CHAPTER 5: Efficiency and

Equity
 SELF-INTEREST AND THE
SOCIAL INTEREST
People are constantly striving to get more out of their scarce
resources – you make choices that further your self-interest.
Markets coordinate ones decisions along with those of
everyone else
Are market outcomes fair outcomes? Do markets enable us to
allocate resources in the social interest?
Does the market achieve an efficient and fair use of resources?
RESOURCE ALLOCATION
METHODS
Resources might be allocated by:
 Market price
 Command
 Majority rule
 Contest
 First-come, first-served
 Lottery
 Personal characteristics
 Force
RESOURCE ALLOCATION
METHODS
Market price
 When a market price allocates a scarce resource, then people who are willing and
able to pay that price get the resource

Command
 A command system allocates resources by the order (command) or someone in
authority

Majority rule
 Allocates resources in the way that a majority of voters choose
RESOURCE ALLOCATION
METHODS
Contest
 Allocates resources to a winner (or a group of winners). Sporting events use this
method

First-come, first-served
 Allocates resources to those who are first in line

Lottery
 Allocates resources to those who pick the winning number, draw the lucky cards, or
come up lucky on some other gaming system.
DEMAND, MARGINAL
BENEFIT, AND CONSUMER
SURPLUS
Demand, willingness to pay, and value
 The value of one more unit of a good or service is its marginal benefit, which we can
measure as maximum price that a person is willing to pay.
 Willingness to pay determines demand.
 A demand curve is a marginal benefit curve.
 DEMAND, MARGINAL
BENEFIT, AND CONSUMER
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 is
called market demand
 The market demand curve is the horizontal sum of the individuals demand curve as shown
in Figure 5.1
INDIVIDUAL DEMAND Figure 5.1

AND MARKET DEMAND

DEMAND, MARGINAL
BENEFIT, AND CONSUMER
SURPLUS
Consumer 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.
 Figure 5.2 on the next slide shows the consumer surplus for pizza for an individual
consumer.
DEMAND AND CONSUMERFigure 5.2
SURPLUS
 SUPPLY, MARGINAL COST,
AND PRODUCER SURPLUS
Supply, cost, and minimum supply price
 The cost of one more unit of a good or service is its marginal cost, which we can measure as
minimum price that a firm is willing to accept.
 A supply curve of a good or service shows the quantity supplied at each price.
 A supply curve is a marginal cost curve.
 SUPPLY, MARGINAL COST,
AND PRODUCER 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 b y all producers is
called market supply.
 The market supply curve is the horizontal sum of the individuals supply curve, as shown in
Figure 5.3 on the next slide.
INDIVIDUAL SUPPLY ANDFigure 5.3
MARKET SUPPLY
 COST, PRICE, AND
PRODUCER SURPLUS
Producer surplus
 Producer surplus is the price of a good minus the marginal cost of producing it, summed
over the quantity sold.
 Producer surplus is measured by the area below the price and above the supply curve, up to
the quantity sold.
 Figure 5.4 on the next slide shows the producer surplus for pizza for an individual producer.
SUPPLY AND PRODUCER Figure 5.4

SURPLUS
 IS THE COMPETITIVE
MARKET EFFICIENT?
Efficiency of competitive equilibrium
 A competitive market creates an efficient allocation of resources at equilibrium.
 In equilibrium, the quantity demanded equals the quantity supplied.
AN EFFICIENT MARKET
FOR PIZZA
Price (dollars per pizza)
Figure 5.5(a)

Consumer S
25 surplus

20
Equilibrium
15

10

5 Producer
Equilibrium
surplus quantity
D

0 5 10 15 20
Quantity (thousands of pizzas per day)
 IS THE COMPETITIVE
MARKET EFFICIENT?
 At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the
efficient quantity.
 The sum of consumer and producer surplus is maximised at this efficient level of output.
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.
 See illustration on page 155 of the text.
IS THE COMPETITIVE
MARKET EFFICIENT?
The invisible hand at work today
 The invisible hand works in our economy today.
 It coordinates the self-interest of producers and consumers of computers, oranges, and just
about every good or service that you can think of.
IS THE COMPETITIVE
MARKET EFFICIENT?
Underproduction and overproduction
 Obstacles to efficiency lead to underproduction or overproduction and create a deadweight
loss.

