Microeconomics ASSIGNMENT

Chapter 5: Efficiency and Equity

· Using prices in markets to allocate scarce resources is one of many alternative methods of allocating scarce resources.

· Tools such as consumer surplus and producer surplus help evaluate efficiency.

· The outcomes from the various methods used to allocate scarce resources, especially markets, can be examined in terms of both their efficiency and fairness.

I. Resource Allocation Methods

Resources are scarce, so they somehow must be allocated. Different methods of allocating resources include:

· Market price: The people who are willing and able to buy a resource get the resource.

· Command: a command system allocates resources by the order (command) of someone in authority. A command system works well in organizations with clear lines of authority but does not work well at allocating resources in the entire economy.

· Majority rule: resources are allocated in accordance with majority vote. Majority rule works well when the allocation decisions being made affect a large number of people and self-interest leads to bad decisions.

· Contest: resources are allocated to the winner. Contests work well when the efforts of the players are hard to measure, such as top managers being in a contest to be named CEO of a company.

· First-come, first-serve: resources are allocated to those who are first in line. This allocation method works well when the resource can serve just one user at a time in a sequence, as is the case with, say, a bank teller or an ATM.

· Lottery: resources are allocated to the people who pick the winning number, choose the lucky card, etc. Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource.

· Personal characteristics: resources are allocated to people with the “right” characteristics.

· Force: resources are allocated to those who can forcibly take the resources.

II. Benefit, Cost, and Surplus

Demand, Willingness to Pay, and Value

· The value of one more unit of a good or service is its marginal benefit. Marginal benefit is the maximum price that people are willing to pay for another unit of a good or service. And the willingness to pay for a good or service determines the demand for it. Consequently the demand curve for a good or service is also its marginal benefit curve.

· The market demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by all the individuals at each price.

· The demand curve in the figure shows that the maximum price a person is willing to pay for the 6 millionth gallon of milk per month is $3, so $3 is the marginal benefit of this gallon.

· MSB curve: In the absence of externalities, which will be discussed later, the market demand curve is also the economy’s marginal social benefit (MSB) curve. It reflects the number of dollars’ worth of other goods and services willingly given up to obtain one more unit of a good.

· The figure shows that the maximum price a consumer is willing and able to pay for the 6 millionth gallon of milk is $3, so the marginal social benefit of the 6 millionth gallon of milk is $3.

· Consumer surplus is the value (or marginal benefit) of the good minus the price paid for it, summed over the quantity bought. The figure illustrates the consumer surplus as the shaded triangle when the price is $3 per gallon.

Supply, Cost, and Minimum Supply-Price

· The cost of producing one more unit of a good or service is its marginal cost. Marginal cost is the minimum price that producers must receive to induce them to produce another unit of the good or service. And the minimum acceptable price determines the quantity supplied. Consequently the supply curve for a good or service is also its marginal cost curve.

· 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.

· MSC curve: In the absence of externalities, the market supply curve is the economy’s marginal social cost (MSC) curve.

· The supply curve in the figure shows that the minimum price a producer must receive to be willing to produce the 6 millionth gallon of milk per month is $3, so $3 is the marginal social cost of this gallon.

· Producer surplus is the price of a good minus its minimum supply-price (or marginal cost), summed over the quantity sold. The figure illustrates the producer surplus as the shaded triangle when the price is $3 per gallon.

III. Is the Competitive Market Efficient?

Efficiency of Competitive Equilibrium

· The marginal benefit to the entire society is the marginal social benefit curve, MSB. If all the benefits from consuming a good go to its consumers, the market demand curve is the same as the MSB curve.

· The marginal cost to the entire society is the marginal social cost curve, MSC. If all the costs of producing a good are paid by the producers, the market supply curve is the same as the MSC curve.

· When the marginal social benefit of the last unit produced equals its marginal social cost, society attains efficiency. However, because the demand curve is the same as the MSB curve and the supply curve is the same as the MSC curve, the efficient quantity that sets the MSB equal to the MSC also sets the quantity demanded equal to the quantity supplied and so is the equilibrium quantity. The figure illustrates how the efficient quantity of milk, 6 million gallons per month, also is the equilibrium quantity of milk.

