COECA1-B11

Chapter 5: Efficiency and Equity

by Joshua van Houten

 Learning Outcomes:

1. Explain the relationship between demand and marginal benefit and define the
term ‘consumer surplus’.

2. Explain the relationship between supply and marginal cost and define the term
‘producer surplus’.

3. 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?

There are Eight alternative methods that might be used are:

1. Market price 5. First-come, first-served

2. Command 6. Lottery
3. Majority rule 7. Personal characteristics
4. Contest 8. Force

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 Resource Allocation Methods
1. Market Price
Market prices allocate scarce resources - individuals that are willing and able to pay for a resource gets that
resource.

2. 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.

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 Resource Allocation Methods
3. 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.

4. 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.

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 Resource Allocation Methods
5. 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. (Traffic Lights)

6. 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.

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 Resource Allocation Methods
7. Personal Characteristics
When resources are allocated on the basis of personal characteristics, people with the ‘right’ characteristics
get the resource. I.E getting married or getting a job position.

8. Force
Force plays a crucial role, for both good and ill, in allocating scarce resources. I.E colonists took land and
natural recourses through force and allocated them as they saw fit. Force can also refer to the rule of law
and legal framework.

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 Demand, Willingness to Pay and Value

We distinguish between value and price.

• Value is what we get, and the price is what we pay.

• The value of one more unit of a good or service is its marginal benefit.

We measure marginal benefit by the maximum price that is willingly paid for

another unit of the good or service.

• Willingness to pay determines demand. A demand curve is a marginal

benefit curve!
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Individual Demand and Market Demand

In Figure 5.1(a)

Busi is willing to pay R1 for the 30th biscuit and R1 is her marginal benefit from
that biscuit.

In Figure 5.1(b)

Nick is willing to pay R1 for the 10th biscuit and R1 is his marginal benefit from
that biscuit. But at what quantity is the market willing to pay R1 for the marginal
biscuit? The answer is provided by the market demand curve.

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 Individual Demand and Market Demand

Figure 5.1(c)

Illustrates the market demand for biscuits if Busi and Nick are the only people in the market. Busi’s
demand curve in part (a) and Nick’s demand curve in part (b) sum horizontally to the market demand
curve in part (c).

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 Individual Demand and Market Demand
• Market Demand – is the relationship between the price of a good and
the quantity demanded by all buyers.

• 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.

• 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.
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 The Relationship Between Demand
Price of a car Demand for a Car
R 700 000 1 & Marginal Benefit
R 600 000 2
R 500 000 3
R 400 000 4 • Demand refers to the quantity of a product or service that
R 300 000 5
R 200 000 6 consumers are willing and able to purchase at a given price.
R 100 000 7
• Marginal benefit represents the additional satisfaction or utility
Demand Curve for a Car gained from consuming one more unit of a good or service.
R800,000
R700,000
• The law of demand states that as the price of a product increases,
R600,000
R500,000
the quantity demanded decreases, assuming all other factors
Price in Rands

R400,000
R300,000 remain constant.
R200,000
R100,000
• The inverse relationship between price and quantity
R0
1 2 3 4 5 6 7
Quantity Demanded demanded can be explained by the concept of marginal benefit.
Demand Curve for cars 10
 The Relationship Between Demand &
Marginal Benefit
• Marginal benefit - is the incremental satisfaction a consumer derives from consuming an additional unit
of a good or service. It is influenced by various factors such as personal preferences, income, and the
availability of substitutes. When the price of a product is high, the marginal benefit of consuming an
additional unit tends to decrease.

• Consumers typically have limited resources and face diminishing returns as they consume more of a
particular good or service. As a result, they become less willing to pay a higher price for each
additional unit, leading to a decrease in quantity demanded.

• 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 which is the most that people are willing to pay for an additional
unit of it. 11
 Consumer Surplus
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

• Figure 5.2(a) shows Busi’s consumer surplus from biscuits when the price

is R1 a biscuit. At this price, she buys 30 biscuits a month because the 30th

biscuit is worth exactly R1 to her.

• Busi is willing to pay R2 for the 10th biscuit, so her marginal benefit from

this biscuit is R1 more than she pays for it – she receives a surplus of R1
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 Consumer Surplus

Busi’s consumer surplus is the sum of the surpluses on all of the biscuits

she buys. This sum is the area of the green triangle – the area below the

demand curve and above the market price line. The area of this

triangle is equal to its base (30 biscuits) multiplied by its height (R1.50)

divided by 2, which is R22.50. The area of the blue rectangle in Figure

5.2(a) shows what Busi pays for 30 biscuits.

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 Consumer Surplus

Figure 5.2(b) shows Nick’s consumer surplus, and part (c) shows the consumer surplus for the market.
The consumer surplus for the market is the sum of the consumer surpluses of Busi, and Nick.

All goods and services have decreasing marginal benefit. People receive more benefit from their
consumption than the amount they pay.

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 The Relationship Between Supply &
Marginal Cost

• Supply - is 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 - represents the additional cost incurred by producing one additional unit of output.

