Chapter 5: Efficiency and Equity
· Using prices in markets to allocate scarce resources is one of
many alternative methods of allocating scarce resources.
· Tools such as consumer surplus and producer surplus help
evaluate efficiency.
· The outcomes from the various methods used to allocate
scarce resources, especially markets, can be examined in terms
of both their efficiency and fairness.
I.
Resource Allocation Methods
Resources are scarce, so they somehow must be allocated.
Different methods of allocating resources include:
· Market price: The people who are willing and able to buy a
resource get the resource.
· Command: a 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 does not
work well at allocating resources in the entire economy.
· Majority rule: resources are allocated in accordance with
majority vote. Majority rule works well when the allocation
decisions being made affect a large number of people and self-
interest leads to bad decisions.
· Contest: resources are allocated to the winner. Contests work
well when the efforts of the players are hard to measure, such as
top managers being in a contest to be named CEO of a company.

· First-come, first-serve: resources are allocated to those who
are first in line. This allocation method works well when the
resource can serve just one user at a time in a sequence, as is
the case with, say, a bank teller or an ATM.
· Lottery: resources are allocated to the people who pick the
winning number, choose the lucky card, etc. Lotteries work best
when there is no effective way to distinguish among potential
users of a scarce resource.
· Personal characteristics: resources are allocated to people with
the “right” characteristics.
· Force: resources are allocated to those who can forcibly take
the resources.
II.
Benefit, Cost, and Surplus
Demand, Willingness to Pay, and Value
· The value of one more unit of a good or service is its marginal
benefit. Marginal benefit is the maximum price that people are
willing to pay for another unit of a good or service. And the
willingness to pay for a good or service determines the demand
for it. Consequently the demand curve for a good or service is
also its 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.
· The demand curve in the figure shows that the maximum price
a person is willing to pay for the 6 millionth gallon of milk per
month is $3, so $3 is the marginal benefit of this gallon.

· MSB curve: In the absence of externalities, which will be
discussed later, the market demand curve is also the economy’s
marginal social benefit (MSB) curve. It reflects the number of
dollars’ worth of other goods and services willingly given up to
obtain one more unit of a good.
· The figure shows that the maximum price a consumer is
willing and able to pay for the 6 millionth gallon of milk is $3,
so the marginal social benefit of the 6 millionth gallon of milk
is $3.
· Consumer surplus is the value (or marginal benefit) of the
good minus the price paid for it, summed over the quantity
bought. The figure illustrates the consumer surplus as the
shaded triangle when the price is $3 per gallon.
Supply, Cost, and Minimum Supply-Price
· The cost of producing one more unit of a good or service is its
marginal cost. Marginal cost is the minimum price that
producers must receive to induce them to produce another unit
of the good or service. And the minimum acceptable price
determines the quantity supplied. Consequently the supply curve
for a good or service is also its marginal cost curve.
· 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.
· MSC curve: In the absence of externalities, the market supply
curve is the economy’s marginal social cost (MSC) curve.
· The supply curve in the figure shows that the minimum price a
producer must receive to be willing to produce the 6 millionth
gallon of milk per month is $3, so $3 is the marginal social cost
of this gallon.

· Producer surplus is the price of a good minus its minimum
supply-price (or marginal cost), summed over the quantity sold.
The figure illustrates the producer surplus as the shaded triangle
when the price is $3 per gallon.
III.
Is the Competitive Market Efficient?
Efficiency of Competitive Equilibrium
· The marginal benefit to the entire society is the marginal
social benefit curve, MSB. If all the benefits from consuming a
good go to its consumers, the market demand curve is the same
as the MSB curve.
· The marginal cost to the entire society is the marginal social
cost curve, MSC. If all the costs of producing a good are paid
by the producers, the market supply curve is the same as the
MSC curve.
· When the marginal social benefit of the last unit produced
equals its marginal social cost, society attains efficiency.
However, because the demand curve is the same as the MSB
curve and the supply curve is the same as the MSC curve, the
efficient quantity that sets the MSB equal to the MSC also sets
the quantity demanded equal to the quantity supplied and so is
the equilibrium quantity. The figure illustrates how the efficient
quantity of milk, 6 million gallons per month, also is the
equilibrium quantity of milk.
· When the efficient quantity of milk is produced, the sum of
the consumer surplus and producer surplus (total surplus) is
maximized.
All the results of efficiency at this point can be summarized as
follows:

