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CHAPTER 5 Efficiency

CHAPTER 5 Efficiency. Efficiency: A Refresher. According to economists, allocative efficiency means the resources have been used to produce the goods and services that people value the most. Efficiency: A Refresher.

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CHAPTER 5 Efficiency

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  1. CHAPTER 5Efficiency

  2. Efficiency: A Refresher • According to economists, allocative efficiencymeans the resources have been used to produce the goods and services that people value the most.

  3. Efficiency: A Refresher • Marginal benefit is the benefit that a person receives from consuming one more unit of a good or service • measured as the maximum amount that a person is willing to give up for one additional unit • Principle of decreasing marginal benefit • marginal benefit decreases as consumption increases

  4. Efficiency: A Refresher • Marginal cost is the opportunity cost of producing one more unit of a good or service. • measured as the value of the best alternative foregone • Principle of increasing marginal cost • marginal cost increases as the quantity produced increases

  5. Efficiency and Inefficiency • Allocative efficiency depends upon a comparison of marginal cost and marginal benefit. • Three possibilities • marginal benefit exceeds marginal cost • marginal cost exceeds marginal benefit • marginal benefit equals marginal cost

  6. Efficiency and Inefficiency What is the economically efficient quantity of pizza?

  7. The Efficient Quantity of Pizza 25 20 Marginal cost and marginal benefit (dollars worth of goods and services) 15 10 5 MB 0 5 10 15 20 Quantity (thousands of pizzas per day)

  8. The Efficient Quantity of Pizza 25 MC 20 Marginal cost and marginal benefit (dollars worth of goods and services) 15 10 5 MB 0 5 10 15 20 Quantity (thousands of pizzas per day)

  9. The Efficient Quantity of Pizza Pizza valued more highly than it costs: Increase production 25 MC Pizza costs more than it is valued: Decrease production 20 Marginal cost and marginal benefit (dollars worth of goods and services) 15 10 5 MB 0 5 10 15 20 Quantity (thousands of pizzas per day)

  10. The Efficient Quantity of Pizza Efficient quantity of pizza 25 MC 20 Marginal cost and marginal benefit (dollars worth of goods and services) 15 10 5 MB 0 5 10 15 20 Quantity (thousands of pizzas per day)

  11. Value, Price, and Consumer Surplus • What is meant by “Value”? • Value of an item is the same thing as its marginal benefit • Marginal benefit - the maximum price people are willing to pay for an additional unit • Willingness determines demand

  12. Consumer Surplus • Consumer surplus is the value of a good minus the price paid for it. • if a person buys something for less than they are willing to pay for it, a consumer surplus exists

  13. A Consumer’s Demand and Consumer Surplus 2.50 Price (dollars per slice) 2.00 1.50 1.00 0.50 D = MB 0 10 20 30 40 Quantity (slices of pizzas per week)

  14. A Consumer’s Demand and Consumer Surplus 2.50 Market price = $1.50 Price (dollars per slice) 2.00 1.50 1.00 0.50 D = MB 0 10 20 30 40 Quantity (slices of pizzas per week)

  15. A Consumer’s Demand and Consumer Surplus 2.50 Market price = $1.50 Price (dollars per slice) 2.00 1.50 1.00 Amount paid = $30 0.50 D = MB 0 10 20 30 40 Quantity (slices of pizzas per week)

  16. A Consumer’s Demand and Consumer Surplus Consumer surplus from 20 pizzas = .5(20x1)=$10 2.50 Market price = $1.50 Price (dollars per slice) 2.00 1.50 1.00 Amount paid = $30 0.50 D = MB 0 10 20 30 40 Quantity (slices of pizzas per week)

  17. A Consumer’s Demand and Consumer Surplus Consumer surplus from 20 pizzas = .5(20x1)=$10 2.50 Market price = $1.50 Price (dollars per slice) 2.00 1.50 Consumption Value of 20 slices =$30 + $10 = $40 1.00 Amount paid = $30 0.50 D=MB 0 10 20 30 40 Quantity (slices of pizzas per week)

  18. Cost, Price, and Producer Surplus • Cost vs. Price • Cost is what the producer gives up. • Price is what the producer receives. • Marginal cost is the cost of producing one more unit.

