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?

The Efficient Quantity of Pizza

MB

0 5 10 15 20

5

10

15

20

25

Quantity (thousands of pizzas per day)

Mar

gina

l cos

t and

mar

gina

l ben

efit

(dol

lars

wor

th o

f go

ods

and

serv

ices

)

The Efficient Quantity of Pizza

0 5 10 15 20

5

10

15

20

25

Quantity (thousands of pizzas per day)

Mar

gina

l cos

t and

mar

gina

l ben

efit

(dol

lars

wor

th o

f go

ods

and

serv

ices

)

MB

MC

The Efficient Quantity of Pizza

0 5 10 15 20

5

10

15

20

25

Quantity (thousands of pizzas per day)

Mar

gina

l cos

t and

mar

gina

l ben

efit

(dol

lars

wor

th o

f go

ods

and

serv

ices

)

MB

MC

Pizza valued morehighly than it costs:Increase production

Pizza costs morethan it is valued:Decrease production

The Efficient Quantity of Pizza

0 5 10 15 20

5

10

15

20

25

Quantity (thousands of pizzas per day)

Mar

gina

l cos

t and

mar

gina

l ben

efit

(dol

lars

wor

th o

f go

ods

and

serv

ices

)

MB

MCEfficient quantityof pizza

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

A Consumer’s Demand and Consumer Surplus

Quantity (slices of pizzas per week)0 10 20 30 40

0.50

1.00

1.50

2.00

2.50

Pric

e (d

olla

rs p

er s

lice

)

D = MB

A Consumer’s Demand and Consumer Surplus

Quantity (slices of pizzas per week)0 10 20 30 40

0.50

1.00

1.50

2.00

2.50

Pric

e (d

olla

rs p

er s

lice

)

Marketprice = $1.50

D = MB

A Consumer’s Demand and Consumer Surplus

Quantity (slices of pizzas per week)0 10 20 30 40

0.50

1.00

1.50

2.00

2.50

Pric

e (d

olla

rs p

er s

lice

)

Marketprice = $1.50

Amountpaid = $30 D = MB

A Consumer’s Demand and Consumer Surplus

Quantity (slices of pizzas per week)0 10 20 30 40

0.50

1.00

1.50

2.00

2.50

Pric

e (d

olla

rs p

er s

lice

)

Marketprice = $1.50

Amountpaid = $30

Consumer surplus from 20 pizzas = .5(20x1)=$10

D = MB

A Consumer’s Demand and Consumer Surplus

Quantity (slices of pizzas per week)0 10 20 30 40

0.50

1.00

1.50

2.00

2.50

Pric

e (d

olla

rs p

er s

lice

)

Marketprice = $1.50

Amountpaid = $30

Consumer surplus from 20 pizzas = .5(20x1)=$10

D=MB

ConsumptionValue of 20 slices=$30 + $10 = $40

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

A Producers Supplyand Producer Surplus

Quantity (pizzas per day)

5

10

15

20

25

Pric

e (d

olla

rs p

er p

izza

)

Price determinesquantity supplied

S=MC

0 50 100 150 200

5

10

15

20

25

Pric

e (d

olla

rs p

er p

izza

)

S=MC

Quantity (pizzas per day)

Marketprice = $15

0 50 100 150 200

A Producers Supplyand Producer Surplus

5

10

15

20

25

Pric

e (d

olla

rs p

er p

izza

)

S=MC

Quantity (pizzas per day)

Marketprice

Cost of Production = .5(100x10) + (100x5) = $1,000

0 50 100 150 200

A Producers Supplyand Producer Surplus

5

10

15

20

25

Pric

e (d

olla

rs p

er p

izza

)

S=MC

Quantity (pizzas per day)

MarketpriceProducer surplus

= .5(10x100) = $500

0 50 100 150 200

A Producers Supplyand Producer Surplus

Cost of Production = .5(100x10) + (100x5) = $1,000

5

10

15

20

25

Pric

e (d

olla

rs p

er p

izza

)

S=MC

Quantity (pizzas per day)

Marketprice

Cost of Production= $1,000

Producer surplusof $500 equals profit

0 50 100 150 200

A Producers Supplyand Producer Surplus

ProductionValue of 100

slices=$1000+$500

=$1,500

Is the CompetitiveMarket Efficient?

Recall– Supply and demand will force the price toward

the equilibrium price

Question: Is this the efficient quantity of pizza?

An Efficient Market for Pizza

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S Marginal cost--opportunity cost--of pizza

Marginal benefit--value--of pizza

Efficient quantityof pizzas

5

10

15

20

25

D

Is the CompetitiveMarket Efficient?

At Competitive Equilibrium

– Resources are being used efficiently– The sum of consumer surplus and producer

surplus is maximized

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

5

10

15

20

25

D

An Efficient Market for Pizza

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

Producersurplus = .5(10x10)=50

5

10

15

20

25

D

An Efficient Market for Pizza

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

Producersurplus= .5(10x10) =50

Consumersurplus= .5(10x10)=50

5

10

15

20

25

D

An Efficient Market for Pizza

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

Producersurplus= .5(10x10) =50

Consumersurplus= .5(10x10)=50

5

10

15

20

25

D

An Efficient Market for Pizza

Consumer Surplus+

Producer Surplus=50 +50 = 100

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

Underproduction (Say Monopoly)

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

5

10

15

20

25

D

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

5

10

15

20

25

D

UnderproductionConsumer Surplus

= .5(5x5)=12.5

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

5

10

15

20

25

D

UnderproductionConsumer Surplus

= .5(5x5)=12.5

Producer Surplus= (5x10) + .5(5x5)= 50 + 12.5 = 62.5

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

5

10

15

20

25

D

UnderproductionConsumer Surplus

= .5(5x5)=12.5

Producer Surplus= (5x10) + .5(5x5)= 50 + 12.5 = 62.5

Deadweightloss = .5(10x5) = 25

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

5

10

15

20

25

D

UnderproductionConsumer Surplus

= .5(5x5)=12.5

Producer Surplus= (5x10) + .5(5x5)= 50 + 12.5 = 62.5

Deadweightloss = .5(10x5) = 25

Consumer Surplus+

Producer Surplus= 12.5 + 62.5 = 75

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

S

5

10

15

20

25

D

Overproduction (Say Government Subsidy)

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

D

S

5

10

15

20

25

Overproduction

A

B

C

D

E

Consumer SurplusGain = B + G

Producer SurplusGain = A + D

Government Subsidy= B + G + A + D + F

FDeadweight Loss= B + G + A + D - B - G - A - D - F= F

G

Quantity (thousands of pizzas per day)0 5 10 15 20

Pric

e (d

olla

rs p

er p

izza

)

D

S

5

10

15

20

25

Deadweightloss

Overproduction

A

B

C

D

E

Consumer SurplusGain = B + G

Producer SurplusGain = A + D

Government Subsidy= B + G + A + D + F

FDeadweight Loss= B + G + A + D - B - G - A - D - F= F

G