Download - Ch 06 Lecture
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Should price gouging be illegal?
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6When you have completed your
study of this chapter, you will be able to
1Describe the alternative methods of allocating scareresources and define and explain the features of an efficientallocation.
2 Distinguish between value and price and define consumersurplus.
3 Distinguish between cost and price and define producer
surplus.
CHAPTER CHECKLIST
Efficiency and Fairnessof Markets
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When you have completed your
study of this chapter, you will be able to
4Evaluate the efficiency of the alternative methods ofallocating scare resources.
5 Explain the main ideas about fairness and evaluate thefairness of alternative methods of allocating scarceresources.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Resource Allocation Methods
Scare resources might be allocated by Market price
Command Majority rule
Contest
First-come, first-served
Sharing equally
Lottery
Personal characteristics
Force
How does each method work?
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6.1 ALLOCATION METHODS AND EFFICIENCY
Market Price
When a market allocates a scarce resource, the peoplewho get the resource are those who are willing to paythe market price.
Most of the scarce resources that you supply getallocated by market price.
You sell your labor services in a market, and you buymost of what you consume in markets.
For most goods and services, the market turns out to doa good job.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Command
Command systemallocates resources by the order
(command) of someone in authority.For example, if you have a job, most likely someone
tells you what to do. Your labor time is allocated to
specific tasks by command.
A command system works well in organizations with
clear lines of authority but badly in an entire economy.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Majority Rule
Majority rule allocates resources in the way that amajority of voters choose.
Societies use majority rule for decisions about tax ratesthat allocate resources between private and public useand tax dollars between competing uses such as
defense and health care.Majority rule works well when the decision affects lots ofpeople and self-interest must be suppressed to useresources efficiently.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Contest
A contest allocates resources to a winner (or group of
winners).The most obvious contests are sporting events but they
occur in other arenas:
For example, The Oscars are a type of contest.
Contest works well when the efforts of the players are
hard to monitor and reward directly.
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6.1 ALLOCATION METHODS AND EFFICIENCY
First-Come, First-Served
A first-come, first-served allocates resources to thosewho are first in line.
Casual restaurants use first-come, first served toallocate tables. Supermarkets use first-come, first-served at checkout. Airlines use first-come, first-servedto allocate standby seats.
First-come, first-served works best when scarceresources can serve just one person at a time in asequence.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Sharing Equally
When a resource is shared equally, everyone gets the
same amount of it.You might use this method to share a dessert in a
restaurant.
To make sharing equally work, people must be in
agreement about its use and implementation.
It works best for small groups who share common goals
and ideals.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Lottery
Lotteries allocate resources to those with the winningnumber, draw the lucky cards, or come up lucky.
State lotteries and casinos reallocate millions of dollarsworth of goods and services each year, but lotteries aremore widespread.
For example, tickets to Michael Jacksons memorialservice were allocated by lottery.
Lotteries work well when there is no effective way todistinguish among potential users of a scarce resource.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Personal Characteristics
Personal characteristics allocate resources to those
with the right characteristics.For example, people choose marriage partners on the
basis of personal characteristics.
But this method gets used in unacceptable ways:
allocating the best jobs to white males and
discriminating against minorities and women.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Force
Force plays a role in allocating resources.
For example, war has played an enormous rolehistorically in allocating resources.
Theft, taking property of others without their consent,also plays a large role.
But force provides an effective way of allocatingresourcesfor the state to transfer wealth from the richto the poor and establish the legal framework in which
voluntary exchange can take place in markets.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Using Resources Efficiently
Allocative efficiency is a situation in which the quantities of goodsand services produced are those that people value most highly.
It is not possible to produce more of one good or service without
producing less of something else.
Efficiency and the PPF
Production efficiencyproducing on PPF
Producing at the highest-valued point on PPF
The PPFtells us what can be produced, but the PPFdoes nottell usabout the value of what we produce.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Marginal Benefit
Marginal benefitis the benefit that a person receives
from consuming one more unit of a good or service.
Peoplespreferences determine marginal benefit.
The marginal benefit from a good is what people are
willing to forgo to get one more unit of the good.
Marginal benefit decreases as the quantity of the good
increasestheprinciple of decreasing marginal benefit.
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PossibilityA and pointA tell us that if we
produce 2,000 pizzasa day,
people are willing togive up 15 units ofother goods andservices up to get onemore pizza.
6.1 ALLOCATION METHODS AND EFFICIENCY
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Point B tells us that ifwe produce 4,000
pizzas a day,
people are willing togive up 10 units ofother goods andservices to get onemore pizza.
6.1 ALLOCATION METHODS AND EFFICIENCY
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Point Ctells us that ifwe produce 6,000pizzas a day,
people are willing togive up 5 units of othergoods and services to
get one more pizza.
