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5 EFFICIENCY AND EQUITY

C H A P T E R 6C h a p t e r K e y I d e a s

Self-Interest and the Social InterestA. Every purchase made by a consumer is an expression of that

consumer’s values over what should be produced with our scarce resources. Consumers make these decisions out of self-interest, trying to make themselves the happiest they can with the limited resources they have. Do these choices necessarily promote the social interest—that is, what is best for society?

B. The market economy generates high incomes for some and low incomes for others. What is a fair distribution of goods and services across society?

C. This chapter explains how economists approach questions about the social interest as well as the conditions under which competitive markets can yield efficient outcomes, and it describes the sources of inefficiency and explores different concepts of fairness.

O u t l i n eI. Efficiency and the Social Interest

A. Recall from Chapter Two that an efficient allocation of resources occurs when we cannot produce more of one good without giving up the production of some other good that is valued more highly.1. This definition implies that it is not possible to make someone

better off without making someone worse off. Efficiency is based on values, which are determined by people’s

preferences.B. Marginal benefit is the benefit a person receives from consuming

one more unit of a good or service.1. We can measure the marginal benefit from a good by the dollar

value of other goods that a person is willing to give up to get one more unit.

2. The concept of decreasing marginal benefit implies that as more of a good is consumed, its marginal benefit decreases.

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3. Figure 5.1 shows the decreasing marginal benefit from each additional slice of pizza, measured in dollars per slice.

C. Marginal cost is the opportunity cost of producing one more unit of a good. The measure of marginal cost is the value of the best alternative forgone to obtain the last unit of the good.1. We can measure the

marginal cost of a good or service by the dollar value of other goods and services that a person is must give up to get one more unit of it.

2. The concept of increasing marginal cost implies that as more of a good or service is produced, its marginal cost increases.

3. Figure 5.1 also shows the increasing marginal cost of each additional slice of pizza, measured in dollars per slice.

D. Efficiency and Inefficiency1. If the marginal benefit from a good exceeds its marginal cost,

producing and consuming one more unit of the good uses resources more efficiently.

2. If the marginal cost of a good exceeds its marginal benefit, producing and consuming one less unit of the good uses resources more efficiently.

3. If the marginal benefit from a good equals its marginal cost, producing and consuming one more unit of the good or one less unit of the good uses resources less efficiently.

4. When marginal benefit equals marginal cost, we cannot improve on this allocation of resources. It is efficient. In Figure 5.1, the efficient quantity of pizza is 10,000 pizzas per day.

II. Value, Price, and Consumer SurplusA. The value of one more unit of a good or service is its marginal benefit,

which we can measure as maximum price that a person is willing to pay.1. A demand curve for a good or service shows the quantity

demanded at each price. A demand curve also shows the maximum price that consumers are willing to pay at each quantity.

2. Figure 5.2 shows two ways of interpreting a demand curve.

3. Because a demand curve shows the maximum price that consumers are willing to pay for the last unit of the good at each quantity available, a demand curve is a marginal benefit curve.

B. Consumer surplus is the value of a good minus the price paid for it, summed over the quantity bought.1. The price paid is the market price, which is the same for each unit

bought. The quantity bought is determined by the demand curve.2. Consumer surplus is measured by the area under the demand curve

and above the price paid, up to the quantity bought.

3. Figure 5.3 shows the consumer surplus for pizza for an individual consumer.

III. Cost, Price, and Producer SurplusA. The cost of one more unit of a

good or service is its marginal cost, which we can measure as minimum price that a firm is willing to accept.1. A supply curve of a good or

service shows the quantity supplied at each price. A supply curve also shows the minimum price that producers are willing to accept at each quantity.

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2. Figure 5.4 shows two ways of interpreting a supply curve.

3. Because a supply curve shows the minimum price that producers are willing to accept for the last unit of the good at each quantity available, a supply curve is a marginal cost curve.

B. Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity sold.1. The price of a good is its market

price, which is the same for each unit sold.

2. The quantity sold is determined by the supply curve.

3. Producer surplus is measured by the area below the price and above the supply curve, up to the quantity sold.

4. Figure 5.5 shows the producer surplus for pizza for an individual producer.

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IV. The Efficiency of a Market EquilibriumA. Figure 5.6 shows that a

competitive market creates an efficient allocation of resources at equilibrium.1. The demand curve can be

thought of as the marginal benefit curve for society, and the supply curve as the marginal cost curve for society.

2. In equilibrium, the quantity demanded equals the quantity supplied, which means the marginal benefit to society of the last unit consumed equals the marginal cost to society of making the last unit available for consumption.

3. The sum of consumer and producer surplus is maximized at this efficient level of output. No other quantity bought and sold will produce as much consumer or producer surplus.

