Exam Focus

The primary focus of this review is the efficient allocation of resources. The concepts of marginal benefit, marginal cost, consumer surplus, and producer surplus are all central to understanding the efficient allocation of productive resources. A basic understanding of the obstacles to the efficient allocation of resources and of the two schools of thought on economic "fairness" should be sufficient.

: ' >S ' iL::;jhun .!. •. various means r>; market;, tc; allocate resource:; dHbcienrlw margina! benefit ana marginal cost, anc demonstrate why the efficient ouanuty occurs where marginal benefit equals margina; cost.

In a capitalist economy, most goods and services are allocated by market price. Those who are willing and able to pav the market price for various goods and services get those woods and services. There are, however, other methods for allocating scarce "oods and v> CO

services.

A command system, under which a central authority determines resource allocation, is used in centrally planned economies and is also used within firms and in the military.

Majority ride is also used to allocate resources. Governmental policies such as taxation and transfer payments are an example of this type of resource allocation.

Sometimes resources are allocated based on personal characteristics, such as race, religion, ethnicity, or sex. Other methods of allocating resources are first-come-first-served, lotteries, contests, and force, such as with extortion, theft, or warfare.

From an economic point of view, allocating resources, goods, and services by market price has some important advantages. When markets are functioning well, competition and allocation by price lead to an efficient allocation of resources, so that the marginal benefit to society just equals the marginal cost for the "last" unit of each good and service produced.

The "marginal" in marginal benefit and marginal cost refers to an additional unit, so the comparison between marginal benefit and marginal cost compares the benefit of one additional unit to the cost of producing that unit. As we shall see, the efficient allocation of a society's resources, and therefore the production of the efficient quantity of each good or service, is achieved when the benefit to society of producing one more unit just equals the cost to society of producing that additional unit. We measure the benefit to society as the value that a user places on the additional unit produced. We measure the cost to society as the opportunity cost of production, i.e., the value of other goods and services we must forego to produce the additional unit.

When markets function well, the demand curve for a good or service illustrates the (decreasing) value to consumers of additional units of a good or service, and the supply curve illustrates the opportunity cost of production of additional units of a good or service. We draw downward sloping demand curves to reflect the fact that each successive unit consumed will be less highly valued by consumers. We draw upward sloping supply curves to reflect the fact that the opportunity cost of producing additional units of a good increases as more and more resources are bid away from other productive uses to produce additional units of the good.

Given these interpretations of demand and supply curves, we can state that the efficient quantity of any good or service is the quantity where the demand curve and supply curve intersect. Figure 1 illustrates this result. If the economy produces less than 3,000 tons of steel, we have not maximized the benefit to society of steel production. The value that consumers place on additional units of steel is greater than the value consumers place on the other goods and services foregone to produce those units. Conversely, if the economv produces more than 3,000 tons of steel, each unit above 3.000 tons requires that societv give up other goods and services more highlv valued by consumers than the additional units of steel above 3.000 tons. As long as the demand curve represent;, the marginal benefit to society and the supply curve represents marginal cost to societv. the benefit to society derived from producing steel is maximized at 3,000 tons.

Figure 1 : Equilibrium and Efficient Quantity

Figure 1 : Equilibrium and Efficient Quantity

We refer to the quantity where the supply and demand curves intersect as the efficient quantity of production and economists measure economic efficiency of production against this idealized solution. In a capitalist economy, each consumers attempts to purchase that combination of goods that he values most highly, and each producer's attempts to maximize profits from production, result in allocative efficiency. Allocative efficiency is attained when the allocation of an economy's productive resources leads to the production of quantities of all goods and services that have the maximum total benefit to consumers. Contrast this with a centrally planned economy, where the government economic authority must determine the "right" quantity of every good or service produced in the economy, and you will understand the magnitude of the problem of providing the quantity of each good and service that will result in the greatest economic welfare for a country's citizens.

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