5x10) + .5(5x5)
= 50 + 12.5 = 62.5
5
0
5
10
15
D
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
Underproduction
Consumer Surplus
= .5(5x5)=12.5
S
25
Consumer Surplus
+
Producer Surplus
= 12.5 + 62.5 = 75
20
Deadweight
loss = .5(10x5) = 25
15
10
Producer Surplus
= (5x10) + .5(5x5)
= 50 + 12.5 = 62.5
5
0
5
10
15
D
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
Overproduction (Say
Government Subsidy)
S
25
20
15
10
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
Overproduction
S
25
Consumer Surplus
Gain = B + G
Producer Surplus
Gain = A + D
C
20
A
F
15
G
10
Government Subsidy
=B+G+A+ D+F
D
B
Deadweight Loss
= B+ G +A+ D
- B- G -A- D- F
= F
E
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)
Price (dollars per pizza)
Overproduction
S
25
Consumer Surplus
Gain = B + G
Producer Surplus
Gain = A + D
C
20
A
F
15
G
10
Deadweight Government Subsidy
=B+G+A+ D+F
loss
D
B
Deadweight Loss
= B+ G +A+ D
- B- G -A- D- F
= F
E
5
0
D
5
10
15
20
Quantity (thousands of pizzas per day)