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Unformatted text preview: 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 103 5 Efficiency and Equity A fter studying this chapter, y ou will be able to: ■ Describe the alternative methods of allocating scarce resources ■ Explain the connection between demand and marginal benefit and define consumer surplus ■ Explain the connection between supply and marginal cost and define producer surplus ■ Explain the conditions under which markets are efficient and inefficient ■ Explain the main ideas about fairness and evaluate claims that markets result in unfair outcomes Every time you pour a glass of water or order a pizza, The social interest has the two dimensions that we’ve just you express your view about how scarce resources should be discussed: efficiency and fairness (or equity). So our central used and you make choices in your self-interest. Markets coordi- question in this chapter is: Do markets operate in the social nate your choices along with those of everyone else. But do interest? At the end of the chapter, in Reading Between the markets do a good job? Do they allocate resources between Lines , we return to the issue of the use of the water water, pizza, and everything else efficiently? resources. Do we use markets and other arrangements that The market economy generates huge income inequality. allocate scarce water efficiently and fairly? You can afford to buy a bottle of fresh spring water, while a student in India must make the best of dirty well water or expensive water from a tanker. Is this situation fair? 103 9160335_CH05_p103-124.qxd 104 6/22/09 8:58 AM Page 104 CHAPTER 5 Efficiency and Equity ◆ Resource Allocation Methods 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. And trading in markets is just one of several alternative methods. Resources might be allocated by ■ ■ ■ ■ ■ ■ ■ ■ Market price Command Majority rule Contest First-come, first-served Lottery Personal characteristics Force Let’s briefly examine each method. Market Price When a 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. For many goods and services, distinguishing between those who choose not to buy and those who can’t afford to buy doesn’t matter. But for a few items, it does matter. For example, poor people can’t afford to pay school fees and doctors’ fees. Because poor people can’t afford items that most people consider to be essential, these items are usually allocated by one of the other methods. Command A command system allocates resources by the order (command) of someone in authority. In the U.S. economy, the command system is used extensively inside firms and government departments. For example, if you have a job, most likely someone tells you what to do. Your labor is allocated to specific tasks by a command. A command system works well in organizations in which the lines of authority and responsibility are clear and it is easy to monitor the activities being performed. But a command system works badly when the range of activities to be monitored is large and when it is easy for people to fool those in authority. The system works so badly in North Korea, where it is used extensively in place of markets, that it fails even to deliver an adequate supply of food. Majority Rule Majority rule allocates resources in the way that a majority of voters choose. Societies use majority rule to elect representative governments that make some of the biggest decisions. For example, majority rule decides the tax rates that end up allocating scarce resources between private use and public use. And majority rule decides how tax dollars are allocated among competing uses such as education and health care. Majority rule works well when the decisions being made affect large numbers of people and selfinterest must be suppressed to use resources most effectively. Contest A contest allocates resources to a winner (or a group of winners). Sporting events use this method. Tiger Woods competes with other golfers, and the winner gets the biggest payoff. But contests are more general than those in a sports arena, though we don’t normally call them contests. For example, Bill Gates won a contest to provide the world’s personal computer operating system. Contests do a good job when the efforts of the “players” are hard to monitor and reward directly. When a manager offers everyone in the company the opportunity to win a big prize, people are motivated to work hard and try to become the winner. Only a few people end up with a big prize, but many people work harder in the process of trying to win. The total output produced by the workers is much greater than it would be without the contest. First-Come, First-Served A first-come, first-served method allocates resources to those who are first in line. Many casual restaurants won’t accept reservations. They use first-come, first-served to allocate their scarce tables. Highway space is allocated in this way too: the first to arrive at 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 105 Resource Allocation Methods the on-ramp gets the road space. If too many vehicles enter the highway, the speed slows and people wait in line for some space to become available. First-come, first-served works best when, as in the above examples, a scarce resource can serve just one user at a time in a sequence. By serving the user who arrives first, this method minimizes the time spent waiting for the resource to become free. Lottery Lotteries allocate resources to those who pick the winning number, draw the lucky cards, or come up lucky on some other gaming system. State lotteries and casinos reallocate millions of dollars worth of goods and services every year. But lotteries are more widespread than jackpots and roulette wheels in casinos. They are used to allocate landing slots to airlines at some airports and have been used to allocate fishing rights and the electromagnetic spectrum used by cell phones. Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource. Personal Characteristics When resources are allocated on the basis of personal characteristics, people with the “right” characteristics get the resources. Some of the resources that matter most to you are allocated in this way. For example, you will choose a marriage partner on the basis of personal characteristics. But this method is also used in unacceptable ways. Allocating the best jobs to white, Anglo-Saxon males and discriminating against visible minorities and women is an example. Force Force plays a crucial role, for both good and ill, in allocating scarce resources. Let’s start with the ill. War, the use of military force by one nation against another, has played an enormous role historically in allocating resources. The economic supremacy of European settlers in the Americas and Australia owes much to the use of this method. Theft, the taking of the property of others without their consent, also plays a large role. Both large-scale organized crime and small-scale petty crime collectively allocate billions of dollars worth of resources annually. 105 But force plays a crucial positive role in allocating resources. It provides the state with an effective method of transferring wealth from the rich to the poor, and it provides the legal framework in which voluntary exchange in markets takes place. A legal system is the foundation on which our market economy functions. Without courts to enforce contracts, it would not be possible to do business. But the courts could not enforce contracts without the ability to apply force if necessary. The state provides the ultimate force that enables the courts to do their work. More broadly, the force of the state is essential to uphold the principle of the rule of law. This principle is the bedrock of civilized economic (and social and political) life. With the rule of law upheld, people can go about their daily economic lives with the assurance that their property will be protected—that they can sue for violations against their property (and be sued if they violate the property of others). Free from the burden of protecting their property and confident in the knowledge that those with whom they trade will honor their agreements, people can get on with focusing on the activity at which they have a comparative advantage and trading for mutual gain. Review Quiz ◆ 1 2 3 4 Why do we need methods of allocating scarce resources? Describe the alternative methods of allocating scarce resources. Provide an example of each allocation method that illustrates when it works well. Provide an example of each allocation method that illustrates when it works badly. Work Study Plan 5.1 and get instant feedback. In the next sections, we’re going to see how a market can achieve an efficient use of resources, examine the obstacles to efficiency, and see how sometimes an alternative method might improve on the market. After looking at efficiency, we’ll turn our attention to the more difficult issue of fairness. 