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Unformatted text preview: Efficiency and Fairness of Markets Chapter CHAPTER CHECKLIST Describe the alternative methods of allocating scarce resources and define and explain the features of an efficient allocation. Ways of allocating resources include: market price; command; majority rule; contest; first‐come, first‐ served; sharing equally; lottery; personal characteristics; and force. Allocative efficiency occurs when we produce the quantities of goods and services on the PPF that people value most highly. Marginal benefit is the benefit that people receive from consuming one more unit of the product; marginal cost is the opportunity cost of producing one more unit of the product. The marginal benefit curve is down‐ ward sloping and the marginal cost curve is upward sloping. Allocative efficiency requires producing where the curves intersect, at the quantity that makes the marginal benefit equal the marginal cost. Distinguish between value and price and define consumer surplus. Value is what buyers get and price is what buyers pay. The value is the marginal benefit, which is the maximum price that buyers are willing to pay for another unit of the good. The demand curve is the marginal benefit curve. Consumer surplus is the marginal benefit from a good minus the price paid for it, summed over the quantity consumed. Distinguish between cost and price and define producer surplus. Cost is what a seller gives up to produce a good and price is what a seller receives when the good is sold. The cost of producing one more unit of a good or service is its marginal cost. The supply curve is the marginal cost curve. Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity produced. Evaluate the efficiency of the alternative methods of allocating scarce resources. When marginal benefit equals the marginal cost, the efficient quantity is produced. The sum of consumer surplus and producer surplus is maximized at a competitive equilibrium. According to Adam Smith, each participant in a competitive market is “led by an invisible hand” to promote the efficient use of resources. Underproduction and overproduction create a deadweight loss. Government imposed price and quantity regulations, taxes and subsidies, externalities, public goods, common re‐ sources, monopoly, and high transactions costs are obstacles to efficiency. Other means of allocation are sometimes but not necessarily efficient. Explain the main ideas about fairness and evaluate the fairness of the alternative methods of allocating scarce resources. Two views of fairness are: it’s not fair if the rules aren’t fair and it’s not fair if the result isn’t fair. When private property and property rights are protected and exchanges are voluntary, competitive markets are fair according to the rules view of fairness. The fair results idea of income equality ignores the cost of mak‐ ing income transfers, which leads to the big tradeoff between efficiency and fairness. 78 Part 2 . A CLOSER LOOK AT MARKETS CHECKPOINT 6.1 Describe the alternative methods of allocating scarce resources and define and explain the features of an efficient allocation. Quick Review • Allocation methods Resources can be allo‐ cated by: using the market price; com‐ mand; majority rule; a contest, first‐ come, first served; sharing equally; lot‐ tery; personal characteristics; and force. • Allocation methods Resources can be allo‐ cated by: using the market price; com‐ mand; majority rule; a contest, first‐ come, first served; sharing equally; lot‐ tery; personal characteristics; and force. • Marginal benefit The benefit that a person receives from consuming one more unit of a good or service. • Marginal cost The opportunity cost of producing one more unit of a good or service. Additional Practice Problems 6.1 1. Why is it necessary to allocate resources? 2. What is the command method of allocating resources? 3. Explain the relationship between production efficiency and allocative efficiency. Solutions to Additional Practice Problems 6.1 1. Resources are scarce, so not everyone’s wants can be fulfilled. As a result, some method must be used to determine whether or not resources are to be allocated to fulfill‐ ing each specific want. 2. The command method of allocating re‐ sources relies upon someone in authority to order how resources shall be allocated. The former Soviet Union and currently North Korea and Cuba are examples of entire economies in which command was (and is for North Korea and Cuba) the major alloca‐ tion method. 3. Production efficiency is a situation in it is im‐ possible to produce more of one good or ser‐ vice without producing less of some other good or service—production is at a point on the PPF. Allocative efficiency is the most highly valued combination of goods and ser‐ vices on the PPF. Self Test 6.1 Fill in the blanks Because only one person can become chair of General Electric and collect a salary of tens of millions of dollars, this position is allocated in a type of ____ (first‐come, first‐served; contest; command) allocation scheme. ____ (Production; Allocative) efficiency occurs at each combina‐ tion of goods and services on the PPF. ____ (Production; Allocative) efficiency occurs when the economy produces the most highly valued combination of goods and services on the PPF. As more of a good is consumed, its marginal benefit ____ (increases; decreases), and as more of a good is produced, its marginal cost ____ (increases; decreases). Allocative efficiency oc‐ curs when the marginal benefit of a good is ____ (greater than; equal to; less than) the mar‐ ginal cost of the good. True or false 1. When market prices are used to allocate re‐ sources, only the people who are able and willing to pay get the resources. 