B. Adam Smith’s Invisible Hand idea in his book Wealth of Nations implied that competitive markets motivate consumers and producers to send resources to their highest valued use in society.1. Consumers and producers make decisions in their own self-interest

when they interact in markets.2. These market transactions can generate an efficient allocation of

resources allocated to their highest-valued use in society.C. Markets are not always efficient. Some obstacles to efficiency

include: 1. Price ceilings and floors: Artificial constraints on price.2. Taxes, subsidies, and quotas: Place a wedge between price received

by sellers and price offered by sellers.3. Monopoly: A lack of competitive pressure places a wedge between

marginal cost and selling price.

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4. Public goods and Common Resources: Marginal benefits (costs) no longer equal social marginal benefits (costs)

5. External costs and external benefits: The full benefits (costs) do not accrue to the consumer (producer)


D. Underproduction and Overproduction1. Obstacles to efficiency lead

to underproduction or overproduction and create a deadweight loss—a decrease in consumer and producer surplus.

2. Figure 5.7 shows the dead weight loss from underproduction and overproduction.

V. Is the Competitive Market Fair?A. Economists agree about

efficiency, but disagree about equity. To help understand why, Ideas about fairness can be divided into two groups:1. It’s not fair if the result isn’t

fair2. It’s not fair if the rules aren’t

fairB. It’s Not Fair if the Result Isn’t Fair

1. The idea that “it’s not fair if the result isn’t fair” began with utilitarianism, which is the principle that states that we should strive to achieve “the greatest happiness for the greatest number.”

2. If everyone gets the same marginal utility from a given amount of income, and if the marginal benefit of income decreases as income increases, taking a dollar from a richer person and given it to a poorer person increases the total benefit. In this way, only when income is equally distributed has the greatest happiness been achieved.

3. Utilitarianism ignores the cost of making income transfers. Recognizing these costs leads to the big tradeoff between efficiency and fairness.

4. Because of the big tradeoff, John Rawls proposed that income should be redistributed to point at which the poorest person is as well off as possible.

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C. It’s Not Fair If the Rules Aren’t Fair1. The idea that “it’s not fair if the rules aren’t fair” is based on the

symmetry principle, which is the requirement that people in similar situations be treated similarly.

2. In economics, this principle means equality of opportunity, not equality of income. Robert Nozick suggested that fairness is based on two rules:a) The state must create and enforce laws that establish and

protect private property.b) Private property may be transferred from one person to another

only by voluntary exchange.

R e a d i n g B e t w e e n t h e L i n e sA news article discusses inefficiency in water use. The analysis points out that in some places, such as Ethiopia, less than the efficient quantity of water is used from the Nile whereas in other places, such as Egypt, more than the efficient quantity of water is used from the Nile. In both circumstances, a deadweight loss results.

N e w i n t h e S e v e n t h E d i t i o nThe discussion of how consumer choices made in self-interest influence the social interest is expanded.

Te a c h i n g S u g g e s t i o n s1. Efficiency: A RefresherThe substance of this section is identical to Chapter 2, pp. 35–37. Explain that this section in Chapter 5 provides an alternative example of the same ideas as those in Chapter 2 and serves as a springboard for going forward and seeing the connection between what they’ve learned about demand, supply, market price, and quantity in Chapter 3 and what they learned about efficiency in Chapter 2. Emphasize that learning economics isn’t memorizing facts, but understanding principles and ideas, and that one idea builds on another. 2. Value, Price, and Consumer SurplusOne thing that students sometimes get hung up on is the exact shape of the consumer surplus area—steps versus the complete triangle. The point isn’t worth laboring, but if students raise the matter and are curious, you might explain that we’re assuming that the good (pizza in the example) is finely divisible so that the whole triangle is (approximately) the consumer surplus. (Note: You will look at consumer surplus again if you cover marginal utility theory.)3. Cost, Price, and Producer Surplus


