Efficiency and Equity: Microeconomics (Eco101)

10
Efficiency and
Equity
MICROECONOMICS (ECO101)
MNU Business School
The Maldives National University
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
The Maldives National
McTaggart, University
Findlay, Microeconomics
Parkin: Microeconomics © 2007 Pearson Education Australia Ahmed Munawar5-2
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

 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
 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.

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
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 and Market
Demand Figure 5.1

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.

Parkin: Microeconomics © 2007 Pearson Education Australia Ahmed Munawar
5-10
Demand and Consumer
Surplus Figure 5.2

5-11
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.

5-12
Supply, Marginal Cost, and
Producer Surplus
 Individual supply and market supply

quantity supplied by one producer is called individual
supply.
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.

5-13
Individual Supply and Market
Supply Figure 5.3

5-14
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.

5-15
Supply and Producer Surplus
Figure 5.4

5-16
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.

5-17
An Efficient Market for Pizza
Price (dollars per pizza)

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)
5-18
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.

5-19
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.

5-20
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.

5-21
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

5-22
Underproduction
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

5-23
Overproduction
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

5-24
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

5-25
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.

5-26
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

5-27
Fair?
1. It’s not fair if the result isn’t fair

 The fair rules approach is consistent with allocative
efficiency, but the distribution might be “too unequal.”
 Most people recognize that there is no easy answer or
principle to guide the amount of equality.
 The fair results approach conflicts with efficiency and
leads to what is called the “big tradeoff.”
 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.‖
5-28
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)
5-29
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.

5-30
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.
 This idea translates into “equality of opportunity.”
 Harvard philosopher, Robert Nozick, in Anarchy, State,
and Utopia (1974), argues that the rules must be fair and
must respect two principles:
1. The state must enforce laws that establish and protect
private property.
2. Private property may be transferred from one person
to another only by voluntary exchange.
5-31
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

5-32
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?

5-33
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.

5-34
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.
5-35
Fair?
 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.

5-36

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10

McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

After studying this chapter, you will be able to:

 People are constantly striving to get more out of their scarce

The Maldives National

 Resources might be allocated by:

The Maldives National

The Maldives National

 Demand, willingness to pay, and value

The Maldives National

 Individual demand and market demand

The Maldives National

The Maldives National

The Maldives National

The Maldives National

 Supply, cost, and minimum supply price

The Maldives National

 Individual supply and market supply

The Maldives National

The Maldives National

The Maldives National

The Maldives National

 Efficiency of competitive equilibrium

The Maldives National

Price (dollars per pizza)

 At the equilibrium quantity, marginal benefit equals

The Maldives National

 The invisible hand

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 The invisible hand at work today

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 Underproduction and overproduction

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Price (dollars per pizza)

The Maldives National

Price (dollars per pizza) S

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 Obstacles to efficiency that bring underproduction or

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 Alternatives to the market

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 Are markets fair?

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1. It’s not fair if the result isn’t fair

Marginal benefit (units)

 Make the poorest as well off as possible

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 Fairness and efficiency

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 Case study: A water shortage in a natural disaster

 Scenario: An earthquake has broken the pipes that deliver

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The Maldives National

Case study option 3:

 Market price with taxes

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