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ECON 1540
Hernan Humana

C HAPTER 5 Efficiency and Equity Resource Allocation Methods - Resources are scarce, so they must be allocated somehow - Trading in markets is just one of the several alternative methods - Resources might be allocated by:  Market price  Command  Majority rule  Contest  First-come, first-served  Lottery  Personal characteristics  Force Market Price - When market price allocates a scarce resource, the people who are willing and able to pay that price get the resource - Two kinds of people decide not to pay the market price: those who can afford to pay but choose not to buy and those who are too poor and simply can’t afford to buy - Becausepoorpeoplecan’tafforditemsthatmostpeopleconsiderto beessential,theseitemsare usually allocated by one of the other methods Command - Command system allocates resources by the order of someone in authority - Command system in Canadian economy, used extensively inside firms and government departments. - Works well in organizations in which the lines of authority and responsibility are clear and it is easy to monitor the activities being performed - Works badly when the range of activities to be monitored is large and when it is easy for people to fool those in authority Majority Rule - Society use majority rule to elect representative governments that make some of the biggest decisions - Works well when the decisions being made affect large numbers of people and self-interest must be suppressed to use resources most effectively Contest - A contest allocates resources to a winner - Contests do a good job when the efforts of the “players” are hard to monitor and reward directly - People work harder so they have a chance to win the price - The total output produced by the workers is much greater than it would be without the contest First Come, First-Served - Allocates resources to those who are first in line - Works best when, a scarce resource can serve just one user at a time in a sequence Lottery - Allocate resources to those who pick the winner numbers, draw the lucky cars, or come up lucky on some other gaming system - Works best when there is no effective way to distinguish among potential users of a scarce resource Personal Characteristics - People with the “right” characteristics get the resources Force - Plays a good and ill role in allocating scarce resources - Ill: war, use of military force by one nation against another. Theft, taking the property of others without their consent - Good: legal system - Force of state is essential to uphold the principle of the rule of law Benefit, Cost and Surplus Going to see whether competitive markets produce the efficient quantities Demand, Willingness to Pay, and Value - Value is what we get and price is what we pay - Value of one more unit of a good or service is its marginal benefit - Measure marginal benefit by the maximum number price that is willingly paid for another unit of the good or service - A demand curve is a marginal benefit curve Individual Demand and Market Demand - Relationship b/w price of a good and the quantity demanded by one person is called individual demand - Relationship between the price of a good and the quantity demanded by all buyers is called market demand - Market demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities of demanded by all the individuals at each price - Call marginal benefit to the entire society marginal social benefit, so demand curve is also the marginal social benefit curve Consumer Surplus - When people buy something for less than it is worth to them, they receive a consumer surplus - Consumer surplus is the excess of the benefit received from a good over the amount paid for it - Calculate: Marginal benefit of a good minus its price, summed over the quantity bought - All goods and services have decreasing marginal benefit, so people receive more benefit from their consumption than the amount they pay Supply and Marginal Cost - Inorderforbusinessestomakeprofit,theymustselltheiroutputforapricethatexceedsthecost of production Supply, Cost and Minimum Supply-Price - Firms make a profit when they receive more from the sale of a good or service that the cost of producing it - Cost is what firm gives up when it produces a good or service and price is what a firm receives when it sells the good or service - Cost of producing one more unit of a good or service is its marginal cost - Marginalcostistheminimumpricethatproducersmustreceivetoinducethemtoofferonemore unit of a good or service for sale - Supply curve is a marginal cost curve Individual Supply and Market Supply - Relationship between the price of a good and the quantity supplied by one producer is called individual supply - Relationship between the price of a good and the quantity supplied by all producers is called market supply - Market supplycurveis thehorizontal sum of the individual supply curves and is formed by adding the quantities supplied by all the producers at each price - We call society’s marginal cost marginal social cost Producer Surplus - When price exceeds marginal cost, the firm receives a producer surplus - Producer surplus is the excess of the amount received from the sale of a good or service over the cost of producing it - Calculate:pricereceivedminusthemarginalcost(ormin.supplyprice),summedoverthequantity sold - Consumer surplus and producer surplus can be used to measure the efficiency