A similar issue about the shapes of the areas arises here too. You might want to emphasize that the total revenue of the producer is the rectangle whose corners are (0, 0) and (P, Q). This total revenue divides into cost and producer surplus and the supply curve (the marginal cost curve) marks the boundary for the division.The issue is not likely to arise at this point in the course, but you might like to keep this up your sleeve for later when explaining the relationship between producer surplus and economic profit. The textbook doesn’t spend any time on this relationship because for most students, it is too esoteric. But a few thoughtful students want to know. You can explain that producer surplus equals total revenue minus total variable cost; economic profit equals total revenue minus total cost; so producer surplus equals economic profit plus total fixed cost. Don’t try to explain this point now. Wait until you get a question when you’re in Chapter 9, 10, 11, or 12.4. The Efficiency of the Competitive Marketa) The Astonishing Market Machine: Although done just with words and a graph, this section explains the so-called “first fundamental theorem of welfare economics” that under appropriate conditions, competitive equilibrium is Pareto efficient (what this textbook calls an efficient allocation). You might want to provide your students with more background to this astonishing result. It begins with Adam Smith’s invisible hand conjecture. Some progress was made by Vilfredo Pareto (1848–1923), an Italian economist (see http://cepa.newschool.edu/het/profiles/pareto.htm), who defined an efficient allocation as one in which it is not possible to rearrange the use of resources an make someone better off without making someone else worse off. But Adam Smith’s conjecture did not receive formal proof until the 1950s. John Hick, Kenneth Arrow, and Gerard Debreu are credited with the major contributions to welfare economics and received the Nobel Prize in Economic Sciences for their work (see http://www.nobel.se/economics/laureates/1972/index.html, http://www.nobel.se/economics/laureates/1983/index.html). Lionel McKenzie (University of Rochester) is also credited with a major independent statement of the theorem and some economists refer to it as the Arrow-Debreu-McKenzie theorem. The A-D-M proof is deeper and more restricted that the arm waving words and diagrams of a principles text. But we do not mislead our students by being enthusiastic and amazed at the astonishing proposition. Selfish people all pursuing their own ends and making themselves as well off as possible end up allocating resources in such a way that no one can be made better off (qualified by the exceptions that we quickly note in the chapter.)b) Don’t get too hung up on the mechanics of how the obstacles to efficiency work. Just note at this stage that they bring either underproduction or overproduction and emphasize the deadweight loss that they generate. You will go into the details in later chapters. The list is guide to what is coming.In the overproduction case, you might like to bring the PPF back into the story and point out that the overproduction of one good means the underproduction of some other good. If you’re brave, you might want to explain that in the two-

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goods world of the PPF, you get the complete efficiency analysis by looking at only one of the markets. If you use guns and butter again, the overproduction of guns implies the underproduction of butter. You can measure the deadweight loss in either the market for guns (overproduction like Figure 5.7b) or in the market for butter (underproduction like Figure 5.7a). Make this extension only with bright students in an honors section.5. Is the Competitive Market “Fair”?You could spend the rest of the course talking about and discussing equity, fairness, or distributive justice as it is sometimes called.This material is not standard and you’ll be hard pressed to find it in any other principles text. It is included here because students are very curious about just what is “fair.” And the news media writes and talks of little else when it discusses economic issues.Some years ago, Jim Tobin told Michael Parkin a nice test of whether a person is a liberal or a conservative. It also generates a good classroom discussion. Here’s how it goes. Give the students the following scenario and question: You are at an oasis in a large desert and you have some ice cream in an unmovable refrigerator. (Ice cream is the only food available). The people in the next oasis some miles away have no ice cream (and no other food) and are too old and infirm to travel. You have plenty of ice cream and you can transport it to the next oasis, but on the journey, some of it will melt. Now the question: How much of the ice cream would have to survive the journey for it to be worth transporting to the next oasis?Your students will not agree. The most liberal would transport if only the smallest percentage survived the journey. The most conservative would want a large proportion to survive before undertaking the redistribution.You can point out that different people choose different points on the big tradeoff.

T h e B i g P i c t u r eWhere we have been

This chapter develops a more concise discussion of efficiency introduced in Chapter 2, and develops a deeper understanding of how the demand and supply model introduced in Chapter 3 influences resource allocations in an economy. It also explains the situations in which a competitive market does and does not allocate resources efficiently.

Where we are goingChapter 6 applies the concepts of efficiency and deadweight loss to market regulation policies such as rent ceilings and minimum wage laws. Students should understand these concepts well to appreciate applying demand and supply to important markets in our economic world. The concepts of efficiency and deadweight loss also recur in Chapters 11 and 12, which examine perfect competition and monopoly, and in Chapters 14, 15, and


16, which cover more complex government regulatory policies, social issues, public goods, and externalities.

O v e r h e a d Tr a n s p a r e n c i e sTransparency Text figure Transparency title

26 Figure 5.1 The Efficient Quantity of Pizza27 Figure 5.3 A Consumer’s Demand and Consumer

Surplus28 Figure 5.5 A Producer’s Supply and Producer Surplus29 Figure 5.6 An Efficient Market for Pizza30 Figure 5.7 Underproduction and Overproduction

E l e c t r o n i c S u p p l e m e n t sMyEconLabMyEconLab provides pre- and post-tests for each chapter so that students can assess their own progress. Results on these tests feed an individualized study plan that helps students focus their attention in the areas where they most need help. Instructors can create and assign tests, quizzes, or graded homework assignments that incorporate graphing questions. Questions are automatically graded and results are tracked using an online grade book.

PowerPoint Lecture NotesPowerPoint Electronic Lecture Notes with speaking notes are available and offer a full summary of the chapter.PowerPoint Electronic Lecture Notes for students are available in MyEconLab.

