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05sg efficiency.pdf

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Department
Economics
Course
ECON 1010
Professor
Shadab Qaiser
Semester
Summer

Description
Chapter EFFICIENCY 5 AND EQUITY FIGURE 5.1 Key Concepts Consumer Surplus „ Efficiency: A Refresher Consumer An efficient allocation of resources occurs when the 5 surplus goods and services produced are those that people value Market most highly. price 4 ♦ Marginal benefit — the benefit a person receives from consuming one more unit of a good or service. The marginal benefit of a product is the amount of P3ice (dollars per unit) other goods and services the person is willing to give2 up to get one more unit of the product. As the quantity of the good consumed increases, its mar- 1 D = MB ginal benefit decreases. ♦ Marginal cost — the opportunity cost of producing one more unit of a good or service. As more of a 0 3 1 2 4 5 6 product is produced, its marginal cost increases. Quantity (units per month) The efficient amount of a good is produced when the marginal benefit from the good equals its marginal cost.mum that someone is willing to pay for another unit of the good. The demand curve shows the maxi- ♦ If the marginal benefit exceeds the marginal cost, the benefit of another unit exceeds the cost to pro- someone is willing to pay for each unit of a good, duce the unit, so resources should be used to pro-o the demand curve for a good is its marginal benefit curve. duce the unit. ♦ If the marginal cost exceeds the marginal benefit,The value of a good can be different than the good’s price. Consumer surplus is the value of a good minus the benefit of the last unit being produced is lethe price paid for it. than the cost of producing it, so the unit should not be produced. ♦ Because the demand curve shows the marginal benefit or value for each unit of a good, consumer surplus is the area under the demand curve (the „ Value, Price, and Consumer Surplus value) and above the market price. Figure 5.1 shows The value of one more unit of a good is its marginal the consumer surplus for the good as the green tri- angle under the demand curve and above the mar- benefit. Marginal benefit can be measured as the ket price. 77 78 CHAPTER 5 „ Cost, Price, and Producer Surplus FIGURE 5.3 Efficiency of Perfect Competition The cost of producing a good is what the producer pays to produce it; the price of a good is what the producer receives for it. The marginal cost of a good is the mini- Consumer mum price a producer must receive to produce the unit 5 surplus S = MC of the good because this amount just covers all the op- portunity costs of producing it. Because a supply curve 4 shows the minimum price a producer must receive to produce another unit of a product, a product’s supply Pr3ce (dollars per unit) Producer surplus curve is also its marginal cost curve. If a firm sells a good for more than it costs to produce 2 it, the firm receives a producer surplus. Producer sur- plus is the price of the good minus the opportunity cost D = MB 1 of producing it. ♦ Because the supply curve is the marginal cost curve, producer surplus equals the area below the market 0 3 1 2 4 5 6 Quantity (units per day) price of the product and above the supply curve. Figure 5.2 shows a producer surplus. equal to the marginal cost, MB = MC. In Figure FIGURE 5.2 5.3, the efficient quantity is 3 units, determined by the MB and MC curves. Producer Surplus ♦ When the market is using resources efficiently, the sum of consumer surplus plus producer surplus is as large as possible, as illustrated in Figure 5.3. 5 Producer surplus S = MC ♦ Adam Smith’s historical idea of the invisible hand concludes that competitive markets send resources 4 to their highest valued use, that is, Adam Smith concluded that competitive markets are efficient. Pr3ce (dollars per unit) Contrary to the invisible hand idea, markets are not always efficient. There are five major obstacles that can 2 Market price lead to inefficiency in which the market overproduces or underproduces the good: 1 ♦ Price ceilings and floors — government regulations that set the highest price legal to charge (a price 0 3 1 2 ceiling) or the lowest price legal to charge (a price 4 5 6 Quantity (units per month) floor). Price ceilings and floors can prevent the mar- ket from reaching its free market equilibrium price and quantity. „ Is the Competitive Market Efficient? ♦ Taxes, subsidies, and quotas — taxes increase the price paid by buyers and lower the price received by ♦ The price in a competitive market is the equilibrium sellers; subsidies decrease the price paid by buyers price; the quantity is the equilibrium quantity. In and raise the price received by sellers; and quotas di- Figure 5.3, the price is $3 and the quantity pro- rectly limit the production that can occur. duced is 3 units, determined by the D and S curves. ♦ Monopoly — a monopoly is a single firm that con- ♦ A competitive market is efficient because the quan- trols the entire market. A monopoly decreases the tity produced is the same as the efficient quantity, output it produces in order to raise its price and in- that is, the quantity that sets the marginal