 After studying this topic, you will be able to:

1. Understand the key methods of allocating scarce resources and define and explain
the features of an efficient allocation
2. Distinguish between value and price and define consumer surplus.
3. Distinguish between cost and price and define producer surplus.
4. Understand the condition of maximizing total surplus and the concept of efficiency.

 Tutorial exercises
 Complete the tutorial exercise of topic 3 for class discussion in the tutorial meeting

*** Textbook Reading and Revision Assignment:

 Chapter 6 (Except Production Possibilities Frontier (PPF))
 Checkpoint 6.1 (Q1), 6.2 6.3, 6.4
 Chapter Summary (Chapter 6)

Copyright © 2024 by PolyU-HKCC. Some copyright materials are from Pearson with
authorization to be posted on the e-learning platform of PolyU-HKCC.

BHMH 2002, Introduction to Economics 1

3.1 ALLOCATION METHODS AND EFFICIENCY

 Because resources are scarce, they must be allocated. There are a variety of
allocation methods that can be used:

 Resource Allocation Methods

1. Command
2. First-come, first-served
3. By Draw (Lottery)
4. Price Competition

BHMH 2002, Introduction to Economics 2

3.1 ALLOCATION METHODS AND EFFICIENCY
Non-price competition
Command
 Command system allocates resources by the order (command) of someone in authority.
 A command system works well in organizations with clear lines of authority but badly in an entire
economy. North Korea and Cuba are the only remaining command economies.

First-Come, First-Served (Waiting in line)

 A first-come, first-served allocates resources to those who are first in line.
 Time cost is involved. The one with lower time cost will be in a better position for competition.
However, it does not mean that they are the highest valued user of the resource.
 First-come, first-served is usually observed to work with the price competition in the market
economy.

By Draw (Lottery)(by luck)

 Using draw to allocate resources to those with the winning number, draw the lucky cards, or
come up lucky.
 For example, the apartments under the Home Ownership Scheme are allocated by draw and
price competition to those qualified applicants.
 Draws work well when there is no effective way to distinguish among potential users of a scarce
resource. However, the efficiency of resource allocation is in doubt.

BHMH 2002, Introduction to Economics 3

3.1 ALLOCATION METHODS AND EFFICIENCY
Price Competition
 People who get the resource are those who are willing and able to pay the market price .
 People who do not value the resource as highly as the market price or are unable to pay the
market price will not compete for the resource under price competition.
 The market could achieve efficiency with the market structure of perfect competition
theoretically.

Illustration
The market price is $15 in the DVD market.
Can a buyer get a DVD if he is willing to pay
$10 for one? How about if he is willing to
pay $20?
3.2 MARGINAL BENEFIT, VALUE, AND PRICE
Marginal Benefit
 Marginal benefit is an economic concept to represent the
benefit that a person receives from consuming one more TB
MB 
unit of a good or service. It is not directly observable. QOutput
 Conceptually, the marginal benefit from a good is what
people are willing to forgo to get one more unit of the
good.
 People’s preferences determine marginal benefit.
 Marginal benefit is asserted to decrease as the quantity of
the good increases according to the principle of decreasing
marginal benefit.
  the Marginal benefit (MB) curve is downward sloping.

To facilitate making comparison, marginal benefit and

value can be measured in dollar term.

BHMH 2002, Introduction to Economics 5

3.2 MARGINAL BENEFIT, VALUE, AND PRICE
Demand and Marginal Benefit
 The demand curve shows the quantity demanded at each price, other things remaining the
same.
 Price is what the consumer pays (consumer’s cost). The demand curve shows the
maximum price willingly paid for the last pizza available.
 Value is what the consumer gets (consumer’s benefit). Value can be interpreted as
marginal benefit which can be measured as the maximum price that people are willing to
pay for another unit of the good or service.
 Thus, the marginal benefit of the last unit purchased by a consumer can be revealed by
price.
 Deductively, a demand curve is also a marginal benefit curve (D = MB).