Instructor CD-ROM with Computerized Test BanksThis CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor’s Manual files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator Software.

A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s1. After the “Perfect Storm”: Do price controls help or hurt disaster

victims? The author introduces the compelling dilemma of whether price controls should be imposed following a natural disaster. Engage the students in a careful discussion on this theme, as it opens their eyes to the

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complexities involved with trying to improve upon the competitive market allocation of scarce resources, even under times of economic duress.Should “price gouging” and “profiteering” be considered criminal acts? Price controls are often imposed for weeks after the devastating event occurs. Goods such as bottled drinking water, bags of ice, batteries, electrical generators, plywood sheets (to seal broken windows), and chain saws (to remove downed trees from roadways) are typical objects for which sellers are not allowed to raise their sale price above pre-disaster levels. Ask students to critically examine the claim that such price restrictions protect the interests of disaster victims who are trying to get their lives back to normal as quickly as possible. What happens to the demand curve for these goods? Ask the students to use the supply and demand model to reflect changes in the market for these goods immediately after the disaster has struck. Clearly the radical change in the local environment causes a rightward shift in the demand curve, sharply raising equilibrium market price. A price ceiling results in a heart-wrenching shortage. What happens to the supply curve for these goods? Emphasize that the devastation that creates trauma for the consumers also significantly increases the cost of replacing the goods sold in a timely fashion. Replacement of these items needs to be rather quick if the victims want to minimize any future damage to the community (continued water damage from damaged homes, illnesses from contaminated drinking water supplies, etc.). The increase in the opportunity cost of supplying these goods pushes the supply curve to the left, aggravating the shortage. Motivate the students to consider how the goods will ultimately be distributed.Distribution under price regulation: There is much pain, but is there any gain (in efficiency or in fairness)? Point out to students that in an unregulated market, only those victims who value the goods at least as much as the unregulated equilibrium price would receive the scarce goods. Under price controls, it is uncertain how the goods will be allocated. Consumers with relatively low valuation of the goods are just as likely end up with the goods as those who have a relatively high valuation, decreasing total consumer surplus. Also, point out that if private resale prices are not closely monitored, then those victims with a relatively low value for their goods would engage in arbitrage by selling the goods at a high price to victims with a relatively high valuation for the goods. This simply transfers producer surplus from sellers to low valuation consumers, the fairness of which would be difficult to justify. Can price regulation contribute to undesirable seller behavior? Since the price control action erases the opportunity cost that suppliers would normally face if they fail to sell their scarce goods to the highest bidder, these sellers may consider any number of non-monetary benefits when they determine who will ultimately receive their goods: Friends and well-networked acquaintances of the suppliers will likely receive consideration over strangers who would otherwise be willing to pay a higher price. Emphasize that a price ceiling effectively erases any opportunity cost that suppliers would otherwise bear for engaging in


socially undesirable actions, such as practicing racial, gender, or religious discrimination when selling their goods.Can price regulation actually prolong victims’ suffering? Point out that for suppliers to quickly replace their depleted inventory they must be willing to bid away the goods from other areas not devastated by the disaster. Also, special deliveries of these goods to the disaster area must be arranged, meaning transportation resources must also be bid away from their usual employment. Both realities increase the cost of inventory replacement. Under a price ceiling there is insufficient incentive for goods to be quickly redistributed to where they are needed the most.

2. The big tradeoff: How can economic analysis makes us more informed citizen voters? How to properly address the big tradeoff in society is the heart of current debates over proposed changes to the federal income tax code between candidates (and their political party platforms) running for federal offices. • Should tax rates be decreased in order to spur greater

economic activity and increase total production of goods and services in the economy? Get the students to identify and describe the opportunity cost of this proposal. Would income inequality increase? Would the “social fabric” change?

• Should the tax rates be increased to fund greater government services and income redistribution programs? This chapter has shown that the economic pie would decrease if income were redistributed. How much decrease in economic activity is worth the greater equality? Greater knowledge of economic analysis lets people weigh these opportunity costs more carefully and thoughtfully.