· When the efficient quantity of milk is produced, the sum of the consumer surplus and producer surplus (total surplus) is maximized.

All the results of efficiency at this point can be summarized as follows:

· By definition, efficiency requires that resources are being used where they are most highly valued.

· When resources are used where they are most highly valued, MSB = MSC.

· When the demand and supply curves intersect, QD = QS, and the market achieves equilibrium.

· At equilibrium the total surplus in the market is maximized. Buyers and sellers acting in their own self-interest maximize social well-being.

The Invisible Hand

· Adam Smith, in his 1776 book The Wealth of Nations, articulated how competition led self-interested consumers and producers to make choices that unintentionally promote the social interest as if they were led by an “invisible hand.”

Underproduction and Overproduction

· Inefficiency can occur because either too little of an item is produced (underproduction) or too much is produced (overproduction).

· In either case, a deadweight loss occurs. A deadweight loss is the decrease in the consumer surplus and producer surplus (decrease in total surplus) that results from producing at an inefficient level of production. The figure illustrates the deadweight loss from overproduction of milk and from underproduction.

Obstacles to Efficiency

Sometimes a market overproduces or underproduces a good or service. The key obstacles to achieving an efficient allocation of resources in a market are:

· Price and Quantity Regulations: A price ceiling sets the highest legal price and a price floor sets the lowest legal price. If a price ceiling or price floor makes the equilibrium price illegal, it can lead to inefficiency. Quantity regulations that limit the amount produced also lead to inefficiency. (Studied in Chapter 6)

· Taxes and Subsidies: Taxes and subsidies place a wedge between the prices consumers pay and the prices producers receive. Both can lead to inefficiency. (Studied in Chapter 6)

· Externalities: An externality is a cost or a benefit that affects someone other than the seller or the buyer. In that case, the demand curve is not the same as the marginal social benefit curve and/or the supply curve is not the same as the marginal social cost curve. In these cases, inefficiency results. (Studied in Chapter 16)

· 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. Public goods lead to a free-rider problem, in which people do not pay for their share of the good. A common resource is owned by no one but available to be used by everyone. Common resources are generally over-used because no one owns the resource. In both cases, inefficiency can occur. (Studied in Chapter 17)

· Monopoly: A monopoly is a firm that has sole control of a market. To maximize its profit, a monopoly produces less than the efficient quantity and so creates inefficiency. (Studied in Chapter 13)

· High transactions costs: The opportunity costs of making a trade are transactions costs. When these costs are high, a market might underproduce because too few transactions take place.

Alternatives to the Market

If markets do not allocate resources efficiently, then one of the alternatives might do a better job. For instance, using first-come, first-serve to allocate spaces in a line at a movie theater probably works better than a market.

IV. Is the Competitive Market Fair?

· Efficiency is a positive term, while equity is a normative term. Not everyone can agree upon what is fair.

· There are two general ways of defining fairness: “It’s not fair if the results aren’t fair” and “It’s not fair if the rules aren’t fair.”

It’s Not Fair If the Result Isn’t Fair

· Utilitarianism adopts this view. Utilitarianism is a principle that states that we should strive to achieve “the greatest happiness for the greatest number.” This principle argues that fairness requires equality of incomes, which requires that incomes be redistributed.

· Redistribution leads to the big tradeoff, the tradeoff between efficiency and fairness. The tradeoff occurs because taxes decrease people’s incentives to work, thereby decreasing the size of the “economic pie.” In addition, taxes lead to administration costs that also decrease the economic pie.

· John Rawls argued that redistribution should strive to make the poorest as well off as possible which may mean a smaller piece of a bigger pie, rather than an equal piece, to keep incentives in place.

It’s Not Fair If the Rules Aren’t Fair

· This perspective relies on the symmetry principle—the requirement that people in similar situations should be treated similarly. In economics, this means equality of economic opportunity rather than equality of economic outcomes.

· Robert Nozick suggests government should promote fairness by establishing property rights for individuals and allowing only voluntary exchange of these resources.

· If private property rights are enforced, if voluntary exchange takes place in a competitive market, and if none of the obstacles to efficiency listed before exist, then according to Nozick, the competitive market is fair.