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 106 CHAPTER 5 Efficiency and Equity ◆ Demand and Marginal Benefit In Fig. 5.1(a), Lisa is willing to pay $1 for the 30th slice of pizza and $1 is her marginal benefit from that slice. In Fig. 5.1(b), Nick is willing to pay $1 for the 10th slice of pizza and $1 is his marginal benefit from that slice. But at what quantity is the market willing to pay $1 for the marginal slice? The answer is provided by the market demand curve. Resources are allocated efficiently when they are used in the ways that people value most highly. This outcome occurs when marginal benefit equals marginal cost (Chapter 2, pp. 35–37). So to determine whether a competitive market is efficient, we need to see whether, at the market equilibrium quantity, marginal benefit equals marginal cost. We begin by seeing how market demand reflects marginal benefit. 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. Demand, Willingness to Pay, and Value In everyday life, we talk about “getting value for money.” When we use this expression, we are distinguishing between 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. And we measure marginal benefit by the 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. 2.50 Lisa is willing to pay $1 for the 30th slice 2.00 1.50 1.00 30 slices Lisa's D = MB 10 20 30 40 50 Quantity (slices per month) (a) Lisa's demand Price (dollars per slice of pizza) Price (dollars per slice of pizza) 3.00 0 Figure 5.1(c) illustrates the market demand for pizza if Lisa and Nick are the only people in the market. Lisa’s demand curve in part (a) and Nick’s demand curve in part (b) sum horizontally to the market demand curve in part (c). Individual Demand, Market Demand, and Marginal Social Benefit FIGURE 5.1 0.50 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. 3.00 2.50 2.00 1.50 Nick is willing to pay $1 for the 10th slice 1.00 0.50 0 10 slices 10 20 30 40 50 Quantity (slices per month) (b) Nick's demand At a price of $1 a slice, the quantity demanded by Lisa is 30 slices and the quantity demanded by Nick is 10 slices, so the quantity demanded by the market is 40 slices. Lisa’s demand animation Nick's D = MB Price (dollars per slice of pizza) 106 3.00 2.50 Society is willing to pay $1 for the 40th slice 2.00 1.50 1.00 0.50 30 + 10 = 40 slices Market D = MSB 0 10 20 30 40 50 60 70 Quantity (slices per month) (c) Market demand curve in part (a) and Nick’s demand curve in part (b) sum horizontally to the market demand curve in part (c). The market demand curve is the marginal social benefit (MSB) curve. 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 107 Demand and Marginal Benefit At a price of $1 a slice, Lisa demands 30 slices and Nick demands 10 slices, so the market quantity demanded at $1 a slice is 40 slices. From the market demand curve, we see that the economy is willing to pay $1 for 40 slices a day. The market demand curve is the marginal social benefit (MSB) curve. Although we’re measuring the price in dollars, think of the price as telling us the number of dollars’ worth of other goods and services willingly forgone to obtain one more slice of pizza. Consumer Surplus We don’t always have to pay what we are willing to pay. We get a bargain. When people buy something for less than it is worth to them, they receive a consumer surplus. A consumer surplus is the value (or marginal benefit) of a good minus the price paid for it, summed over the quantity bought. Figure 5.2(a) shows Lisa’s consumer surplus from pizza when the price is $1 a slice. At this price, she buys 30 slices a month because the 30th slice is worth exactly $1 to her. But Lisa is willing to pay $2 for the 10th slice, so her marginal benefit from this slice is 2.50 Lisa's consumer surplus Lisa's surplus from the 10th slice 2.00 1.50 1.00 0.50 0 Lisa's D = MB 10 Review Quiz ◆ 1 2 How do we measure the value or marginal benefit of a good or service? What is consumer surplus? How is it measured? Work Study Plan 5.2 and get instant feedback. 20 30 40 50 Quantity (slices per month) (a) Lisa's consumer surplus 3.00 2.50 2.00 Nick's consumer surplus 1.50 1.00 0.50 0 Nick's D = MB 10 20 30 40 50 Quantity (slices per month) (b) Nick's consumer surplus Lisa is willing to pay $2.00 for her 10th slice of pizza in part (a). At a market price of $1 a slice, Lisa receives a surplus of $1 on the 10th slice. The green triangle shows her consumer surplus on the 30 slices she buys at $1 a slice. animation Price (dollars per slice of pizza) 3.00 $1 more than she pays for it—she receives a surplus of $1 on the 10th slice. Lisa’s consumer surplus is the sum of the surpluses on all of the slices she buys. This sum is the area of the green triangle—the area below the demand curve and above the market price line. The area of this triangle is equal to its base (30 slices) multiplied by its height ($1.50) divided by 2, which is $22.50. The area of the blue rectangle in Fig. 5.2(a) shows what Lisa pays for 30 slices of pizza. Figure 5.2(b) shows Nick’s consumer surplus, and part (c) shows the consumer surplus for the market. The consumer surplus for the market is the sum of the consumer surpluses of Lisa and Nick. All goods and services, like pizza, have decreasing marginal benefit, so people receive more benefit from their consumption than the amount they pay. Demand and Consumer Surplus Price (dollars per slice of pizza) Price (dollars per slice of pizza) FIGURE 5.2 107 3.00 Consumer surplus 2.50 2.00 Market price 1.50 1.00 0.50 Market D = MSB 0 10 20 30 40 50 60 70 Quantity (slices per month) (c) Market consumer surplus The green triangle in part (b) shows Nick’s consumer surplus on the 10 slices that he buys at $1 a slice. The green area in part (c) shows the consumer surplus for the market. The blue rectangles show the amounts spent on pizza. 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 108 CHAPTER 5 Efficiency and Equity ◆ Supply and Marginal Cost We are now going to see how market supply reflects marginal cost. This section closely parallels the related ideas about market demand and marginal benefit that you’ve just studied. Firms are in business to make a profit. To do so, they must sell their output for a price that exceeds the cost of production. Let’s investigate the relationship between cost and price. Supply, Cost, and Minimum Supply-Price Firms make a profit when they receive more from the sale of a good or service than the cost of producing it. Just as consumers distinguish between value and price, so producers distinguish between cost and price. Cost is what a producer gives up, and price is what a producer receives. 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 offer one more unit of a good or service for sale. But the minimum supply-price determines supply. A supply curve is a marginal cost curve. Max's S = MC 25.00 100 pizzas 15.00 Price (dollars per pizza) Price (dollars per pizza) 30.00 The relationship between the price of a good and the quantity supplied by one producer is called individual supply. And the relationship between the price of a good and the quantity supplied by all producers 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. Figure 5.3(c) illustrates the market supply if Max and Mario are the only producers of pizzas. Max’s supply curve in part (a) and Mario’s supply curve in part (b) sum horizontally to the market supply curve in part (c). 30.00 Mario's S = MC 25.00 50 pizzas 20.00 15.00 10.00 Max is willing to supply the 100th pizza for $15 5.00 0 Individual Supply and Market Supply Individual Supply, Market Supply, and Marginal Social Cost FIGURE 5.3 20.00 In Fig. 5.3(a), Max is willing to produce the 100th pizza for $15, his marginal cost of that pizza. In Fig. 5.3(b), Mario is willing to produce the 50th pizza for $15, his marginal cost of that pizza. But what quantity is this market willing to produce for $15 a pizza? The answer is provided by the market supply curve. 50 100 150 200 250 Quantity (pizzas per month) (a) Max's supply Mario is willing to supply the 50th pizza for $15 5.00 50 100 150 200 250 Quantity (pizzas per month) (b) Mario's supply At a price of $15 a pizza, the quantity supplied by Max is 100 pizzas and the quantity supplied by Mario is 50 pizzas, so the quantity supplied by the market is 150 pizzas. animation 30.00 100 + 50 = 150 pizzas Market S = MSC 25.00 20.00 15.00 10.00 0 Price (dollars per pizza) 108 10.00 Society is willing to supply the 150th pizza for $15 5.00 0 50 150 250 350 Quantity (pizzas per month) (c) Market supply Max’s supply curve in part (a) and Mario’s supply curve in part (b) sum horizontally to the market supply curve in part (c). The market supply curve is the marginal social cost (MSC ) curve. 