3. Does the concept of decreasing marginal benefits actually imply that rich people will lose fewer benefits from an income transfer than the gain in benefits to the poor? Emphasize to the students that many social policies (both private and public) that favor the poor at the expense of the rich are justified on utilitarian grounds. Marginal income tax rates that rise with income is one obvious example. A business discount for seniors (who are presumed to be poorer than the general population) is another example. Yet the students should understand that the ability to make a direct comparison of benefits lost for one person against the benefits gained by another is not implied by the concept of diminishing marginal benefits. Explain to them that the assumption of decreasing marginal benefits allows us to compare the marginal benefits across different levels of consumption for the same person, but it says nothing about comparing the marginal benefits across different people at different consumption levels. To clarify this, ask them the following question:Can we truly measure and compare the happiness from a rich person’s consumption level to a poor person’s consumption level for the same good? Have the students assume that the quantity of income taken away from a rich mother means that she is now able to send only one, rather than both, of her children to college. Assume also that the same quantity of income given to a poor mother enables her to send one of her two children to college when she otherwise couldn’t have afforded to send

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either child to college. Ask the students, “Does this imply that the happiness, or perceived value, lost by the rich mother is somehow smaller than the happiness, or perceived value gained by the poor mother?” Ask the students if anyone can honestly claim to know that one mother’s concern about providing for her second child is smaller in magnitude than another mothers’ concern about providing for her first child. Obviously not! Explain that if this claim is false for this example, then it is false for all examples comparing benefit gains and losses across people at different levels of in income.


A n s w e r s t o t h e R e v i e w Q u i z z e sPage 103

1. If the marginal benefit of pizza exceeds the marginal cost of pizza, we are producing too little pizza and too much of other goods. The marginal benefit reveals how much other things people are willing to give up for the last unit of pizza consumed, while the marginal cost reveals what people must give up in order to produce it. This means if more resources were devoted to producing one more unit of pizza, the benefits that unit of pizza will generate will be higher than the lost benefits of the next best alternative good that could have been produced by those resources. The result will be a net increase in benefits for society.

2. If the marginal cost of pizza exceeds the marginal benefit of pizza, we are producing too much pizza and too much of some other good. The marginal benefit reveals what people are willing to give up for the last unit of pizza consumed, while the marginal cost reveals what people must give up in order to produce it. This means the resources that were used to produce the last unit of pizza could have been used to make one more unit of the highest valued alternative good. The lost benefits of that last unit of pizza forgone will be less than the additional benefits provided by consuming the additional unit of the alternative good. The result will be a net increase in benefits for society.

3. The marginal benefit of pizza and the marginal cost of pizza are equal when we are producing the efficient quantity of pizza. At this level of pizza, changing the quantity produced cannot increase net benefits to society. If one less unit of pizza is produced, the marginal benefit of the previous unit would be relatively higher (due to decreasing marginal benefits) and the marginal cost of that unit would be relatively lower (due to increasing marginal cost). In this case, the marginal benefit of consuming last unit of pizza would exceed the marginal cost of producing it, which means that society could enjoy a net increase in benefits by producing one more unit of pizza. On the other hand, if one more unit of pizza is produced, the marginal benefit of that unit would be relatively lower and the marginal cost of that unit would be relatively higher. In this case, the marginal cost of producing the last unit of pizza would exceed the marginal benefit of consuming it, which means that society could enjoy a net increase in benefits by producing one less unit of pizza.

Page 1051. The value, or marginal benefit, of a good or service is measured by the

maximum amount that consumers are willing to pay for one more unit of a good or service.

2. The demand curve for a good shows the quantity demanded by consumers at each price. The demand curve is the same as the marginal benefit curve because the demand curve shows the maximum price consumers are willing to pay for the last unit of the good purchased at each quantity.

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3. Consumer surplus is the marginal benefit of a good minus the sale price paid, summed over the quantity of the good purchased. The sale price per unit of a good is assumed to equal for all units of the good purchased. The quantity purchased is determined by equating the marginal benefit the sale price paid. This means that the consumer surplus can be measured as the area under the demand curve and above the sale price paid, summed over the entire quantity purchased.

Page 1071. The minimum supply price for a producer of a good or service is the

marginal cost of producing that unit of the good or service. The producer must receive a price that at least meets that cost in order to produce the good or service.

2. The supply curve for a good shows the quantity provided by producers at each price. The supply curve is the same as the marginal cost curve because the supply curve shows the minimum price producers are willing to receive for the last unit of the good produced at each quantity.

3. Producer surplus is the sale price received for each unit of a good minus the cost of producing it, summed over all units produced. The sale price per unit of a good is assumed to be the same for all units of the good sold. The quantity purchased is that quantity where the marginal cost is equal to the sale price received. This means that the producer surplus can be measured as the area under the sale price and above the supply curve, summed over the entire quantity sold.

Page 1111. In the absence of the obstacles mentioned earlier in the chapter,

competitive markets use society’s resources efficiently. For resources to be used efficiently they must be allocated to produce the quantity of a good or service where the marginal cost of the last unit produced in the market is equal to the marginal benefit. This condition will be met in a competitive market because equilibrium quantity occurs where the demand curve (which equals the marginal benefit curve) intersects the supply curve (which equals the marginal cost curve).

