Econ 101:
Microeconomics
Chapter 14:
Economic Efficiency and
the Role of Government
The Meaning of Efficiency
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What, exactly, does efficiency mean?
•
Economic efficiency is achieved when there is no way to rearrange the
production or allocation of goods in a way that makes one person better
off without making anybody else worse off
A trade in which both parties are made better off, and no one is
harmed
Named after Italian economist, Vilfredo Pareto (1848-1923)
•
First systematically explored the issue of economic efficiency
Helps us arrive at a formal definition of economic efficiency
•
Achieved when every possible Pareto improvement is exploited
Alternatively, we can look at the economy as a whole
•
If we discover remaining Pareto improvements that are not occurring then
we would deem the economy economically inefficient
Perfectly competitive markets tend to be economically efficient
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Side Payments and Pareto
Improvements

There are more complicated situations in which a Pareto
improvement will come about
•
•
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If an action creates more total benefits for gainers than total
harm to losers
•
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Only if one side makes a special kind of payment to the other—called
a side payment
Situations in which action will benefit one group and harm another
Than a side payment exists which—if transferred from gainers to
losers—would make the action a Pareto improvement
Important implication for economic efficiency
•
If there is an action that benefits some more than it harms others, and
if an appropriate side payment can be easily arranged
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Than not taking the action is a waste of an opportunity to make everyone
better off
When a side payment cannot be made—or for any reason is
not made—then event of action might create greater gain than
harm, it might not be considered fair
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The Efficient Quantity of a Good
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Figure 3 combines supply and demand curves for guitar
lessons
Whenever demand curve lies above supply curve,
producing the lesson is a Pareto improvement
•
•
•
Whenever demand curve lies below supply curve, producing the
lesson cannot be a Pareto improvement
Efficient quantity of guitar lessons—the quantity at which all Pareto
improvements are exploited—is where the demand curve and
supply curve intersect
At this quantity, value of the last good produced will be equal to—
or possibly a tiny bit greater than—the cost of providing it
•
Efficient quantity of a good is quantity at which market demand curve and
market supply curves intersect
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Economics: Principles
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Figure 3: Efficiency In The Market
For Guitar Lessons
Price
$25
$23
$21
$19
$17
$15
$13
Flo
Joe
Supply
1. Joe would pay as much as
$23 for the second lesson . . .
Flo
Bo
McCollum
Martin
Gibson Zoe
Martin
Demand
Martin
3. Four lessons is the equilibrium
and the efficient quantity.
2. while Martin would offer
it for as little as $15.
1
2
3
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Economics: Principles
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5
Number of Lessons per Week
5
Consumer Surplus
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Useful to measure the benefits that producers
and consumers receive from their economic
activities
A buyer’s consumer surplus on a unit of a good
•
Difference between its value to buyer and what buyer
actually pays for the unit
Total consumer surplus enjoyed by all consumers
in a market is called market consumer surplus
•
•
Sum of consumer surplus on all units
Market consumer surplus at any price—measured in
dollars—is total area under market demand curve and
above market price
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Economics: Principles
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Figure 4(a): Consumer Surplus in a Small and
Large Market for Guitar Lessons
(a)
1. When market price is $19, someone (Flo) gets
$6 in consumer surplus on the first lesson . . .
Price
2. someone (Joe) gets $4 in consumer
surplus on the second . . .
$25
$23
$21
$19
$17
3. and someone (Flo again) gets $2
in consumer surplus on the third.
Demand
The total shaded area is
market consumer surplus.
Assumed
Market Price
1
2
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Economics: Principles
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4
5
Number of Lessons per Week
7
Figure 4(b): Consumer Surplus in a Small and
Large Market for Guitar Lessons
(b)
Price
In a market with many buyers, market
consumer surplus is the entire area
under the demand curve and above
the market price.
$19
Market Price
Demand
4,000
Hall & Leiberman;
Economics: Principles
Number of Lessons per Week
8
Producer Surplus
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An individual seller’s producer surplus on a
unit of a good
•
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Difference between what seller actually gets and
additional cost of providing it
Total producer surplus gained by all sellers in a
market is called market producer surplus
•
•
Found by adding up producer surplus gained by all
sellers in market
Market producer surplus at any price—measured in
dollars—is total area above market supply curve and
below market price
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Economics: Principles
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Figure 5(a): Producer Surplus From
Selling Guitar Lessons
(a)
Price
1.When market price is $19, someone (Martin) gets
$6 in producer surplus on the first lesson . . .