D=

BHMH 2002, Introduction to Economics 6

3.2 MARGINAL BENEFIT, VALUE, AND PRICE
 Consumer’s decision rule:
• The consumer will buy one more unit of a good or service if its price is less than or
equal to the value the consumer places on it.
• For maximization, the consumer is expected to consume to the last unit at which
its price equal marginal benefit (value at the margin).

Remark: When you read

MB from the Demand
curve, you must mark D =
MB, but not just mark “D”
in the diagram. Same logic
applies to Supply curve.

D=

BHMH 2002, Introduction to Economics 7

 3.2 MARGINAL COST AND PRICE
Marginal Cost
 Conceptually, marginal cost (MC) is the opportunity cost one must give up to produce one
more unit of a good or service.
 To facilitate making comparison, the marginal cost can be measured in dollar term.
 The marginal cost of producing a good is asserted to increase as more of the good is
produced according to the principle of increasing marginal cost (To be discussed in Topic 6).
 The marginal cost curve is upward sloping.
TC
Supply and Marginal Cost MC 
 Cost is what a seller must give up to produce the good. The cost of producing
QOutput
one more unit of a good or service is its marginal cost.
 Price is what a seller receives when the good is sold. (Seller’s Revenue)
 It is just worth producing one more unit of a good or service if the price for
which it can be sold higher than or equals marginal cost.
S=
 General speaking, a supply curve is a marginal cost curve. (S = MC)

Producer’s/Seller’s decision rule:

The seller will produce one more unit of a good or service if the
price for which it can be sold exceeds or equals its marginal cost.
For maximization, the seller is expected to produce to the last
unit at which its unit price equal marginal cost.

BHMH 2002, Introduction to Economics 8

 3.3 Value, Price, and Consumer Surplus
• We don’t always have to pay as much as we’re willing to pay. When people buy something
for less than it is worth to them, they receive a consumer surplus.
• Economists use the concept of consumer surplus to represent and measure the welfare that
people gain from consuming goods and services.
• In other word, consumer surplus is the difference between the total amount that consumers
are willing and able to pay for a good or service (indicated by the demand curve) and the total
amount that they actually do pay (i.e. the market price).
Consumer surplus of a unit Total consumer surplus
= Marginal Benefit of the unit – Unit Price = Total Benefit – Total Expenditure

Illustration
Mary is willing to pay $50 for a Christmas tree and John is willing to pay $45. The price of a
tree is $40.
• Mary 's consumer surplus from the tree is __________________ .
• The total consumer surplus for Mary and John is ___________________________ .

Consumer surplus is the excess of marginal benefit from a good over the price paid
for it, summed over the quantity consumed.

BHMH 2002, Introduction to Economics 9

 3.3 Value, Price, and Consumer Surplus
Consumer surplus is the excess of marginal benefit from a good over the price paid
for it, summed over the quantity consumed.

Checkpoint exercise:

= MC
• When you get MB and
MC from the demand-
and-supply digamma,
indicate in the diagram:
= MB
D = MB
S = MC

• Don’t miss out the unit,

 The quantity of DVDs bought is _________ a day. i.e. dollar sign ($)
 The amount spent on DVDs = __________= ________
 The total consumer surplus = ___________________ = ________
 The total benefit from DVDs
= total expenditure + consumer surplus = __________ = _____
 The consumer surplus of the 10th DVD = _________ = ____

BHMH 2002, Introduction to Economics 10

3.3 Cost, Price, and Producer Surplus
When the price exceeds marginal cost, the firm obtains a producer surplus.
Producer surplus is the excess of the price of a good Producer surplus per unit
over the marginal cost of producing it, summed over = Unit Price – Marginal Cost
the quantity produced.
In other words, producer surplus is the difference between the actual amount a producer
receives and the opportunity cost of producing that quantity of product.
Producer surplus is a measure of producer Total producer surplus
welfare. = Total Revenue – Production Cost

Checkpoint exercise:
 The quantity of DVDs sold is 20 a day.
 The total revenue = ___________________= ________
= MC
 The producer surplus = ___________________ = _______
 The cost of producing DVDs
= total revenue - producer surplus
= _______________ = ______ = MB

BHMH 2002, Introduction to Economics 11

 3.4 Is the Market Efficient?
Efficiency of resource allocation is achieved Total surplus is the sum
• when marginal benefit equals marginal cost at the last unit, of consumer surplus and
• when the total surplus is maximized, and producer surplus.
• no deadweight loss.

