LOS 14d Discuss the relationship between consumer surplus producer surplus and equilibrium

Note that the efficient quantity of steel (where marginal cost equals marginal benefit) is also the quantity of production that maximizes total consumer surplus and producer surplus. The combination of consumers seeking to maximize consumer surplus and producers seeking to maximize producer surplus (profits) leads to the efficient allocation of resources to steel production because it maximizes the total benefit to society from steel production. We can say that when the demand curve for a good is its marginal social benefit curve and the supply curve for the good is its marginal social cost curve, producing the equilibrium quantity at the price where quantity supplied and quantity demanded are equal maximizes the sum of consumer and producer surplus and brings about an efficient allocation of resources to the production of the good.

LOS J 4 ,e-. Explain U how efficient markets ensure optima! resource utilization i'lul 2} xbe obstacle.': so efficiency and the resulting, imdernrndtiction or isvefpfou'.sctjon, :jt.:'.t;dm£, the concern m ueaihveignr ios;,.

Consider a situation where the allocation of resources to steel production is not efficient. In Figure 5, we have a disequilibrium situation where the quantity of steel supplied is greater than the quantity demanded at a price of S600/ton. Clearly, steel inventories will build up and competition will put downward pressure on the price of steel. As the price falls, steel producers will reduce production and free up resources to be used in the production of other goods and services until equilibrium output and price are reached.

If steel prices were §400/ton, inventories would be drawn down, which would put upward pressure on prices as buyers competed for the available steel. Suppliers would increase production in response to rising prices and buyers would decrease their purchases as prices rose. Again, competitive markets tend toward the equilibrium price and quantity consistent with an efficient allocation of resources to steel production.

Figure 5: Movement Toward Allocative Efficiency

Figure 5: Movement Toward Allocative Efficiency

supplied demanded at S400/ton at S400/ton supplied demanded at S400/ton at S400/ton

Obstacles to Efficiency and Deadweight Loss

Our analysis so far has presupposed that the demand curve represents the marginal social benefit curve, the supply curve represents the marginal social cost curve, and competition leads us to a supply/demand equilibrium quantity consistent with efficient resource allocation. Wc now will consider how deviations from these ideal conditions can result in an inefficient allocation of resources. The allocation of resources is inefficient if the quantity supplied does not maximize the sum of consumer and producer surplus. The reduction in consumer and producer surplus due to underproduction or overproduction is called a deadweight loss.

Figure 6: Deadweight Loss

Consumers Surplus Over Production

Obstacles to the efficient allocation of productive resources include:

• Price controls, such as price ceilings and price floors. These distort the incentives of supply and demand, leading to levels of production different from those of an unregulated market. Rent control and a minimum wage are examples of a price ceiling and a price floor.

• Taxes and trade restrictions, such as subsidies and quotas. Taxes increase the price that buyers pav and decrease the amount that sellers receive. Subsidies are government payments to producers that effectively increase the amount sellers receive and decrease the price buyers pay, leading to production of more than the efficient quantity of the good. Quotas are government-imposed production limits, resulting in production of less than the efficient quantity of the good. All three lead markets away from producing the quantity for which marginal cost equals marginal benefit.

• Monopoly, a situation where there is a single seller of a particular good or service. A single seller will choose a (profit-maximizing) quantity of production that is less than the efficient level of production.

• External costs, costs imposed on others by the production of goods which are not taken into account in the production decision. An example of an external cost is the cost imposed on fishermen by a firm that pollutes the ocean as part of its production process. The firm does not necessarily consider the resulting decrease in the fish population as part of its cost of production, even though this cost is borne by the fishing industry and society. In this case, the output quantity of the polluting firm is greater than the efficient quantity. The societal costs are greater than the direct costs of production the producer bears. The result is an over-allocation of resources to production by the polluting firm.

» External benefits, benefits of consumption enjoyed by people other than the buyers of the good that are not taken into account in buyers' consumption decisions. An example of an external benefit is the development of a tropical garden on the grounds of an industrial complex that is located along a busy thoroughfare. The developer of the grounds only considers the marginal benefit to the firms within the complex when deciding whether to take on the grounds improvement, not the benefit received by the travelers who take pleasure in the view of the garden. External benefits result in demand curves that do not represent the societal benefit of the good or service, so that the equilibrium quantity produced anil consumed is less than the efficient quantity.