2. All combinations of goods and services on the production possibilities frontier are com‐ binations of allocative efficiency. 3. The marginal benefit of a good increases as more of the good is consumed. 4. A production point can be allocative efficient but not production efficient. Chapter 6 . Efficiency and Fairness of Markets 79 Multiple choice 1. If a person will rent an apartment only to married couples over 30 years old, that per‐ son is allocating resources using a ____ allo‐ cation method. a. first‐come, first‐served b. market price c. contest d. personal characteristics e. command 2. Allocative efficiency occurs when a. the most highly valued goods and services are produced. b. all citizens have equal access to goods and services. c. the environment is protected at all cost. d. goods and services are free. e. production takes place at any point on the PPF. 3. Marginal benefit equals the a. benefit that a person receives from con‐ suming another unit of a good. b. additional efficiency from producing an‐ other unit of a good. c. increase in profit from producing another unit of a good. d. cost of producing another unit of a good. e. total benefit from consuming all the units of the good or service. 4. In general, the marginal cost curve a. has a positive slope. b. has a negative slope. c. is horizontal. d. is vertical. e. is U‐shaped. 5. Allocative efficiency is achieved when the marginal benefit of a good a. exceeds marginal cost by as much as pos‐ sible. b. exceeds marginal cost but not by as much as possible. c. is less than its marginal cost. d. equals the marginal cost. e. equals zero. Complete the graph 1. An economy produces only trucks and trac‐ tors and Figure 6.1 shows the marginal bene‐ fit and marginal cost of tractors. How many tractors are produced at the point of alloca‐ tive efficiency? Short answer and numeric questions 1. Suppose the price of a new BMW is $50,000. Which two kinds of people decide not to buy these BMWs? Is it true that when resources are allocated by market price, the rich always consume everything? 2. Only one person can become President of Sony, yet many of Sony’s top executives would like that job. What allocation method is typically used to determine who becomes President? How does this allocation method benefit Sony? 3. Along a production possibilities frontier, to produce the first skateboard, 1 pair of roller blades must be forgone. To produce the sec‐ ond skateboard, 2 more pairs of roller blades must be forgone. Is the marginal cost of the second skate board 2 or 3 pairs of roller blades? 4. Why does allocative efficiency require pro‐ ducing where marginal benefit equals mar‐ ginal cost rather than where marginal benefit exceeds marginal cost? 80 Part 2 . A CLOSER LOOK AT MARKETS CHECKPOINT 6.2 Distinguish between value and price and define consumer surplus. Quick Review • Value In economics the idea of value is called marginal benefit, which we meas‐ ure as the maximum price that people are willing to pay for another unit of a good or service. • Consumer surplus Consumer surplus is the marginal benefit from a good or ser‐ vice minus the price paid for it, summed over the quantity consumed. Additional Practice Problem 6.2 1. The figure shows the demand curve for magazines and the market price of a magazine. Use the figure to an‐ swer the following questions. a. What is the value of the 1st maga‐ zine? What is the marginal benefit of the 1st magazine? What is the consumer surplus of the 1st magazine? b. What is the marginal benefit of the 2nd magazine? What is the consumer surplus of the 2nd magazine? c. What is the total quantity of magazines bought and the consumer surplus? d. If the price of a magazine rises to $10, what is the quantity bought and what is the consumer surplus? 2. Your friend paid a lawyer $50 for the hour it took the lawyer to write a letter to settle a rent dispute. Your friend wonders if the concepts of value, marginal benefit, and consumer surplus apply not only to goods but also to services, such as the lawyer’s letter. What do you tell your friend? Solutions to Additional Practice Problems 6.2 1a. The value of the 1st magazine equals the maxi‐ mum price a con‐ sumer is willing to pay for the magazine. The figure shows that the maximum price for the 1st magazine is $15, so the value of the magazine equals $15. The marginal bene‐ fit of the magazine is equal to the maximum price the consumer will pay, which is $15. The consumer surplus is equal to the mar‐ ginal benefit of the 1st magazine ($15) minus the price of the magazine ($5) so the con‐ sumer surplus is $10. 1b. The marginal benefit of the magazine is equal to the maximum price the consumer will pay. The fig‐ ure shows that the maximum price for the 2nd magazine is $10, so the marginal benefit of the magazine equals $5. The con‐ sumer surplus is equal to $5. 1c. The quantity bought is 3 maga‐ zines because the demand curve shows that the quantity demand‐ ed at the price of $5 is 3 magazines. The consumer surplus equals the area of the darkened triangle in the figure. Calculating the area of the con‐ Chapter 6 . Efficiency and Fairness of Markets 81 sumer surplus triangle, which is equal to one half the base of the triangle multiplied by the height or 1/2 × (3 − 0) × ($20 − $5), which is $22.50. 1d. If the price of a magazine rises to $10, the quantity bought is 2 magazines. The con‐ sumer surplus now equals 1/2 × (2 − 0) × ($20 − $10), which is $10.00. 