6.3 Cost,Price, and Producer Surplus
Supply and Marginal Cost
The cost of one producing 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. So, as illustrated in the figure, a supply curve for a good or service is also its marginal cost curve.
· Thesupply curve in the figure shows that the minimum price a producer must receiveto be willing to produce the 6,000,000th gallon of milk per month is $3, so $3is the marginal cost of this gallon.
- Producer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity produced. The figure illustrates the producer surplus as the shaded triangle when the price is $3 per gallon.
n 6.4 Are Markets Efficient?
MarginalBenefit Equals Marginal Cost
A competitive equilibrium is the quantity at which the quantity demanded equals the quantity supplied. In the figure, the equilibrium quantity is 6 million gallons.
The efficient quantity is the quantity at which the marginal benefit of the last unit produced equals its marginal cost. In the figure, the efficient quantity is 6 million gallons.
Because the demand curve is the same as the MB curve and the supply curve is the same as the MC curve, the quantity that sets the MB equal to the MC also sets the quantity demanded equal to the quantity supplied and so is the equilibrium quantity. The equilibrium quantity is, therefore, also the efficient quantity.
Total SurplusIs Maximized
The totalsurplusfrom a good or service is the sum of the producer surplus plus the consumersurplus. As the figure shows, when the efficient quantity of milk is produced,the sum of the consumer surplus and producer surplus is maximized.
The InvisibleHand
Adam Smith, in his1776 book The Wealth of Nations, articulatedhow competition led self-interested consumers and producers to make choicesthat unintentionally promote the social interest as if they were led by an “invisiblehand.”
Market Failure
A market failure is a situation in which the market delivers an inefficient market outcome.
If the market does not produce the efficient quantity, it will either produce less than the efficient quantity—underproduction—or produce more than the efficient quantity—overproduction.
In either case, a deadweight loss occurs. A deadweight loss is the decrease in the consumer surplus and producer surplus that results from producing an inefficient quantity of a good. The figure illustrates the deadweight loss from overproduction of milk and from underproduction.
Sources ofMarket Failure
qLand Mine: Don’t get too hung up on the mechanics of how the sources of marketfailure work at this point. Just note at this stage that they bring eitherunderproduction or overproduction and emphasize the deadweight loss that theygenerate. The list is a guide to what is coming with details coming in laterchapters.
The key obstacles to achieving an efficient allocation of resources in a market are:
· Price and QuantityRegulations:Price regulations include price ceilings (which sets the highest legal price,such as rent ceilings) and price floors (which set the lowest legal price, suchas a minimum wage). If a price regulation makes the equilibrium price illegal,it leads to inefficiency. Quantity regulations can limit the amount that can beproduced and so lead to inefficiency.
· Taxes and Subsidies: Taxes and subsidiesplace a wedge between the prices consumers pay and the prices producersreceive. Both can lead to inefficiency.
· Externalities: Externalities meanthat the demand curve is not the same as the marginal benefit curve and/or thesupply curve is not the same as the marginal cost curve. In these cases, the equilibrium quantity is not the same as theefficient quantity.
· Public Goods andCommon Resources:A public good benefits everyone and no one can be excluded from its benefit. Apublic good leads to a free-rider problem, in which people do not pay for theirshare of the good, which can lead to inefficient underproduction. Commonresources are owned by no one but used by everyone. They are over-used and leadto the tragedy of the commons.
· Monopoly: A monopoly is afirm that is the sole provider of a good or service. To maximize its profit, amonopoly produces less than the efficient quantity and so creates inefficiency.
· High Transactions Costs: The opportunitycost of buying and selling in a market is the transactionscosts.If transactions costs become too high, the market might underproduce.
Alternativesto the Market
When a market overproduces or underproduces, one of the alternative allocation methods might work better.
· Managersin firms issue commands and avoid the transactions costs of having to pay foreach individual bit of work.
· First-come,first-serve is used in many instances, such as lines at the ATM, rather thanbuying a spot in the line.
· Sometimes,however, the deadweight loss is the result of a self-interested group takingadvantage of majority rule to benefit themselves at a cost to everyone else.
n 6.5 Are Markets Fair?
It’s Not FairIf the Rules Aren’t Fair
This perspective emphasizes equality of economic opportunity rather than equality of economic outcomes. Robert Nozick suggests governments 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 there are none of the obstacles to efficiency listed before, then the competitive market is fair.
qLand Mine: Studentsgenerally expect to be graded based on their performance in the class. Thisscheme is a “fair rules” view of fairness. Discuss this observation with theclass, and then ask if it would be fairer to grant everyone an A—a “fairresults” view. How about automatically giving every student a C or a D or anF—would this be fair? If automatically giving students an A is fair, why isn’tit equally fair to automatically give each student an F? Or, suppose on thefinal day of class, the rules of the course are changed so that regardless of astudent’s previous scores, the student will be given an A—is this change fair?What if the student was automatically given an F—is this change fair?
It’s Not FairIf the Result Isn’t Fair
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 equity. 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.
qLandMine: You could spend the rest of the coursetalking about and discussing equity, fairness, or distributive justice as it issometimes called. The textbook contains a nice section laying out the basicsneeded to discuss fairness. This material is not standard and you’ll be hardpressed to find it in any other principles text. It is included here becausestudents are very curious about what is fair - and the news media writes andtalks of little else when it discusses economic issues.
Compromise
The extremity of Nozick’s argument is alleviated in practice through taxes which redistribute income from the rich to the poor. Because the taxes are voluntarily agreed upon in democratic process, these income transfers may be considered fair. What constitutes a fair tax system will be examined further in Chapter 8.
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