Supply
$21
$19
$17
$15
$13
2. someone (Martin again) gets $4 in
producer surplus on the second . . .
3. and someone (Gibson) gets $2 on the third.
Assumed
Market Price
The total shaded area is
market producer surplus.
1
2
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Economics: Principles
3
4
5
Number of Lessons per Week
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Figure 5(b): Producer Surplus From
Selling Guitar Lessons
(b)
Price
Supply
Market Price
$19
In a market with many sellers, market
producer surplus is the entire area
above the market supply curve and
below the market price.
4,000
Hall & Leiberman;
Economics: Principles
Number of Lessons per Week
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Figure 6: Total Net Benefits in a
Competitive Market for Guitar Lessons
Price
S
Market
Equilibrium consumer
Price
surplus
$19
Market
producer
surplus
Total net benefits - Sum of consumer
and producer surplus in that market.
D
4,000
Hall & Leiberman;
Economics: Principles
Equilibrium Quantity
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Perfect Competition and Efficiency:
The Total Benefits View
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Each time we make a Pareto improvement in a market
•
•
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We make at least one party better off and make no one else
worse off
Therefore, a Pareto improvement will increase total net
benefits available in a market
Thus, we have a new way of viewing efficiency
•
A market is efficient when sum of producer and consumer
surplus is maximized in that market
In a well-functioning, perfectly competitive market
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Equilibrium quantity provides maximum possible benefit to
buyers and sellers combined, and is the efficient quantity
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Economics: Principles
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A Price Ceiling
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Creates greater harm for sellers than gains for
buyers
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Reduces total net benefits in the market in a perfectly
competitive market
Welfare loss in a market is dollar value of
potential benefits not achieved due to
inefficiency in that market
Although a price ceiling may benefit
consumers as a group it will always reduce
total net benefits in the market
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Economics: Principles
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Figure 7(a): Why Price Ceilings and
Price Floors Are Inefficient
1. A price ceiling of $15 . . .
2. transfers surplus from
producers to consumers.
Price
S
$23
C
3. It also decreases market
quantity, taking away
some consumer surplus
E
$19
B
D
$15
D
A
4 . . . . and some producer
surplus, which are not
transferred to anyone.
2,000
Hall & Leiberman;
Economics: Principles
4,000
6,000
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Figure 7(b): Why Price Ceilings and
Price Floors Are Inefficient
1. A price floor of $21 . . .
Price
2. transfers surplus from
consumers to producers.
S
C
$21
$19
$17
B
3. It also decreases market
quantity, taking away
some consumer surplus
E
D
A
D
4 . . . . and some producer
surplus, which are not
transferred to anyone.
3,000
Hall & Leiberman;
Economics: Principles
4,000
5,000
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Calculating the Welfare Loss
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Let’s calculate dollar value of welfare loss
caused by price ceiling
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Area of unshaded triangle formed by areas D and E
together
• From high school algebra, area of any triangle is ½ x
base x height
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Welfare loss = ½ x base x height = ½ x $8 x
2,000 = $8,000
When this market is delivering only 2,000
lessons per week instead of the efficient 4,000
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Guitar teachers and students together lose $8,000 in
potential benefits per week or
Welfare loss would be 52 weeks x $8,000 per week =
$416,000 per year
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Economics: Principles
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A Price Floor
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In a perfectly competitive market, the
price floor will always shrink total net
benefits
Reduces total benefits in market (causes
a welfare loss)
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Economics: Principles
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The Efficiency Role of Government
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When a well-functioning, perfectly competitive market is
permitted to reach its equilibrium, the outcome is efficient
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No opportunities for mutual gain remain unexploited
Any government intervention that changes the market
quantity (say, a price ceiling or a price floor) will create
inefficiency—a welfare loss
But government can—and does—contribute to the
economic efficiency of markets
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Provides infrastructure that permits markets to function
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Physical infrastructure—bridges, airports, waterways, and
buildings
Institutional infrastructure—laws, courts, and regulatory
agencies
Stepping in when markets are not working properly
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When they leave Pareto improvements unexploited and
therefore fail to achieve economic efficiency
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Economics: Principles
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Market Failures
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Another vitally important role for government
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To intervene in situations of market failure
• When a market equilibrium—even with the proper
institutional support—is economically inefficient
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General types of market failures to which
economists have devoted a lot of attention
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Monopoly power
Externalities
Public goods
While economists and policy-makers agree in
theory on what causes a market failure
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Dealing with real-world market failures remains one of
the most controversial aspects of government policy
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Economics: Principles
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Externalities

When a private action has side effects
that affect other people in important
ways, we have the problem of
externalities
• By-product of a good or activity that affects
someone not immediately involved in
transaction
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Economics: Principles
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The Private Solution to a Negative
Externality
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Under certain conditions, inefficiency
that would be caused by a negative
externality will automatically be resolved
by the parties themselves
• The outcome is the efficient outcome
• Achieves maximization of total net benefits
possible in the situation
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Economics: Principles
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The Coase Theorem
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What if building a theater would create $100,000 of benefits for
some but $70,000 worth of harm for others?
