Economics 1A COECA1 Chapter 5 PDF

Economics 1A COECA1 Chapter 5 - Efficiency and Equity Eduvos (Pty) Ltd (formerly Pearson Institute of Higher Education) is registered with...

Economics 1A COECA1 Chapter 5 - Efficiency and Equity Eduvos (Pty) Ltd (formerly Pearson Institute of Higher Education) is registered with the Department of Higher Education and Training as a private higher education institution under the Higher Education Act, 101, of 1997. Registration Certificate number: 2001/HE07/008 Week 3: Lesson 1 Efficiency and Equity By the end of this lesson, you should be able to: Grasp the relationship between demand and marginal benefit, as well as between supply and marginal cost in order to understand how markets appropriate resources efficiently.  What will be covered in today’s lesson? Explain the relationship between demand and marginal benefit and define the term ‘consumer surplus’. Week 3 Lesson 1 Explain the relationship between supply and marginal cost and define the term ‘producer surplus’. Explain how markets move resources to their highest value uses and identify the sources of inefficiencies in an economy.  Resource Allocation Methods If resources were not scarce, there would not need to allocate them among alternative uses. However, resources are scarce: and they need to be allocated. Therefore, how can resources be allocated efficiently and fairly? What are the alternative methods of allocating scarce resources? Alternative methods that might be used are: 1. Market price 2. Command 3. Majority rule 4. Contest 5. First-come, first-served 6. Lottery 7. Personal Characteristics 8. Force  Resource Allocation Methods 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. Command A command system allocates resources by the order (command) of someone in authority. I.E firms and government departments. A command system works well in organizations but poorly on a national level such as North Korea. 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. Contest A contest allocates resources to a winner (or a group of winners). 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.  Resource Allocation Methods First-Come, First-Served A first-come, first-served method allocates resources to those who are first in line. First-come, first-served works best when, 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. Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource. Personal Characteristics When resources are allocated based on personal characteristics, people with the ‘right’ characteristics get the resource. i.e. getting married or getting a job position. Force Force plays a crucial role, for both good and ill, in allocating scarce resources. i.e. colonists took land and natural resources through force and allocated them as they saw fit. Force can also refer to the rule of law and legal framework.  The Demand Side… Benefit, Cost, and Surplus Remember, Demand refers to the quantity of a product or service that consumers are willing and able to purchase at a given price, while marginal benefit represents the additional satisfaction or utility gained from consuming one more unit of a good or service. In general, the law of demand states that as the price of a product increases, the quantity demanded decreases, assuming all other factors remain constant. This inverse relationship between price and quantity demanded can be explained by the concept of 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. So, The relationship between the price of a good and the quantity demanded by all buyers is called market demand.  The Demand Side… Benefit, Cost, and Surplus Individual Demand The relationship between the price of a good and the quantity demanded by one person is called individual demand. Remember: A demand Curve can be seen as a willingness-and-ability-to-pay curve. The willingness and ability to pay is a measure of marginal benefit. Therefore, the demand curve can be seen as a marginal benefit curve. The market demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by all the individuals at each price. Note: Consumers distinguish between value and price.  The Demand Side… Benefit, Cost, and Surplus For Busi and Nick, their demand curves are their marginal benefit curves. For society, the market demand curve is the marginal benefit curve. We call the marginal benefit to the entire society marginal social benefit. So, the market demand curve is also the marginal social benefit (MSB) curve.  Consumer Surplus The Demand Side… When people buy something for less than it is worth to them, they receive a consumer surplus. Consumer surplus is the excess of the benefit received from a good over the amount paid for it. We can calculate consumer surplus as the marginal benefit (or value) of a good minus its price, summed over the quantity bought: Area of the triangle = (Base x Height) ÷ 2. Where, The base is the quantity bought and the height is the maximum price minus the market price. Busi is willing to pay R2 for her 10th slice of pizza in part (a). At a market price of R1 a slice, Busi receives a surplus of R1 on the 10th slice. The green triangle shows her consumer surplus on the 30 slices she buys at R1 a slice. The consumer surplus for the market is the sum of the consumer surpluses of Lisa and Nick. All goods and services have decreasing marginal benefit, so people receive more benefit from their consumption than the amount they pay.  The Supply Side… Benefit, Cost, and Surplus Remember, Supply refers to the quantity of goods or services that producers are willing and able to offer for sale in the market at a given price during a specific period. Marginal cost, on the other hand, represents the additional cost incurred by producing one additional unit of output. In general, the supply of a good or service is positively related to its marginal cost. As the price of a good increase, producers are motivated to increase their production in order to capture higher profits. This leads to an expansion of supply. When producers increase their output, they incur additional costs, such as labour, raw materials, and other inputs. The marginal cost reflects these additional costs associated with producing each additional unit. Individual Supply and Market Supply The relationship between the price of a good and the quantity supplied by one producer is called individual supply. So, The relationship between the price of a good and the quantity supplied by all sellers is called market supply.  