1. McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Chapter 5: Efficiency and Equity

2. 5-2 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Objectives 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  Explain the connection between supply and marginal cost and define producer surplus  Explain the conditions under which markets are efficient and describe the sources of inefficiency in our economy  Explain the main ideas about fairness and evaluate claims that markets result in unfair outcomes

3. 5-3 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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?

4. 5-4 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Resource Allocation Methods  Resources might be allocated by:  Market price  Command  Majority rule  Contest  First-come, first-served  Lottery  Personal characteristics  Force

5. 5-5 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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

6. 5-6 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

7. 5-7 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

8. 5-8 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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

9. 5-9 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Individual Demand and Market Demand Figure 5.1

10. 5-10 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

11. 5-11 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Demand and Consumer Surplus Figure 5.2

12. 5-12 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

13. 5-13 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

14. 5-14 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Individual Supply and Market Supply Figure 5.3

15. 5-15 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

16. 5-16 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Supply and Producer Surplus Figure 5.4

17. 5-17 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

18. 5-18 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Producer surplus Consumer surplus Quantity (thousands of pizzas per day) 0 5 101520 Price (dollars per pizza) S 5 10 15 20 25 D An Efficient Market for Pizza Equilibrium Equilibrium quantity Figure 5.5(a)

19. 5-19 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

20. 5-20 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

21. 5-21 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

22. 5-22 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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

23. 5-23 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Quantity (thousands of pizzas per day) 0 5 101520 Price (dollars per pizza) S 5 10 15 20 25 D Underproduction Efficient output If output is reduced to 5,000 Deadweight loss Figure 5.6(a)

24. 5-24 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Deadweight loss Quantity (thousands of pizzas per day) 0 5 101520 Price (dollars per pizza) D S 5 10 15 20 25 Overproduction If output is increased to 15,000 pizzas Figure 5.6(b)

25. 5-25 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Is the Competitive Market Efficient?  Obstacles to efficiency that bring underproduction or overproduction are:  Price and quantity regulations  Taxes and subsidies  Externalities  Public goods and common resources  Monopoly  High transactions costs

26. 5-26 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

27. 5-27 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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

28. 5-28 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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. ”

29. 5-29 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Utilitarian Fairness MB 0 5 25 45 1 2 3 Income (thousands of dollars) Marginal benefit (units) Tom a Maximum total benefit b c Steve Figure 5.7

30. 5-30 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Is the Competitive Market Fair?  The Big Tradeoff  Recognising the cost of making income transfers leads to what is called “the big tradeoff,” which is a tradeoff between efficiency and fairness.

31. 5-31 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

32. 5-32 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

33. 5-33 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Is the Competitive Market Fair?  Fairness and efficiency  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

34. 5-34 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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?

35. 5-35 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Is the Competitive Market Fair? Case study option 1:  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.

36. 5-36 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Is the Competitive Market Fair? Case study option 2:  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.

37. 5-37 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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.

38. 5-38 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia END CHAPTER 5