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 109 Supply and Marginal Cost 109 At a price of $15 a pizza, Max supplies 100 pizzas and Mario supplies 50 pizzas, so the quantity supplied by the market at $15 a pizza is 150 pizzas. So from the market supply curve, we see that the market is willing to supply 150 pizzas a month for $15 each. The market supply curve is the marginal social cost (MSC ) curve. Again, although we’re measuring price in dollars, think of the price as telling us the number of dollars’ worth of other goods and services that must be forgone to produce one more pizza. angle—the area below the market price and above the supply curve. The area of this triangle is equal to its base (100) multiplied by its height ($10) divided by 2, which is $500. The red area in Fig. 5.4(a) below the supply curve shows what it costs Max to produce 100 pizzas. The area of the blue triangle in Fig. 5.4(b) shows Mario’s producer surplus and the blue area in Fig. 5.4(c) shows the producer surplus for the market. The producer surplus for the market is the sum of the producer surpluses of Max and Mario. Producer Surplus Review Quiz ◆ When price exceeds marginal cost, the firm receives a producer surplus. A producer surplus is the price received for a good minus its minimum supply-price (or marginal cost), summed over the quantity sold. Figure 5.4(a) shows Max’s producer surplus from pizza when the price is $15 a pizza. At this price, he sells 100 pizzas a month because the 100th pizza costs him $15 to produce. But Max is willing to produce the 50th pizza for his marginal cost, which is $10, so he receives a surplus of $5 on this pizza. Max’s producer surplus is the sum of the surpluses on pizzas he sells. This sum is the area of the blue tri- Max's S = MC Max's producer surplus 20.00 15.00 Consumer surplus and producer surplus can be used to measure the efficiency of a market. Let’s see how we can use these concepts to study the efficiency of a competitive market. 30.00 25.00 Mario's producer surplus Mario's S = MC 20.00 30.00 Market S = MSC 25.00 20.00 15.00 5.00 50 100 150 200 250 Quantity (pizzas per month) (a) Max's producer surplus 10.00 Market price 10.00 5.00 0 50 100 150 200 250 Quantity (pizzas per month) (b) Mario's producer surplus Max is willing to produce the 50th pizza for $10 in part (a). At a market price of $15 a pizza, Max gets a surplus of $5 on the 50th pizza. The blue triangle shows his producer surplus on the 100 pizzas he sells at $15 each. The animation Producer surplus 15.00 5.00 Max's surplus from the 50th pizza 10.00 0 Work Study Plan 5.3 and get instant feedback. Price (dollars per pizza) 30.00 25.00 2 What is the relationship between the marginal cost, minimum supply-price, and supply? What is producer surplus? How is it measured? Supply and Producer Surplus Price (dollars per pizza) Price (dollars per pizza) FIGURE 5.4 1 0 50 150 250 350 Quantity (pizzas per month) (c) Market producer surplus blue triangle in part (b) shows Mario’s producer surplus on the 50 pizzas that he sells at $15 each. The blue area in part (c) shows producer surplus for the market. The red areas show the cost of producing the pizzas sold. 9160335_CH05_p103-124.qxd 8:58 AM Page 110 CHAPTER 5 Efficiency and Equity ◆ Is the Competitive Market Efficient? Figure 5.5(a) shows the market for pizza. The market forces that you studied in Chapter 3 (pp. 64–65) pull the pizza market to its equilibrium price of $15 a pizza and equilibrium quantity of 10,000 pizzas a day. Buyers enjoy a consumer surplus (green area) and sellers enjoy a producer surplus (blue area), but is this competitive equilibrium efficient? S 25 Consumer surplus 20 Equilibrium 15 10 Efficiency of Competitive Equilibrium Producer surplus 5 Equilibrium quantity D 0 20 25 10 15 Quantity (thousands of pizzas per day) 5 (a) Equilibrium and surpluses Marginal social benefit and marginal social cost (dollars per pizza) You’ve seen that the demand curve tells us the marginal benefit from a pizza. If the only people who benefit from pizza are the people who buy it, then the demand curve for pizzas measures the marginal benefit to the entire society from pizza. We call the marginal benefit to the entire society, marginal social benefit, MSB. In this case, the demand curve is also the MSB curve. You’ve also seen that the supply curve tells us the marginal cost of a pizza. If the only people who bear the cost of pizza are the people who produce it, then the supply curve of pizzas measures the marginal cost of a pizza to the entire society. We call the marginal cost to the entire society, marginal social cost, MSC. In this case, the supply curve is also the MSC curve. So where the demand curve and the supply curve intersect in part (a), marginal social benefit equals marginal social cost in part (b). This condition delivers an efficient use of resources for the entire society. If production is less than 10,000 pizzas a day, the marginal pizza is valued more highly than it costs to produce. If production exceeds 10,000 pizzas a day, the marginal pizza costs more to produce than the value that consumers place on it. Only when 10,000 pizzas a day are produced is the marginal pizza worth exactly what it costs. The competitive market pushes the quantity of pizzas produced to its efficient level of 10,000 a day. If production is less than 10,000 pizzas a day, a shortage raises the price, which increases production. If production exceeds 10,000 pizzas a day, a surplus of pizzas lowers the price, which decreases production. So a competitive pizza market is efficient. When the efficient quantity is produced, total surplus (the sum of consumer surplus and producer surplus) is maximized. Buyers and sellers acting in their self-interest end up promoting the social interest. An Efficient Market for Pizza FIGURE 5.5 Price (dollars per pizza) 110 6/22/09 S = MSC 25 MSC equals MSB 20 15 MSB exceeds MSC MSC exceeds MSB 10 Efficient quantity 5 D = MSB 0 5 10 15 20 25 Quantity (thousands of pizzas per day) (b) Efficiency Competitive equilibrium in part (a) occurs when the quantity demanded equals the quantity supplied. Consumer surplus is the area under the demand curve and above the market price (the green triangle). Producer surplus is the area above the supply curve and below the market price (the blue triangle). Resources are used efficiently in part (b) when marginal social benefit, MSB, equals marginal social cost, MSC. The efficient quantity in part (b) is the same as the equilibrium quantity in part (a). The competitive pizza market produces the efficient quantity of pizzas. animation 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 111 Is the Competitive Market Efficient? 111 Markets At Work The Invisible Hand Writing in his Wealth of Nations in 1776, Adam Smith was the first to suggest that competitive markets send resources to the uses in which they have the highest value (see p. 51). 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.” You can see the invisible hand at work in the cartoon and in the world today. Umbrella for Sale The cold drinks vendor has cold drinks and shade and he has a marginal cost and a minimum supply-price of each. The reader on the park bench has a marginal benefit and willingness to pay for each. The reader’s marginal benefit from shade exceeds the vendor’s marginal cost; but the vendor’s marginal cost of a cold drink exceeds the reader’s marginal benefit. They trade the umbrella. The vendor gets a producer surplus from selling the shade for more than its marginal cost, and the reader gets a consumer surplus from buying the shade for less than its marginal benefit. Both are better off and the umbrella has moved to its highest-valued use. The Invisible Hand at Work Today The market econ- omy relentlessly performs the activity illustrated in the cartoon to achieve an efficient allocation of resources. A Florida frost cuts the supply of oranges. With fewer oranges available, the marginal social benefit increases. A shortage of oranges raises their price, so the market allocates the smaller quantity available to the people who value them most highly. A new technology cuts the cost of producing a computer. With a lower production cost, the supply of computers increases and the price of a computer falls. The lower price encourages an increase in the quantity demanded of this now less-costly tool. The marginal Underproduction and Overproduction Inefficiency can occur because either too little of an item is produced (underproduction) or too much is produced (overproduction). Underproduction In Fig. 5.6(a), the quantity of pizzas produced is 5,000 a day. At this quantity, consumers © The New Yorker Collection 1985 Mike Twohy from cartoonbank.com. All Rights Reserved. social benefit from a computer is brought to equality with its marginal social cost. In both the oranges and computer examples, market forces persistently bring marginal social cost and marginal social benefit to equality, allocate scarce resources efficiently, and maximize total surplus (consumer surplus plus producer surplus). are willing to pay $20 for a pizza that costs only $10 to produce. By producing only 5,000 pizzas a day, total surplus is smaller than its maximum possible level. The quantity produced is inefficient—there is underproduction. We measure the scale of inefficiency