· By definition, efficiency requires that resources are being used
where they are most highly valued.
· When resources are used where they are most highly valued,
MSB = MSC.
· When the demand and supply curves intersect, QD = QS, and
the market achieves equilibrium.
· At equilibrium the total surplus in the market is maximized.
Buyers and sellers acting in their own self-interest maximize
social well-being.
The Invisible Hand
· Adam Smith, in his 1776 book The Wealth of Nations,
articulated how competition led self-interested consumers and
producers to make choices that unintentionally promote the
social interest as if they were led by an “invisible hand.”
Underproduction and Overproduction
· Inefficiency can occur because either too little of an item is
produced (underproduction) or too much is produced
(overproduction).
· In either case, a deadweight loss occurs. A deadweight loss is
the decrease in the consumer surplus and producer surplus
(decrease in total surplus) that results from producing at an
inefficient level of production. The figure illustrates the
deadweight loss from overproduction of milk and from
underproduction.
Obstacles to Efficiency

Sometimes a market overproduces or underproduces a good or
service. The key obstacles to achieving an efficient allocation
of resources in a market are:
· Price and Quantity Regulations: A price ceiling sets the
highest legal price and a price floor sets the lowest legal price.
If a price ceiling or price floor makes the equilibrium price
illegal, it can lead to inefficiency. Quantity regulations that
limit the amount produced also lead to inefficiency. (Studied in
Chapter 6)
· Taxes and Subsidies: Taxes and subsidies place a wedge
between the prices consumers pay and the prices producers
receive. Both can lead to inefficiency. (Studied in Chapter 6)
· Externalities: An externality is a cost or a benefit that affects
someone other than the seller or the buyer. In that case, the
demand curve is not the same as the marginal social benefit
curve and/or the supply curve is not the same as the marginal
social cost curve. In these cases, inefficiency results. (Studied
in Chapter 16)
· Public Goods and Common Resources: A public good is a
good or service that is consumed simultaneously by everyone
even if they don’t pay for it. Public goods lead to a free-rider
problem, in which people do not pay for their share of the good.
A common resource is owned by no one but available to be used
by everyone. Common resources are generally over-used
because no one owns the resource. In both cases, inefficiency
can occur. (Studied in Chapter 17)
· Monopoly: A monopoly is a firm that has sole control of a
market. To maximize its profit, a monopoly produces less than
the efficient quantity and so creates inefficiency. (Studied in
Chapter 13)

· High transactions costs: The opportunity costs of making a
trade are transactions costs. When these costs are high, a market
might underproduce because too few transactions take place.
Alternatives to the Market
If markets do not allocate resources efficiently, then one of the
alternatives might do a better job. For instance, using first-
come, first-serve to allocate spaces in a line at a movie theater
probably works better than a market.
IV.
Is the Competitive Market Fair?
· Efficiency is a positive term, while equity is a normative term.
Not everyone can agree upon what is fair.
· There are two general ways of defining fairness: “It’s not fair
if the results aren’t fair” and “It’s not fair if the rules aren’t
fair.”
It’s Not Fair If the Result Isn’t Fair
· Utilitarianism adopts this view. Utilitarianism is a principle
that states that we should strive to achieve “the greatest
happiness for the greatest number.” This principle argues that
fairness requires equality of incomes, which requires that
incomes be redistributed.
· Redistribution leads to the big tradeoff, the tradeoff between
efficiency and fairness. The tradeoff occurs because taxes
decrease people’s incentives to work, thereby decreasing the
size of the “economic pie.” In addition, taxes lead to
administration costs that also decrease the economic pie.
· John Rawls argued that redistribution should strive to make
the poorest as well off as possible which may mean a smaller
piece of a bigger pie, rather than an equal piece, to keep

incentives in place.
It’s Not Fair If the Rules Aren’t Fair
· This perspective relies on the symmetry principle—the
requirement that people in similar situations should be treated
similarly. In economics, this means equality of economic
opportunity rather than equality of economic outcomes.
· Robert Nozick suggests government should promote fairness
by establishing property rights for individuals and allowing
only voluntary exchange of these resources.
· If private property rights are enforced, if voluntary exchange
takes place in a competitive market, and if none of the obstacles
to efficiency listed before exist, then according to Nozick, the
competitive market is fair.
Chapter 4: Elasticity
Elasticity
· The price elasticity of demand measures how strongly buyers
respond to a change in the price of a good.
· The price elasticity of demand can be used to make
quantitative predictions of how changes affect the price and
quantity demanded of a good.
· The income elasticity of demand measures how strongly
demanders respond to a change in income, and the cross
elasticity of demand measures how strongly demanders respond
to the change in the price of another good.

