Chapter5

Efficiency&Equity

Figures from the text Copyright 2014 Pearson Addison Wesley

Whenyoubuyapairofshoesoratextbookorfillyourgastank,orevenjusttake
ashower,youexpressyourviewabouthowscarceresourcesshouldbeused.
Youmakechoicesthatareinyourselfinterest.
Pricesinmarketscoordinateyourchoiceswiththoseofeveryoneelse.Do
marketsdoagoodjob?
Dotheyenableourselfinterestedchoicestoalsobeinthesocialinterest?
Youcanaffordtobuyapizza,butitmightbeanunaffordableluxuryforavery
poorperson.
Isthissituationfair?
Howdootherresourceallocationmethodscompare?

ResourceAllocationMethods
Scareresourcesmightbeallocatedby

Marketprice>allocativeefficiency
Command(insidefirms)
Majorityrule(elections)
Contest(sportingevents,promotions)
Firstcome,firstserved(restaurants)
Lottery(incomereallocation)
Personalcharacteristics(friends,discrimination)
Force(war,theft)

Efficiency
Allocativeefficiencymeansresourcesareusedtoproducethe
goodsandservicesthatpeoplevaluethemost.(Efficientuse
ofresources.)
Impossibletoproducemoreofagoodorservicewithout
givingupsomeothergoodorservicethatismorehighly
valued.
Efficiencyispartlybasedonvalue,andpeoplespreferences
determinevalue.

Marginalbenefitisthebenefitthataperson
receivesfromconsumingonemoreunitofagood
orservice.
Measuredasthemaximumamountthatapersonis
willingtogiveupforoneadditionalunit.
Canbemeasuredinothergoodsorasthedollar
valueofthoseothergoods.
Principleofdecreasingmarginalbenefit:marginal
benefitdecreasesasconsumptionincreases.
Ademandcurveisamarginalbenefitcurve.

IndividualDemand&MarketDemand
Therelationshipbetweenthepriceofagoodandthe
quantitydemandedbyonepersoniscalledindividual
demand.
Therelationshipbetweenthepriceofagoodandthe
quantitydemandedbyallbuyersinthemarketiscalled
marketdemand.
Wehorizontallysumtheindividualdemandstogetthe
marketdemand(foreachprice,addeachpersonsquantity
demanded).
Themarketdemandcurveisamarginalsocialbenefit
(MSB)curve.Itreflectsthetotalbenefitstosocietyof
producingeachunit.

Horizontallysummingtwoconsumersdemands.

Valuev.Price
Priceofanitemistheamountabuyeractuallypaysfor
anadditionalunit.
Valueofanitemisthesamethingasitsmarginalbenefit
themaximumpricepeoplearewillingtopayforan
additionalunit.

ConsumerSurplus
Consumersurplusisthevalueofsomethingminusthe
pricepaidforit.

Consumersurplus=ValuePrice

Ifapersonbuyssomethingforlessthans/heiswillingto
payforit,s/heenjoysaconsumersurplus.
Consumersurplusisthevalueofagoodminustheprice
paidforit,summedoverthequantitybought.
Itismeasuredbytheareaunderthedemandcurveand
abovethepricepaid,uptothequantitybought.

Application:
Ifthepriceofasliceofpizzais$1.00,whatisLisastotal
consumersurplus?WhatisLisasconsumersurplusonjust
the10thslice?Whatisthetotalmarketconsumersurplus?

Opportunitycost:thevalueofthenextbest
alternativeforegone.
Marginalcostistheopportunitycostofproducing
onemoreunitofagoodorservice.
Theminimumamountthatapersonmustreceiveto
bewillingtoproduceoneadditionalunit.
Canbemeasuredinothergoodsorasthedollarvalue
ofthoseothergoods.
Principleofincreasingmarginalcost:marginalcost
increasesasthequantityproducedincreases.
Asupplycurveisamarginalcostcurve.

IndividualSupply&MarketSupply
Therelationshipbetweenthepriceofagoodandthequantity
suppliedbyoneproduceriscalledindividualsupply.
Therelationshipbetweenthepriceofagoodandthequantity
suppliedbyallproducersinthemarketiscalledmarket
supply.
Wehorizontallysumtheindividualsuppliestogetthemarket
supply(foreachprice,addeachfirmsquantitysupplied).
Themarketsupplycurveisamarginalsocialcost(MSC)
curve.Itreflectsthetotalcoststosocietyofproducingeach
unit.

Horizontallysummingtwoproducerssupplies.

Costv.Price
Priceofanitemistheamountaselleractually
receivesforanadditionalunit.
Costofanitemisthesameasitsopportunitycost
ormarginalcost:
whatthesellermustgiveupinorderto
produceanadditionalunit;
theminimumsupplypriceforanadditional
unit.

ProducerSurplus

Producersurplusisthepricereceivedforsomethingminustheopportunitycostof
producingit.
Producersurplus=PriceCost
Ifafirmsellssomethingformorethanitcoststoproduce,aproducersurplus
exists.
Producersurplusisthepriceofagoodminusthemarginalcostofproducingit,
summedoverthequantitysold.
Producersurplusismeasuredbytheareabelowthepriceandabovethesupply
curve,uptothequantitysold.
Producersurplusisacomponentofprofit.