2. Markets with price ceilings or floors, taxes, subsidies, quotas, monopoly power, public goods or externalities will not produce the efficient quantity of a good or service. In each of these situations, the market prices charged or quantities produced and sold will not result in the efficient allocation of resources. Efficiency requires that the marginal benefit of the last unit produced to be equal to the marginal cost, and the intersection of the demand and supply curves in the competitive market create that result. When the market sales price or quantity is pulled away from the normal market equilibrium, the marginal benefit of the last unit produced does not equal its marginal cost.

3. The deadweight loss is the disappearance of realized gains from production and exchange between producers and consumers. This is a net decrease in potential consumer and/or producer surplus relative to


the allocation of resources resulting from the normal market equilibrium price and quantity.

4. No, there is no deadweight loss in a competitive market when the quantity produced equals the equilibrium quantity and the resource allocation is efficient. At the competitive market equilibrium, the quantity demanded equals the quantity supplied, which implies the marginal benefit is equal to the marginal cost at that quantity. This quantity is the efficient quantity of the good since there is no other allocation of resources that can create any higher valued quantity of the good or service.

Page 1151. The two big approaches to thinking about fairness are:

“It’s not fair if the result isn’t fair,” or utilitarianism. “It’s not fair if the rules aren’t fair,” or equal economic opportunity.

2. The utilitarian idea of fairness implies that equality of incomes is necessary for the allocation of resources to be “fair.” There should be income transfers from the rich to the poor until equality is achieved, because the marginal benefit of the last dollar of income is the same for everybody. There are two problem with utilitarianism:

It ignores the cost of implementing the income transfers, which will decrease the total goods and services that the finite resources of society can produce. The size of the economic pie will be smaller.

It assumes that the existence of decreasing marginal benefits allows us to make inter-personal comparisons about value gained and lost at different levels of consumption of a good or service. While one can compare the marginal benefits from consuming different levels of a good or service for an individual, this is not the same as comparing the marginal benefits from consuming different levels of a good or service across individuals.

3. The big tradeoff is the tradeoff between equality and efficiency. Redistributing incomes changes the incentives facing producers and consumers. Taxing income decreases producer surplus and taxing purchases decreases consumer surplus. Producers produce less and consumers consume less, and total economic activity declines, such that the size of the economic pie decreases.

4. The fair rules idea of fairness is that of providing equality of opportunity is necessary for the allocation of resources to be “fair.” This is the economic application of the symmetry principle, that people in similar situations be treated similarly. Equality of opportunity can be achieved if two rules are obeyed:

The government must enforce laws that establish and protect rights to private property that are held by individuals in society, and

Private property may be transferred from one person to another only by voluntary exchange and without fraudulent representation.

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A n s w e r s t o t h e P r o b l e m s1. a. Equilibrium price is $1.00 a floppy disc, and the equilibrium quantity is

3 floppy discs a month.b. Consumers paid $3.

The amount paid equals quantity bought multiplied by the price paid. That is, the amount paid equals 3 floppy discs multiplied by $1.00 a disc.

c. The consumer surplus is $2.25.The consumer surplus is the area of the triangle under the demand curve above the market price. The market price is $1.00 a disc. The area of the triangle equals (2.50 1.00)/2 multiplied by 3, which is $2.25.

d. Producer surplus is $0.75.The producer surplus is the area of the triangle above the supply curve below the price. The price is $1.00 a disc. The area of the triangle equals (1.00 0.50)/2 multiplied by 3, which is $0.75.

e. The cost of producing the discs sold is $2.25.The cost of producing the discs is the amount received minus the producer surplus. The amount received is $1.00 a disc for 3 discs, which is $3.00. Producer surplus is $0.75, so the cost of producing the discs sold is $2.25.

f. The efficient quantity is 3 floppy discs a month.The efficient quantity is the quantity that makes the marginal benefit from the last disc equal to the marginal cost of producing the last disc. The demand curve shows the marginal benefit and the supply curve shows the marginal cost. Only if 3 floppy discs are produced is the quantity produced efficient.

2. a. Equilibrium price is $10.00 a CD, and the equilibrium quantity is 100 CDs a month.

b. Consumers paid $1,000.The amount paid equals quantity bought multiplied by the price paid. That is, the amount paid equals 100 CDs multiplied by $10 a CD, which equals $1,000.

c. Consumer surplus is $500.The consumer surplus is the area of the triangle under the demand curve above the market price. The market price is $10.00 a CD. The area of the triangle equals (20 10)/2 multiplied by100, which is $500.

d. Producer surplus is $250.The producer surplus is the area of the triangle above the supply curve below the market price. The market price is $10.00 a CD. The area of the triangle equals (10 5)/2 multiplied by 100, which is $250.

e. The cost of producing the CDs sold is $750.The cost of producing the CDs is the amount received minus the producer surplus. The amount received is $10 a CD for 100 CDs, which is $1,000. Producer surplus id $250, so the cost of producing the CDs sold is $750.

f. The efficient quantity is 100 CDs a month.