by deadweight loss, which is the decrease in total surplus that results 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 112 CHAPTER 5 Efficiency and Equity 112 Underproduction and Overproduction Price (dollars per pizza) F IGURE 5.6 from an inefficient level of production. The gray triangle in Fig. 5.6(a) shows the deadweight loss. Overproduction In Fig. 5.6(b), the quantity of pizzas produced is 15,000 a day. At this quantity, consumers are willing to pay only $10 for a pizza that costs $20 to produce. By producing the 15,000th pizza, $10 of resources are wasted. Again, the gray triangle shows the deadweight loss, which reduces the total surplus to less than its maximum. The deadweight loss is borne by the entire society: It is a social loss. S 25 Deadweight loss 20 15 10 Obstacles to Efficiency 5 D 0 5 20 25 10 15 Quantity (thousands of pizzas per day) The obstacles to efficiency that bring underproduction or overproduction are ■ ■ (a) Underproduction ■ ■ Price (dollars per pizza) ■ S Price and quantity regulations Taxes and subsidies Externalities Public goods and common resources Monopoly High transactions costs 25 ■ 20 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 and lead to underproduction. Quantity regulations that limit the amount that a farm is permitted to produce also lead to underproduction. Deadweight loss 15 10 5 D 0 5 10 15 20 25 Quantity (thousands of pizzas per day) (b) Overproduction If pizza production is 5,000 a day in part (a), total surplus (shown by the green and blue areas) is smaller than its maximum level by the amount of the deadweight loss (shown by the gray triangle). At all production levels below 10,000 pizzas a day, the benefit from one more pizza exceeds its cost. If pizza production is 15,000 a day in part (b), total surplus is also smaller than its maximum level by the amount of the deadweight loss. At all production levels in excess of 10,000 pizzas a day, the cost of one more pizza exceeds its benefit. animation Taxes and Subsidies Taxes increase the prices paid by buyers and lower the prices received by sellers. So taxes decrease the quantity produced and lead to underproduction. Subsidies, which are payments by the government to producers, decrease the prices paid by buyers and increase the prices received by sellers. So subsidies increase the quantity produced and lead to overproduction. Externalities An externality is a cost or a benefit that affects someone other than the seller or the buyer. An external cost arises when an electric utility burns coal and emits carbon dioxide. The utility doesn’t consider the cost of climate change when it decides how much power to produce. The result is overproduction. An external benefit arises when an apartment owner installs a smoke detector and decreases her neighbor’s 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 113 Is the Competitive Market Efficient? fire risk. She doesn’t consider the benefit to her neighbor when she decides how many detectors to install. The result is underproduction. 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. National defense is an example. Competitive markets would underproduce national defense because it is in each person’s interest to free ride on everyone else and avoid paying for her or his share of such a good. A common resource is owned by no one but available to be used by everyone. Atlantic salmon is an example. It is in everyone’s self-interest to ignore the costs they impose on others when they decide how much of a common resource to use. The result is that the resource is overused. Monopoly A monopoly is a firm that is the sole provider of a good or service. Local water supply and cable television are supplied by firms that are monopolies. The monopoly’s self-interest is to maximize its profit. Because the monopoly has no competitors, it can set the price to achieve its selfinterested goal. To achieve its goal, a monopoly produces too little and charges too high a price. It leads to underproduction. High Transactions Costs Stroll around a shopping mall and observe the retail markets in which you participate. You’ll see that these markets employ enormous quantities of scarce labor and capital resources. It is costly to operate any market. Economists call the opportunity costs of making trades in a market transactions costs. To use market price as the allocator of scarce resources, it must be worth bearing the opportunity cost of establishing a market. Some markets are just too costly to operate. For example, when you want to play tennis on your local “free” court, you don’t pay a market price for your slot on the court. You hang around until the court becomes vacant, and you “pay” with your waiting time. When transactions costs are high, the market might underproduce. You now know the conditions under which resource allocation is efficient. You’ve seen how a competitive market can be efficient, and you’ve seen some obstacles to efficiency. Can alternative allocation methods improve on the market? 113 Alternatives to the Market When a market is inefficient, can one of the alternative nonmarket methods that we described at the beginning of this chapter do a better job? Sometimes it can. Often, majority rule might be used in an attempt to improve the allocation of resources. But majority rule has its own shortcomings. A group that pursues the self-interest of its members can become the majority. For example, a price or quantity regulation that creates inefficiency is almost always the result of a self-interested group becoming the majority and imposing costs on the minority. Also, with majority rule, votes must be translated into actions by bureaucrats who have their own agendas based on their self-interest. Managers in firms issue commands and avoid the transactions costs that they would incur if they went to a market every time they needed a job done. First-come, first-served works best in some situations. Think about the scene at a busy ATM. Instead of waiting in line people might trade places at a “market” price. But someone would need to ensure that trades were honored. At a busy ATM, first-come, first-served is the most efficient arrangement. There is no one efficient mechanism that allocates all resources efficiently. But markets, when supplemented by other mechanisms such as majority rule, command systems, and first-come, first-served, do an amazingly good job. Review Quiz ◆ 1 2 3 Do competitive markets use resources efficiently? Explain why or why not. What is deadweight loss and under what conditions does it occur? What are the obstacles to achieving an efficient allocation of resources in the market economy? Work Study Plan 5.4 and get instant feedback. Is an efficient allocation of resources also a fair allocation? Does the competitive market provide people with fair incomes for their work? Do people always pay a fair price for the things they buy? Don’t we need the government to step into some competitive markets to prevent the price from rising too high or falling too low? Let’s now study these questions. 9160335_CH05_p103-124.qxd 114 6/22/09 8:58 AM Page 114 CHAPTER 5 Efficiency and Equity ◆ Is the Competitive Market Fair? When a natural disaster strikes, such as a severe winter storm or a hurricane, the prices of many essential items jump. The reason prices jump is that the demand and willingness to pay for these items has increased, but the supply has not changed. So the higher prices achieve an efficient allocation of scarce resources. News reports of these price hikes almost never talk about efficiency. Instead, they talk about equity or fairness. The claim that is often made is that it is unfair for profit-seeking dealers to cheat the victims of natural disaster. Similarly, when low-skilled people work for a wage that is below what most would regard as a “living wage,” the media and politicians talk of employers taking unfair advantage of their workers. How do we decide whether something is fair or unfair? You know when you think something is unfair. But how do you know? What are the principles of fairness? Philosophers have tried for centuries to answer this question. Economists have offered their answers too. But before we look at the proposed answers, you should know that there is no universally agreed upon answer. Economists agree about efficiency. That is, they agree that it makes sense to make the economic pie as large as possible and to produce it at the lowest possible cost. But they do not agree about equity. That is, they do not agree about what are fair shares of the economic pie for all the people who make it. The reason is that ideas about fairness are not exclusively economic ideas. They touch on politics, ethics, and religion. Nevertheless, economists have thought about these issues and have a contribution to make. Let’s examine the views of economists on this topic. 