2. All the concepts of value, marginal benefit, and consumer surplus apply to services as well as to goods. In your friend’s case, there was some maximum amount your friend was willing to pay the attorney to write the letter. This maximum amount was the value to your friend of the letter. It is also the mar‐ ginal benefit of the letter. Presumably your friend got the letter for some amount less than the maximum your friend was willing to pay. The difference between the marginal benefit of the letter and the price paid it is the consumer surplus your friend enjoyed from the letter. Multiple choice 1. Value is a. the price we pay for a good. b. the cost of resources used to produce a good. c. objective so that it is determined by mar‐ ket forces, not preferences. d. the marginal benefit we get from consum‐ ing another unit of a good or service. e. the difference between the price paid for a good and the marginal cost of producing that unit of the good. 2. A marginal benefit curve a. is the same as a demand curve. b. is the same as a supply curve. c. slopes upwards. d. is a vertical line at the efficient quantity. e. is U‐shaped. 3. In general, as the consumption of a good or service increases, the marginal benefit from consuming that good or service a. increases. b. decreases. c. stays the same. d. at first increases and then decreases. e. at first decreases and then increases. 4. The difference between the marginal benefit from a new pair of shoes and the price of the new pair of shoes is a. the consumer surplus from that pair of shoes. b. what we get. c. what we have to pay. d. the price when the marginal benefit is maximized. e. the consumer’s expenditure on the shoes. 5. Suppose the price of a scooter is $200 and Cora Lee is willing to pay $250. Cora Lee’s a. consumer surplus from that scooter is $200. b. consumer surplus from that scooter is $50. c. marginal benefit from that scooter is $200. d. consumer surplus from that scooter is $200. e. consumer surplus from that scooter is $250. Self Test 6.2 Fill in the blanks The benefit a person receives from consuming one more unit of a good is its ____. The oppor‐ tunity cost of producing one more unit of a good is its ____. Allocative efficiency is at the quantity where the marginal benefit is ____ (greater than; equal to; less than) marginal cost. The demand curve ____ (is; is not) the marginal benefit curve. The consumer surplus equals the marginal benefit of a good ____ (plus; multi‐ plied by; minus) the price paid for it. True or false 1. In economics, value and price refer to the same thing. 2. A demand curve is a marginal benefit curve. 3. The consumer surplus from one unit of a good is the marginal benefit from the good minus the price paid for it. 4. Consumer surplus always equals zero because consumers always pay for the goods and ser‐ vices they consume. 82 Part 2 . A CLOSER LOOK AT MARKETS 6. If the price of a pizza is $10 per pizza, the consumer surplus from the first pizza con‐ sumed ____ the consumer surplus from the second pizza consumed. a. is greater than b. equals c. is less than d. cannot be compared to e. None of the above answers is correct be‐ cause more information is needed about the marginal cost of producing the pizzas to answer the question. Complete the graph 2. Figure 6.3 shows the demand curve for bags of potato chips. a. What is the maximum price a consumer is willing to pay for the 10 millionth bag of chips? b. What is the marginal benefit from the 10 millionth bag of chips? What is the rela‐ tionship between your answer to part (a) and your answer to this part? c. If the price of a bag of chips equals $2, in Figure 6.3 shade the area that equals the amount of the consumer surplus. d. If the price of a bag of chips equals $2, what is the amount of consumer surplus? 1. Figure 6.2 shows the demand curve for roller blades. a. What is the marginal benefit of the 20,000th pair of roller blades? b. What is the marginal benefit of the 40,000th pair of roller blades? c. If the price of a pair of roller blades is $100, what is the consumer surplus on the 20,000th pair of roller blades? d. If the price of a pair of roller blades is $100, what is the consumer surplus on the 40,000th pair of roller blades? e. If the price of a pair of roller blades is $100, what is the quantity of roller blades purchased? What is the amount of the consumer surplus? Short answer and numeric questions Price Quantity (dollars per (millions of MP3 Consumer surplus MP3 player) players per year) (dollars) 500 4 ____ 400 8 ____ 300 12 ____ 200 16 ____ 100 20 ____ 1. The table above gives the demand schedule for MP3 players. Suppose the price of an MP3 player is $200. a. Complete the table by calculating the con‐ sumer surplus. In the first row, calculate the consumer surplus for the 4 millionth MP3 player; in the second row, calculate the consumer surplus for the 8 millionth MP3 player; and so on. Chapter 6 . Efficiency and Fairness of Markets 83 b. As more MP3 players are purchased, what happens to the consumer surplus of the last unit purchased? Why? 2. What is the relationship between the value of a good, the maximum price a consumer is willing to pay for the good, and the marginal benefit from the good? 3. What is the relationship between the mar‐ ginal benefit of a slice of pizza, the price paid for the slice, and its consumer surplus? CHECKPOINT 6.3 Distinguish between cost and price and define producer surplus. Quick Review • Cost Cost is what the seller must give up to produce a good. • Producer surplus The producer surplus of a good equals the price of a good minus the marginal cost of producing it. Additional Practice Problems 6.3 1. The figure shows the supply curve of magazines and the market price of a magazine. Use the figure to answer the following questions. a. What is the marginal cost of the 10 mil‐ lionth maga‐ zine? b. What is the minimum supply price of the 10 millionth magazine? c. What is the producer surplus on the 10 millionth magazine? d. What are the quantity of magazines sold and the total producer surplus? 