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Efficiency Equity
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 Efficiency and Equity
5

1
After studying this chapter you will be able to

 Describe the alternative methods of allocating scarce

resources
 Explain the connection between demand and marginal
benefit and define consumer surplus; and ...
explain the connection between supply and marginal
cost and define producer surplus
 Explain the conditions under which markets are efficient
and inefficient

2
Resource Allocation Methods
Scare resources might be allocated by
 Market price
 Command
 Majority rule
 Contest
 First-come, first-served
 Sharing equally
 Lottery
 Personal characteristics
 Force
How does each method work?
3
Resource Allocation Methods
 Market Price
When a market allocates a scarce resource, the
people who get the resource are those who are
willing to pay the market price.
Most of the scarce resources that you supply get
allocated by market price.
You sell your labour services in a market, and you
buy most of what you consume in markets.
For most goods and services, the market turns out
to do a good job.

4
Resource Allocation Methods
 Command
Command system allocates resources by the
order (command) of someone in authority.
For example, if you have a job, most likely
someone tells you what to do. Your labour time is
allocated to specific tasks by command.
A command system works well in organizations
with clear lines of authority but badly in an entire
economy.

5
Resource Allocation Methods
 Majority Rule
Majority rule allocates resources in the way the
majority of voters choose.
Societies use majority rule for some of their
biggest decisions.
For example, tax rates that allocate resources
between private and public use and tax dollars
between competing uses such as defense and
health care.
Majority rule works well when the decision affects
lots of people and self-interest must be suppressed
to use resources efficiently.

6
 Resource Allocation Methods
 Contest
A contest allocates resources to a winner (or
group of winners).
The most obvious contests are sporting events
but they occur in other arenas:
For example: The Oscars are a type of contest. So
is the CEO the winner of a contest.
Contest works well when the efforts of the
“players” are hard to monitor and reward directly.
7
 Resource Allocation Methods
 First-Come, First-Served
A first-come, first-served allocates resources to
those who are first in line.
Casual restaurants use first-come, first served to
allocate tables. Supermarkets also uses first-come,
first-served at checkout.
First-come, first-served works best when scarce
resources can serve just one person at a time in a
sequence.

8
 Resource Allocation Methods
 Lottery
Lotteries allocate resources to those with the
winning number, draw the lucky cards, or come up
lucky on some other gaming system.
State lotteries and casinos reallocate millions of
dollars worth of goods and services each year.
But lotteries are more widespread. For example,
they are used to allocate landing slots at some
airports.
Lotteries work well when there is no effective way
to distinguish among potential users of a scarce
resource.
9
 Resource Allocation Methods
 Personal Characteristics
Personal characteristics allocate resources to
those with the “right” characteristics.
For example, people choose marriage partners
on the basis of personal characteristics.
But this method gets used in unacceptable ways:
allocating the best jobs to white males and
discriminating against minorities and women.

10
 Resource Allocation Methods
 Force
Force plays a role in allocating resources.
For example, war has played an enormous role
historically in allocating resources.
Theft, taking property of others without their
consent, also plays a large role.
But force provides an effective way of allocating
resources—for the state to transfer wealth from
the rich to the poor and establish the legal
framework in which voluntary exchange can take
place in markets.
11
 Benefit, Cost, and Surplus
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.
But willingness to pay determines demand.
A demand curve is a marginal benefit curve.

12
 Benefit, Cost, and Surplus
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.
Figure 5.1 on the next slide shows the connection
between individual demand and market demand.

13
Benefit, Cost, and Surplus
Lisa and Nick are the only buyers in the market for
pizza.

At $1 a slice, the quantity demanded by Lisa is 30 slices.

14
Benefit, Cost, and Surplus
Lisa and Nick are the only buyers in the market for
pizza.

At $1 a slice, the quantity demanded by Nick is 10 slices.

15
 Benefit, Cost, and Surplus
At $1 a slice, the quantity demanded by Lisa is 30 slices
and by Nick is 10 slices.
The quantity demanded by all buyers in the market is 40 slices.

16
 Benefit, Cost, and Surplus
The market demand curve is the horizontal sum of the
individual demand curves.

17
Benefit, Cost, and Surplus
are to
what
Consumer Surplus youwhat willing pay
youpay
Consumer surplus is the excess of the benefit
received from a good over the amount paid for it.
We can calculate consumer surplus as the
marginal benefit (or value) of a good minus its
price, 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.
Figure 5.2 on the next slide shows the consumer
surplus from pizza when the market price is $1 a
slice.
18
Benefit, Cost, and Surplus
Lisa and Nick pay the market price, which is $1 a slice.
The value Lisa places on the 10th slice is $2.
Lisa’s consumer surplus from the 10th slice is the value
minus the price, which is $1.

19
Benefit, Cost, and Surplus
At $1 a slice, Lisa buys 30 slices.

So her consumer surplus is the area of the green

triangle.

20
 Benefit, Cost, and Surplus
At $1 a slice, Nick buys 10 slices.

So his consumer surplus is the area of the green triangle.

21
 Benefit, Cost, and Surplus
At $1 a slice, the consumer surplus for the economy is the
area under the market demand curve above the market
price, summed over the 40 slices bought.

22
 Benefit, Cost, and Surplus
At $1 a slice, Lisa spends $30, Nick spends $10, and
together they spend $40 on pizza.
The consumer surplus is the value from pizza in excess of
the expenditure on it.

23
Benefit, Cost, and Surplus
Supply and Marginal Cost
Firms are in business to make a profit.
To make a profit, firms must sell their output for a
price that exceeds the cost of production.
Firms distinguish between cost and price.