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 The earliest efforts to establish a principle of fairness were based on the view that the result is what matters. The general idea was that it is unfair if people’s incomes are too unequal. For example, it is unfair that a bank president earns millions of dollars a year while a bank teller earns only thousands of dollars. It is unfair that a store owner makes a larger profit and her customers pay higher prices in the aftermath of a winter storm. During the nineteenth century, economists thought they had made the incredible discovery: Efficiency requires equality of incomes. To make the economic pie as large as possible, it must be cut into equal pieces, one for each person. This idea turns out to be wrong. But there is a lesson in the reason that it is wrong, so this idea is worth a closer look. Utilitarianism The nineteenth century idea that only equality brings efficiency is called utilitarianism. Utilitarianism is a principle that states that we should strive to achieve “the greatest happiness for the greatest number.” The people who developed this idea were known as utilitarians. They included the most eminent thinkers, such as Jeremy Bentham and John Stuart Mill. Utilitarians argued that to achieve “the greatest happiness for the greatest number,” income must be transferred from the rich to the poor up to the point of complete equality—to the point at which there are no rich and no poor. They reasoned in the following way: First, everyone has the same basic wants and a similar capacity to enjoy life. Second, the greater a person’s income, the smaller is the marginal benefit of a dollar. The millionth dollar spent by a rich person brings a smaller marginal benefit to that person than the marginal benefit that the thousandth dollar spent brings to a poorer person. So by transferring a dollar from the millionaire to the poorer person, more is gained than is lost. The two people added together are better off. Figure 5.7 illustrates this utilitarian idea. Tom and Jerry have the same marginal benefit curve, MB. (Marginal benefit is measured on the same scale of 1 to 3 for both Tom and Jerry.) Tom is at point A. He earns $5,000 a year, and his marginal benefit from a dollar is 3 units. Jerry is at point B. He earns $45,000 a year, and his marginal benefit from a dollar is 1 unit. If a dollar is transferred from Jerry to Tom, Jerry loses 1 unit of marginal benefit and Tom gains 3 units. So together, Tom and Jerry are better off—they are sharing the economic pie more efficiently. If a second dollar is transferred, the same thing happens: Tom gains more than Jerry loses. And the same is true for every dollar transferred until they both reach point C. At point C, Tom and Jerry have $25,000 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 115 Is the Competitive Market Fair? Utilitarian Fairness Marginal benefit (units) FIGURE 5.7 A Tom 3 Maximum total benefit C 2 Jerry B 1 MB 0 5 25 45 Income (thousands of dollars) Tom earns $5,000 and has 3 units of marginal benefit at point A. Jerry earns $45,000 and has 1 unit of marginal benefit at point B. If income is transferred from Jerry to Tom, Jerry’s loss is less than Tom’s gain. Only when each of them has $25,000 and 2 units of marginal benefit (at point C ) can the sum of their total benefit increase no further. animation each and a marginal benefit of 2 units. Now they are sharing the economic pie in the most efficient way. It brings the greatest happiness to Tom and Jerry. The Big Tradeoff One big problem with the utilitarian ideal of complete equality is that it ignores the costs of making income transfers. Recognizing the costs of making income transfers leads to what is called the big tradeoff, which is a tradeoff between efficiency and fairness. The big tradeoff is based on the following facts. 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. It results in the quantity of labor being less than the efficient quantity. Taxing people’s income from capital makes them save less. It results in the quantity of capital being less than the efficient quantity. With smaller quantities of both labor and capital, the quantity of goods and services produced is less than the efficient quantity. The economic pie shrinks. 115 The tradeoff is between the size of the economic pie and the degree of equality with which it is shared. The greater the amount of income redistribution through income taxes, the greater is the inefficiency— the smaller is the economic pie. There is a second source of inefficiency. A dollar taken from a rich person does not end up as a dollar in the hands of a poorer person. Some of the dollar is spent on administration of the tax and transfer system. The cost of tax-collecting agencies, such as the IRS, and welfare-administering agencies, such as the Health Care Financing Administration, which administers Medicaid and Medicare, must be paid with some of the taxes collected. Also, taxpayers hire accountants, auditors, and lawyers to help them ensure that they pay the correct amount of taxes. These activities use skilled labor and capital resources that could otherwise be used to produce goods and services that people value. When all these costs are taken into account, taking a dollar from a rich person does not give a dollar to a poor person. It is possible that with high taxes, people with low incomes might end up being worse off. Suppose, for example, that highly taxed entrepreneurs decide to work less hard and shut down some of their businesses. Low-income workers get fired and must seek other, perhaps even lower-paid, work. Today, because of the big tradeoff, no one says that fairness requires equality of incomes. Make the Poorest as Well Off as Possible A new solution to the big tradeoff problem was proposed by philosopher John Rawls in a classic book entitled A Theory of Justice, published in 1971. Rawls says that, taking all the costs of income transfers into account, the fair distribution of the economic pie is the one that makes the poorest person as well off as possible. The 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. But the taxes must not be so high that they make the economic pie shrink to the point at which the poorest person ends up with a smaller piece. A bigger share of a smaller pie can be less than a smaller share of a bigger pie. The goal is to make the piece enjoyed by the poorest person as big as possible. Most likely, this piece will not be an equal share. The “fair results” idea requires a change in the results after the game is over. Some economists say that these changes are themselves unfair and propose a different way of thinking about fairness. 9160335_CH05_p103-124.qxd 116 6/22/09 8:58 AM Page 116 CHAPTER 5 Efficiency and Equity It’s Not Fair If the Rules Aren’t Fair The idea that it’s 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 similarly. It is the moral principle that lies at the center of all the big religions and that says, in some form or other, “Behave toward other people in the way you expect them to behave toward you.” In economic life, this principle translates into equality of opportunity. But equality of opportunity to do what? This question is answered by the philosopher Robert Nozick in a book entitled Anarchy, State, and Utopia, published in 1974. Nozick argues that the idea of fairness as an outcome or result cannot work and that fairness must be based on the fairness of the rules. He suggests that fairness obeys two rules: 1. The state must enforce laws that establish and protect private property. 2. Private property may be transferred from one person to another only by voluntary exchange. The first rule says that everything that is valuable must be owned by individuals and that the state must ensure that theft is prevented. The 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. If these rules, which are the only fair rules, are followed, then the result is fair. It doesn’t matter how unequally the economic pie is shared, provided that the pie is made by people, each one of whom voluntarily provides services in exchange for the share of the pie offered in compensation. These rules satisfy the symmetry principle. If these rules are not followed, the symmetry principle is broken. You can see these facts by imagining a world in which the laws are not followed. First, suppose that some resources or goods are not owned. They are common property. Then everyone is free to participate in a grab to use them. The strongest will prevail. But when the strongest prevails, the strongest effectively owns the resources or goods in question and prevents others from enjoying them. Second, suppose that we do not insist on voluntary exchange for transferring ownership of resources from one person to another. The alternative is involuntary transfer. In simple language, the alternative is theft. Both of these situations violate the symmetry principle. Only the strong acquire what they want. The weak end up with only the resources and goods that the strong don’t want. In a majority rule political system, the strong are those in the majority or those with enough resources