The line through pointsA, B, and Cis themarginal benefit curve.
6.1 ALLOCATION METHODS AND EFFICIENCY
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6.1 ALLOCATION METHODS AND EFFICIENCY
Marginal Cost
Marginal costis the opportunity cost of producing one
more unit of a good or service and is measured by the
slope of the PPF.
The marginal cost of producing a good increases as
more of the good is produced.
The marginal cost curve shows the amount of othergoods and services that we must give up to produce
one more pizza.
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PossibilityA and pointA tell us that if we
produce 2,000 pizzasa day,
we must give up 5units of other goods
and services toproduce one morepizza.
6.1 ALLOCATION METHODS AND EFFICIENCY
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6.1 ALLOCATION METHODS AND EFFICIENCY
Point B tells us that ifwe produce 4,000
pizzas a day,
we must give up 10units of other goodsand services to
produce one morepizza.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Point Ctells us that ifwe produce 6,000pizzas a day,
we must give up 15units of other goods andservices to produce onemore pizza.
The line through pointsA, B, and Cis themarginal cost curve.
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6.1 ALLOCATION METHODS AND EFFICIENCY
Efficient Allocation
The efficient allocation is the highest-valued allocation.
That is, the allocation is efficient if it is not possible toproduce more of any good without producing less of
something else that is valued more highly.
To find the efficient allocation, we compare marginal
benefit and marginal cost.
Figure 6.3 on the next slide shows the efficient quantity
of pizzas.
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Production efficiency occurs atall points on the PPF.
Allocative efficiency occurs atthe intersection of the marginalbenefit curve (MB) and themarginal cost curve (MC).
6.1 ALLOCATION METHODS AND EFFICIENCY
Allocative efficiency occurs atonly one pointon the PPF.
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1. When 2,000 pizzas areproduced, marginal benefitexceeds marginal cost,
so the efficient quantity islarger.
Too few pizzas are being
produced.
Increase the quantity ofpizzas by moving along thePPF.
6.1 ALLOCATION METHODS AND EFFICIENCY
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6.1 ALLOCATION METHODS AND EFFICIENCY
2. When 6,000 pizzas areproduced, marginal costexceeds marginal benefit,
so the efficient quantity issmaller.
Too many pizzas are being
produced.
Decrease the quantity ofpizzas by moving along thePPF.
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6.2 VALUE, PRICE, AND CONSUMER SURPLUS
Demand and Marginal Benefit
Buyers distinguish between value andprice.
Value is what the buyer gets. Price is what the buyer pays.
The value of one more unit of a good or service is its
marginal benefit.
Marginal benefit can be measured as the maximum
price that people are willing to pay for another unit of
the good or service.
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6.2 VALUE, PRICE, AND CONSUMER SURPLUS
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.
A demand curve is a marginal benefit curve.
For example, the demand curve for pizzas tells us the
dollars worth of other goods and services that people
are willing to forgo to consume one more pizza.That is, the demand curve for pizzas shows the value
the consumer places on each pizza.
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6.2 VALUE, PRICE, AND CONSUMER SURPLUS
The demand curve shows:
1. The quantity demanded ateach price, other thingsremaining the same.
Figure 6.4 shows demand,willingness to pay, andmarginal benefit.
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6.2 VALUE, PRICE, AND CONSUMER SURPLUS
The demand curve shows:
2. The maximum price willinglypaid for the last pizzaavailable.
Figure 6.4 shows demand,willingness to pay, andmarginal benefit.
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6.2 VALUE, PRICE, AND CONSUMER SURPLUS
Consumer Surplus
Consumer surplusis the marginal benefit from a
good or service minus the price paid for it, summedover the quantity consumed.
Figure 6.5 on the next slide shows the consumer
surplus from pizzas.
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6.2 VALUE, PRICE, AND CONSUMER SURPLUS
1. The market price of apizza is $10.
2.People buy 10,000
pizzas and spend$100,000 a day on pizzas.
3. But people are willing to
pay $15 for the 5,000th
pizza, so consumersurplus from that pizza is$5.
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6.2 VALUE, PRICE, AND CONSUMER SURPLUS
4. Consumer surplus fromthe 10,000 pizzas thatpeople buy is the area of
the green triangle.Consumer surplus frompizzas is $50,000.
The total benefit from
pizzas is $150,000the$100,000 that peoplespend on pizzas plus the$50,000 of consumersurplus.
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6.3 COST, PRICE, AND PRODUCER SURPLUS
Supply and Marginal Cost
Sellers distinguish between costandprice.
Cost is what a seller must give up to produce thegood.
Price is what a seller receives when the good issold.
The cost of producing one more unit of a good orservice is its marginal cost.