Whether the theater will or will not be built depends entirely on
whether it is the efficient or inefficient outcome
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•
•
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Regardless of who holds the legal rights
Negative externality is solved by market
No government intervention is required, other than the initial
assignment of legal rights
Rather surprising result is known as the Coase Theorem—
named after economist Ronald Coase
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•
States that private market will solve externality problem on its own,
always arriving at the efficient outcome
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When side payments can be negotiated and arranged without cost
While initial distribution of legal rights will determine allocation of gains
and losses among the parties, it will not affect action taken
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Economics: Principles
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The Coase Theorem
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Requires that side payments can be arranged without cost—or,
in practice, that cost is so low relative to gains or losses at
stake that it doesn’t matter
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This requirement is most likely to be satisfied when all of the following
conditions are present
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•
•
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Unfortunately, many real world situations do not satisfy these
conditions
Biggest problem is applying Coase theorem to many real-world
externalities is the third condition
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Legal rights are clearly established
Legal rights can be easily transferred
The number of people involved is very small
Often, a large number of people are involved
When many people are involved, achieving efficiency with side
payments is plagued by an often insoluble problem
•
Free rider problem
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Economics: Principles
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The Free Rider Problem
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Occurs when efficient outcome requires a side
payment but individual gainers—each obligated
to pay a small share of the side payment—will
not contribute
If extensive enough—can shrink the side
payment until it isn’t large enough to compensate
losers and still leave gainers better off
Stands in the way of many Pareto improvements
•
One of the main reasons why we typically turn to
government to deal with important externalities that
affect many people
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Economics: Principles
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Market Externalities and
Government Solutions
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A competitive market has many buyers and sellers
•
A market with a negative externality associated with producing
or consuming a good will produce more than the efficient
quantity
•
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When a negative externality affects a market, the private solution
is unlikely to work
Creating a welfare loss
Unfortunately, with so many people involved, it would take too
much time and trouble for individual producers and
consumers to arrange appropriate side payments and
production cutbacks
•
•
In any case, free rider problem would effectively destroy the
arrangement
Efficient outcome requires government intervention in the market
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Economics: Principles
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Figure 11a: A Tax on Producers to
Correct a Negative Externality
(a)
Dollars
1. This market has a negative
externality of $0.50 per unit.
MSC
C
2. The efficient quantity is here . . .
$0.50
B
S
A
3. but the equilibrium
quantity is here.
$1.00
D
4. In equilibrium, the welfare
loss is triangle ABC.
Hall & Leiberman;
Economics: Principles
100
125
Millions of Gallons
per Period
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Figure 11b: A Tax on Producers to
Correct a Negative Externality
5. A(b)
tax per unit on producers, equal
to the negative externality per unit,
Dollars
6. shifts the supply curve upward . . .
SAfter Tax
B
$1.30
SBefore Tax
$0.50
A
$1.00
$0.80
7. and moves the
equilibrium to the
efficient quantity.
D
100
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Economics: Principles
125
Millions of Gallons
per Period
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Taxing a Negative Externality
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Government could use a tax on producers to move gasoline market to
point B
Payment of the externality tax is shared between consumers and
producers, as is the payment of any tax, and will depend on elasticities
of supply and demand
•
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A tax on each unit of a good, equal to the external harm it causes, can correct a
negative externality and bring market to an efficient output level
Consider the logic of this result
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Tax cures the inefficiency because it forces market to internalize the externality
•
To take account of the harm caused by gasoline
Suggests that a tax on consumers of gasoline would work just as well
as a tax on producers
Taxes to correct negative externalities have been used in countries
around the world
•
In United States, however, taxes designed to correct negative externalities are
less common
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Economics: Principles
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Dealing with a Positive Externality
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What about the case of a positive externality?