2. Why is the minimum price for which a seller will produce a product equal to the product’s marginal cost? Solutions to Additional Practice Problems 6.3 1a. The marginal cost of the 10 millionth magazine is equal to the minimum sup‐ ply price of the 10 millionth magazine. The supply curve, which is also the marginal cost curve, shows this price. In the figure, the supply curve shows that the marginal cost of 10 millionth magazine is $2.50. 1b. The minimum supply price of the 10 mil‐ lionth magazine equals its marginal cost, $2.50. 1c. The producer surplus on the 10 millionth magazine is equal to its market price minus its marginal cost, which is $5 − $2.50 = $2.50. 1d. At the market price of $5, 20 million maga‐ zines are sold. The producer surplus equals the area of the grey triangle in the figure. Calculating the area of the triangle as one half the base multiplied by the height, or 1/2 × (20 million − 0) × ($5 − 0), the producer surplus equals $50 million. 2. A seller is willing to produce a good as long as the price the seller receives covers all the costs of producing the good. So the mini‐ mum price for which a seller is willing to produce a unit of the good must be the amount that just equals the cost of the pro‐ ducing that unit. But the cost of producing any unit of a good is its marginal cost, so the minimum supply price equals the good’s marginal cost. 84 Part 2 . A CLOSER LOOK AT MARKETS Self Test 6.3 Fill in the blanks ____ (Price; Cost) is what a seller must give up to produce a good and ____ (price; cost) is what a seller receives when the good is sold. A ____ (demand; supply) curve is a marginal cost curve. A firm receives a producer surplus when price is ____ (greater; less) than marginal cost. True or false 1. In economics, cost and price are the same thing. 2. The minimum price for which Bobby will grow another pound of rice is 20¢, so the marginal cost of an additional pound of rice is 20¢. 3. A supply curve is a marginal benefit curve. 4. Producer surplus equals the marginal benefit of a good minus the cost of producing it. Multiple choice 1. Cost a. is what the buyer pays to get the good. b. is always equal to the marginal benefit for every unit of a good produced. c. is what the seller must give up to produce the good. d. is greater than market price, which results in a profit for firms. e. means the same thing as price. 2. If a firm is willing to supply the 1,000th unit of a good at a price of $23 or more, we know that $23 is the a. highest price the seller hopes to realize for this output. b. minimum price the seller must receive to produce this unit. c. average price of all the prices the seller could charge. d. price that sets the marginal benefit equal to the marginal cost. e. only price for which the seller is willing to sell this unit of the good. 3. A supply curve shows the ____ of producing one more unit of a good or service. a. producer surplus b. consumer surplus c. total benefit d. marginal cost e. marginal benefit to the producer 4. Producer surplus is a. equal to the marginal benefit from a good minus its price. b. equal to the price of a good minus the marginal cost of producing it. c. always equal to consumer surplus. d. Both answers (a) and (c) are correct. e. Both answers (b) and (c) are correct. 5. Suppose you’re willing to tutor a student for $10 an hour. The student pays you $15 an hour. What is your producer surplus? a. $5 an hour b. $10 an hour c. $15 an hour d. $25 an hour e. more than $25 an hour 6. In a figure that shows a supply curve and a demand curve, producer surplus is the area a. below the demand curve and above the market price. b. below the supply curve and above the market price. c. above the demand curve and below the market price. d. above the supply curve and below the market price. e. between the demand curve and the sup‐ ply curve. Complete the graph 1. Figure 6.4 (on the next page) shows the sup‐ ply curve for bags of potato chips. a. What is the minimum price for which a supplier is willing to produce the 10 mil‐ lionth bag of chips? b. What is the marginal cost of the 10 mil‐ lionth bag of chips? What is the relation‐ ship between your answer to part (a) and your answer to this part? Chapter 6 . Efficiency and Fairness of Markets 85 • Deadweight loss The decrease in consumer surplus and producer surplus that results from an inefficient level of production. c. If the price of a bag of chips equals $2, in Figure 6.4 shade the area that equals the amount of the producer surplus. d. If the price of a bag of chips equals $2, cal‐ culate the producer surplus. Short answer and numeric questions 1. What is the relationship between the mini‐ mum price a supplier must receive to pro‐ duce a slice of pizza and the marginal cost of the slice of pizza? What is the relationship between the marginal cost curve and the supply curve? 2. What is producer surplus? As the price of a good or service rises and the supply curve does not shift, what happens to the amount of the producer surplus? Additional Practice Problems 6.4 1. The figure shows the market for paper. Use the figure to answer the following questions. a. What are the equilibrium price and the equilibrium quantity of paper? What is the efficient quantity of paper? b. In the market equilibrium, use the figure above to shade the consumer surplus and the producer surplus. c. What does the consumer surplus equal? What does the producer surplus equal? What does the total surplus equal? d. Is the market for paper efficient? Why or why not? Can the total surplus be any lar‐ ger at any other level of production? 