benefit crease its profit. EFFICIENCY AND EQUITY 79 ♦ Public goods — a public good is a good or service looks at the results of the process. Redistribution to that can be consumed simultaneously by everyone achieve equality in incomes (the “fair” outcome) regardless of whether they paid for it. Public goods leads to the big tradeoff, the tradeoff between effi- create a free rider problem, in which people are un- ciency and fairness. Redistribution weakens the in- willing to pay for the product. centive to work so that a more equal income distribution leads to inefficiency. ♦ External costs and external benefits — an external cost is a cost imposed on someone other than the ♦ Symmetry Principle — the requirement that producer of the product; an external benefit is a similar people should be treated the same. The benefit that goes to someone other than the buyer of symmetry principle looks at the rules of the proc- the good. ess. If the market is efficient (there are no price When a market underproduces or overproduces a good, ceilings, price floors, subsidies, quotas, monopo- lies, public goods, external benefits, or external a deadweight loss is created. Deadweight loss is de- crease in consumer surplus and producer surplus that costs), competitive markets are fair according to results from an inefficient level of production. the symmetry principle. ♦ The deadweight loss is inflicted on the entire society; it is not something that the producer gains Helpful Hints at the expense of the consumer or vice versa. ♦ Figure 5.4 illustrates the deadweight loss triangles 1.. W HY MB = MC ISEFFICIENT : Efficiency requires from overproduction (producing 4 units rather than producing the level of output such thatMB = MC. 3) and underproduction (producing 2 units rather It might seem more reasonable to produce where than 3). MB > MC. However, this presumption is wrong. Why? As long as people value another unit of the FIGURE 5.4 good more than it costs to produce the good, that Deadweight Loss is, MB > MC, society’s total surplus increases if the good is produced. Look at Figure 5.5. The first unit Deadweight has a large difference between MB and MC, equal loss from 5 underproduction S = MC FIGURE 5.5 Efficiency and MB = MC 4 Pr3ce (dollars per unit) Deadweight loss from overproduction 5 S = MC 2 4 1 D = MB Price (dollars per unit) 3 0 3 1 2 4 5 6 2 Quantity (units per month) D = MB 1 „ Is the Competitive Market Fair? The two approaches to fairness are “It’s not fair if the 0 3 1 2 4 5 6 result isn’t fair” and “It’s not fair if the rules aren’t Quantity (units per month) fair.” to the length of the long gray arrow. The second ♦ Utilitarianism — aims for “the greatest happiness for the greatest number of people.” Utilitarianism unit also has MB greater than MC but by less than the first unit, as indicated by the shorter pink ar- 80 CHAPTER 5 row. However, producing this unit still adds to so- Cost, Price, and Producer Surplus ciety’s total net surplus; it just adds less than the 19. Cost and price are the same thing. first unit. As long as MB is larger than MC, the unit has a greater value to someone than its cost of 10. The supply curve and the marginal benefit curve production, so the unit should be produced. Only are the same. when MB = MC should production stop expanding 11. Producer surplus equals the price of the good mi- because beyond this point the marginal benefit nus the opportunity cost of producing the unit. from more units falls short of the marginal cost. Is the Competitive Market Efficient? 2.. M ARGINAL B ENEFIT AND M ARGINAL C OST : In casual conversation we talk about “how much a 12. A competitive market is always efficient. good cost us”. We also talk about “how much a 13. When producing the efficient quantity of a good, firm benefited by selling us the good.” But be the sum of consumer surplus plus producer surplus careful not to confuse conversation with the precise is as large as possible. language of economic science. In particular, the 14. Deadweight loss is comprised of a loss of consumer marginal benefit from a good is received by the consumer and the marginal cost is paid by the surplus and/or producer surplus. producer. It is that the consumer of the good who Is the Competitive Market Fair? benefits from the product. You, when you drive 15. Utilitarianism says that a competitive market pro- your car, benefit from your car. It is the producer ducing the efficient quantity is always fair. of the good who pays for the production. The firm that manufactured your car paid the steel mill for 16. The idea of making the poorest as well off as pos- the steel used to produce it. sible uses the “results” to judge fairness. 17. The symmetry principle states that people should have identical, this is, “symmetric” incomes. Questions „ True/False and Explain „ Multiple Choice Efficiency: A Refresher Efficiency: A Refresher 11. Resource use is efficient when the goods with the 11. In general, resources are used efficiently when the lowest opportunity cost are produced. a. opportunity cost of the goods being produced is 12. As more of a product is consumed, its marginal as low as possible. b. marginal benefit from a good exceeds its mar- benefit decreases. ginal cost by as much as possible. 