The efficient quantity is the quantity that makes the marginal benefit from CDs equal to the marginal cost of producing CDs. The demand curve shows the marginal benefit and the supply curve shows the marginal cost. Only if 100 CDs are produced is the quantity produced efficient.

3. a. The maximum price that consumers will pay is $3.The demand schedule shows the maximum price that consumers will pay for each sandwich. The maximum price that consumers will pay for the 250th sandwich is $3.

b. The minimum price that producers will accept is $5.The supply schedule shows the minimum price that producers will accept for each sandwich. The minimum price that produces will accept for the 250th sandwich is $5.

c. 250 sandwiches exceed the efficient quantity.The efficient quantity is such that marginal benefit from the last sandwich equals the marginal cost of producing it. The efficient quantity is the equilibrium quantity—200 sandwiches an hour.

d. Consumer surplus is $400.The equilibrium price is $4. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the triangle is (8 4)/2 multiplied by 200, which is $400.

e. Producer surplus is $400.The producer surplus is the area of the triangle above the supply curve below the price. The price is $4. The area of the triangle is (4 0)/2 multiplied by 200, which is $400.

f. The deadweight loss is $50.Deadweight loss is the sum of the consumer surplus and producer surplus that is lost because the quantity produced is not the efficient quantity. The deadweight loss equals the quantity (250 200) multiplied by (5 3)/2, which is $50.

4. a. The maximum price that consumers will pay is $6.00.The demand schedule shows the maximum price that consumers will pay for each bottle of sunscreen. The maximum price that consumers will pay for the 300th bottle is $6.00.

b. The minimum price that producers will accept is $3.00.The supply schedule shows the minimum price that producers will accept for each bottle of sunscreen. The minimum price that produces will accept for the 300th bottle is $3.00.

c. 300 bottles is less than the efficient quantity.The efficient quantity is such that marginal benefit from sunscreen equals the marginal cost of producing it. The efficient quantity is the equilibrium quantity—450 bottles a day.

d. Consumer surplus is $1,012.50The equilibrium price is $4.50 a bottle. The consumer surplus is the area of the triangle under the demand curve above the market price. The area of the triangle is (9.00 4.50)/2 multiplied by 450, which is $1,012.50.

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e. Producer surplus is $1,012.50.The producer surplus is the area of the triangle above the supply curve below the market price. The market price is $4.50. The area of the triangle is (4.50 0)/2 multiplied by 450, which is $1,012.50.

f. The deadweight loss is $225.Deadweight loss is the sum of the consumer surplus and producer surplus that is lost because the quantity produced is not the efficient quantity. The deadweight loss equals the quantity (450 300) multiplied by (6 3)/2, which is $225.

5. a. Ben’s consumer surplus is $122.50. Beth’s consumer surplus is $22.50, and Bo’s consumer surplus is $4.50.Consumer surplus is the area under the demand curve above the price. At 40 cents, Ben will travel 350 miles, Beth will travel 150 miles, and Bo will travel 30 miles. To find Ben’s consumer surplus extend his demand schedule until you find the price at which the quantity demanded by Ben is zero—the price at which Ben’s demand curve cuts the y-axis. This price is 110 cents. So Ben’s consumer surplus equals (110 40)/2 multiplied by 350, which equals $122.50. Similarly, Beth’s consumer surplus equals (70 40)/2 multiplied by 150, which equals $22.50. And Bo’s consumer surplus equals (70 40)/2 multiplied by 30, which equals $4.50.

b. Ben’s consumer surplus is the largest because he places a higher value on each unit of the good than the other two do.

c. Ben’s consumer surplus falls by $32.50. Beth’s consumer surplus falls by $12.50, and Bo’s consumer surplus falls by $2.50.At 50 cents a mile, Ben travels 300 miles and his consumer surplus is $90. Ben’s consumer surplus equals (110 50)/2 multiplied by 300, which equals $90. Ben’s consumer surplus decreases from $122.50 to $90, a decrease of $32.50. Beth travels 100 miles and her consumer surplus is $10, a decrease of $12.50. Bo travels 20 miles and her consumer surplus is $2.00, a decrease of $2.50.

6. a. Ann’s consumer surplus is $2,250. Arthur’s consumer surplus is $500, and Abby’s consumer surplus is $250.Consumer surplus is the area under the demand curve above the market price. At $20, Ann will travel 300 miles, Arthur will travel 200 miles, and Abby will travel 100 miles. To find Ann’s consumer surplus extend her demand schedule until you find the price at which the quantity demanded by Ann is zero—the price at which Ann’s demand curve cuts the y-axis. This price is $35 a passenger mile. So Ann’s consumer surplus equals (35 20)/2 multiplied by 300, which equals $2,250. Similarly, Arthur’s consumer surplus equals (25 20)/2 multiplied by 200, which equals $500. And Abby’s consumer surplus equals (25 20)/2 multiplied by 100, which equals $250.

b. Ann’s consumer surplus is the largest because she places a higher value on each unit of the good than the other two do.

c. Ann’s consumer surplus rises by $1,750. Arthur’s consumer surplus rises by $1,500, and Abby’s consumer surplus rises by $750.


