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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
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
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
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
Efficiency and Inefficiency
What is the economically efficient
quantity of pizza?
The Efficient Quantity of Pizza
MB
0 5 10 15 20
5
10
15
20
25
Quantity (thousands of pizzas per day)
Mar
gina
l cos
t and
mar
gina
l ben
efit
(dol
lars
wor
th o
f go
ods
and
serv
ices
)
The Efficient Quantity of Pizza
0 5 10 15 20
5
10
15
20
25
Quantity (thousands of pizzas per day)
Mar
gina
l cos
t and
mar
gina
l ben
efit
(dol
lars
wor
th o
f go
ods
and
serv
ices
)
MB
MC
The Efficient Quantity of Pizza
0 5 10 15 20
5
10
15
20
25
Quantity (thousands of pizzas per day)
Mar
gina
l cos
t and
mar
gina
l ben
efit
(dol
lars
wor
th o
f go
ods
and
serv
ices
)
MB
MC
Pizza valued morehighly than it costs:Increase production
Pizza costs morethan it is valued:Decrease production
The Efficient Quantity of Pizza
0 5 10 15 20
5
10
15
20
25
Quantity (thousands of pizzas per day)
Mar
gina
l cos
t and
mar
gina
l ben
efit
(dol
lars
wor
th o
f go
ods
and
serv
ices
)
MB
MCEfficient quantityof pizza
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
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
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
D = MB
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
Marketprice = $1.50
D = MB
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
Marketprice = $1.50
Amountpaid = $30 D = MB
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
Marketprice = $1.50
Amountpaid = $30
Consumer surplus from 20 pizzas = .5(20x1)=$10
D = MB
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
Marketprice = $1.50
Amountpaid = $30
Consumer surplus from 20 pizzas = .5(20x1)=$10
D=MB
ConsumptionValue of 20 slices=$30 + $10 = $40
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.
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
A Producers Supplyand Producer Surplus
Quantity (pizzas per day)
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
Price determinesquantity supplied
S=MC
0 50 100 150 200
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S=MC
Quantity (pizzas per day)
Marketprice = $15
0 50 100 150 200
A Producers Supplyand Producer Surplus
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S=MC
Quantity (pizzas per day)
Marketprice
Cost of Production = .5(100x10) + (100x5) = $1,000
0 50 100 150 200
A Producers Supplyand Producer Surplus
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S=MC
Quantity (pizzas per day)
MarketpriceProducer surplus
= .5(10x100) = $500
0 50 100 150 200
A Producers Supplyand Producer Surplus
Cost of Production = .5(100x10) + (100x5) = $1,000
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S=MC
Quantity (pizzas per day)
Marketprice
Cost of Production= $1,000
Producer surplusof $500 equals profit
0 50 100 150 200
A Producers Supplyand Producer Surplus
ProductionValue of 100
slices=$1000+$500
=$1,500
Is the CompetitiveMarket Efficient?
Recall– Supply and demand will force the price toward
the equilibrium price
Question: Is this the efficient quantity of pizza?
An Efficient Market for Pizza
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S Marginal cost--opportunity cost--of pizza
Marginal benefit--value--of pizza
Efficient quantityof pizzas
5
10
15
20
25
D
Is the CompetitiveMarket Efficient?
At Competitive Equilibrium
– Resources are being used efficiently– The sum of consumer surplus and producer
surplus is maximized
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
An Efficient Market for Pizza
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
Producersurplus = .5(10x10)=50
5
10
15
20
25
D
An Efficient Market for Pizza
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
Producersurplus= .5(10x10) =50
Consumersurplus= .5(10x10)=50
5
10
15
20
25
D
An Efficient Market for Pizza
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
Producersurplus= .5(10x10) =50
Consumersurplus= .5(10x10)=50
5
10
15
20
25
D
An Efficient Market for Pizza
Consumer Surplus+
Producer Surplus=50 +50 = 100
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.”
Sources of Inefficiency
Price ceilings and floors
Taxes, subsidies, and quotas
Monopoly
Public goods
External costs and benefits
These lead to underproduction or overproduction.
Sources of Inefficiency
Deadweight Loss– The decrease in consumer and producer surplus
that results from an inefficient allocation of resources
Underproduction (Say Monopoly)
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
UnderproductionConsumer Surplus
= .5(5x5)=12.5
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
UnderproductionConsumer Surplus
= .5(5x5)=12.5
Producer Surplus= (5x10) + .5(5x5)= 50 + 12.5 = 62.5
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
UnderproductionConsumer Surplus
= .5(5x5)=12.5
Producer Surplus= (5x10) + .5(5x5)= 50 + 12.5 = 62.5
Deadweightloss = .5(10x5) = 25
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
UnderproductionConsumer Surplus
= .5(5x5)=12.5
Producer Surplus= (5x10) + .5(5x5)= 50 + 12.5 = 62.5
Deadweightloss = .5(10x5) = 25
Consumer Surplus+
Producer Surplus= 12.5 + 62.5 = 75
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
Overproduction (Say Government Subsidy)
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
D
S
5
10
15
20
25
Overproduction
A
B
C
D
E
Consumer SurplusGain = B + G
Producer SurplusGain = A + D
Government Subsidy= B + G + A + D + F
FDeadweight Loss= B + G + A + D - B - G - A - D - F= F
G
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
D
S
5
10
15
20
25
Deadweightloss
Overproduction
A
B
C
D
E
Consumer SurplusGain = B + G
Producer SurplusGain = A + D
Government Subsidy= B + G + A + D + F
FDeadweight Loss= B + G + A + D - B - G - A - D - F= F
G
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