María Alejandra Martíne

TOPIC 4
EFFICIENCY AND EQUITY

1. Resource allocation methods

1.1. Market Price
1.2. Command
1.3. Majority rule
1.4. Contest
1.5. First-come, first-served
1.6. Lottery
1.7. Personal Characteristics
1.8. Force

2. Benefit, Cost and Surplus

2.1. Demand, willingness to pay and Value
2.2. Demand
2.2.1. Individual Demand and Market Demand
2.2.2. Consumer Surplus
2.3. Supply
2.3.1. Supply, Cost and Minimum Supply-Price
2.3.2. Individual Supply and Market Supply
2.3.3. Producer Surplus

3. Is the competitive market efficient?

3.1. Efficiency of competitive equilibrium
3.1.1. Efficient quantity
3.1.2. The Invisible hand
3.2. Market Failure
3.2.1. Sources of Market Failure

4. Is the competitive market fair?

4.1. It’s Not Fair if the Result isn’t Fair
4.2. It’s Not Fair if the Rules aren’t Fair
 María Alejandra Martíne

1. RESOURCE ALLOCATION METHODS

Scarce resources might be allocated by:
1.1. Market Price
When a market allocates a scarce resource, they are bought to those who are
willing to pay a market price. The market is the one that, with its own functioning,
allocates the price of the products.

1.2. Command
Scarce resources are allocated by command when someone who has an
authority makes the order to allocate it. This works well in clear lines of command,
but in an economy it is more abstract, so it's more difficult.

1.3. Majority rule

The majority rule is used when the scarce resource affects a majority, and a
better decision is made if self-interests are suppressed.

1.4. Contest
Allocates resources to a winner.
Eg: The Oscars
Scarce resource: The awards

1.5. First-come, first-served

First-come first-served allocates resources to those who are first in line. It is
better used when the resource is better served one at a time.
Eg: In a restaurant, the first that come are first served.
Scarce resource: The tables

1.6. Lottery
Lottery allocates resources to the winning number. Lottery works well when
there is no effective way to distinguish among potential users.
Eg: The lottery.
Scarce resource: The winning money.

1.7. Personal characteristics

This way wants to allocate the resources to those with the best/right
characteristics.
Eg: A job position.
Scarce resource: The job position.

1.8. Force
Allocating resources by force. It can be violent (war) or passive and effective
(laws).
 María Alejandra Martíne

2. BENEFIT, COST AND SURPLUS

2.1. DEMAND, WILLINGNESS TO PAY AND VALUE
Value: It’s what we get from a purchase. The maximum price people are
willing to pay.
Marginal benefit: The value of one more unit of a good or service; the
additional satisfaction or utility we get from that purchase. It’s a maximum
amount a consumer is willing to pay for an additional good or service.
Willingness to pay: is the price of a good. It determines the demand. A
demand curve is a marginal benefit curve.

2.2. DEMAND
2.2.1. Individual Demand and Market Demand
Individual Demand: Relationship between the price of a good and the
quantity demanded by one person.
Market Demand: Relationship between the price of a good and the
quantity demanded by all buyers of a market
Market Demand Curve: The market demand curve is the horizontal
sum of the individual demand curves.

Example: Lisa and Nick are the only buyers in the pizza. The price of a slice is 1$.
Individual demand: Lisa is willing to buy 30 slides.
Nick is willing to buy 10 slides.
Market demand curve: Lisa’s demand + Nick’s demand = 40 slides.
 María Alejandra Martíne

2.2.2. Consumer Surplus

Is the difference between what the consumer is willing to pay as a
maximum for a good and what the consumer is actually paying for it.
Example: Lisa is actually paying 1$. But because of the demand curve, she is willing
to pay from 1$ to 2.50$.
Nick is actually paying 1$. But because of the demand curve, he is willing
to pay from 1$ to 1.50$
Market demand curve: All buyers are actually paying 1$. But are willing
to pay from 1$ to 2.50$
 María Alejandra Martíne

2.3. SUPPLY
To make profit, businesses must sell their products for a price that exceeds
the cost of production
2.3.1. Supply, Cost and Minimum Supply-Price
Cost: is what the producer gives up.
Price: is what the producer receives.
Minimum Supply Price/Marginal cost: Is the minimum price a
business is willing to accept. It determines supply. A supply curve is a
marginal cost curve.