• Public goods and common resources. Public goods are goods and services that are consumed bv people regardless of whether or not thev paid for them. National defense is a public good. If others choose to pay to protect a country from outside attack, all the residents of the country enjov such protection, w hether they have paid for their share of it or not. Competitive markets will produce less t-han the efficient quantity of public goods because each person can benefit from public goods without paying for their production. This is often referred to as the "free rider" problem. A common resource is one which all may use. An example of a common resource is an unrestricted ocean fishery. Each fisherman will fish in the ocean at no cost and will have little incentive to maintain or improve the resource. Since individuals do not have the incentive to fish at the economically efficient (sustainable) level, over-fishing is the result. Left to competitive market forces, common resources are generally over-used and production of related goods or services is greater than the efficient amount.

LOS l4.f: Explain the two groups of ideas about the fairness principle (utilitarianism ana the symmetry principie) and cnscu;;s the relation oetvveei, fairness and efficiency.

Two schools of thought regarding the fairness of the efficient allocation of resources in a competitive market focus on whether the results of the allocation of resources are fair and on whether the rules of the economic allocation of resources are fair.

One school of economic thought regarding efficient resource allocation is based on the general idea that it is not fair that individuals have dramatically different incomes. For instance, this school of thought contends that it is not fair that the CEO of a firm earns a significantly higher income than the common laborer. From within this framework, some early economists believed in the idea of utilitarianism—that the value of an economy is maximized when each person owns an equal amount of the resources. This early belief in utilitarianism has been proven wrong, but it warrants a closer look.

Utilitarianism is an idea that proposes that the greatest good occurs to the greatest number of people when wealth is transferred from the rich to the poor to the point where everyone has the same wealth. Proponents of utilitarianism argue that: (1) everyone wants and needs the same things and has the same capacity to enjoy life, and (2) the marginal benefit of a dollar is greater for the poor than the rich, so the gain in marginal benefit to the poor from a transfer of wealth is greater than the loss of marginal benefit to the rich. Since more is gained than lost, the end result after the wealth transfer is that the total combined marginal benefit of the rich and the poor will be greater.

The biggest problem with the utilitarian concept is the trade-off between fairness and efficiency resulting from the cost of executing the utilitarian wealth transfer. The most important criticism of utilitarianism is based on the following argument. Wealth can be transferred from high income earners to low income earners by taxing the high income earners. This will cause the high income earners to work less, resulting in a less-than-efficient quantity of labor being supplied. Further, the taxation of income earned from capital investments will lead to reduced savings and investment. The end result is that the quantities of both labor and capital will decrease, and the economy will shrink in absolute size.

A second source of inefficiency associated with transferring wealth from the rich to the poor through taxation is administrative costs. Taxation involves costs of collecting taxes and auditing returns to enforce compliance. There is significant time and effort devoted to calculating taxes by taxpayers. Welfare agencies have significant administrative costs, which also reduce the amount of the actual transfer. All of the resources and labor used in these activities could be used to produce other goods and services that have value to consumers.

A second school of economic thought is based on the symmetry principle. The symmetry principle holds that people in similar situations should be treated similarly. It is basically a moral principle that advocates treating other people the way you prefer to be treated. Economically speaking, this means equality of opportunity.

In Anarchy, State, and Utopia (1974), Robert Nozick argues that results are irrelevant to the idea of fair resource allocation—fairness must be based on the fairness of the rules. He suggests that fairness adhere to two rules: (1) governments must recognize and protect private property, and (2) private property must be given from one part)' to another only when it is voluntarily done. Rule (1) means that everything that is valuable must be owned by individuals, and the government must enforce private property rights. Rule (2) means that the only way an individual can acquire property is through its exchange for something else that he owns (including his own labor).

Nozick argues that if these uniquely fair rules are followed, the result will be fair. It doesn't matter if the whole economy is shared equally, as long as it is constructed by the same individuals, each of whom provides services on a voluntary basis in exchange for economic benefit. This is what is meant by symmetry—individuals get goods and services from the economy that are equal in value to their contributions to the economy.

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