· The price elasticity of supply measures how strongly
producers respond to a change in the price of a good.
I.
Price Elasticity of Demand
· In general, elasticity measures responsiveness. The price
elasticity of demand measures how responsive demanders are to
a change in the price of the good. This information is often
useful for both businesses and governments because it can
predict the impact of a price change on total revenue or total
expenditure.
Calculating Price Elasticity of Demand
· The price elasticity of demand is a units-free measure of the
responsiveness of the quantity demanded of a good to a change
in its price when all other influences on a buyer’s plans remain
unchanged. The price elasticity of demand is equal to the
absolute value of:
·
.
price
in
change
Percentage
demanded
quantity

in
change
Percentage
The demand elasticity formula yields a negative value, because
price and quantity move in opposite directions. However, it is
the magnitude, or absolute value, of the measure that reveals
how responsive the quantity change has been to a price change.
So we use the magnitude or the absolute value of the price
elasticity of demand.
· The table to the right has two points on the demand curve for
pizza from a particular pizza parlor.
· The absolute value of the percent change in quantity demanded
is [(500 ( 400) ( 450] ( 100 = 22.2 percent.
· The absolute value of the percentage change in price is
[($14 ( $16) ( $15] ( 100 = 13.3 percent.
· Between these two points on the demand curve, the price
elasticity of demand is 22.2% ( 13.3% = 1.67.
Inelastic and Elastic Demand
· If the price elasticity of demand is less than 1.0, the good is
said to have an inelastic demand. In this case, the percentage
change in the quantity demanded is less than the percentage
change in price.
· If the quantity demanded remains constant when the price
changes, then the good is said to have perfectly inelastic
demand. The price elasticity of demand is 0 and the good’s

demand curve is a vertical line.
· If the price elasticity of demand is equal to 1.0, the good is
said to have a unit elastic demand. In this case, the percentage
change in the quantity demanded equals the percentage change
in price.
· If the price elasticity of demand is greater than 1.0, the good
is said to have an elastic demand. In this case, the percentage
change in the quantity demanded exceeds the percentage change
in price.
Furniture
1.26
Motor Vehicles
1.14
Clothing
0.64
Oil
0.05
· If the quantity demanded changes by an infinitely large
percentage in response to a tiny price change, then the good is
said to have perfectly elastic demand. The price elasticity of
demand is infinite.
· The table has some “real-life” elasticities from the book.
Elasticity Along a Linear Demand Curve
· With the exception of a vertical demand curve and a horizontal
demand curve (along which the elasticity is 0 and infinite,
respectively) the price elasticity of demand changes when
moving along a linear demand curve.
· As the figure illustrates, at points on the demand curve above
the midpoint, the price elasticity of demand is elastic while at
points below the midpoint, the price elasticity of demand is

inelastic. At the midpoint, the price elasticity of demand is unit
elastic.
Total Revenue and Elasticity
· The total revenue from the sale of a good equals the price of
the good multiplied by the quantity sold.
· If demand is elastic, a 1 percent price cut increases the
quantity sold by more than 1 percent and total revenue
increases.
· If demand is unit elastic, a 1 percent price cut increases the
quantity sold by 1 percent and total revenue does not change.
· If demand is inelastic, a 1 percent price cut increases the
quantity sold by less than 1 percent and total revenue decreases.
· The total revenue test is a method of estimating the price
elasticity of demand by observing the change in total revenue
that results from a change in price, when all other influences on
the quantity sold remain the same.
· If a price cut increases total revenue, demand is elastic. And if
a price hike decreases total revenue, demand is elastic.
· If a price cut does not change total revenue, demand is unit
elastic. And if a price hike does not change total revenue,
demand is unit elastic.
· If a price cut decreases total revenue, demand is inelastic. And
if a price hike increases total revenue, demand is inelastic.
· Similarly, when a price changes, a consumer’s change in
expenditure depends on the consumer’s elasticity of demand.