2.3.2. Individual Supply and Market Supply

Individual Supply: The relationship between the price of a good and
what one producer is willing to supply.
Market Supply: The relationship between the price of a good and
what all producers are willing to supply.
Market supply curve: The horizontal sum of all individual supplies.
Example: Maria and Max are the only producers in the pizza. The price of a pizza is
15$.
Individual supply: Maria is willing to produce 100 pizzas.
Max is willing to produce 50 pizzas.
Market supply curve: Maria’s supply + Max’s supply = 150 pizzas
 María Alejandra Martíne

2.3.3. Producer Surplus

Is the difference between what the producers are willing to supply and
the amount they are actually supplying.

Example: The market price of a pizza is $15 and Maria is willing to produce
the 50th pizza x $10.
Maria’s surplus: The price (15$) minus The marginal cost (10$) = $5.
Max’s surplus: At $15 a pizza, Max sells 50 pizzas. The price (15$)
minus Maria’s surplus (5$) = 10$
Producer Surplus: Market supply curve: 150 pizzas at $15. 50 pizzas
for 10$, and 0 pizzas for 5$.
 María Alejandra Martíne

3. IS THE COMPETITIVE MARKET EFFICIENT?

3.1. EFFICIENCY OF COMPETITIVE EQUILIBRIUM
Marginal Social Cost (MSC): is the total cost
society pays for the production of another
unit.. (Supply)
Marginal Social Benefit (MSB): is the total
benefit to society from producing or
consuming a good/service. (Demand)
Equilibrium quantity: Is when the quantity
demanded equals the quantity supplied.
MSB = MSC
Resources are used efficiently if MSB=MSC.
When this is produced the total surplus
(CS+PS) is maximized.

3.1.1. The Invisible Hand by Adam Smith

The invisible hand theory states that there are unseen forces that
guide a free market economy to give us the best possible market outcomes.
These unseen forces come into action when individuals work towards
fulfilling their self-interests. The theory states that in the process of
promoting their own interest, individuals promote the public interest without
intending to do so.

3.2. MARKET FAILURE

Markets are not perfect, there can be failures. Market failure is when a market
delivers an inefficient outcome. It can happen because of:
Underproduction: Too little of an item is produced (< equilibrium quantity)
Overproduction: Too much of an item is produced (> equilibrium quantity)
 María Alejandra Martíne

3.2.1. Sources of Market Failure

● Price and quantity regulations
Price regulations: A forced block on the price can lead to underproduction
Quantity regulations: A forced block on the production can also lead to
underproduction.

● Taxes and subsidies

Taxes: Taxes increase the price paid by consumers and decrease the price
received by producers. Leading to underproduction.
Subsidies: Lower the price paid by buyers and increase the price paid by
producers. Leading to overproduction.

● Externalities:
Depending on the situation can cause over or underproduction.

● Public goods and common resources

Public good: A public product or service that is non-excludable and
nondepletable. It can lead to underproduction.
Common resource: Is owned by no one but can be used by everyone. It can
lead to overproduction (Tragedy of the Commons).

● Monopoly
A monopoly is a firm that is the sole provider of a good or service, its
self-interest is to maximize its profit. To do so, a monopoly sets a price to
achieve its self interest goal. As a result, a monopoly produces too little and
underproduction results.

● High transactions costs

Transactions costs are the opportunity cost of making trades in a
market, for example, transport. When transaction costs are high, the market
might underproduce.
 María Alejandra Martíne

4. IS THE COMPETITIVE MARKET FAIR?

4.1. It’s Not Fair if the Result isn’t Fair
Utilitarianism: is the principle that states that we should strive to achieve
“the greatest happiness for the greatest number.” It ignores the cost of
making this income.
Redistribution of wealth: Allocating money from the rich to the poor.
The Big Tradeoff: Recognizing the costs of income. Because of this John
Rawls proposed that the income should be redistributed so that the poorest
person is as well off as possible.

Example: Tom: Marginal Benefit = 3

Income: 5.000$
Jerry: Marginal Benefit = 1
Income: 45.000$
Taking dollars from Jerry and giving
them to Tom until they have equal
incomes increases total benefit.
(Maximum total benefit)

4.2. It’s Not Fair if the Rules aren’t Fair

Symmetry principle: is the requirement that people in similar situations be
treated similarly. Equality in opportunity not in income.
Robert Nozick suggested that fairness is based on two rules:
1. The state must create and enforce laws that establish and protect
private property.
2. 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.