to influence opinion and achieve a majority. In contrast, if the two rules of fairness are followed, everyone, strong and weak, is treated in a similar way. Everyone is free to use their resources and human skills to create things that are valued by themselves and others and to exchange the fruits of their efforts with each other. This set of arrangements is the only one that obeys the symmetry principle. Fairness and Efficiency If private property rights are enforced and if voluntary exchange takes place in a competitive market, resources will be allocated efficiently if there are no 1. Price and quantity regulations 2. Taxes and subsidies 3. Externalities 4. Public goods and common resources 5. Monopolies 6. High transactions costs And according to the Nozick rules, the resulting distribution of income and wealth will be fair. Let’s study an example to check the claim that if resources are allocated efficiently, they are also allocated fairly. Case Study: A Water Shortage in a Natural Disaster An earthquake has broken the pipes that deliver drinking water to a city. Bottled water is available, but there is no tap water. What is the fair way to allocate the bottled water? Market Price Suppose that if the water is allocated by market price, the price jumps to $8 a bottle—five times its normal price. At this price, the people who own water can make a large profit by selling it. People who are willing and able to pay $8 a bottle get the water. And because most people can’t afford the $8 price, they end up either without water or consuming just a few drops a day. You can see that the water is being used efficiently. There is a fixed amount available, some people are willing to pay $8 to get a bottle, and the water goes 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 117 Is the Competitive Market Fair? to those people. The people who own and sell water receive a large producer surplus and total surplus is maximized. In the rules view, the outcome is fair. No one is denied the water they are willing to pay for. In the results view, the outcome would most likely be regarded as unfair. The lucky owners of water make a killing, and the poorest end up the thirstiest. Nonmarket Methods Suppose that by a majority vote, the citizens decide that the government will buy all the water, pay for it with a tax, and use one of the nonmarket methods to allocate the water to the citizens. The possibilities now are Command Someone decides who is the most deserving and needy. Perhaps everyone is given an equal share. Or perhaps government officials and their families end up with most of the water. Contest Bottles of water are prizes that go to those who are best at a particular contest. Water goes to the first off the mark or to those who place the lowest value on their time and can afford to wait in line. First-come, first-served Lottery Water goes to those in luck. Water goes to those with the “right” characteristics. Perhaps the old, the young, or pregnant women get the water. Personal characteristics Except by chance, none of these methods delivers an allocation of water that is either fair or efficient. It is unfair in the rules view because the tax involves involuntary transfers of resources among citizens. And it is unfair in the results view because the poorest don’t end up being made as well off as possible. The allocation is inefficient for two reasons. First, resources have been used to operate the allocation scheme. Second, some people are willing to pay for more water than the quantity they have been allocated and others have been allocated more water than they are willing to pay for. The second source of inefficiency can be overcome if, after the nonmarket allocation, people are permitted to trade water at its market price. Those who value the water they have at less than the market price sell, and people who are willing to pay the market price to obtain more water buy. Those who value the water most highly are the ones who consume it. 117 Market Price with Taxes Another approach is to allocate the scarce water using the market price but then to alter the redistribution of buying power by taxing the sellers and providing benefits to the poor. Suppose water owners are taxed on each bottle sold and the revenue from these taxes is given to the poorest people. People are then free, starting from this new distribution of buying power, to trade water at the market price. Because the owners of water are taxed on what they sell, they have a weaker incentive to offer water for sale and the supply decreases. The equilibrium price rises to more than $8 a bottle. There is now a deadweight loss in the market for water—similar to the loss that arises from underproduction on pp. 111–112. (We study the effects of a tax and show its inefficiency in Chapter 6 on pp. 131–136.) So the tax is inefficient. In the rules view, the tax is also unfair because it forces the owners of water to make a transfer to others. In the results view, the outcome might be regarded as being fair. This brief case study illustrates the complexity of ideas about fairness. Economists have a clear criterion of efficiency but no comparably clear criterion of fairness. Most economists regard Nozick as being too extreme and want a fair tax system. But there is no consensus about what a fair tax system looks like. Review Quiz ◆ 1 2 3 4 What are the two big approaches to thinking about fairness? What is the utilitarian idea of fairness and what is wrong with it? Explain the big tradeoff. What idea of fairness has been developed to deal with it? What is the idea of fairness based on fair rules? Work Study Plan 5.5 and get instant feedback. ◆ You’ve now studied the two biggest issues that run through the whole of economics: efficiency and equity, or fairness. In the next chapter, we study some sources of inefficiency and unfairness. At many points throughout this book—and in your life—you will return to and use the ideas about efficiency and fairness that you’ve learned in this chapter. Reading Between the Lines on pp. 118–119 looks at an example of an inefficiency in our economy today. 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 118 READING BETWEEN THE LINES Is Water Use Efficient? India Digs Deeper, but Wells Are Drying Up, and a Farming Crisis Looms http://www.nytimes.com September 30, 2006 … Across India, where most people still live off the land, the chief source of irrigation is groundwater, at least for those who can afford to pump it. Indian law has virtually no restrictions on who can pump groundwater, how much and for what purpose. Anyone, it seems, can—and does—extract water as long as it is under his or her patch of land. That could apply to homeowner, farmer or industry. … “We forgot that water is a costly item,” lamented K. P. Singh, regional director of the Central Groundwater Board, in his office in the city of Jaipur. “Our feeling about proper, judicious use of water vanished.” … On a parched, hot morning … a train pulled into the railway station at a village called Peeplee Ka Bas. Here, the wells have run dry and the water table fallen so low that it is too salty even to irrigate the fields. The train came bearing precious cargo: 15 tankers loaded with nearly 120,000 gallons of clean, sweet drinking water. The water regularly travels more than 150 miles, taking nearly two days, by pipeline and then by rail, so that the residents of a small neighboring town can fill their buckets with water for 15 minutes every 48 hours. It is a logistically complicated, absurdly expensive proposition. Bringing the water here costs the state about a penny a gallon; the state charges the consumer a monthly flat rate of 58 cents for about 5,300 gallons, absorbing the loss. … Copyright 2006 The New York Times Company. Reprinted with permission. Further reproduction prohibited. Essence of the Story ■ In India, groundwater is the chief source of irrigation. ■ ■ Indian law has few restrictions on who can pump groundwater. Where the wells have run dry, water is delivered by pipeline and then by train. ■ Water is rationed by permitting residents to fill their buckets with water for 15 minutes every 48 hours. ■ Transporting water costs 1 cent per gallon, but consumers pay about 11 cents per 1,000 gallons. ■ 118 A regional director of the Central Groundwater Board laments that Indians are behaving as if water were a free resource. 