13. The marginal cost of the one millionth pizza is the c. goods produced are those valued most highly. total cost of producing all million pizzas. d. None of the above. 14. If the marginal benefit from a good exceeds its 12. Susan is eating two slices of pizza. Which of the marginal cost, resources are used more efficiently if following statements is necessarily true? less of the good is produced. a. Susan’s marginal benefit from the second slice of pizza is equal to the sum of the benefit she gets 15. Resource efficiency requires that the marginal benefit of a good equal its marginal cost. from the first slice plus her benefit from the sec- ond slice. Value, Price, and Consumer Surplus b. Susan’s marginal benefit from the second slice of 16. The price of a product always equals its value. pizza equals the maximum she is willing to pay for the second slice. 17. The demand curve for tacos shows the maximum c. Susan has no consumer surplus from the second someone is willing to pay for the ten millionth taco. slice of pizza. 18. Consumer surplus equals the area above the de- d. Susan has some consumer surplus from the sec- mand curve and below the market price. ond slice of pizza. EFFICIENCY AND EQUITY 81 16. Susan is willing to pay $3.00 for the second slice of FIGURE 5.6 Multiple Choice Question 3 pizza she eats. The price she actually pays is $2.00. Susan’s consumer surplus for this slice of pizza 6 equals MC a. $3.00. 5 b. $2.00. c. $1.50. 4 d. $1.00. Price (dollars per unit) 3 17. Because of decreasing marginal benefit, the con- sumer surplus from the first unit of a good is ____ 2 the consumer surplus from the second unit. a. greater than 1 b. equal to c. less than MB d. not comparable to 0 3 1 2 4 5 6 Quantity (units per day) Cost, Price, and Producer Surplus 18. The cost of producing one more unit of a good is 13. What is the efficient amount of output in Figure the good’s 5.6? a. price. a. 0 units, where MB exceeds MC by as much as b. marginal benefit. possible. c. marginal cost. b. 3 units, where MB equals MC. d. producer surplus. c. 6 units, where MC exceeds MB by as much as possible. 19. The supply curve shows the d. None of the above. a. minimum price suppliers must receive in order to produce another unit of the good. Value, Price, and Consumer Surplus b. maximum price suppliers must receive in order 14. Which of the following statements is FALSE? to produce another unit of the good. a. The value of one more unit of a good is the c. amount of producer surplus suppliers receive. d. profit that suppliers receive from producing an- good’s marginal benefit. b. A good’s marginal benefit is the maximum price other unit of the good. people are willing to pay for another unit. 10. The producer surplus from a good is equal to the c. The maximum price people are willing to pay for one more unit of a good is its value. a. maximum amount a consumer is willing to pay for the good minus the price that actually must d. None of the above because all the statements are true. be paid. b. actual price of the good minus the maximum 15. The marginal benefit curve for a product is the same amount a consumer is willing to pay for the as the good’s good. c. opportunity cost of producing the good minus its a. marginal cost curve. b. supply curve. price. c. demand curve. d. price of the good minus its opportunity cost of d. consumer surplus curve. production. 82 CHAPTER 5 Is the Competitive Market Efficient? Use Figure 5.8, and the areas illustrated in it, for the next Figure 5.7 illustrates a perfectly competitive market four questions. without any external costs, external benefits, taxes, subsi- FIGURE 5.8 dies, quotas, price ceilings, or price floors. Use Figure 5.7Multiple Choice Questions 14, 15, 16, 17 for the next two questions. 6 FIGURE 5.7 S = MC Multiple Choice Questions 11 and 12 5 6 4 S = MC 5 Price (dolaars per bnit) 3 d c 4 2 Price (dollars per unit) 3 1 D = MB 2 0 3 1 2 4 5 6 1 D = MB Quantity (units per day) 14. When production is 3 units with a price of $3, con- 0 3 1 2 4 5 6 Quantity (units per day) sumer surplus in the market illustrated in Figure 5.8 equals 11. The equilibrium quantity produced equals a. area a. b. area b. a. 0 units. c. area a + b. b. 3 units. d. area a + d. c. 6 units. d. None of the above. 15. When production is 3 units with a price of $3, pro- 12. The efficient quantity equals ducer surplus in this market equals a. area a + b. a. 0 units. b. area c. b. 3 units. c. area c + d. c. 6 units. d. None of the above. d. area a + c. 13. Which of the following is NOT a potential source of 16. If the quantity is restricted to 2, then the deadweight loss equals inefficiency? a. External costs a. area c. b. area c +d. b. Decreasing marginal benefit c. Monopoly c. area a +b. d. area b + c. d. A tax EFFICIENCY AND EQUITY 83 17. How does the sum of the consumer surplus and 21. Suppose the marginal cost of producing a product producer surplus when 3 units are produced com- rises. Then, the efficient quantity to produce of that pare to the sum when 2 units are produced? product ____. a. The sum is larger when 3 units are produced. a. increases. b. The sum is the same. b. does not change. c. The sum is larger when 2 units are produced. c. decreases. d. The sum cannot be compared between these two d. perhaps changes, but without more information situations. the direction of the change cannot be told. FIGURE 5.9 Is the Competitive Market Fair? Multiple Choice Question 18 22. Susan thinks the only fair outcome is one in which 6 she has three slices of pizza a week. Susan is using a ____ concept of fairness. 