2. Who benefits from a deadweight loss? Solutions to Additional Practice Problems 6.4 1a. The equilibrium is shown in the figure and is where the supply and demand curves inter‐ sect. The equilibrium price is $5 a ton and the equilibrium quantity is 30 tons a day. The ef‐ ficient quantity is where the marginal benefit and marginal cost curves intersect. Because the demand curve is the marginal benefit curve and the supply curve is the marginal cost curve, the efficient quantity is 30 tons a day. 1b. The consumer surplus is illustrated in the figure on the next page as the area of the top, dark triangle. The producer surplus equals the area of the lower, lighter triangle. 1c. The consumer surplus equals the area of the darker triangle, or 1/2 × (30 tons) × ($4 per ton) = $60, where $4 a ton is the height of the CHECKPOINT 6.4 Evaluate the efficiency of the alternative methods of allocating scarce resources. Quick Review • Efficiency of competitive equilibrium The condition that marginal benefit equals marginal cost delivers an efficient use of resources. It allocates resources to the ac‐ tivities that create the greatest possible value. Marginal benefit equals marginal cost at a competitive equilibrium, so a competitive equilibrium is efficient. 86 Part 2 . A CLOSER LOOK AT MARKETS triangle, $9 a ton − $5 a ton. The producer sur‐ plus equals the area of the lighter triangle, or 1/2 × (30 tons) × ($5 per ton) = $75, where $5 a ton is the height of the triangle, $5 a ton − $0 a ton. The total surplus equals the sum of the con‐ sumer surplus plus the producer surplus, which is $135. 1d. The efficient use of resources occurs when marginal benefit equals marginal cost. The market equilibrium is efficient because the marginal benefit of a ton of paper equals its marginal cost. The sum of the consumer sur‐ plus and producer surplus, which equals the total surplus, is at its maximum at the effi‐ cient level of production so the total surplus cannot be larger at any other amount of pro‐ duction. 2. No one gains from a deadweight loss. Deadweight loss is a decrease in consumer surplus and producer surplus that results from an inefficient level of production. The deadweight loss is borne by the entire soci‐ ety. It is not a loss for the consumers and a gain for the producer. It is a social loss. and producer surplus; only producer surplus) that results from an inefficient level of produc‐ tion. True or false 1. When the demand curve is the marginal benefit curve and the supply curve is the marginal cost curve, the competitive equilib‐ rium is efficient. 2. When the efficient quantity of a good is pro‐ duced, the consumer surplus is always zero. 3. According to Adam Smith, the invisible hand suggests that competitive markets require government action to ensure that resources are allocated efficiently. 4. Producing less than the efficient quantity of a good results in a deadweight loss but pro‐ ducing more than the efficient quantity does not result in a deadweight loss. Multiple choice Self Test 6.4 Fill in the blanks Equilibrium in a competitive market ____ (is; is not) efficient. Adam Smith believed that each participant in a competitive market is “led by ____ (an invisible hand; government actions).” A price ____ (ceiling; floor) is a regulation that makes it illegal to charge a price higher than a specified level. ____ (An externality; A public good) is a good or service that is consumed si‐ multaneously by everyone, even if they don’t pay for it. Deadweight loss is the decrease in ____ (only consumer surplus; consumer surplus 1. Figure 6.5 shows the market for computers. What is the equilibrium quantity of com‐ puters? a. 0 computers per week b. 200,000 computers per week c. 400,000 computers per week d. 600,000 computers per week e. more than 600,000 computers per week Chapter 6 . Efficiency and Fairness of Markets 87 2. Figure 6.5 shows the market for computers. What is the efficient quantity of computers? a. 0 computers per week b. 200,000 computers per week c. 400,000 computers per week d. 600,000 computers per week e. more than 600,000 computers per week 3. When a market is efficient the a. sum of consumer surplus and producer surplus is maximized. b. deadweight gain is maximized. c. quantity produced is maximized. d. marginal benefit of the last unit produced exceeds the marginal cost by as much as possible. e. total benefit equals the total cost. 4. Which of the following occurs when a mar‐ ket is efficient? a. producers earn the highest income possi‐ ble b. production costs equal total benefit c. consumer surplus equals producer surplus d. scarce resources are used to produce the goods and services that people value most highly e. every consumer has all of the good or ser‐ vice he or she wants. 5. The concept of “the invisible hand” suggests that markets a. do not produce the efficient quantity. b. are always fair. c. produce the efficient quantity. d. are unfair though they might be efficient. e. allocate resources unfairly and ineffi‐ ciently. 6. When underproduction occurs, a. producers gain more surplus at the ex‐ pense of consumers. b. marginal cost is greater than marginal benefit. c. consumer surplus increases to a harmful amount. d. there is a deadweight loss that is borne by the entire society. e. the deadweight loss harms only consumers. 7. When production moves from the efficient quantity to a point of overproduction, a. consumer surplus definitely increases. b. the sum of producer surplus and con‐ sumer surplus increases. c. there is a deadweight loss. d. consumers definitely lose and producers definitely gain. e. consumers definitely gain and producers definitely lose. 8. Which of the following can result in a market producing an inefficient quantity of a good? i. competition ii. an external cost or an external benefit iii. a tax a. i only. b. ii only. c. iii only. d. ii and iii. e. i and iii. Complete the graph 1. In Figure 6.6, what is the equilibrium quan‐ tity of automobiles? What is the efficient quantity of automobiles? Shade the con‐ sumer surplus and the producer surplus and calculate their amounts. 