EFFICIENCY AND

EQUITY
5
CHAPTER
Objectives

After studying this chapter, you will able to

 Define efficiency
 Distinguish between value and price and define
consumer surplus
 Distinguish between cost and price and define producer
surplus
 Explain the conditions under which markets move
resources to their highest-valued uses and the sources
of inefficiency in our economy
 Explain the main ideas about fairness and evaluate
claims that markets result in unfair outcomes
Self-Interest and the Social Interest

When you buy a pair of shoes or a textbook or fill your gas

tank, or even just take a shower, you express your view
about how scarce resources should be used.
You make choices that are in your self-interest.
Markets coordinate your choices with those of everyone
else.
Do markets do a good job?
Do they enable our self-interest choices to be in the social
interest?
And do markets produce a fair outcome?
Efficiency and the Social Interest

Allocative efficiency is one aspect of the social interest and

the aspect about which economists have most to say.
An efficient allocation of resources occurs when we
produce the goods and services that people value most
highly.
Resources are allocated efficiently when it is not possible
to produce more of a good or service without giving up
some other good or service that is valued more highly.
Efficiency is based on value, and people’s preferences
determine value.
Efficiency: A Refresher

Marginal Benefit
Marginal benefit is the benefit a person receives from
consuming one more unit of a good or service.
We can measure the marginal benefit from a good or
service by the dollar value of other goods and services
that a person is willing to give up to get one more unit of it.
The concept of decreasing marginal benefit implies that as
more of a good or service is consumed, its marginal
benefit decreases.
Efficiency: A Refresher

Figure 5.1 shows the

decreasing marginal
benefit from each
additional slice of pizza,
measured in dollars per
slice.
Efficiency: A Refresher

Marginal Cost
Marginal cost is the opportunity cost of producing one
more unit of a good or service. The measure of marginal
cost is the value of the best alternative forgone to obtain the
last unit of the good.
We can measure the marginal cost of a good or service by
the dollar value of other goods and services that a person is
must give up to get one more unit of it.
The concept of increasing marginal cost implies that as
more of a good or service is produced, its marginal cost
increases.
Efficiency: A Refresher

Figure 5.1 shows the

increasing marginal cost
of each additional slice
of pizza, measured in
dollars per slice.
Efficiency: A Refresher

Efficiency and
Inefficiency
If the marginal benefit
from a good exceeds its
marginal cost, producing
and consuming more of
the good uses resources
more efficiently.
Efficiency: A Refresher

If the marginal cost of a

good exceeds its
marginal benefit,
producing and
consuming less of the
good uses resources
more efficiently.
Efficiency: A Refresher

If the marginal cost of a

good equals its marginal
benefit, resources are
being use efficiently.
Value, Price, and Consumer Surplus

Value, Willingness to Pay, and Demand

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.
A demand curve for a good or service shows the quantity
demanded at each price.
A demand curve also shows the maximum price that
consumers are willing to pay at each quantity.
Value, Price, and Consumer Surplus

Figure 5.2 shows these

two ways of interpreting a
demand curve.
In part a, shown here, the
demand curve tells us the
quantity that consumers
plan to buy at a given
price.
Value, Price, and Consumer Surplus

In part b, shown here, the

demand curve tells us the
maximum price that
consumers are willing to
pay for a given quantity.
This price measures the
marginal benefit of the
good at that given quantity.
Value, Price, 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 5.3 on the next slide shows the consumer surplus
for pizza for an individual consumer.
Value, Price, and Consumer Surplus

The price paid is the

market price, which is the
same for each unit bought.
The quantity bought is
determined by the demand
curve and the blue
rectangle shows the
amount paid for pizza.
The green triangle shows
the consumer surplus from
pizza.
Value, Price, and Consumer Surplus

The consumer surplus on

the 10th slice is the $2 that
the consumer is willing to
pay minus the $1.50 that
she does pay, which is 50
cents a slice.
Cost, Price, and Producer Surplus