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6.3 COST, PRICE, AND PRODUCER SURPLUS
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.
A supply curve is a marginal cost curve.
For example, the supply curve of pizzas tells us the
dollars worth of other goods and services that firms
must forgo to produce one more pizza.That is, the supply curve of pizzas shows the sellers
cost of producing each unit of pizza.
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6.3 COST, PRICE, AND PRODUCER SURPLUS
The supply curve shows:
1. The quantity supplied ateach price, other thingsremaining the same.
Figure 6.6 shows supply,minimum supply price, andmarginal cost.
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6.3 COST, PRICE, AND PRODUCER SURPLUS
The supply curve shows:
2. The minimum price thatfirms must be offered tosupply a given quantity of
pizzas.
1. The quantity supplied ateach price, other thingsremaining the same.
Figure 6.6 shows supply,minimum supply price, andmarginal cost.
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6.3 COST, PRICE, AND PRODUCER SURPLUS
Producer Surplus
Producer surplusis the price of a good minus the
opportunity cost of producing it, summed over thequantity produced.
Figure 6.7 shows the producer surplus for pizza
producers.
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6.3 COST, PRICE, AND PRODUCER SURPLUS
1. The market price of apizza is $10.
At that price producers
plan to sell 10,000 pizzas.
2. The marginal cost ofproducing the 5,000th pizzais $6,
so the producer surplus onthe 5,000th pizza is $4.
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6.3 COST, PRICE, AND PRODUCER SURPLUS
3. Producer surplus from the10,000 pizzas sold is$40,000 a daythe area of
the blue triangle.
4. The cost of 10,000 pizzasis $60,000 a daythered area under the
marginal cost curve.The cost equals totalrevenue of $100,000minus the producer
surplus of $40,000.
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6.4 ARE MARKETS EFFICIENT?
5.Consumer surplus plus
6. Producer surplus is
maximized.
3. Marginal benefit curve.
4. When marginal cost
equals marginal benefit,quantity is efficient.
2. Marginal cost curve.
Figure 6.8 shows anefficient pizza market
1. Market equilibrium.
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6.4 ARE MARKETS EFFICIENT?
In a competitive market:
The demand curve shows buyers marginal benefit.
The supply curve shows the sellers marginal cost.
So at the equilibrium in a competitive market, marginal
benefit equals marginal cost.
Resources allocation is efficient.
So the competitive market delivers the efficient quantity.
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6.4 ARE MARKETS EFFICIENT?
Total Surplus Is Maximized
Total surplusis the sum of consumer surplus and
producer surplus.The competitive equilibrium maximizes total surplus.
Buyers seek the lowest possible price and sellers seek
the highest possible price.
But as buyers and sellers pursue their self-interest, the
social interest is served.
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6.4 ARE MARKETS EFFICIENT?
The Invisible Hand
Adam Smith in the Wealth of Nations (1776) suggested
that competitive markets send resources to the uses inwhich they have the highest value.
Smith believed that each participant in a competitive
market is led by an invisible hand to promote an end
which was no part of his intention.
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6.4 ARE MARKETS EFFICIENT?
Market Failure
Market failure is a situation in which the marketdelivers an inefficient outcome.
Inefficiency can occur because:
Too little is producedunderproduction.
Too much is producedoverproduction.
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6.4 ARE MARKETS EFFICIENT?
Underproduction
When a firm cuts production to less than the efficient
quantity, a deadweight loss is created.
Deadweight lossis the decrease in total surplus and
that results from an inefficient underproduction or
overproduction.
The deadweight loss is borne by the entire society. It is
a social loss.
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Efficient quantity is 10,000
pizzas.If production is 5,000 pizzas a
day:
Figure 6.9(a) shows theeffects of underproduction.
Total surplus is reduced by theamount of the deadweight loss.
Deadweight loss arises.
6.4 ARE MARKETS EFFICIENT?
Underproduction is inefficient.
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6.4 ARE MARKETS EFFICIENT?
Overproduction
When the government pays producers a subsidy, the
quantity produced exceeds the efficient quantity.
A deadweight loss arises than reduces total surplus to
less than its maximum.
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6.4 ARE MARKETS EFFICIENT?
If production is 15,000 pizzas:
Figure 6.9(b) shows theeffects of overproduction.
Efficient quantity is 10,000
pizzas.
A deadweight loss arises.
Total surplus is reduced by the
amount of the deadweightloss.
Overproduction is inefficient.
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6.4 ARE MARKETS EFFICIENT?
Sources of Market Failure
Markets generally do a good job of sending resources
to where they are most highly valued.
But obstacles to efficient that bring market failure are:
Price and quantity regulations
Taxes and subsidies
Externalities Public goods and common resources
Monopoly
High transactions costs
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6.4 ARE MARKETS EFFICIENT?