6/22/09 8:58 AM Page 119 Economic Analysis ■ Water is one of the world’s most vital resources, and it is used inefficiently. ■ Markets in water are not competitive. They are controlled by governments or private producers, and they do not work like the competitive markets that deliver an efficient use of resources. ■ Price (cents per gallon) 9160335_CH05_p103-124.qxd The major problem in achieving an efficient use of water is to get it from the places where it is most abundant to the places in which it has the most valuable uses. The news article tells us that the owners of land that has groundwater under it pump the water and sell it and pay little attention to the fact that they will pump the well dry. ■ Figure 1 illustrates this situation. The curve D shows the demand for water and its marginal social benefit MSB. The curve S shows the supply of water and its marginal social cost MSC. ■ Ignoring the high marginal social cost, land owners produce WA gallons a day, which is greater than the efficient quantity. Farmers are willing to pay B, which is less than the marginal social cost C but enough to earn the land owner a profit. ■ Figure 2 shows the situation in places where the wells have run dry. ■ A limited quantity of water, WB, is transported in, and each consumer is restricted to the quantity that can be put into a bucket in 15 minutes every 48 hours. ■ Consumers are willing to pay B per gallon, which is much more than the marginal social cost C. 0 D = MSB WA Quantity (gallons per day) Figure 1 Overproduction where wells are not dry Consumer surplus Deadweight loss from underproduction S = MSC A deadweight loss arises from overproduction. ■ C Quantity produced Some places have too little water, and some have too much. ■ S = MSC B Price (cents per gallon) ■ Deadweight loss from overproduction ■ C 0 Quantity restricted: fill bucket for 15 minutes every 48 hours D = MSB WB Quantity (gallons per day) Figure 2 Underproduction where wells run dry A deadweight loss arises from underproduction. ■ Cost paid by taxpayers The green area shows the consumer surplus, and the red rectangle shows the cost of the water, which is paid by the government and borne by the taxpayers. ■ B The situation in India is replicated in thousands of places around the world. 119 9160335_CH05_p103-124.qxd 120 6/22/09 8:58 AM Page 120 CHAPTER 5 Efficiency and Equity SUMMARY ◆ Key Points ■ Resource Allocation Methods (pp. 104–105) ■ ■ ■ Because resources are scarce, some mechanism must allocate them. The alternative allocation methods are market price; command; majority rule; contest; first-come, firstserved; lottery; personal characteristics; and force. Demand and Marginal Benefit (pp. 106–107) ■ ■ ■ ■ The maximum price willingly paid is marginal benefit, so a demand curve is also a marginal benefit curve. The market demand curve is the horizontal sum of the individual demand curves and is the marginal social benefit curve. Value is what people are willing to pay; price is what people must pay. Consumer surplus equals value minus price, summed over the quantity bought. Supply and Marginal Cost (pp. 108–109) ■ ■ Is the Competitive Market Efficient? (pp. 110–113) ■ ■ ■ ■ ■ In a competitive equilibrium, marginal social benefit equals marginal social cost and resource allocation is efficient. Buyers and sellers acting in their self-interest end up promoting the social interest. The sum of consumer surplus and producer surplus is maximized. Producing less than or more than the efficient quantity creates deadweight loss. Price and quantity regulations; taxes and subsidies; externalities; public goods and common resources; monopoly; and high transactions costs can lead to underproduction or overproduction and create inefficiency. Is the Competitive Market Fair? (pp. 114–117) ■ The minimum supply-price is marginal cost, so a supply curve is also a marginal cost curve. The market supply curve is the horizontal sum of the individual supply curves and is the marginal social cost curve. Cost is what producers pay; price is what producers receive. Producer surplus equals price minus marginal cost, summed over the quantity sold. ■ ■ Ideas about fairness can be divided into two groups: fair results and fair rules. Fair-results ideas require income transfers from the rich to the poor. Fair-rules ideas require property rights and voluntary exchange. Key Figures Figure 5.1 Figure 5.2 Figure 5.3 Individual Demand, Market Demand, and Marginal Social Benefit, 106 Demand and Consumer Surplus, 107 Individual Supply, Market Supply, and Marginal Social Cost, 108 Figure 5.4 Figure 5.5 Figure 5.6 Supply and Producer Surplus, 109 An Efficient Market for Pizza, 110 Underproduction and Overproduction, 112 Key Terms Big tradeoff, 115 Command system, 104 Consumer surplus, 107 Deadweight loss, 111 Producer surplus, 109 Symmetry principle, 116 Transactions costs, 113 Utilitarianism, 114 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 121 Problems and Applications PROBLEMS and APPLICATIONS 121 ◆ Work problems 1–9 in Chapter 5 Study Plan and get instant feedback. Work problems 10–16 as Homework, a Quiz, or a Test if assigned by your instructor. 1. At Chez Panisse, the restaurant in Berkeley that is credited with having created California cuisine, reservations are essential. At Mandarin Dynasty, a restaurant near the University of California San Diego, reservations are recommended. At Eli Cannon’s, a restaurant in Middletown, Connecticut, reservations are not accepted. a. Describe the method of allocating scarce table resources at these three restaurants. b. Why do you think restaurants have different reservations policies? c. Why might each restaurant be using an efficient allocation method? d. Why do you think restaurants don’t use the market price to allocate their tables? 2. The table provides information on the demand schedules for train travel for Ann, Beth, and Cy, who are the only buyers in the market. Price Quantity demanded (miles) (dollars per mile) Ann Beth Cy 3 4 5 6 7 8 9 30 25 20 15 10 5 0 25 20 15 10 5 0 0 20 15 10 5 0 0 0 a. Construct the market demand schedule. b. What are the maximum prices that Ann, Beth, and Cy are willing to pay to travel 20 miles? Why? c. What is the marginal social benefit when the total distance travelled is 60 miles? d. What is the marginal private benefit for each person when they travel a total distance of 60 miles and how many miles does each of the people travel? e. What is each traveler’s consumer surplus when the price is $4 a mile? f. What is the market consumer surplus when the price is $4 a mile? 3. eBay Saves Billions for Bidders If you think you would save money by bidding on eBay auctions, you would likely be right. … Two associate professors … calculate the difference between the actual purchase price paid for auction items and the top price bidders stated they were willing to pay … and the Maryland researchers found it averaged at least $4 per auction. InformationWeek, January 28, 2008 a. What method is used to allocate goods on eBay? b. How do eBay auctions influence consumer surplus? 4. The table provides information on the supply schedules of hot air balloon rides by Xavier, Yasmin, and Zack, who are the only sellers in the market. Quantity supplied Price (rides per week) (dollars per ride) Xavier Yasmin Zack 100 90 80 70 60 50 40 30 25 20 15 10 5 0 25 20 15 10 5 0 0 20 15 10 5 0 0 0 a. Construct the market supply schedule. b. What are the minimum prices that Xavier, Yasmin, and Zack are willing to accept to supply 20 rides? Why? c. What is the marginal social cost when the total number of rides is 30? d. What is the marginal cost for each supplier when the total number of rides is 30 and how many rides does each of the firms supply? e. What is each firm’s producer surplus when the price is $70 a ride? f. What is the market producer surplus when the price is $70 a ride? 5. Based on the information provided in the news clip in problem 3, 9160335_CH05_p103-124.qxd 122 6/22/09 8:58 AM Page 122 CHAPTER 5 Efficiency and Equity Price (dollars per cell phone) a. Can an eBay auction give the seller a surplus? b. Draw a graph to illustrate an eBay auction and show the consumer surplus and producer surplus that it generates. 6. The figure illustrates the market for cell phones. 60.00 S 45.00 30.00 15.00 D 0 50 100 150 200 Quantity (cell phones per month) a. What are the equilibrium price and equilibrium quantity of cell phones? b. Shade in and label the consumer surplus and the producer surplus. c. Shade in and label the cost of producing the cell phones sold. d. Calculate total surplus. e. What is the efficient quantity of cell phones? 7. The table gives the demand and supply schedules for sunscreen. Price (dollars per bottle) 0 5 10 15 20 Quantity demanded Quantity supplied (bottles per day) 400 300 200 100 0 0 100 200 300 400 Sunscreen factories are required to limit production to 100 bottles a day. a. What is the maximum price that consumers are willing to pay for the 100th bottle? b. What is the minimum price that producers are willing to accept for the 100th bottle? c. Describe the situation in this market. d. How can the 100 bottles be allocated to beachgoers? Which possible methods would be fair and which would be unfair? 