  19. Producer Surplus • Producer surplus is the revenue from a good minus the opportunity cost of producing it. • if a firm sells something for more than it costs to produce, a producer surplus exists

  20. A Producers Supplyand Producer Surplus S=MC 25 20 Price (dollars per pizza) Price determines quantity supplied 15 10 5 0 50 100 150 200 Quantity (pizzas per day)

  21. A Producers Supplyand Producer Surplus S=MC 25 Market price = $15 20 Price (dollars per pizza) 15 10 5 0 50 100 150 200 Quantity (pizzas per day)

  22. A Producers Supplyand Producer Surplus S=MC 25 Market price 20 Price (dollars per pizza) 15 10 Cost of Production = .5(100x10) + (100x5) = $1,000 5 0 50 100 150 200 Quantity (pizzas per day)

  23. A Producers Supplyand Producer Surplus S=MC 25 Market price 20 Price (dollars per pizza) Producer surplus = .5(10x100) = $500 15 10 Cost of Production = .5(100x10) + (100x5) = $1,000 5 0 50 100 150 200 Quantity (pizzas per day)

  24. A Producers Supplyand Producer Surplus S=MC Producer surplus of $500 equals profit 25 Market price 20 Price (dollars per pizza) 15 10 Production Value of 100 slices =$1000+$500 =$1,500 Cost of Production = $1,000 5 0 50 100 150 200 Quantity (pizzas per day)

  25. Is the CompetitiveMarket Efficient? • Recall • Supply and demand will force the price toward the equilibrium price Question: Is this the efficient quantity of pizza?

  26. An Efficient Market for Pizza S Marginal cost-- opportunity cost --of pizza 25 20 Price (dollars per pizza) 15 Marginal benefit-- value--of pizza 10 5 Efficient quantity of pizzas D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  27. Is the CompetitiveMarket Efficient? • At Competitive Equilibrium • Resources are being used efficiently • The sum of consumer surplus and producer surplus is maximized

  28. An Efficient Market for Pizza S 25 20 Price (dollars per pizza) 15 10 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  29. An Efficient Market for Pizza S 25 20 Price (dollars per pizza) 15 10 Producer surplus = .5(10x10)=50 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  30. An Efficient Market for Pizza Consumer surplus = .5(10x10)=50 S 25 20 Price (dollars per pizza) 15 10 Producer surplus = .5(10x10) =50 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  31. An Efficient Market for Pizza Consumer surplus = .5(10x10)=50 S 25 Consumer Surplus + Producer Surplus =50 +50 = 100 20 Price (dollars per pizza) 15 10 Producer surplus = .5(10x10) =50 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  32. The Invisible Hand • Adam Smith - Wealth of Nations in 1776 • Participants in a competitive market are “led by an invisible hand to promote an end (the efficient use of resources) which was not part of his intention.”

  33. Sources of Inefficiency • Price ceilings and floors • Taxes, subsidies, and quotas • Monopoly • Public goods • External costs and benefits These lead to underproduction or overproduction.

  34. Sources of Inefficiency • Deadweight Loss • The decrease in consumer and producer surplus that results from an inefficient allocation of resources

  35. Underproduction (Say Monopoly) S 25 20 Price (dollars per pizza) 15 10 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  36. Underproduction Consumer Surplus = .5(5x5)=12.5 S 25 20 Price (dollars per pizza) 15 10 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  37. Underproduction Consumer Surplus = .5(5x5)=12.5 S 25 20 Price (dollars per pizza) 15 10 Producer Surplus = (5x10) + .5(5x5) = 50 + 12.5 = 62.5 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  38. Underproduction Consumer Surplus = .5(5x5)=12.5 S 25 20 Price (dollars per pizza) Deadweight loss = .5(10x5) = 25 15 10 Producer Surplus = (5x10) + .5(5x5) = 50 + 12.5 = 62.5 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  39. Underproduction Consumer Surplus + Producer Surplus = 12.5 + 62.5 = 75 Consumer Surplus = .5(5x5)=12.5 S 25 20 Price (dollars per pizza) Deadweight loss = .5(10x5) = 25 15 10 Producer Surplus = (5x10) + .5(5x5) = 50 + 12.5 = 62.5 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  40. Overproduction (Say Government Subsidy) S 25 20 Price (dollars per pizza) 15 10 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  41. Overproduction Consumer Surplus Gain = B + G S Producer Surplus Gain = A + D 25 C 20 Price (dollars per pizza) Government Subsidy = B + G + A + D + F D A F 15 G B Deadweight Loss = B + G + A + D - B - G - A - D - F = F 10 E 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

  42. Overproduction Consumer Surplus Gain = B + G S Producer Surplus Gain = A + D 25 C 20 Price (dollars per pizza) Government Subsidy = B + G + A + D + F D Deadweight loss A F 15 G B Deadweight Loss = B + G + A + D - B - G - A - D - F = F 10 E 5 D 0 5 10 15 20 Quantity (thousands of pizzas per day)

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