Deadweight loss
 The decrease in consumer and producer surplus that results from an inefficient allocation of
resources
 UNDERPRODUCTION Figure 5.6(a)
Price (dollars per pizza)

Deadweight S
25 loss

20

15
Efficient
10 output

If output is
reduced to 5
D
5,000
0 5 10 15 20
Quantity (thousands of pizzas per day)
OVERPRODUCTION Figure 5.6(b)
Price (dollars per pizza)

S
25

20
Deadweight
15 loss

10

5 If output
D is increased to
15,000 pizzas
0 5 10 15 20
Quantity (thousands of pizzas per day)
IS THE COMPETITIVE
MARKET EFFICIENT?
Obstacles to efficiency that bring underproduction or overproduction are:
 Price and quantity regulations
 Taxes and subsidies
 Externalities
 Public goods
 Monopoly
 High transactions costs
 IS THE COMPETITIVE
MARKET EFFICIENT?
Alternatives to the market
 When a market is inefficient can an alternative non-market method do a better job?
 Majority rule might be used in a number of ways to improve the allocation of resources, but
it has its own shortcomings.
 There is no one efficient mechanism for allocating resources efficiently.
IS THE COMPETITIVE
MARKET FAIR?
Are markets fair?
 Ideas about fairness can be divided into two groups:
1. It’s not fair if the result isn’t fair
2. It’s not fair if the rules aren’t fair
 IS THE COMPETITIVE
MARKET FAIR?
1. It’s not fair if the result isn’t fair
 The idea that “it’s not fair if the result isn’t fair” began with utilitarianism, which is
the principle that states that we should strive to achieve “the greatest happiness for the
greatest number.”
UTILITARIAN FAIRNESS Figure 5.7

Marginal benefit (units) Tom

3 a Maximum
total
benefit
2 c
Steve
1 b

MB

0 5 25 45
Income (thousands of dollars)
 IS THE COMPETITIVE
MARKET
The Big Tradeoff
FAIR?
 Recognising the cost of making income transfers leads to what is called “the big tradeoff,”
which is a tradeoff between efficiency and fairness .
 IS THE COMPETITIVE
MARKET FAIR?
Make the poorest as well off as possible
 Harvard philosopher, John Rawls, proposed a modified version of utilitarianism in a
classic book entitled A Theory of Justice, published in 1971. Rawls says that, taking all
the costs of income transfers into account, the fair distribution of the economic pie is the
one that makes the poorest person as well off as possible.
 IS THE COMPETITIVE
MARKET FAIR?
2. 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.
 IS THE COMPETITIVE
MARKET
Fairness and efficiency
FAIR?
 If private property rights are enforced and if voluntary exchange takes place in competitive
markets, and if there are no:
 Price and quantity regulations
 Taxes and subsidies
 Externalities
 Public goods and common resources
 Monopolies
 High transactions costs
IS THE COMPETITIVE
MARKET FAIR?
Case study: A water shortage in a natural disaster

Scenario: An earthquake has broken the pipes that deliver drinking water to a city.
Bottled water is available, but there is no tap water
What is the fair and efficient way to allocate the bottled water?
 IS THE COMPETITIVE
MARKET
Case study option 1: FAIR?
Market price
 Water is allocated by market price, the price jumps to $8 a bottle. At this price, people who own
water can make a large profit
 People who are willing and able to pay $8 a bottle get the water, and those who can’t afford the
$8 end up without or consume less water .
 Water is, thus, used efficiently, with maximum consumer and producer surplus, and the outcome
is also fair.
 IS THE COMPETITIVE
MARKET
Case study option 2: FAIR?
Non-market methods
 The government buys all the water, pay for it with a tax, and allocate to its citizens using one of
the following non-market methods
 Command
 Contest
 First-come first-served
 Lottery
 Personal characteristics
 None of these methods delivers an allocation of water that is either fair or efficient.
IS THE COMPETITIVE
MARKET FAIR?
Case study option 3:
Market price with taxes
 The third approach is to allocate the scarce water using the market price but after
redistributing buying power by taxing the sellers of water and providing benefits to
the poor.
 The tax is inefficient, but the outcome might be regarded as being fair.
END
CHAPTER 5