Price and Quantity Regulations
Price regulations sometimes put a block on the price
adjustments and lead to underproduction.
Quantity regulations that limit the amount that a farm is
permitted to produce also leads to underproduction.
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6.4 ARE MARKETS EFFICIENT?
Taxes and Subsidies
Taxes increase the prices paid by buyers and lower theprices received by sellers.
So taxes decrease the quantity produced and lead tounderproduction.
Subsidies lower the prices paid by buyers and increasethe prices received by sellers.
So subsidies increase the quantity produced and lead tooverproduction.
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6.4 ARE MARKETS EFFICIENT?
Externalities
An externalityis a cost or benefit that affects someone
other than the seller or the buyer of a good.
An electric utility creates an external costby burning
coal that creates acid rain.
The utility doesnt consider this cost when it chooses the
quantity of power to produce. Overproduction results.
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6.4 ARE MARKETS EFFICIENT?
An apartment owner would provide an externalbenefitif
she installed an smoke detector. But she doesnt
consider her neighbors marginal benefit and decides
not to install the smoke detector.
The result is underproduction.
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6.4 ARE MARKETS EFFICIENT?
Public Goods and Common Resources
Apublic goodbenefits everyone and no one can be
excluded from its benefits.
It is in everyones self-interest to avoid paying for a
public good (called the free-rider problem), which leads
to underproduction.
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6.4 ARE MARKETS EFFICIENT?
A common resource is owned by no one but used by
everyone.
It is in everyones self interest to ignore the costs of
their own use of a common resource that fall on others
(called tragedy of the commons), which leads to
overproduction.
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6.4 ARE MARKETS EFFICIENT?
Monopoly
A monopolyis a firm that is sole provider of a good or
service.
The self-interest of a monopoly is to maximize its profit.
To do so, a monopoly sets a price to achieve its self-
interested goal.
As a result, a monopoly produces too little andunderproduction results.
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6.4 ARE MARKETS EFFICIENT?
High Transactions Costs
Transactions costsare the opportunity costs ofmaking trades in a market.
To use market prices as the allocators of scarceresources, it must be worth bearing the opportunity costof establishing a market.
Some markets are just too costly to operate.When transactions costs are high, the market mightunderproduce.
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6.4 ARE MARKETS EFFICIENT?
Alternatives to the Market
No one method allocates resources efficiently. But
supplemented by other methods, markets do an
amazingly good job.
Table 6.1 on the next slide shows some possible
remedies for market inefficiencies.
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6.4 ARE MARKETS EFFICIENT?
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6.5 ARE MARKETS FAIR?
Two broad and generally conflicting views of fairness
are:
Its not fair if the rules arent fair
Its not fair if the resultisnt fair.
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6.5 ARE MARKETS FAIR?
Its Not Fair if the RulesArent Fair
This idea translates into equality of opportunity.
Harvard philosopher, Robert Nozick, inAnarchy, State,and Utopia (1974), argues that the rules must be fair
and must respect two principles:
The state must enforce laws that establish and
protect private property.
Private property may be transferred from oneperson to another only by voluntary exchange.
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6.5 ARE MARKETS FAIR?
Its Not Fair if the Resul tIsnt Fair
The fair rules approach is consistent with allocative
efficiency, but the distribution might be too unequal.
Most people recognize that there is no easy answer or
principle to guide the amount of equality.
The fair results approach conflicts with efficiency and
leads to what is called the big tradeoff.
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6.5 ARE MARKETS FAIR?
The big tradeoffis a tradeoff between efficiency and
fairness that recognizes the cost of making income
transfers.
The tradeoff is between the size of the economic pie
and the degree of equality with which it is shared.
The greater the amount of income redistribution through
income taxes, the greater is the inefficiency thesmaller is the economic pie.
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6.5 ARE MARKETS FAIR?
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.
The fair results ideas require a change in the resultsafter the game is over. Some say that this in itself is
unfair.
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Should Price Gouging Be Illegal?
The figure illustrates themarket for camp stoves.
The supply of stoves is thecurve S, and in normaltimes, the demand forstoves is D0.
The price is $20 per stove
and the equilibrium quantityis 5 stoves per day.
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Should Price Gouging Be Illegal?
Following a hurricane, thedemand for camp stovesincreases to D1.
With no price gouging law, theprice jumps to $40 and thequantity increases to 7 stovesper day.
This outcome is efficientbecause the marginal cost ofa stove equals the marginalbenefit from a stove.
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Should Price Gouging Be Illegal?
If a strict price gouging lawrequired the price after thehurricane to be $20 a stove,...
Then the quantity of stovessupplied would remain at 5per day.
A deadweight loss shown bythe gray triangle arises.
The price gouging law isinefficient, but is it fair?