• The supply of a good or service is positively related to its marginal cost.

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 The Relationship Between Supply &
Marginal Cost

• As the price of a good increases, 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.

• When production expands, marginal costs tend to rise. As production increases, resources become

scarcer, and producers must allocate additional resources, this may be less efficient or more expensive.

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 Cost, Price and Supply

Firms make a profit when they receive more from the sale of a good or service than the cost of producing
it. Producers distinguish between cost and price.

• Cost - is what a firm gives up when it produces a good or service

• Price - is what a firm receives when it sells the good or service.

• Marginal cost - is cost of producing one more unit of a good or service. Marginal cost is the minimum
price that producers must receive to induce them to offer one more unit of a good or service for sale.

• A supply curve can be seen as a marginal cost curve.

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 Individual Supply
• The relationship between the price of a good and
the quantity supplied by one producer is called
individual supply.

• In Figure 5.3(a), Matthew is willing to produce

the 100th packet of biscuits for R15, his
marginal cost of that packet of biscuits.

• Figure 5.3(b), Sabrina is willing to produce the

50th packet of biscuits for R15, her marginal
cost of that packet of biscuits.

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 Market Supply

• Market supply - the relationship between the price of a good and

the quantity supplied by all producers.
• The market supply curve is the horizontal sum of the individual
supply curves and is formed by adding the quantities supplied by all
the producers at each price.
• Figure 5.3(c) illustrates the market supply of biscuits if Matthew and
Sabrina are the only producers. Matthew’s supply curve in part (a)
and Sabrina’s supply curve in part (b) sum horizontally to the
market supply curve in part (c).

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 Market Supply

At a price of R15 a packet of biscuits, Matthew supplies 100 packets of biscuits and Sabrina supplies 50
packets of biscuits, so the quantity supplied by the market at R15 a packet of biscuits is 150 packets of
biscuits.

For Matthew and Sabrina, their supply curves are their marginal cost curves. For society, the market
supply curve is the marginal cost curve. We call the society’s marginal cost marginal social cost. So, the
market supply curve is also the marginal social cost (MSC) curve.
Price (R Mathew’s Supply of biscuits Sabrina’s Supply of biscuits
per biscuit) (Biscuits per month) (Busicuits per month) Market Demand
5.00 0 0 0
10.00 50 0 50
15.00 100 50 150
20.00 150 100 250
25.00 200 150 350

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 Producer Surplus

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.

• Figure 5.4(a) shows Matthew’s producer surplus from biscuits when

the price is R15 a packet of biscuits. At this price, he sells 100
packets of biscuits a month because the 100th packet of biscuits
costs him R15 to produce. But Matthew is willing to produce the
50th packet of biscuits for his marginal cost, which is R10, so he
receives a surplus of R5 on this packet of biscuits.
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 Producer Surplus

Matthew’s producer surplus is the sum of the surpluses on the

packets of biscuits he sells. This sum is the area of the blue
triangle – the area below the market price and above the supply
curve. The area of this triangle is equal to its base (100) multiplied
by its height (R10) divided by 2, which is R500.

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 Producer Surplus

The area of the blue triangle in Figure 5.4(b) shows Sabrina’s producer surplus and the blue area in
Figure 5.4(c) shows the producer surplus for the market. The producer surplus for the market is the sum
of the producer surpluses of Matthew and Sabrina.

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 Efficiency in Competitive Markets

• Equilibrium in a competitive market occurs when the quantity

demanded equals the quantity supplied.

• 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.

• In equilibrium, a competitive market achieves allocative

efficiency

• Total surplus - is the sum of consumer surplus (the green

triangle) and producer surplus (the blue triangle) is maximised. 24

 Distinguishing Between a Consumer
Surplus and Producer Surplus

• 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.

• 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.

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 Efficiency in Competitive Markets

• 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) – 10
thousand biscuits per day.
• The competitive biscuit market produces the
efficient quantity biscuits
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 Market Failures
Markets are not always efficient, and when a market is inefficient, we call the outcome market failure.
In a market failure, an underproduction or an overproduction of an item is produced.

Underproduction – Figure 5.6 (a)

• The quantity of biscuits produced is 5,000 a day. At this quantity,

consumers are willing to pay R20 for a biscuit that costs only R10 to

produce. The quantity produced is inefficient as there is

underproduction and 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 shows the deadweight loss. 27

 Market Failures

Overproduction – Figure 5.6 (b)

• The quantity of biscuits produced is 15,000 a day. At this
quantity, consumers are willing to pay only R10 for a
pizza that costs R20 to produce.
• By producing the 15,000th biscuit, R10 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.

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 Sources of Market Failures

1. 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.

2. 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.

3. Externalities - An externality is a cost or a benefit that affects someone other than the seller or the
buyer.

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 Sources of Market Failures

4. 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.

5. 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.

6. 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 transactions costs.

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 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 31
 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 • Public goods and common resources
• Taxes and subsidies • Monopolies
• Externalities • High transactions costs
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 Thank you,
Class is Dismissed