5 a. “it’s not fair if the result isn’t fair” b. “it’s not fair if the rules aren’t fair” 4 c. “big tradeoff” d. “symmetry principle” Price (dollars per unit) S = MC 3 23. The assertion that if resources are allocated effi- ciently, they also are allocated fairly is made by 2 a. all utilitarians. b. John Rawls, who proposed making the poorest as 1 well off as possible. D = MB c. Robert Nozick, who believes that equality of opportunity is fair. 0 3 1 2 4 5 6 Quantity (units per day) d. all economists who understand the big tradeoff. 18. In Figure 5.9, when 2 units are produced, what is „ Short Answer Problems the dollar value of the deadweight loss? 1. a. Table 5.1 presents the marginal benefit and a. $0 marginal cost schedules for video games. There b. $2 are no external costs or benefits. Based on Table c. $3 5.1, complete Table 5.2 (on the next page). d. $8 TABLE 5.1 19. A deadweight loss Marginal Benefit and Marginal Cost of a. is possible only if the good is underproduced but Video Games is not possible if the good is overproduced. b. subtracts only from producer surplus. Quantity Marginal benefit Marginal cost c. is a loss to consumers and a gain to producers. (millions of (dollars per (dollars per video games) game) game) d. is a loss inflicted on the entire society. 0 0 1 1 5 20. Suppose consumers decide they value a product 0 0 2 2 4 more highly than before. Then the efficient quantity 0 0 3 3 3 to produce of that product ____. 0 0 4 4 2 a. increases. 0 0 5 5 1 b. does not change. c. decreases. d. perhaps changes, but without more information the direction of the change cannot be told. 84 CHAPTER 5 TABLE 5.2 FIGURE 5.11 The Demand For Jeans Short Answer Problem 1 (a) Quantity Marginal benefit 60 (millions of minus video games) marginal cost 50 1 ____ 2 ____ 40 3 ____ 30 4 ____ 5 ____ Price (dollars per pair of jeans) 20 FIGURE 5.10 10 D = MB Short Answer Problems 1 and 2 0 3 1 2 4 5 6 50 Quantity (millions of jeans per year) 40 4. a. Figure 5.11 shows the market demand curve for jeans. In the figure, indicate consumer surplus if 30 the market price is $40 for a pair of jeans. What (dollars per video game) dollar amount does the consumer surplus equal? b. In Figure 5.11, indicate the consumer surplus if 20 the market price is $30 for a pair of jeans. What Marginal benefit and marginal cost does the consumer surplus now equal? 10 c. When is the consumer surplus larger? 0 1 2 3 4 5 6 FIGURE 5.12 Quantity (millions of video games per year) The Supply Of Jeans 60 b. In Figure 5.10 draw the marginal benefit and marginal cost curves from Table 5.1. S = MC 50 c. What is the efficient number of video games to produce? 2. a. Using the data in Table 5.1, in Figure 5.10 now 40 draw the demand curve for video games and the supply curve for video games. 30 b. There are no price ceilings, price floors, taxes, P20ce (dollars per pair of jeans) subsidies, or quotas in this market. The market also is competitive, that is, it is not a monopoly. 10 What quantity of video games will be produced? c. Compare your answer to part (c) of problem 2 with your answer to part (c) of problem 1. 0 3 1 2 4 5 6 3. What is the relationship between the marginal Quantity (millions of jeans per year) benefit of a good, its value, and the maximum amount that a consumer is willing to pay for 5. a. Figure 5.12 shows the market supply curve for the good? jeans. In the figure, indicate the producer sur- EFFICIENCY AND EQUITY 85 plus if the market price is $40 for a pair of jeans. e. When are the gains from trade the largest: What dollar amount does the producer surplus When 2 million jeans are produced? When 4 equal? million jeans are produced? Or when the effi- b. In Figure 5.12, indicate the producer surplus if cient quantity of jeans is produced? the market price is $30 for a pair of jeans. What 7. What is a deadweight loss? does the producer surplus now equal? 8. a. Igor has a job as Minister of Agriculture. He is c. When is the producer surplus larger? interested in the market for mushrooms because he has a fondness for mushrooms. Igor realizes FIGURE 5.13 that this market is competitive. He also knows Short Answer Problem 6 (a) that there are no external benefits or external costs and that there are no government policies, 60 such as taxes or subsidies, affecting the market. The equilibrium quantity of mushrooms is 10 50 million pounds a year. Igor wants to know what would be the quantity produced if resources are 40 being used efficiently. Based on the information given, what is the efficient quantity of mush- 30 rooms? b. Igor can’t believe that the efficient quantity is as Price (dollars per pair of jeans) 20 low as you answered. (He really likes mush- rooms!) Igor asks: What would be the loss if 11 10
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