· If demand is elastic, then a price cut means that expenditure
on the item increases.
· If demand is inelastic, then a price cut means that expenditure
on the item decreases.
· If demand is unit elastic, then a price cut means that
expenditure on the item does not change.
The Factors that Influence the Elasticity of Demand
The magnitude of the price elasticity of demand depends on:
· The closeness of substitutes: The closer and more numerous
the substitutes for a good or service, the more elastic the
demand. This is critical for understanding demand in the market
structure section later in the book.
· The proportion of income spent on the good: The greater the
proportion of income spent on a good or service, the more
elastic the demand.
· The amount of time elapsed since the price change: The longer
the time elapsed since the price change, the more elastic the
demand.
II.
More Elasticities of Demand
Income Elasticity of Demand
· The income elasticity of demand is a measure of the
responsiveness of the demand for a good to a change in the
income, other things remaining the same.
· The income elasticity of demand is equal to:

.
income
in
change
Percentage
demanded
quantity
in
change
Percentage
The changes in the quantity demanded and income are
percentages of the average income and quantity demanded over
the range of change.
· The income elasticity of demand is positive for normal goods
and negative for inferior goods.
· If the income elasticity of demand is greater than 1, demand is
income elastic and the good is a normal good. As income
increases, the percentage of income spent on income elastic
goods increases.
Airline Travel
5.82
Restaurant Meals

1.61
Clothing
0.51
Food
0.14
· If the income elasticity of demand is positive but less than 1,
demand is income inelastic and the good is a normal good. As
income increases, the percentage of income spent on income
inelastic goods decreases.
· If the income elasticity of demand is negative the good is an
inferior good.
· The table has some “real-life” income elasticities from the
book.
Cross Elasticity of Demand
· The cross elasticity of demand is a measure of the
responsiveness of the demand for a good to a change in the
price of a substitute or complement, other things remaining the
same.
· The cross elasticity of demand is equal to:
.
complement
or
substitute
a
of

price
in
change
Percentage
demanded
quantity
in
change
Percentage
The changes in the quantity demanded and the price are
percentages of the average price and quantity demanded over
the range of change.
· The cross elasticity of demand is positive for substitutes and
negative for complements.
III.
Elasticity of Supply
· The elasticity of supply measures how responsive producers
are to a change in the price of the good.
· The elasticity of supply measures the responsiveness of the
quantity supplied to a change in the price of a good when all
other influences on selling plans remain unchanged.
· The elasticity of supply is equal to:

.
price
in
change
Percentage
supplied
quantity
in
change
Percentage
Three Cases of Elasticity of Supply
· Supply is perfectly inelastic if the elasticity of supply equals
0. In this case, the supply curve is vertical.
· Supply is unit elastic if the elasticity of supply equals 1. In
this case, the supply curve is linear and passes through the
origin. If any supply curve is linear and passes through the
origin, the supply is unit elastic; the slope of the supply curve is
irrelevant.
· Supply is perfectly elastic if the elasticity of supply is
infinite. In this case, the supply curve is horizontal.
Price
(dollars per pizza)
Quantity supplied
(pizzas per week)

14
300
16
400
· The table to the right has two points on the supply curve for
pizza from a particular pizza parlor.
· The percentage change in the quantity supplied is
[(400 ( 300) ( 350] ( 100 = 28.6 percent.
· The percentage change in price is [($16 ( $14) ( $15] ( 100 =
13.3 percent.
· Between these two points, the elasticity of supply is 28.6%
( 13.3% = 2.15.
· Supply is elastic if the elasticity of supply exceeds 1.0, unit
elastic if the elasticity of supply equals 1.0, and inelastic if the
elasticity of supply is less than 1.0.
The Factors that Influence the Elasticity of Supply
· Resource substitution possibilities: The more unique or rare
the resources used to produce the good, the smaller the
elasticity of supply. The more common the resources used to
produce the good, the larger the elasticity of supply.
· The time frame for substitution possibilities: The longer the
amount of time producers have to adjust to a change in price,
the more elastic the supply will be.
· Momentary supply refers to the period of time immediately
following a price change. For some goods, the momentary
supply can be perfectly inelastic—fresh fish the day of a price
hike. For other goods, the momentary supply can be quite
elastic—when the number of telephone calls increases on a
holiday, the supply increases with no change in price.