The Supply Side… Benefit, Cost, and Surplus Individual supply The relationship between the price of a good and the quantity supplied by one producer is called individual supply. Remember: A supply curve can be seen as a marginal cost curve. Producers distinguish between cost and price. The market supply curve is the vertical sum of the individual supply curves and is formed by adding the quantities supplied by all the individuals at each price.  The Supply Side… Benefit, Cost, and Surplus For Matthews and Sabrina, their supply curves are their marginal cost curves. For society, the market supply curve is the marginal cost curve. We call the marginal cost to the entire society marginal social cost. So, the market supply curve is also the marginal social cost (MSC) curve.  Producer Surplus The Supply Side… When price exceeds marginal cost, the firm receives a producer surplus. Producer surplus is the excess of the amount received from the sale of a good or service over the cost of producing it. We calculate producer surplus as the price received minus the marginal cost (or minimum supply-price), summed over the quantity sold: Area of the triangle = (Base x Height) ÷ 2. Where, The base is the quantity sold and the height is the market price minus the minimum cost. The producer surplus for the market is the sum of the producer surpluses of Matthews and Sabrina. Efficiency in Competitive Markets Equilibrium in a competitive market occurs when the quantity demanded equals the quantity supplied at the intersection of the demand curve and the supply curve. At this intersection point, marginal social benefit on the demand curve equals marginal social cost on the supply curve. This equality is the condition for allocative efficiency. So in equilibrium, a competitive market achieves allocative efficiency. Competitive equilibrium in part (a) occurs when the quantity demanded equals the quantity supplied. Total surplus, which is the sum of consumer surplus (the green triangle) and producer surplus (the blue triangle) is maximised. 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 biscuit market produces an efficient quantity of biscuits  Market Failures Markets are not always efficient, and when a market is inefficient, we call the outcome market failure. In a market failure, either too little (underproduction) or too much (overproduction) of an item is produced. Underproduction In Fig. 5.6(a), the quantity of pizzas produced is 5,000 a day. At this quantity, consumers are willing to pay $20 for a pizza that costs only $10 to produce. The quantity produced is inefficient as there is underproduction and the total surplus is smaller than its maximum possible level. We measure the scale of inefficiency by deadweight loss, which is the decrease in total surplus that results from an inefficient level of production. The grey triangle in Fig. 5.6(a) shows the deadweight loss.  Market Failures 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 grey triangle shows the deadweight loss, which reduces the total surplus to less than its maximum. Inefficient production creates a deadweight loss that is borne by the entire society: It is a social loss.  Market Failures In conclusion, Markets are not always efficient, and when a market is inefficient, we call the outcome market failure. In a market failure, either too little (underproduction) or too much (overproduction) of an item is produced.  Market Failures Sources of Market Failure Price and quantity regulations Taxes and subsidies Externalities Public goods and common resources Monopoly High transaction costs  Market Failures Price and quantity regulations - A price regulation, either a price cap or a price floor, blocks the price adjustments that balance the quantity demanded and the quantity supplied and lead to underproduction. Taxes and subsidies - Taxes increase the prices paid by buyers, lower the prices received by sellers, and lead to underproduction. Subsidies, which are payments by the government to producers, decrease the prices paid by buyers, increase the prices received by sellers, and lead to overproduction. Externalities - An externality is a cost or a benefit that affects someone other than the seller or the buyer. Public goods and common resources - A public good is a good or service from which everyone benefits, and no one can be excluded. A common resource is owned by no one but is available to be used by everyone. Monopoly - The monopoly’s self-interest is to maximize its profit, and because it has no competitors, it produces too little and charges too high a price: It underproduces. High Transaction Costs -When you buy your first house, you will also buy the services of an agent and a lawyer to do the transaction. Economists call the costs of the services that enable a market to bring buyers and sellers together transaction costs. Is a Competitive Market Fair? Utilitarianism Utilitarianism is a principle that states that we should strive to achieve ‘the greatest happiness for the greatest number’. The Big Trade-off One big problem with the utilitarian ideal of complete equality is that it ignores the costs of making income transfers. Recognising the costs of making income transfers leads to what is called the big trade-off, which is a trade-off between efficiency and fairness. Make the Poorest as Well Off as Possible 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. Is a Competitive Market Fair? Fairness obeys two rules: The state must enforce laws that establish and protect private property. Private property may be transferred from one person to another only by voluntary exchange. 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: Price and quantity regulations Taxes and subsidies Externalities Public goods and common resources Monopolies High transaction costs What Happens Next? In the next session we will look at Government Action in Markets.