2. Figure 6.7 (on the next page) is identical to Figure 6.6. a. Suppose that 8,000 automobiles are pro‐ duced. Shade the deadweight loss light grey and calculate its amount. 88 Part 2 . A CLOSER LOOK AT MARKETS person, would the transaction be fair? Com‐ ment on your answers. Solution to Additional Practice Problem 6.5 1. If Mr. Gates gives $1,000 to a homeless per‐ son, the action is considered fair. The ex‐ change is fair according to the fair rules prin‐ ciple because the exchange is voluntary. And the outcome is fair according to the fair re‐ sults principle because there is more equality of income. If Mr. Gates is taxed by the gov‐ ernment, the outcome is fair according to the fair results principle because there is more equality of income. But the transaction is not fair according to the fair rules principle be‐ cause the exchange does not occur voluntar‐ ily. b. Suppose that 4,000 automobiles are pro‐ duced. Shade the deadweight loss dark grey and calculate its amount. Short answer and numeric questions 1. What is the relationship between a com‐ petitive market, efficiency, and the invisi‐ ble hand? 2. Suppose the demand for cotton clothing increases. What effect does the increase in demand have on the equilibrium quantity and on the efficient quantity? 3. What factors might lead a market to pro‐ duce an inefficient amount of a product? Self Test 6.5 Fill in the blanks Two views of fairness are that “it’s not fair if the ____ (result; income distribution) isn’t fair;” and “it’s not fair if the ____ (rules; tradeoffs) aren’t fair.” According to Robert Nozick, fair‐ rules ideas require ____ (government interven‐ tion; property rights and voluntary exchange). True or false 1. The principle that “it’s not fair if the result isn’t fair” can conflict with the principle that “it’s not fair if the rules aren’t fair.” 2. The big tradeoff is the tradeoff between effi‐ ciency and happiness. 3. According to the “fair‐rules” view of fair‐ ness, in times of natural disasters it is fair to force people to make available necessary goods and services at lower than usual prices. Multiple choice 1. The “fair‐rules” view of fairness is based on a. income transfers from the rich to the poor. b. property rights and voluntary exchange. c. efficiency. d. the big tradeoff. e. allocating resources using majority rule. CHECKPOINT 6.5 Explain the main ideas about fairness and evaluate the fairness of alternative methods of allocating scarce resources. Quick Review • Big tradeoff The big tradeoff is the trade‐ off between efficiency and fairness that results when income transfers are made. Additional Practice Problem 6.5 1. If Bill Gates gives $1,000 to a homeless person, would the transaction be fair? If Mr. Gates is taxed $1,000 by the government and the gov‐ ernment gives the $1,000 to the same homeless Chapter 6 . Efficiency and Fairness of Markets 89 2. The idea that unequal incomes is unfair gen‐ erally uses the ____ principle of fairness. a. big tradeoff b. involuntary exchange c. voluntary exchange d. it’s not fair if the result isn’t fair e. it’s not fair if the rules aren’t fair 3. Which of the following is an example in which “the big tradeoff” can occur? a. the government redistributes income from the rich to the poor b. Ford increases the price of a pickup truck c. a basketball player signs a $5 million con‐ tract d. a college lowers tuition e. the price of personal computers falls year after year 4. Suppose a hurricane is poised to strike Mi‐ ami and the price of plywood jumps from $15 a board to $28. If the government buys all the plywood at $28 and offers it to con‐ sumers for $15, which of the following is true? a. There will be enough plywood for every‐ one at the $15 government price. b. There will be a surplus of plywood at the $15 government price. c. Some people who buy plywood at the $15 government price will resell the plywood to consumers who are willing to pay $28, earning a producer surplus of $13. d. Because the government is both buying and selling the plywood, there is no need to impose a tax to pay for the government intervention. e. The big tradeoff means that more ply‐ wood will be purchased with the govern‐ ment intervention than would be the case without the government intervention. Short answer and numeric questions 1. In the United States, richer people gener‐ ally pay a larger fraction of their income as taxes than do poorer people. Is this ar‐ rangement fair? Answer from a fair‐ results view and from a fair‐rules view. 2. Suppose that during their working life‐ times, Matt and Pat have earned identical incomes as computer programmers. The only difference between the two is that Matt spent all of his income while Pat saved a large portion of hers. Now that they are retired, Pat’s income is substan‐ tially higher than Matt’s because of Pat’s saving. Is it fair for Pat’s income to be higher than Matt’s? Answer from a fair re‐ sults and from a fair rules perspective. 3. What is the effect of the big tradeoff in transferring income from people with high incomes to people with low incomes? 