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Chapter 5

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Department
Economics
Course
Economics 1021A/B
Professor
Brendan Murphy
Semester
Fall

Description
Chapter 5: Efficiency and Equity The goal of this chapter is to evaluate the ability of markets to allocate resources efficiently and fairly. But to see whether the market does a good job, we must compare it with its’ alternatives Resources are scarce, so they must be allocated somehow.. Resources might be allocated by: 1. Market Price 2. Command 3. Majority Rule 4. Contest 5. First cone, first serve 6. Lottery 7. Personal Characteristics 8. Force Market Price Two kinds of people decide not to pay: 1. Those who can afford but choose not to buy 2. Those who are too poor and can’t afford to buy For many goods and services, the above doesn’t matter but for essential items (ie. school fees, doctor fees..) are usually allocated by one of the other methods Command Allocates resources by the order (command) of a someone in authority (ie. if you have a job, most likely someone tells you what to do) Your labor is allocated to specific tasks by a command Weakness: when the range of activities to be monitored is large and when it is east for people to fool those in authority Majority Rule Allocates resources in the way that a majority of voters choose For example, majority rule decides how tax dollars are allocated among competing uses such as education and health care Contest Allocates resources to a winner (or a group of winners) Sporting events (tournaments) are another example of a contest Another example: a company offers a big prize, people are motivated to win it and although not everyone wins, 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 Examples: casual restaurants won’t accept reservations, highways (first to arrive at the ramp gets the road space) Works best when, as in the above examples, a scarce resource can serve just one user at a time Lottery Allocate resources to those who pick the winning number, draw the lucky cards, or come up lucky on some other gaming system Work best when there is no effective way to distinguish among potential users of a scarce resource Personal Characteristics Allocate resources to the people with the “right” characteristics For example: you will choose a marriage partner on the basis of personal characteristics, allocating the best jobs to a certain gender or race and discriminating against other genders or races Force Crucial role for both good and ill Ill: war (military force by one nation against another), theft (the taking of the property of others without their consent) Good: enforcing contracts (without courts to enforce contracts, it would not be possible to do business), rule of law Benefit, Cost, Surplus We’re now going to see whether competitive markets produce the efficient quantities Demand, Willingness to Pay, and Value Value and price; value is what we get, and price is what we pay. The value of one more unit of a good or service is its marginal benefit. We measure marginal benefit by maximum price that is willingly paid for another unit of the good or service. But willingness to pay determines demand. A demand curve is a marginal benefit curve. Individual Demand and Market Demand The relationship between the price of a good and the quantity demanded by one person is called individual demand. And the relationship between the price of a good and the quantity demanded by all buyers is called market demand. The market demand curve is the horizontal sum of the individual demand curves and is formed by adding the individuals at each price. Consumer Surplus Is the excess of the benefit received from a good over the amount paid for it. We can calculate consumer surplus as the marginal benefit (or value) of a good minus its price, 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. Supply and Marginal Cost Your next task is to see how market supply reflects marginal cost. The connection between supply and cost closely parallels the related ideas about demand and benefit that you’ve studied. Firms are in business to make a profit and to make a profit firms must sell their output for a price that exceeds the cost of production. Firms distinguish between cost and price. Supply, Cost, and Minimum Supply-Price Cost is what the producer gives up, price is what the producer receives. The cost of one more unit of a good or service is its marginal cost. Marginal cost is the minimum price that a firm is willing to accept; but the minimum supply-price determines supply. A supply curve is a marginal cost curve. Individual Supply and Market Supply The relationship between the price of a good and the quantity supplied by one producer is called individual supply. The relationship between the price of a good and the quantity supplied by all producers in the market is called market supply. The market supply curve is the horizontal sum of the individual supply curves and is formed by adding the quantities supplied by all the producers at each price. Producer Surplus Is the excess of the amount received from the sale of a good over the cost of producing it. We calculate it as the price received for a good minus the minimum- supply price (marginal cost), summed over the quantity sold. On a graph, producer surplus is shown by the area below the market price and above the supply curve, summed over the quantity sold. Is the Competitive Market Efficient? When production is:  Less than the equilibrium quantity, MSB>MSC  Greater than the equilibrium quantity, MSC>MSB  Equal to the equilibrium quantity, MSC=MSB Resources are used efficiently when marginal social benefit equals marginal social cost. When the efficient quantity is produced, total surplus (the sum of consumer surplus and producer surplus) is maximized. The Invisible Hand Adam Smith was the first to suggest that competitive markets send resources to the uses in which they have highest value. Smith believed that each participant in a competitive market is “led by an invisible hand to promote an end (the efficient use of resources) which was no part of his intention.” Adam Smith’s “invisible hand” idea in the Wealth of Nations implied hat competitive markets end resources to their highest valued use in society. Consumers and producers pursue their own self-interest a
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