Application:
Ifthepriceofapizzais$15.00,whatisMariastotal
producersurplus?WhatisMariasproducersurplusonjust
the50thpizza?Whatisthetotalmarketproducersurplus?

Marias S = MC
Marias producer
surplus

Maxs S = MC
Maxs
producer
surplus

Marias producer
surplus from the
50th pizza

Marias producer surplus

Maxs producer surplus

Market producer surplus

Socialv.PrivateCostsandBenefits
Iftheonlypeoplewhobearthecostofproducing
pizzaarethepeoplewhoactuallyproducethe
pizza,thenthemarginalcostofpizza(MC)also
equalsthemarginalsocialcostofpizza(MSC).

Iftheonlypeoplewhoreapthebenefitofpizza
arethepeoplewhoactuallybuyit,thenthe
marginalbenefitofpizza(MB)alsoequalsthe
marginalsocialbenefitofpizza(MSB).

Wewillassumethisunlessyouaretoldotherwise.

EfficientUseofResources
OurRulesofMarginalAnalysisbecome:
IfMSB>MSC,weshouldincrease
productionofthatgood.
IfMSC>MSB,weshoulddecrease
productionofthatgood.
WhenMSB=MSC,resourcesarebeingused
efficiently.

Marginal social cost and marginal social benefit

(dollars worth of goods and services)

TheEfficientQuantityofPizza
25

Pizza valued more

highly than it costs
(MSB > MSC):
Increase production

S=MSC
Pizza costs more
than it is valued
(MSC>MSB):
Decrease
production

20
15
10
5
05

Efficient quantity
of pizza (MSB=MSC)

10

15

D=MSB

20

Quantity (thousands of pizzas per day)

Application:
Startingattheefficientlevelofpizzaproduction,think
aboutproducingonemoreunitofpizza.
Whatisgivenupandwhatisgained?
Whichislarger?

Application:
Startingattheefficientlevelofpizzaproduction,think
aboutproducingonelessunitofpizza.
Whatisgivenupandwhatisgained?
Whichislarger?

 Attheefficientlevelofpizzaproduction:
Ifweproducemorepizza,wegiveupgoodsand
services(MSC)wevalueevenmorehighlythanthe
additionalpizza(MSB).
Ifweproducelesspizza,thepizzawegiveup(MSB)is
morevaluablethanthegoodsandservicesweget
insteadofthepizza(MSC).

CompetitiveMarketsareEfficient
Marketforceswillpullthepizzamarkettoan
equilibriumpriceof$15andanequilibriumquantity
of10,000pizzas.(Moreaboutthiswhenwegoback
toChapter3.)
Q: Istheresultingequilibriumquantitytheefficient
quantityofpizza?
A: AtCompetitiveEquilibrium
Resourcesareusedefficiently(MSB=MSC).
Thesumofconsumersurplusandproducer
surplus(thetotalsurplustosociety)is maximized.

= MSC

= MSB

Thisisaverynicepropertyofcompetitivemarkets:
Inacompetitivemarket,theforcesofsupplyanddemand
allocateresourcestotheirhighestvalueduseand
maximizethegainsfromtrade.
Thecompetitiveequilibriumquantityistheallocative
efficientquantity.
Nooneplansthis,nooneintendsforthistohappen,no
oneeventhinksaboutit.
Itjusthappensandthemarketmechanismisself
correctingandmaintenancefree!

Famousquote:
AdamSmithTheWealthofNations(1776)
Eachparticipantinacompetitivemarketisledby
aninvisiblehandtopromoteanend[theefficient
useofresources]whichwasnotpartofhis
intention.

Notethatallthesenicepropertiesapplyonlytoa
competitivemarket.
Thereareseveralsituationswheremarketsfailto
deliverefficientoutcomes

SourcesofInefficiency
Priceceilingsandpricefloors
Taxes,subsidies,andquotas
Monopoly(andmonopsony)
Publicgoodsandcommonresources
Externalcostsandexternalbenefits(externalities)
HighTransactionsCostsand/orIncompleteinformation

Thesesituationsleadtoeitherunderproductionor
overproductionofthegood.
Theamountofresourcesallocatedtoproductionofthe
goodiseithergreaterorlessthantheefficientamount.
Thismeansthateconomicwelfarecouldbeincreased
byallocatingresourcesdifferently;however,themarket
failstodothis.

DeadweightLossisthedecreaseinconsumerand
producersurplusthatresultsfromaninefficient
allocationofresources.
Calleddeadweightlossbecauseitissurplusthat
isnotcapturedbyanyoneitisasocialloss.
(Itisnotthecasethatitisalossforconsumersbut
againforproducers,orviceversa.Nobody
capturesthelostsurplus.)

