CHAPTER OUTLINE

1. Describe the alternative methods of allocatingscarce resources and define and explain the features of an efficientallocation.

A. ResourceAllocation Methods

1.  Market Price

2.  Command

3.  Majority Rule

4.  Contest

5.  First-Come, First-Served

6.  Sharing Equally

7.  Lottery

8.  Personal Characteristics

9.  Force

B.  UsingResources Efficiently

1.  Efficiency and the PPF

2.  Marginal Benefit

3.  Marginal Cost

4.  Efficient Allocation

 

n What’s New in this Edition?

Chapter 6 is a slightly revised versionof Chapter 6 from the fifth edition, with the term “market failure” introducedwhen analyzing inefficient market outcomes.

n Where We Are

We explore the conditions of market efficiencyand whether market outcomes are fair. On the consumer side, we make thedistinction between value and price. On the producer side, we make thedistinction between cost and price. We mention factors that prevent efficiency fromoccurring.

n Where We’ve Been

We’ve explored the motivation behindstudying economics. We’ve developed the demand and supply model that helps us visualizehow markets determine prices and quantities.

n Where We’re Going

The nextchapters continue to use the demand and supply framework to study governmentintervention in the market. Chapter 7 studies price ceilings, price floors, andprice supports and demonstrates how these polices can lead to inefficiency.Chapter 8 covers the same topics for taxes. Then Chapter 9 looks at globalmarkets, Chapter 10 examines public goods and external benefits, and Chapter 11concludes by studying external costs and common resources. Efficiency plays akey role in all these chapters.

IN THECLASSROOM

nClass Time Needed

You might be able to complete this chapter intwo sessions, but because this material is so important, consider using threesessions and making sure that students understand why efficiency requires theequality of marginal benefit and marginal cost and why underproduction andoverproduction lead to deadweight losses. Also, the more time spent introducingthe obstacles to efficiency, the better students will understand where thiscourse is moving towards later in the semester.

           Anestimate of the time per checkpoint is:

·            6.1 Allocation Methods andEfficiency—10 to 15 minutes

·            6.2 Value, Price, and ConsumerSurplus—30 to 45 minutes

·            6.3 Cost, Price, and ProducerSurplus—30 to 45 minutes

·            6.4 Are Markets Efficient?—30to 45 minutes

·            6.5 Are Markets Fair?—10 to 15minutes

Class Activity: Some years ago, JimTobin told Michael Parkin a nice test of whether a person is a liberal or aconservative. It also generates a good classroom discussion. Here’s how itgoes. Give the students the following scenario and question: You are at anoasis 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 milesaway have no ice cream (and no other food) and are too old and infirm totravel. You have plenty of ice cream and you can transport it to the nextoasis, but on the journey, some of it will melt. Now the question: How much ofthe ice cream would have to survive the journey for it to be worth transportingto the next oasis? The most liberal would transport if only the smallestpercentage survived the journey. The most conservative would want a largeproportion to survive before undertaking the redistribution.

CHAPTER LECTURE

n 6.1       Allocation Methods and Efficiency

Lecture Launcher: Launch your lecture bydrawing a demand curve and telling your students that this curve has twointerpretations. The common interpretation, that the students have seen manytimes before, starts at a price, goes horizontally to the demand curve, andthen down vertically to the quantity. The interpretation of this approach isthe “standard” one: At the given price, the demand curve shows the quantitydemanded. But then point out to the students that it is possible to pick aquantity, go vertically up to the demand curve, and then horizontally to theprice. The interpretation of this method differs from the first. The interpretationhere is that for the given quantity, the demand curve shows the maximum pricefor which someone is willing to buy the selected quantity. Point out that themaximum price equals the value to the consumer and that the value also equalsthe marginal benefit. Thus you have demonstrated to the students that thedemand curve is the same as the marginal benefit curve. (Depending upon yourstudent population, you may want to use actual numbers for the price andquantity, as it can make the otherwise abstract discussion more concrete andapproachable.) Although done just with words and a diagram, this chapterexplains the astonishing so-called “first fundamental theorem of welfareeconomics” that under appropriate conditions, a competitive equilibrium is Paretoefficient. Though the textbook does not discuss Pareto efficiency, if you chooseyou can provide your students with more background to this astonishing result.It begins with Adam Smith’s invisible hand conjecture. But Adam Smith’sconjecture did not receive formal proof until the 1950s. Sir John Hicks, KennethArrow, and Gerard Debreu, are credited with the major contributions to welfareeconomics and all received the Nobel Prize in Economic Sciences for their workfor Kenneth Arrow and Gerard Debreu. Lionel McKenzie is also credited with amajor independent statement of the theorem and some economists refer to it asthe Arrow-Debreu-McKenzie theorem. The A-D-M proof is deeper and morerestricted that the arm waving words and diagrams of a principles text. But wedo not mislead our students by being enthusiastic and amazed at the astonishingproposition. Selfish people all pursuing their own ends and making themselvesas well off as possible end up allocating resources in such a way that no onecan be made better off (qualified by the exceptions that we quickly note in thechapter.)

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

·        Market price: The people who are willing and able to pay theprice get the resource.

·        Command: A command systemallocates resources by the order of someone in authority. Current examples areNorth KoreaandCuba.

·        Majority rule: A vote determines who gets the resource. Electedgovernments allocate some of our resources.

·        Contest: The winner gets the resource. Contests work wellwhen the efforts of the players are hard to monitor and reward directly. Anexample is the contest of top executives to become the next CEO.

·        First-come,first-served: National parks and tickets to college football games oftenare allocated using first-come, first-served.

·        Sharing equally: Works well with small groups, for example, roommates.

·        Lottery: The winner gets the resource. Landing slots atsome airlines and some draft choices in the NBA are allocated using lotteries.

·        Personal characteristics: People with the rightcharacteristics get the resource. This method can lead to discrimination.

·        Force: The strongest gets the resource. Theft is anexample; so, too, is taxation.

Allocativeefficiency is achieved when the quantities of goods andservices produced are those that people value most highly. The productionpossibilities frontier is the boundary between the combinations of goodsand services that can be produced and the combinations that cannot be produced,given the available factors of production and the state of technology. 

·        Allocative Efficiency and the PPF:

·        Allocative efficiency is achieved when thecombination of goods and services produced onthe PPF are those that are valuedmost highly.

·        To know what combination of goods and services is most valued, we need tounderstand marginal cost and marginal benefit.

·        MarginalBenefit is the benefit people receive from consuming one more unit of a good or service. Preferences determine marginal benefitand we can measure the marginal benefit from a good or service by what peopleare willing to give up to get one moreunit of it.

                                               

	Books	Marginal cost of a book  (movies per book)
A	0
		0.5
B	200
		1.0
C	400
		1.5
D	600

·        Marginal Cost is the opportunity cost of producing one more unit of a good or serviceand is measured by the slope of the PPF.

• An allocatively     efficient use of resources requires that marginal benefit equal marginal     cost.

·        Inthe figure, when 100 books per month are produced, the marginal benefit fromanother book exceeds its marginal cost, which means that people prefer anotherbook more than the movies they must give up.

·        Whenthe allocatively efficient number of books, 200 per month, is produced, the PPFshows that the allocatively efficient number of movies is 500 movies per month.

·        Whenmarginal cost equals marginal benefit, the efficientallocation—the highest-valued allocation—has been achieved because it is impossible tomake people better off by reallocating resources.