Cost, Minimum Supply-Price, and Supply

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 also shows the
minimum price that producers are willing to accept at each
quantity.
Cost, Price, and Producer Surplus

Figure 5.4 shows these

two ways of interpreting a
supply curve.
In part a, shown here, the
supply curve tells us the
quantity that producers
plan to sell at a given
price.
Cost, Price, and Producer Surplus

In part b, shown here, the

supply curve tells us the
minimum price that
producers are willing to
accept for a given quantity.
This price measures the
marginal cost of producing
that given quantity of the
good.
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 5.5 on the next slide shows the producer surplus for
pizza for an individual producer.
Cost, Price, and Producer Surplus

The price is the market

price, which is the same
for each unit sold.
The quantity sold is
determined by the supply
curve and the red area
shows the total cost of
producing pizza.
The blue triangle shows
the producer surplus from
pizza.
Cost, Price, and Producer Surplus

The producer surplus on

the 50th pizza is the $15
that the producer receives
minus the $10 that it cost
to produce, which is $5 a
pizza.
Is the Competitive Market Efficient?

Efficiency of Competitive
Equilibrium
Figure 5.6 shows that a
competitive market creates
an efficient allocation of
resources at equilibrium.
In equilibrium, the quantity
demanded equals the
quantity supplied.
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
maximized 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.
Is the Competitive Market Efficient?

The Invisible Hand at Work Today

The invisible 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.
The cartoon on page 109 shows how the invisible hand
sometimes works in surprising ways.
Is the Competitive Market Efficient?

Obstacles to Efficiency
Markets are not always efficient and the obstacles to
efficiency are:
 Price ceilings and floors
 Taxes, subsidies, and quotas.
 Monopoly
 External costs and external benefits.
 Public goods and common resources
Is the Competitive Market Efficient?

Underproduction and
Overproduction
Obstacles to efficiency
lead to underproduction or
overproduction and create
a deadweight loss—a
decrease in consumer and
producer surplus.
Is the Competitive Market Efficient?

Figure 5.7a shows the

effects of underproduction.
The efficient quantity is
10,000 pizzas a day.

If production is restricted to
5,000 pizzas a day, a dead
weight loss arises from
underproduction.
Is the Competitive Market Efficient?

Figure 5.7b shows the

effects of overproduction.
Again, the efficient quantity
is 10,000 pizzas a day.

If production is expanded
to 15,000 pizzas a day, a
dead weight loss arises
from overproduction.
Is the Competitive Market Fair?

Ideas about fairness can be divided into two groups:

 It’s not fair if the result isn’t fair
 It’s not fair if the rules aren’t fair
Is the Competitive Market Fair?

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.”
If everyone gets the same marginal utility from a given
amount of income, and if the marginal benefit of income
decreases as income increases, taking a dollar from a
richer person and given it to a poorer person increases the
total benefit. Only when income is equally distributed has
the greatest happiness been achieved.
Is the Competitive Market Fair?

Figure 5.8 shows how

redistribution increases
efficiency.
Tom is poor and has a high
marginal benefit of income.

Jerry is rich and has a low

marginal benefit of income.
Taking dollars from Jerry and
giving them to Tom until they
have equal incomes
increases total benefit.
Is the Competitive Market Fair?

Utilitarianism ignores the cost of making income transfers.

Recognizing these costs leads to the big tradeoff
between efficiency and fairness.
Because of the big tradeoff, John Rawls proposed that
income should be redistributed to point at which the
poorest person is as well off as possible.
Is the Competitive Market Fair?

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 Fair?

In economics, this principle means equality of opportunity,

not equality of income. Robert Nozick suggested that
fairness is based on two rules:
 The state must create and enforce laws that establish
and protect private property.
 Private property may be transferred from one person to
another only by voluntary exchange.
Pages 114–115 present an extended illustration of two
proposals for achieving a fair and efficient use of
resources.
THE END