· Short-run supply shows how the quantity supplied responds to
a price change when only some of the technological adjustments
have been made.
· Long-run supply shows how the quantity supplied responds to
a price change when all of the technological adjustments have
been made.
Price�(dollars per pizza)�
Quantity demanded�(pizzas per week)�
�
14�
500�
�
16�
400�
�
_1143217591.unknown
_1143217956.unknown
_1143217114.unknown
_1143213000.unknown
Chapter 5 Assignment
The purpose of this assignment is to give you a better
understanding of consumer and producer
surplus. To keep it simple, keep in mind the formula for

finding the area of a triangle which is:
Area equals one-half of the height of the triangle multiplied by
the base of the triangle, or
A=.5(h x b)
A local restaurant sells the best hotwings in town. A single
consumer’s demand for the hotwings
is shown in the table and graph below
Price
14
Price Quantity
$14 0 12
$12 1
$10 2 10
$8 3
A Supply
$6 4 8
$4 5
$2 6 6
$0 7

B
4
2 Demand
0
1 2 3 4 5 6 7 8 Quantity
a) If the equilibrium price of a serving of hotwings is $6.00,
how much consumer surplus does
the consumer receive? (figure out the area of triangle A)
b) Explain how you calculated it.
c) What is the producer surplus? (figure out the area of triangle
B)
14
12

10 A
Supply
8
B D
6
C
4
2 Demand
0
1 2 3 4 5 6 7 8
d) Now, let the price of a serving of hotwings increase to $8.00.
By how much does your
consumer surplus decrease? (Your new consumer surplus is area
A above. Compare that to
your answer to question “a” above. The difference is your
reduction in consumer surplus.)

e) What is the producer surplus with the $8.00 price?
(Remember, producer surplus is the area
above the supply curve and below the price. So it will be the
sum of areas B and C (area of
C is 7.5).)
f) By how much did the producer surplus increase? (You need to
compare your answer to “e”
with your answer to “c”.)
g) With the price being $8.00, what is the deadweight loss?
(You can figure that out by
calculating the areas of the two small triangles I labeled as D,
or you can subtract the sum of
the consumer and producer surplus when the price is $8.00 from
the sum of the consumer
and producer surplus when the price is $6.00)
The next week, the restaurant owner decides to offer an “all you
can eat” special for $20. This
means that you pay $20 at the door. And once you enter, you
can eat all the wings you want for
no additional charge.
h) Assuming your demand curve for servings of hotwings is still
represented by the demand

curve in the graphs above, how many servings of hotwings will
you eat now, and how much
consumer surplus do you receive now? (Once you pay the $20,
your marginal cost for each
serving of hotwings that you eat is zero. So, figure out your
consumer surplus with a zero
price (the entire triangle), then subtract the $20 you had to pay
to get in.)
i) If you want to press your luck, answer this one. If your
demand curve represents the demand
of the “typical customer” of this restaurant, what is the highest
price the restaurant could
charge for the “all you can eat” special and still attract
customers?
(At this point, price is 5, and
the quantity supplied is 3)
Chapter 4 Assignment:
The tables below show the cumulative demand for 12 ounce
cans of Coca-Cola as provided by students in a previous class.
Original
Income Doubles

Pepsi is $.20 cheaper than Coke
Price
950
200
Avg.
Price
950
200
Avg.
Price
950
200
Avg.
$1.50
54
26
40
$1.50
87
40
64
$1.50
44
20
32
$1.25
63
30
47
$1.25
100

46
73
$1.25
55
27
41
$1.00
83
36
60
$1.00
125
56
91
$1.00
67
35
51
$0.75
115
53
84
$0.75
175
82
129
$0.75
92
48
70
$0.50

160
75
118
$0.50
241
106
174
$0.50
140
70
105
1. Using the “Avg.” column in the first table calculate self-price
elasticity assuming the price of Coke increases from $1.00 to
$1.25 per can (use the mid-point formula).
2. Using the first table and the second table (the “Avg. columns)
calculate the income elasticity for Coke assuming income
doubles and the price is $1.00 per can (again, use the mid-point
formula). No matter what level of income you have, if you
double it the percent change in income (when using the mid-
point formula) will always be 66.7%. So, 66.7% will be your
denominator.
3. Using the first table and the third table (the “Avg. columns)
calculate the cross-price elasticity of demand for Coke
assuming that table one shows the demand for Coke when the
price of Coke is $1.00 per can and the price of Pepsi is $1.00
per can, and that table three shows the demand for Coke when
the price of Coke is $1.00 per can and the price of Pepsi is $.80
per can (again, use the mid-point formula).