Checkpoint exercise
(Complete the points below by
referring to the diagram on the left)
 marginal benefit equals marginal
cost at _______ at the last unit of
__________________ .
 The total surplus is maximized at
______________________________
______________________________ .
 There is / is no deadweight loss.
1  Conclusion: The resource allocation
is efficient / inefficient.

Figure 6.8 shows an efficient pizza market

BHMH 2002, Introduction to Economics 12

 3.4 Is the Market Efficient?

Figure 6.8 shows an efficient pizza market

Market Efficiency and Perfect Competitive Market:
In a competitive market:
 The demand curve shows buyers’ marginal benefit. The
supply curve shows the sellers’ marginal cost.
 Under a competitive market, marginal benefit equals
marginal cost at the equilibrium .
 Thus, resources allocation is efficient and the competitive
market delivers the efficient quantity.
 The competitive equilibrium maximizes total surplus.
 Buyers seek the lowest possible price and sellers seek the
highest possible price.
 When buyers and sellers pursue their self-interest, the
social interest is served.

BHMH 2002, Introduction to Economics 13

 3.4 Is the Market Efficient?

 Market failure is a situation in which

the market delivers an inefficient
outcome.

 Inefficiency can occur because of

underproduction or overproduction

 Deadweight loss is the decrease in

total surplus that results from an
inefficient underproduction or
overproduction. It is a social loss.

Checkpoint:
Indicate the area of consumer surplus and
producer surplus in the diagram.

BHMH 2002, Introduction to Economics 14

 Tips for Assessment
- Proper way to ‘describe’ and ‘label’ of consumer surplus,
producer surplus and total surplus
Concepts of surpluses are commonly integrated in different analyses such as demand and
supply analysis or impacts of different market structures to illustrate the changes of welfare
among different parties like the ones of consumers, producers and the society.

However, students always encounter problems in

presenting different surpluses accurately. Here is a
‘bad example’!

 It is very difficult and unclear describe the original

area of consumer surplus, producer surplus and total
surplus in your written explanation. Even worse, how
to describe the changes of these areas after there is
an increase in the supple of apple in your written
explanation accurately?

BHMH 2002, Introduction to Economics 15

Correct way of labelling different surpluses for written explanation

Figure 1  Use the ‘lower case letters’ (i.e. a, b, c, …) to label the intercepts or
any intersection of relevant points.
 The concept of surplus is “an area” on the diagram. The followings
are the proper way to describe the surpluses on the diagram.
• In figure 1, the consumer surplus is the area abP1.
• Area P1bc represents the producer surplus.
• Area abc represents the total surplus.


 “Change” is frequently used in asking question because the
meaning is unclear. Therefore, it is the task of students to
clarify the direction of change.
 When you describe the ‘change’ of surpluses, it is a must
that you need to state clearly whether there is “an increase”
or “a decrease” in the surplus. Don’t use the word “change”
again in your answer. Students are expected to provide clear
direction of change in their answers.

 In figure 1, the consumer surplus increases from the area abP1 to the area aeP2.
 In figure 1, the consumer surplus increases by the area P1beP2.

 In figure 1, the consumer surplus increases by the area P1bP2e. (What is wrong with this statement?)

BHMH 2002, Introduction to Economics 16

 What is wrong with this illustration?

DON’T use the upper case letters! Why?

As a convention in Economics, upper case letter ‘D’ is reserved for ‘demand’ in a demand and supply diagram.

If you use the upper case letters for labels of intersection points on the diagram, probably, the letter ‘D’ will
appear two times. However, it refers to two different positions on the same diagram and two different
meaning. It will lead to ambiguity for the readers and markers. No mark is given for this inconsistency of
labelling.

BHMH 2002, Introduction to Economics 17