At $15 a mile, Ann travels 400 miles and her consumer surplus is $4,000. Ann’s consumer surplus equals (35 15)/2 multiplied by 400, which equals $4,000. Ann’s consumer surplus increases from $2,250 to $4,000, an increase of $1,750. Arthur travels 400 miles and his consumer surplus is $2,000, an increase of $1,500. Abby travels 200 miles and her consumer surplus is $1,000, an increase of $750.

A d d i t i o n a l P r o b l e m s1. The table gives the demand and supply schedules for spring water.

Price(dollars per

bottle)

Quantity demanded

(bottles per day)

Quantity supplied

(bottles per day)

0 80 00.50 70 101.00 60 201.50 50 302.00 40 402.50 30 503.00 20 603.50 10 704.00 0 80

a. What is the maximum price that consumers are willing to pay for the 30th bottle?

b. What is the minimum price that producers are willing to accept for the 30th bottle?

c. Are 30 bottles a day less than or greater than the efficient quantity?d. What is the consumer surplus if the efficient quantity of spring water is

produced?e. What is the producer surplus if the efficient quantity is of spring water

is produced?f. What is the deadweight loss if 30 bottles are produced?

2. The table gives the demand and supply schedules for bus travel for Joe, Jean, and Joy.

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Price(cents per passenger

mile)

Quantity demanded(passenger miles)

Joe Jean Joy10 50 600 30020 45 500 25030 40 400 20040 35 300 15050 30 200 10060 25 100 5070 20 0 0

a. If the price of train travel is 50 cents a passenger mile, what is the consumer surplus of each consumer?

b. Which consumer has the largest consumer surplus? Explain why.c. If the price of train travel falls to 30 cents a passenger mile, what is the

change in consumer surplus of each consumer?


S o l u t i o n s t o A d d i t i o n a l P r o b l e m s1. a. The maximum price that consumers will pay is $2.50.

The demand schedule shows the maximum price that consumers will pay for each bottle of spring water. The maximum price that consumers will pay for the 30th bottle is $2.50.

b. The minimum price that producers will accept is $1.50.The supply schedule shows the minimum price that producers will accept for each bottle of spring water. The minimum price that produces will accept for the 30th bottle is $1.50.

c. 30 bottles is less than the efficient quantity.The efficient quantity is such that marginal benefit from the last bottle equals the marginal cost of producing it. The efficient quantity is the equilibrium quantity—40 bottles a day.

d. Consumer surplus is $40.The equilibrium price is $2. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the triangle is (4 2)/2 multiplied by 40, which is $40.

e. Producer surplus is $40.The producer surplus is the area of the triangle above the supply curve below the price. The price is $2. The area of the triangle is (2 0)/2 multiplied by 40, which is $40.

f. The deadweight loss is $5.Deadweight loss is the sum of the consumer surplus and producer surplus that is lost because the quantity produced is not the efficient quantity. The deadweight loss equals the quantity (40 30) multiplied by (2.50 1.50)/2, which is $5.

2. a. Joe’s consumer surplus is $9. Jean’s consumer surplus is $20, and Joy’s consumer surplus is $10.Consumer surplus is the area under the demand curve above the price. At 50 cents, Joe will travel 30 miles, Jean will travel 200 miles, and Joy will travel 100 miles. To find Joe’s consumer surplus extend his demand schedule until you find the price at which the quantity demanded by Joe is zero—the price at which Joe’s demand curve cuts the y-axis. This price is 110 cents. So Joe’s consumer surplus equals (110 50)/2 multiplied by 30, which equals $9. Similarly, Jean’s consumer surplus equals (70 50)/2 multiplied by 200, which equals $20. And Joy’s consumer surplus equals (70 50)/2 multiplied by 100, which equals $10.

b. Jean’s consumer surplus is the largest because she places a higher value on each unit of the good than the other two do.

c. Joe’s consumer surplus rises by $7. Jean’s consumer surplus rises by $60, and Joy’s consumer surplus rises by $30.At 30 cents a mile, Joe travels 40 miles and his consumer surplus is $16. Joe’s consumer surplus equals (110 30)/2 multiplied by 40, which equals $16. Joe’s consumer surplus increases from $9 to $16, an increase of $7. Jean travels 400 miles and her consumer surplus is $80, an increase of $60. Joy travels 200 miles and her consumer surplus is $40, an increase of $30.

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