Econ 2113: Principles of Microeconomics

Spring 2009 ECU

Efficiency and Equity

Chapter 5

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:

  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

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Market demand

7 D1

D2

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

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CS

Total Paid

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If the price of a soda is $6 per can, then:

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

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PS

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If the price of a soda is $6 per can, then:

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

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Q (mill.)

6

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CS

11 S

D

PS

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  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)

Total Surplus

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

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.

The efficient quantity is 10,000 pizzas a day.

Deadweight loss from overproduction

 Overproduction

If production is expanded to 15,000 pizzas a day, a deadweight loss arises from overproduction. This loss is a social loss.

Again, the efficient quantity is 10,000 pizzas a day.

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

  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.