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A market with a positive externality associated with producing
or consuming a good will produce less than the efficient
quantity, creating a welfare loss
A subsidy on each unit of a good, equal to the external benefits
it creates, can correct a positive externality and bring the
market to an efficient output level
If a good is rivalrous, efficiency requires that people pay a price
for its use
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By-product of an activity or a service benefits other parties, rather than
harms them
In the absence of any market failure, private provision will lead to
efficient level of production
If a good is excludable, it can be provided by private market
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Figure 12a: A Subsidy for Consumers to
Correct a Positive Externality
1.This market has a positive externality
(a)
of $30,000 per college degree.
Dollars
2. The equilibrium quantity is here . . .
S
$30,000
B
$100,000
3. but the efficient
quantity is here.
A
MSB
C
D
800,000
1,000,000
Number of
Degrees per Year
4. In equilibrium, the welfare loss is triangle ABC.
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Economics: Principles
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Figure 12b: A Subsidy for Consumers to
Correct a Positive Externality
5. A subsidy per unit for consumers equal
to the positive externality per unit(b)
...
6. shifts the demand curve upward . . .
Dollars
$30,000
B
$114,000
$100,000
A
7. and moves
the
S
market to the
efficient quantity
DAfter Subsidy
$84,000
DBefore Subsidy
800,000
Hall & Leiberman;
Economics: Principles
1,000,000
Number of
Degrees per Year
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Public Goods
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Pure private good
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When a good is nonexcludable, people have an incentive to
become free riders
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In most cases, if we want such a good, government must provide it
When a good or service is nonrivalrous, market cannot provide
it efficiently
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To let others pay for the good, so they can enjoy it without paying
When a good is nonexcludable, private sector will generally be
unable to provide it
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One that is both rivalrous and excludable
In absence of any significant market failure, private firms will provide
these goods at close to efficient levels
Rather, to achieve economic efficiency, good or service would have to
be provided free of charge
Pure public good
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One that is both nonrivalrous and nonexcludable
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Figure 13: Pure Private, Pure Public
and Mixed Goods
Pure Private Good
More Excludable
More Rival
More Nonrival
• food, clothing,
housing
• sold-out movie
• crowded
highway
• newspaper
Mixed Good
• software
• movie with empty
seats
• uncrowded highway
• cable
television
• downloaded
music file
• urban park
• crowded
city streets
• fish in international
waters
• police and fire
protection
• national defense,
legal system
More Nonexcludable
Mixed Good
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Economics: Principles
Pure Public Good
34
Mixed Goods
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Goods that appear in upper right and
lower left corners of Figure 13 can be
called mixed goods
• Share features of both public and private
goods

These goods are becoming increasingly
important in our society
• Are responsible for some growing tension and
controversy
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Economics: Principles
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Excludable But Nonrivalrous Goods

Goods near lower left hand corner are excludable but
nonrivalrous
•
•
•
•
Includes most information products
Software is an essentially nonrivalrous good, but an excludable
one
•
Neither pure public nor pure private
Digital music files are another example of this type of mixed good
•
Currently, music remains somewhat excludable
•
•
It is against the law to make copyrighted music available online
Many people—either because of respect for the law, fear of getting
caught, lack of technical expertise, or scarce time—still prefer to buy their
music from a store or online shipping service
Music industry is desperately looking for ways to achieve greater
excludability
•
Has not yet found a good solution
Hall & Leiberman;
Economics: Principles
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Nonexcludable But Rivalrous Goods
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
Tragedy of commons occurs when rivalrous but nonexcludable
goods are overuse to detriment of all
An economy with well-functioning, perfectly competitive
markets tends to be economically efficient
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
Many types of government involvement are needed to ensure that
markets function well and to deal with market failures
Cases of government involvement are not without controversy
•
Debates about public education, Social Security, international trade,
and immigration center on questions of proper role for government
Some of the disagreement is over government’s role in bringing
about a more fair economy
•
Also debate about the government’s role in bringing about economic
efficiency
Hall & Leiberman;
Economics: Principles
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Nonexcludable But Rivalrous Goods
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
Information problems
•
While government may be able to move us closer to efficiency, it can also fall
short or overshoot based on inaccurate information
Incentive problems for government
•
Government officials are agents of the general public, and are supposed to
serve public interest
•
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However, they can be influenced by lobbies for special interest groups
In order for government to have the funds it needs to support markets
and do other things, it must raise revenue through taxes
Inherent problem with provision of public goods that almost guarantees
dissatisfaction about them
Other important roles for government besides fostering efficiency
•
Equity, fairness, justice, and more
Anyone studying role of government in the economies is struck by one
glaring fact
•
Most economic activity is carried out among private individuals
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Economics: Principles
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