24
 Benefit, Cost, and Surplus
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.
But the minimum supply-price determines supply.
A supply curve is a marginal cost curve.

25
 Benefit, Cost, and Surplus
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.
Figure 5.3 on the next slide shows the connection
between individual supply and market supply.

26
 Benefit, Cost, and Surplus Price
Price Market
Maria and Mario are the only producers of pizza.
At $15 a pizza, the quantity supplied by Maria is 100
pizzas.

27
 Benefit, Cost, and Surplus
Maria and Mario are the only producers of pizza.
At $15 a pizza, the quantity supplied by Mario is 50
pizzas.

28
 Benefit, Cost, and Surplus
At $15 a pizza, the quantity supplied by Maria is 100
pizzas and by Mario is 50 pizzas.
The quantity supplied by all producers is 150 pizzas.

29
 Benefit, Cost, and Surplus
The market supply curve is the horizontal sum of the
individual supply curves.

30
Benefit, Cost, and Surplus
Price sold for price
Producer Surplus are to sell for you
willing
Producer surplus is the excess of the amount
received from the sale of a good over the cost of
producing it.
We calculate it as the price received for a good minus
the minimum-supply price (marginal cost), summed
over the quantity sold.
On a graph, producer surplus is shown by the area
below the market price and above the supply curve,
summed over the quantity sold.
Figure 5.4 on the next slide shows the producer
surplus from pizza when the market price is $15 a pizza.
31
Benefit, Cost, and Surplus
Maria is willing to produce the 50th pizza for $10.
Maria’s surplus from the 50th pizza is the price
minus the marginal cost, which is $5.

32
Benefit, Cost, and Surplus
At $15 a pizza, Maria sells 100 pizzas.

So her producer surplus is the area of the blue

triangle.

33
Benefit, Cost, and Surplus
At $15 a pizza, Mario sells 50 pizzas.

So his producer surplus is the area of the blue

triangle.

34
 Benefit, Cost, and Surplus
At $15 a pizza, the producer surplus for the
economy is the area under the market price above
the market supply curve, summed over the 150
pizzas sold.

35
Benefit, Cost, and Surplus
The red areas show the cost of producing the
pizzas sold.
The producer surplus is the value of the pizza sold
in excess of the cost of producing it.

36
Is the Competitive Market Efficient?
Efficiency of
Competitive Equilibrium
Figure 5.5 shows that a
competitive market
creates an efficient
allocation of resources at
equilibrium.
In equilibrium, the
quantity demanded
equals the quantity
supplied.
37
Is the Competitive Market Efficient?
When production is:

 less than the

equilibrium quantity,
MSB > MSC.

 greater than the

equilibrium quantity,
MSC > MSB.

 equal to the equilibrium

quantity, MSC = MSB.

38
Is the Competitive Market Efficient?
Resources are used
efficiently when
marginal social
benefit equals
marginal social cost.

When the efficient

quantity is produced,
total surplus (the sum
of consumer surplus and
producer surplus) is
maximized.

39
Is the Competitive Market Efficient?
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.

40
 Is the Competitive Market
Efficient?
Market Failure
Markets don’t always achieve an efficient
outcome.
Market failure arises when a market delivers
in inefficient outcome.
Market failure can occur because
 Too little of an item is produced
(underproduction) or
 Too much of an item is produced
(overproduction).
41
Is the Competitive Market
Efficient?
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 grey triangle.

This loss is a social loss.

42
 Is the Competitive Market
Efficient?
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.

43
 Is the Competitive Market
Efficient?
Sources of Market Failure
In competitive markets, underproduction or
overproduction arise when there are
 Price and quantity regulations
 Taxes and subsidies
 Externalities
 Public goods and common resources
 Monopoly
 High transactions costs 44
Is the Competitive Market
Efficient?
Price and Quantity Regulations
Price regulations sometimes put a block of the
price adjustments and lead to underproduction.
Quantity regulations that limit the amount that
a farm is permitted to produce also leads to
underproduction.

45
 Is the Competitive Market
Efficient?
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.

46
 Is the Competitive Market
Efficient?
Externalities
An externality is a cost or benefit that affects
someone other than the seller or the buyer of a
good.
An electric utility creates an external cost by
burning coal that creates acid rain.
The utility doesn’t consider this cost when it
chooses the quantity of power to produce.
Overproduction results.

47
Is the Competitive Market
Efficient?
An apartment owner would provide an external
benefit if she installed an smoke detector. But she
doesn’t consider her neighbor’s marginal benefit
and decides not to install the smoke detector.
The result is underproduction.

48
 Is the Competitive Market
Efficient?
Public Goods and Common Resources
A public good benefits everyone and no one can be
excluded from its benefits.
It is in everyone’s self-interest to avoid paying for a
public good (called the free-rider problem), which
leads to underproduction.

49
Is the Competitive Market
Efficient?
A common resource is owned by no one but can be
used by everyone.
It is in everyone’s self interest to ignore the costs of
their own use of a common resource that fall on
others (called tragedy of the commons).
The tragedy of the commons leads to
overproduction.

50
 Is the Competitive Market
Efficient?
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.

51
 Is the Competitive Market
Efficient?
High Transactions Costs
Transactions costs are the costs of services that
enable a market to bring buyers and sellers
together.
To use the market price as the allocator of scarce
resources, it must be worth bearing the transactions
costs of establishing a market.
Some markets are just too costly to operate.
When transactions costs are high, the market
might underproduce.

52