8. Wii Sells Out Across Japan … Japan finally came in for its share of Wii madness this weekend. … However, given the large amount of interest in the console—which Nintendo has flogged with a TV-ad blitz for the past two months—demand is expected to be much higher than supply. … Yodobashi Camera was selling Wii games on a first-come, first-served basis, so eager customers showed up early so as not to miss out on their favorite titles. [But] customers who tried to get in the … line after 6 or 7 a.m. were turned away. … [and] many could be spotted rushing off to the smaller Akihabara stores that were holding raffles to decide who got a Wii. Gamespot News, December 1, 2006 a. Why was the quantity demanded of Wii expected to exceed the quantity supplied? b. Did Nintendo produce the efficient quantity of Wii? Explain. c. Can you think of reasons why Nintendo might want to underproduce and leave the market with fewer Wii than people want to buy? d. What are the two methods of resource allocation described in the news clip? e. Is either method of allocating Wii efficient? f. What do you think some of the people who managed to buy a Wii did with it? g. Explain which is the fairer method of allocating the Wii: the market price or the two methods described in the news clip. 9. “Two Buck Chuck” Wine Cult It’s the California wine with the cult following. “Charles Shaw is known in local circles as “Two Buck Chuck,” … the $1.99 nectar of the gods that is sinfully cheap and good. … A full year after flooding the market largely on the West Coast, it’s still being sold by the case to wine lovers who can’t get enough. … It’s an overabundance of grapes that’s made Charles Shaw cheap to bottle—an estimated 5 million cases so far. CBS, June 2, 2003 a. Explain how the Invisible Hand has worked in the market for this California wine. b. How has “Two Buck Chuck” influenced consumer surplus from wine? c. How has “Two Buck Chuck” influenced producer surplus for its producer and for the producers of other wines? 9160335_CH05_p103-124.qxd 6/22/09 8:58 AM Page 123 Problems and Applications 10. The table gives the supply schedules for jet-ski rides by three owners: Rick, Sam, and Tom, the only suppliers of jet-ski rides. Quantity supplied Price (dollars per ride) a. b. c. d. (rides per day) Rick Sam Tom 10.00 0 0 0 12.50 5 0 0 15.00 10 5 0 17.50 15 10 5 20.00 20 15 10 What is each owner’s minimum supply-price of 10 rides a day? Which owner has the largest producer surplus when the price of a ride is $17.50? Explain. What is the marginal social cost of producing 45 rides a day? Construct the market supply schedule of jet-ski rides. 11. The table gives the demand and supply schedules for sandwiches. Price (dollars per sandwich) a. b. c. d. e. f. Quantity demanded Quantity supplied (sandwiches per hour) 0 300 0 1 250 50 2 200 100 3 150 150 4 100 200 5 50 250 6 0 300 What is the maximum price that consumers are willing to pay for the 200th sandwich? What is the minimum price that producers are willing to accept for the 200th sandwich? Are 200 sandwiches a day less than or greater than the efficient quantity? If sandwich makers produce 200 a day, what is the deadweight loss? If the sandwich market is efficient, what is the consumer surplus, what is the producer surplus, and what is the total surplus? If the demand for sandwiches increases and sandwich makers produce the efficient quantity, what happens to producer surplus and deadweight loss? 123 12. The Right Price for Digital Music: Why 99 cents per Song is Too Much, and Too Little Apple’s 99-cents-for-everything model isn’t perfect. Isn’t 99 cents too much to pay for music that appeals to just a few people? What we need is a system that will continue to pack the corporate coffers yet be fair to music lovers. The solution: a real-time commodities market that combines aspects of Apple’s iTunes, Nasdaq, the Chicago Mercantile Exchange, Priceline, and eBay. … Songs would be priced strictly on demand. The more people who download [a particular song] … the higher the price [of that song] will go. … The fewer people who buy a [particular] song, the lower the price [of that song] goes. … In essence, this is a pure free-market solution—the market alone would determine price. Slate, December 5, 2005 Assume that the marginal social cost of downloading a song from the iTunes Store is zero. (This assumption means that the cost of operating the iTunes Store doesn’t change if people download more songs.) a. Draw a graph of the market for downloadable music with a price of 99 cents for everything. On your graph, show consumer surplus and producer surplus. b. With a price of 99 cents for everything, is the market efficient or inefficient? If it is inefficient, show the deadweight loss on your graph. c. If the pricing scheme described in the news clip were adopted, how would consumer surplus, producer surplus, and the deadweight loss change? d. If the pricing scheme described in the news clip were adopted, would the market be efficient or inefficient? Explain. e. Is the pricing scheme described in the news clip a “pure free-market solution”? Explain. 13. Was Katie Holmes’ Marathon Entrance Unfair? Runners in the recent New York Marathon have been asking why Katie Holmes was admitted to the race when 60,000 hopefuls were denied. … Holmes was admitted to the race as a VIP. She was not given a spot through a lottery system, or for running in one of the 26 sanctioned New York Marathon charities … or even for having a competitive running time. The minimum qualifying 9160335_CH05_p103-124.qxd 124 6/22/09 8:58 AM Page 124 CHAPTER 5 Efficiency and Equity run time for a woman runner is 3 hours and 23 minutes. Katie completed the marathon in 5 hours, 29 minutes and 58 seconds. MSNBC, November 9, 2007 a. By what allocation method did Holmes obtain entrance to the marathon? b. Evaluate the “fairness” of Holmes being admitted to the marathon. 14. MYTH: Price-Gouging Is Bad Mississippi Attorney General Jim Hood announced a crackdown on gougers after Hurricane Katrina. John Shepperson was one of the “gougers” authorities arrested. Shepperson and his family live in Kentucky. They watched news reports about Katrina and learned that people desperately needed things. Shepperson thought he could help and make some money, too, so he bought 19 generators. He and his family then rented a U-Haul and drove 600 miles to an area of Mississippi that was left without power in the wake of the hurricane. He offered to sell his generators for twice what he had paid for them, and people were eager to buy. Police confiscated his generators, though, and Shepperson was jailed for four days for price-gouging. ABC News, May 12, 2006 a. Explain how the invisible hand (Shepperson) actually reduced deadweight loss in the market for generators following Katrina. b. Evaluate the “fairness” of Shepperson’s actions. 15. After you have studied Reading Between the Lines on pp. 118–119, answer the following questions: a. What is the major problem in achieving an efficient use of the world’s water? b. If there were a global market in water, like there is in oil, how do you think the market would work? c. Would a free world market in water achieve an efficient use of the world’s water resources? Explain why or why not. d. Would a free world market in water achieve a fair use of the world’s water resources? Explain why or why not and be clear about the concept of fairness that you are using. 16. Fight over Water Rates; Escondido Farmers Say Increase would Put Them out of Business The city is considering significant increases in water rates for agriculture, which historically has paid less than residential and business users. … [S]ince 1993, water rates have gone up more than 90 percent for residential customers while agricultural users … have seen increases of only about 50 percent, … The San Diego Union-Tribune, June 14, 2006 a. Do you think that the allocation of water among San Diego agricultural and residential users is likely to be efficient? Explain your answer. b. If agricultural users pay a higher price for water, will the allocation of resources become more efficient? c. If agricultural users pay a higher price for water, what will happen to consumer surplus and producer surplus from water? d. Is the difference in price paid by agricultural and residential users fair? 17. Use the link on MyEconLab (Chapter Resources, Chapter 5, Web links) to visit the Web site of Health Action International and read the article by Catrin Schulte-Hillen entitled “Study concerning the availability and price of AZT.” Then answer the following questions and explain your answers using the concepts of marginal benefit, marginal cost, price, consumer surplus, and producer surplus. a. What is the range of retail prices of AZT across the countries covered by the study? b. What, if anything, do you think could be done to increase the quantity of AZT and decrease its price? c. Canadian online pharmacies sell AZT to Americans for a price below the U.S. price. Does this practice increase or decrease consumer surplus, producer surplus, and deadweight loss from AZT in the United States? ...
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This note was uploaded on 02/07/2010 for the course ECON 251 taught by Professor Blanchard during the Fall '08 term at Purdue University-West Lafayette.

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