CHAPTER 3.

ECONOMIC EFFICIENCY
AND MARKET
CHAPTER 3.
ECONOMIC EFFICIENCY
AND MARKET
 1. DEMAND
v Definition

The amount of a particular good or service that

a consumer is willing and able to buy at a
given price in a given time period
Demand and Marginal Benefit
v People value many different goods and services

v The total benefit (value)-TB- of a good to a

person is the benefit gained from the whole of
the amount of the good consumed
v The marginal benefit (value)-MB- of a good to a
person is the additional benefit that consuming
the last unit provides
v A person’s relative valuation of a good is
expressed in their willingness to pay
 Willingness to Pay (WTP)
v People vary in their willingness to pay depending on their
incomes and preferences

v Willingness to pay for additional units of a good declines with

quantity for each individual

v Marginal WTP describes the additional willingness to pay of

a person for one more unit of a good or service.

v Total WTP for a given consumption level refers to the total

amount a person would be willing to pay to attain that
consumption level rather than go without the good entirely.
 Willingness to Pay and
Demand Curves
demand curve = marginal benefit
curve = marginal WTP curve
P

Total benefit or total WTP for Q1

(green shaded area)

P1 P1 = MB or marginal WTP at Q1

D
Q1 Q
 Consumers’ Surplus
v Consumer Surplus = ∑(WTP – Price)

v Total Expenditure = P*Q

P
Consumers’ Surplus: excess
of total WTP over amount actually paid

P1 P1 = MB or marginal WTP at Q1

D
Q1 Q
Amount actually paid (P1 x Q1)
 II. SUPPLY
v Supply is defined as the quantity of a product that a
producer is willing and able to supply onto the market
at a given price in a given time period.
 II. SUPPLY
v Supply is defined as the quantity of a product that a
producer is willing and able to supply onto the market
at a given price in a given time period.
 Supply and Marginal Cost
v The cost of production of a good is its opportunity cost-
the other goods that could have been produced instead
with the resources used

v Provided all productive resources are priced in

competitive markets, the opportunity cost of producing
something will be reflected in the cost of production
(cost of the productive resources used)
 Supply and Marginal Cost
v The marginal cost of production is the
opportunity cost of producing one more unit of
the good

v Marginal opportunity costs tend to rise with

output

v Producers will only produce up to the point

where the price they receive equals the marginal
cost of production (profit max)
 Supply and Marginal Cost
P
MC=S

15

Marginal opportunity cost

Of the 10th unit = $15

10 Q

Firm will supply the 10th unit if the price is

$15. This is the minimum price that producers
will accept for that unit of production
 Producers’ Surplus
P
S=MC
Producers’ Surplus

15

Cost of production

10 Q
v Producer Surplus = ∑(Price – Marginal Cost)
 Is the Competitive Market Efficient?
Free Market
Outcome: P*, Q*

Maximizes social S=MC

P welfare: SW = CS + PS

CS E
P*
(15)
PS

D=MB

Q* (10) Q

At E the Social Welfare is maximized

Underproduction and
Overproduction

P
Deadweight loss S

Underproduction

Q’ Q* Q
P
S
Deadweight loss

Overproduction
D
Q
Q* Q’
 Efficiency and Equity
v Efficiency is an allocation v Equity is tied closely to
of resources where the distribution of
MB=MC wealth in a society

v An efficient allocation can v The distribution of

only be defined given income and wealth can
some initial allocation of have effects on how
resources between resources are allocated
individuals
v Efficient markets may well
v Willingness to pay is result in very unequal
budget constrained distributions of income
 Market Failure
v Imperfect information means merit goods are under-
produced or under-consumed while demerit goods are over-
produced or over-consumed
v Market dominance by monopolies can lead to under-
production and higher prices than would exist under
conditions of competition
v Externalities causing the social cost/benefit of production
to exceed the private cost/benefit.
v Public goods problems are often closely related to the free
rider problem

v Badly defined property rights environmental goods

perceived as commons
 Problems with
Current Economic Theory
v Assumes market prices reflect consumer willingness to pay.
v Assumes that consumers are the best judge of value and that
community considerations are irrelevant.
v Assumes consumers understand the value of ecological
resources provided by many biological resources. Assumes
consumer, aided by the market place, knows which species
are unnecessary for ecosystem maintenance.
v Assessment of economic value ignores many equity and
moral considerations.
v General failure to recognize that market prices are highly
distorted.
 Externalities
² Distort the economic rationality by influencing decisions
on the allocation of means.

§ Social externalities may be due to features of the good

or service to be allocated (e.g., public goods) or due to
the human institutions charged with managing the
resource.
§ External costs:
§ the difference between private costs and social costs.

§ External benefits:
§ the difference between private benefits and social
benefits.
FREE RIDERS
The free rider problem is a
market failure that occurs when
people take advantage of
being able to use a common
resource, or collective good,
without paying for it

A free rider is a person who pays

less for a good than her/his true
marginal willingness to pay; a
person who underpays, that is,
relative to the benefits they receive
THANK YOU!