InefficiencyDueToUnderproduction

Application:
Whatisthevalueofthedeadweightlossinthepreviousslide?
Iftheequilibriumpricewere$15butthequantityboughtandsoldwas
restrictedto5thousandpizzasforsomereason,whatwouldbethe
consumersurplus?
Whatwouldbetheproducersurplus?

InefficiencyDueToOverproduction

Application:
Whatisthevalueofthedeadweightlossintheprevious
slide?

Efficiencyisaveryimportantconceptineconomics
andwewillreturntoitmanytimes.
Economistsagreeaboutefficiencyitmakessenseto
maketheeconomicpieaslargeaspossibleandto
produceitatthelowestpossiblecost.
However,efficiencyimpliesabsolutelynothingabout
equityorfairness.
Economistsdonotagreeaboutequity,thoughthey
havethoughtaboutit.

IstheCompetitiveMarketFair?
Ideasaboutequityorfairnesscanbedividedintotwo
groups:

1.Itsnotfairiftheresultisntfair.
2.Itsnotfairiftherulesarentfair.

ItsNotFairIfTheResultIsntFair
Utilitarianismistheprinciplethatstatesthatweshould
strivetoachievethegreatesthappinessforthegreatest
number.(JeremyBentham,JohnStuartMill)
Utilitariansbelievedonlyincomeequalitybringsefficiency.
Ifeveryonegetsthesamesatisfactionfromagivenamount
ofincome,andifthemarginalbenefitofincomedecreases
asincomeincreases,thentakingadollarfromaricher
personandgivingittoapoorerpersonincreasesthetotal
benefittosociety.
Onlywhenincomeisequallydistributedhasthegreatest
totalsocialhappinessbeenachieved.

Tomispoorandhasa
highmarginalbenefitof
income.
Jerryisrichandhasalow
marginalbenefitof
income.
TakingdollarsfromJerry
andgivingthemtoTom
untiltheyhaveequal
incomesincreasestotal
benefit.

Utilitarianismignoresthecostofmakingincometransfers.
Recognizingthesecostsleadstothebigtradeoffbetween
efficiencyandfairness.
Taxingindividualsincomesreducestheirincentivetobe
productive
Administrativecostsmaymeanthat$1takenfromarich
resultsinlessthan$1giventoapoorperson.
Inthefollowingslide,noticethateventhoughthepieis
dividedequally(2,2)afterredistribution,Tomisworseoff
thanbeforebecausethepiehasshrunkensodramaticallyin
theActual?scenario.

TheBigTradeoff:a10ozpizza

Jerry
5

Jerry
7

Tom
3

Tom
5

l
a
e
Id

Act
ual

Jerry Tom
2
2

IftoomuchpizzaistakenawayfromJerry,hisincentive
toproduceisreduced.Lesspizzatodividebetweenthetwo.

Becauseofthebigtradeoff,JohnRawlsproposedthat,
takingallthecostsofincometransfersintoaccount,thefair
distributionoftheeconomicpieistheonethatmakesthe
poorestpersonaswelloffaspossible.

Taxtheincomesoftherich
Paythecostsofthetax/transfersystem
Givewhatislefttothepoor
Besurewhatpoorgetsisbetterthanwhattheydget
withouttheredistribution.

Thismaynotresultinanequaldistribution.

RawlssModifiedUtilitarianism

Jerry
7

Tom
3

Rawls

Jerry
5

Tom
4

ItsNotFairIfTheRulesArentFair
Theideathatitsnotfairiftherulesarentfairisbasedon
thesymmetryprinciple.
Thesymmetryprincipleistherequirementthatpeoplein
similarsituationsbetreatedsimilarly.
Ineconomics,thisprinciplemeansequalityofopportunity,
notequalityofincome.

RobertNozicksuggestedthatfairnessisbasedontworules:

1. Thestatemustcreateandenforcelawsthatestablish
andprotectprivateproperty.

(everythingvaluablemustbeownedandtheftisprevented)

2. Privatepropertymaybetransferredfromonepersonto
anotheronlybyvoluntaryexchange.

(toacquirepropertyapersonbuysitinexchangeforsomething
s/heowns.)

Iftheserules,whicharetheonlyfairrules,arefollowed,
thentheresultisfair.
Thismeanstheefficientallocationisafaironeevenifthe
pieisunequallyshared.

HowtoAllocateGenerators?
CaseStudy:
HurricaneKatrinashutdownelectricitysuppliesovera
wideareaandincreaseddemandforportablegenerators.
Onlyafewpeopleinitiallypossessportablegenerators.
Comparemethodsofallocatingthegenerators.Arethey
efficient?Aretheyfair?Bywhatstandardfairresultsor
fairrules?

HowtoAllocateGenerators?

MarketPrice:

EfficientYes,FairRulesYes,FairResultsNotlikely

Alternativemethods(command,majorityrule,contest,
firstcomefirstserved,lottery,personalcharacteristics,
andforce)
EfficientOnlybychance,
FairRulesNo(distributioninvolvesinvoluntary
transfers)
FairResultsNotlikely(poorarentmadeaswelloffas
possible)