Lecture Eight: Efficiency and Equity Con’t
October 25, 2011
Underproduction and Overproduction
Inefficiency can occur because too little of an item is produced, or too much of
an item is produced.
Deadweight loss - the decrease in total surplus, coming from the inefficient
allocation of resources.
Social loss - the marginal benefit to society is less than the marginal cost to
Obstacles to Efficiency
In competitive markets, underproduction and overproduction arise when there
- Price and quantity regulations
- Taxes and subsidies
- Public goods and common resources
- High transaction costs
Price and Quantity Regulations
Price Regulations sometimes put a block of the price adjustments and lead to
Quantity regulations that limit the amount that a firm is allowed to product and
lead to underproduction
Taxes and Subsidies
Taxes increase the prices paid by buyers and lower the prices received by
Taxes lead to decreases the quantity produced.
Subsidies lower the prices paid by buyers and increase the prices received by
sellers, which leads to overproduction because the price doesn't accurately
reflect the cost of producing the good. Externalities
An externality is a cost of benefit that affects someone other than the seller or
buyer of a good.
An electric utility creates an external cost by burning coal that creates acid rain.
The utility doesn't consider this cost when it chooses the quantity of power to
produce, overproduction results.
Public Goods and Common Resources
A public good benefits everyone and no one can be excluded from its benefits.
It is in everyone’s self interest to avoid paying for a public good (called the free-
rider problem), which leads to underproduction
Examples - national defense, roads, public green spaces (such as parks)
A common resource is owned by no one but can be used by everyone.
It is in everyones self interest to ignore the cost of their own use of this good.
There is no one person who can enforce who uses the good, or who can
determine the exact usage of each person.
A monopoly is a firm that has sole provider of a good or service.
The self interest of a monopoly is to maximize its profit. To do so, a monopoly
sets a price to achieve its self interested goal.
As a result, a monopoly produces too little and underproduction results.
High Transaction Costs
Transaction coss are the opportunity ost of making rades in a mark