4. Is it fair for the government to limit the prices sellers charge for bottled water after a flood destroys a town’s water supply? Why or why not? 90 Part 2 . A CLOSER LOOK AT MARKETS SELF TEST ANSWERS CHECKPOINT 6.1 Fill in the blanks Because only one person can become chair of General Electric and collect a salary of tens of millions of dollars, this position is allocated in a type of contest allocation scheme. Production efficiency occurs at each combination of goods and services on the PPF. Allocative efficiency occurs when the economy produces the most highly valued combination of goods and ser‐ vices on the PPF. As more of a good is con‐ sumed, its marginal benefit decreases, and as more of a good is produced, its marginal cost increases. Allocative efficiency occurs when the marginal benefit of a good is equal to the mar‐ ginal cost of the good. True or false 1. True; page 138 2. False; page 141 3. False; page 142 4. False; page 138 Multiple choice 1. d; page 140 2. a; page 141 3. a; page 142 4. a; page 143 5. d; pages 143‐144 Complete the graph 1. Allocative efficiency is the most highly val‐ ued combination of goods and services on the PPF. It is the combination where mar‐ ginal cost equals marginal benefit. In Figure 6.1, allocative efficiency is achieved when 30 tractors a week are produced; page 144. Short answer and numeric questions 1. The people who do not buy these BMWs are the people cannot afford to pay $50,000 for the new BMW and the people who can af‐ ford to pay but choose not to pay it. The fact that people can decide not to buy a particular good or service shows that the rich do not necessary consume everything; they buy and consume only the goods and services for which they choose to pay the market price; page 138. 2. Sony is using a contest allocation method. Sony benefits from this allocation scheme be‐ cause all the top executives who want to be President will work extremely hard for Sony in an effort to win the contest; page 139. 3. The marginal cost of the second skate board is 2 pairs roller blades. Marginal cost is the opportunity cost of producing one more unit of a good or service. It is not the cost of all the units produced; pages 142‐143. 4. As long as the marginal benefit from an ad‐ ditional good or service exceeds the marginal cost, the unit should be produced because its production benefits society more than it costs society to produce. Producing where mar‐ ginal benefit equals marginal cost insures that all units that have a net benefit for soci‐ ety are produced, so this level of production is the point of allocative efficiency; page 144. CHECKPOINT 6.2 Fill in the blanks The benefit a person receives from consuming one more unit of a good is its marginal benefit. The opportunity cost of producing one more unit of a good is its marginal cost. Allocative ef‐ ficiency is at the quantity where the marginal benefit is equal to marginal cost. The demand curve is the marginal benefit curve. The con‐ sumer surplus equals the marginal benefit of a good minus the price paid for it. True or false 1. False; page 146 2. True; page 146 3. True; page 147 4. False; page 147 Multiple choice 1. d; page 146 2. a; page 146 3. b; page 146 Chapter 6 . Efficiency and Fairness of Markets 91 4. a; page 147 5. b; page 147 6. a; page 147 Complete the graph 1. a. The marginal benefit of the 20,000th pair of roller blades is the maximum price a consumer is willing to pay for that pair, which is $150; page 146. b. The marginal benefit of the 40,000th pair of roller blades is the maximum price a consumer is willing to pay for that pair, which is $100; page 146. c. The consumer surplus is the difference be‐ tween the marginal benefit, $150, minus the price paid, $100, or $50; page 147. d. The consumer surplus is the difference be‐ tween the marginal benefit, $100, minus the price paid, $100, or $0; page 147. e. If the price is $100, then 40,000 pairs of roller blades will be purchased. The con‐ sumer surplus equals 1/2 × ($200 − $100) × (40,000 − 0), or $40,000,000; page 147. 2. a. The maximum price is $3; page 146. b. The marginal benefit is $3. The marginal benefit is the maximum price a consumer is willing to pay for another bag of potato chips; page 146. 1/2 × ($4 − $2) × 20 million = $20 million; page 147. Short answer and numeric questions Price Quantity (dollars per (millions of MP3 Consumer surplus MP3 player) players per year) (dollars) 500 4 300 400 8 200 300 12 100 200 16 0 100 20 0 1. a. The table above has the consumer sur‐ pluses. The consumer surplus is zero for the 20 millionth MP3 player because when the price is $200, the 20 millionth MP3 player is not purchased. For the remaining quantities, the consumer surplus is the marginal benefit, which equals the maxi‐ mum price consumers are willing to pay minus the price; page 147. b. The consumer surplus decreases as more MP3 players are purchased because the value of an additional MP3 player de‐ creases as more are purchased; page 147. 2. The value of a good is equal to the maximum price a buyer is willing to pay, which also equals the marginal benefit; page 146. 3. The marginal benefit of the slice of pizza equals the price paid plus the consumer sur‐ plus on that slice; page 147. CHECKPOINT 6.3 Fill in the blanks Cost is what a seller must give up to produce a good and price is what a seller receives when the good is sold. A supply curve is a marginal cost curve. A firm receives a producer surplus when price is greater than marginal cost. True or false 1. False; page 149 2. True; page 149 3. False; page 149 4. False; page 150 Multiple choice 1. c; page 149 c. Figure 6.8 shades the area of the consumer surplus; page 147. d. The consumer surplus equals the area of the shaded triangle in Figure 6.8, which is 92 Part 2 . A CLOSER LOOK AT MARKETS 2. b; page 149 3. d; page 149 4. b; page 150 5. a; page 150 6. d; page 150 Complete the graph 1. a. The minimum price is $1; page 149. b. The marginal cost is $1. The marginal cost of