of a market Is the Competitive Market Efficient? Efficiency of Competitive Equilibrium - Equilibrium in a competitive market occurs when the quantity demanded equals the quantity supplied at the intersection of the demand curve and the supply curve - At intersection point,marginal social benefitonthe demand curveequalsthemarginal socialcost on the supply curve - In equilibrium, a competitive market achieves allocative efficiency - The sum of a consumer surplus and producer surplus is called total surplus - When the efficiency quantity is produced, total surplus is maximized. Market Failure - Situation in which a market delivers an inefficient outcome one of market failure - Market failure can occur because too little on an item is produced or too much is produced - Underproduction: Too little of an item  Measure the scale of inefficiency by deadweight loss, which is the decrease in total surplus that results from an inefficient level of production - Overproduction: Too much of an item  Inefficientproductioncreatesadeadweightlossthatisbornebytheentiresociety,social loss Sources of Market Failure - Price and quantity regulations  Price regulations that put a cap on the rent a landlord is permitted to charge and laws that require employers to pay a minimum wage sometimes block the price adjustments that balance the quantity demanded and the quantity supplied  Quantity regulations that limit the amount that a firm is permitted to produce also lead to underproduction - Taxes and subsidies  Taxesincreasethepricespaidbybuyersandlowerthepricesreceivedbysellers(decrease quantity produced)  Subsidies, which are payments by the government to producers, decrease the prices paid by buyers and increase the prices received by sellers (Increase quantity produced) - Externalities  Anexternalityisacostorabenefitthataffectssomeoneotherthanthesellerorthebuyer - Public goods and common resources  A public good is a good or service that is consumed simultaneously by everyone even if they don’t pay for it  A common resource is owned by no one but is available to be used by everyone - Monopoly  Monopoly is a firm that is the sole provider of a good or service (leads underproduction) - High transaction costs  Economists call the costs of the services that enable a market to bring buyers and sellers together transaction costs  It is costly to operate any market, so to use market price to allocate resources, it must be worth bearing the transactions costs (Too high, market might under produce) Alternatives to the Market - No efficient mechanism that allocates all resources efficiently. - Markets,whensupplementedbyothermechanismssuchasmajorityrule,commandsystems,and first-come, first-served, do an amazingly good job. Is the Competitive Market Fair? - When natural disasteroccur, prices of items jump because the demand and willingness to pay for these items has increased, but the supply hasn’t changed - To think about fairness, think of economic life as a game- a serious game - All ideas about fairness can be divided into two broad groups, they are:  It’s not fair if the result isn’t fair  It’s not fair if the rules aren’t fair It’s Not Fair If the Result Isn’t Fair - General idea was that it is unfair if people’s incomes are too unequal - Efficiency requires equality of incomes, this idea was wrong - Utilitarianism: principle that states that we should strive to achieve “the greatest happiness for the greatest number - Income must be transferred from the rick to the poorup to the pointof complete equality- to the point which there are no rick and no poor - One big problem with utilitarian ideal of complete equality is that it ignores the costs of making income transfers - The Big Trade-off: Recognizing the costs of making income transfers leads to what is called the big trade off, which is a trade off between efficiency and fairness - Based on; income can be transferred from people with high incomes to people with low incomes only by taxing the high incomes - Taxing people’s income from employment makes them work less - Taxing people’s income from capital makes them save less - Make the poorest as well of as possible: taking all costs of income transfers into account, the air distribution of the economic pie is the one that makes the poorest person as well off as possible - Incomes of rich people should be taxed, and after paying the costs of administering the tax and transfer system, what is left should be transferred to the poor It’s Not Fair If the Rules Aren’t Fair - The idea that isn’t not fair if the rules aren’t fair is based on a fundamental principle that seems to be hardwired into the human brain: the symmetry principle - The symmetry principle is the requirement that people in similar situations be treated - In economic life, this principle translates into equality of opportunity - Fairness obeys two rules:  The state must enforce laws that establish and protect private property  Private property may be transferred from one person to another only by voluntary exchange - First rule says that everything that is valuable must be owned by individuals and that the state must ensure that theft it prevented - Second rule says that the only legitimate way a person can acquire property is to buy it in exchange for something else that the person owns - These rules satisfy the symmetry principle - If the two rules of fairness are follow
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