the 10 millionth bag is the minimum price for which a supplier is willing to produce that bag of chips; page 149. CHECKPOINT 6.4 Fill in the blanks Equilibrium in a competitive market is efficient. Adam Smith believed that each participant in a competitive market is “led by an invisible hand.” A price ceiling is a regulation that makes it illegal to charge a price higher than a specified level. A public good is a good or ser‐ vice that is consumed simultaneously by every‐ one, even if they don’t pay for it. Deadweight loss is the decrease in consumer surplus and producer surplus that results from an inefficient level of production. True or false 1. True; page 152 2. False; page 152 3. False; page 153 4. False; page 155 Multiple choice 1. d; page 152 2. d; page 152 3. a; page 153 4. d; page 152 5. c; page 153 6. d; page 155 7. c; page 155 8. d; page 156 Complete the graph c. Figure 6.9 shades the area of the producer surplus; page 150. d. The producer surplus equals the area of the shaded triangle in Figure 6.9, so pro‐ ducer surplus is 1/2 × ($2 − $0) × 20 mil‐ lion, which equals $20 million; page 150. Short answer and numeric questions 1. The minimum price for which a firm will produce a slice of pizza equals the marginal cost of producing that slice. It is just worth producing one more slice of pizza if the price for which it can be sold equals its marginal cost. The supply curve tells us this price. So the supply curve is the same as the marginal cost curve; page 149. 2. Producer surplus equals the price of a good or service minus the marginal cost of produc‐ ing it. As the price of a good or service rises and the supply curve does not shift, the pro‐ ducer surplus increases; page 150. 1. In Figure 6.10 the equilibrium quantity of Chapter 6 . Efficiency and Fairness of Markets 93 automobiles is 6,000 a week. The efficient quantity of automobiles is also 6,000 a week because that is the quantity at which the marginal benefit equals the marginal cost. The consumer surplus and producer surplus are the shown in the figure. The consumer surplus is the area of the light grey triangle, which is 1/2 × ($40.00 − $30.00) × (6,000) = $60,000. The producer surplus is the area of the dark grey triangle, which is 1/2 × ($30.00 − $0.00) × (60,000) = $90,000; page 152. said that each participant in a competitive market is “led by an invisible hand to pro‐ mote an end [the efficient use of resources] which is no part of his intention;” page 153. 2. If the demand for cotton clothing increases, the demand curve for cotton clothing shifts rightward and the equilibrium quantity in‐ creases. The demand curve is the marginal benefit curve, so when the demand curve shifts rightward, the marginal benefit curve also shifts rightward. The efficient quantity also increases; page 152. 3. Governments influence markets by setting price and quantity regulations as well as taxes and subsidies, all of which can create inefficiency. Other obstacles to achieving an efficient allocation of resources are external‐ ities, public goods, common resources, mo‐ nopoly, and high transactions costs; pages 156‐157. CHECKPOINT 6.5 Fill in the blanks Two views of fairness are that “it’s not fair if the result isn’t fair;” and “it’s not fair if the rules aren’t fair.” According to Robert Nozick, fair‐ rules ideas require property rights and volun‐ tary exchange. True or false 1. True; page 159 2. False; page 160 3. False; page 161 Multiple choice 1. b; page 159 2. b; page 160 3. a; page 160 4. c; page 161 Short answer and numeric questions 1. The tax arrangement is fair from a fair‐ results view because it leads to a greater equality of income. The tax arrangement is not fair from a fair‐results view because the tax is not a voluntary exchange; pages 159‐ 160. 2. a. When 8,000 automobiles are produced, there is a deadweight loss from overpro‐ duction because for the last 2,000 automo‐ biles, the marginal cost exceeds the mar‐ ginal benefit. The deadweight loss is the area of the light grey triangle in Figure 6.11, which is 1/2 × ($40.00 − $26.67) × (8,000 − 6,000) = $1,330; page 155. b. If 4,000 automobiles are produced, there again is a deadweight loss, this time from underproduction, because automobiles for which the marginal benefit exceeds the marginal cost are not produced. The amount of the deadweight loss is the area of dark grey triangle in Figure 6.11, which is 1/2 × ($33.33 − $20.00) × (6,000 − 4,000) = $1,330; page 155. Short answer and numeric questions 1. Adam Smith was the first to suggest that competitive markets send resources to the uses in which they have the highest value so that competitive markets are efficient. Smith 94 Part 2 . A CLOSER LOOK AT MARKETS 2. From a fair‐results view, it is not fair for Pat’s income to be substantially higher than Matt’s. From a fair‐rules view, it is fair be‐ cause Pat and Matt had the same opportuni‐ ties; pages 159‐160. 3. Income can be transferred from people with high incomes to people with low incomes only by taxing incomes, which discourages work. This tax results in the quantity of labor being less than the efficient quantity. Simi‐ larly, taxing income from capital discourages saving, which results in the quantity of capi‐ tal being less than the efficient quantity. With less labor and less capital than the efficient amounts, the total amount of production is less than the efficient amount. So the greater the amount of income redistribution through income taxes, the greater is the inefficiency and the smaller is the economic pie; page 160. 4. Limiting the price that can be charged is un‐ fair because it compels the seller to help and such compulsion is unfair; page 161. ...
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