Chapter 7: Efficiency, Equity, and Market Failure – Microeconomics Study Notes

Efficiency, Equity, and Market Failure

Introduction

This chapter explores how economists evaluate public policies, measure economic surplus, assess market efficiency, and analyze the causes and consequences of market failure. It also considers the limitations of economic efficiency and the role of government intervention.

Evaluating Public Policies

Positive vs. Normative Analysis

• Positive Analysis: Describes what is happening, explains cause and effect, and predicts outcomes. It is objective and based on facts.

• Normative Analysis: Prescribes what should happen, involving value judgments and opinions about what is desirable or fair.

Example: Analyzing the effects of raising the minimum wage:

• Positive: Predicts changes in employment, wages, and business profitability using supply-and-demand models.

• Normative: Considers whether the benefits to workers outweigh the costs to employers, based on personal or societal values.

Concept Check: Positive vs. Normative Statements

• "College tuition should be lower so that more people can attend." – Normative

• "Lower college tuition will lead to more children from low-income families attending college." – Positive

• "Income taxes are too high, and the federal government should lower them." – Normative

• "The United States should increase tariffs on goods from China." – Normative

Measuring Economic Surplus

Economic Surplus and Efficiency

• Economic Surplus: The total benefits minus total costs from a decision or policy.

• Efficiency: An outcome is more economically efficient if it yields a larger economic surplus.

• Economic surplus measures the size of the economic pie—the total welfare created by market transactions.

Consumer Surplus

• Definition: The difference between what a consumer is willing to pay (marginal benefit) and the price actually paid.

• Formula: $\text{Consumer Surplus} = \text{Marginal Benefit} - \text{Price}$

• Graphically, consumer surplus is the area between the demand curve and the price line, up to the quantity purchased.

• Example: If you are willing to pay $2 for a song but the price is $1.29, your consumer surplus is $0.71.

Producer Surplus

• Definition: The difference between the price received by the seller and the marginal cost of production.

• Formula: $\text{Producer Surplus} = \text{Price} - \text{Marginal Cost}$

• Graphically, producer surplus is the area between the price line and the supply curve, up to the quantity sold.

• Example: If the marginal cost to produce a pair of jeans is $35 and the market price is $50, the producer surplus is $15.

Total Economic Surplus

• Definition: The sum of consumer surplus and producer surplus.

• Formula: $\text{Economic Surplus} = \text{Consumer Surplus} + \text{Producer Surplus}$

• Alternatively, $\text{Economic Surplus} = \text{Marginal Benefit} - \text{Marginal Cost}$ for each transaction.

Market Efficiency

Conditions for Efficiency

• Markets are efficient when they maximize total economic surplus.

• Efficiency requires:

  • Each good is produced at the lowest possible marginal cost.

  • Each good is consumed by the person who values it most (highest marginal benefit).

  • The quantity produced is where marginal benefit equals marginal cost.

The Rational Rule

• For Buyers: Buy more of a good if the marginal benefit exceeds the price; stop when marginal benefit equals price.

• For Sellers: Sell more if the price exceeds marginal cost; stop when price equals marginal cost.

• For Society: The efficient quantity is where marginal benefit equals marginal cost.

Graphical Representation

• At equilibrium, the area between the demand and supply curves up to the equilibrium quantity represents total economic surplus.

• Producing less or more than the equilibrium quantity reduces economic surplus.

Market Failure and Deadweight Loss

Sources of Market Failure

• Market Power: When firms have the ability to set prices above marginal cost, leading to underproduction.

• Externalities: When market transactions have side effects (positive or negative) on third parties not involved in the transaction.

• Information Problems: When one party has more or better information than the other, undermining trust and efficient outcomes.

• Irrationality: When buyers or sellers do not act in their own best interests, leading to suboptimal decisions.

• Government Regulation: Taxes, price controls, and quantity regulations can reduce the quantity traded below the efficient level.

Deadweight Loss

• Definition: The reduction in economic surplus that results from a market not being in equilibrium (i.e., not at the efficient outcome).

• Formula: $\text{Deadweight Loss} = \text{Economic Surplus at Efficient Quantity} - \text{Actual Economic Surplus}$

• Deadweight loss can result from both overproduction and underproduction.

• Graphically, deadweight loss is the area between the demand and supply curves for units that are not traded due to market failure.

Role of Government

• Government intervention can sometimes correct market failures (e.g., taxes on negative externalities, subsidies for positive externalities).

• However, government policies can also create inefficiencies if poorly designed or implemented.

Beyond Economic Efficiency: Equity and Fairness

Limitations of Efficiency

• Efficiency focuses on maximizing the size of the economic pie, not on how it is divided.

• Equity concerns the fairness of the distribution of resources and outcomes.

• Policies that are efficient may not be considered fair or equitable by all members of society.

• Willingness to pay reflects both preferences and ability to pay, which may not align with societal notions of fairness.

Process vs. Outcome

• Some argue that the process by which outcomes are determined (e.g., competition, opportunity) is as important as the outcome itself.

• Debates about equity often focus on whether the process or the outcome is more important for justice.

Summary Table: Sources of Market Failure

Source	Description	Effect on Efficiency
Market Power	Firms set prices above marginal cost	Underproduction, deadweight loss
Externalities	Side effects on third parties	Over- or underproduction
Information Problems	Asymmetric or incomplete information	Reduced trust, inefficient transactions
Irrationality	Decisions not in self-interest	Suboptimal allocation
Government Regulation	Taxes, price controls, quotas	Reduced quantity traded, deadweight loss

Key Takeaways

• Economic efficiency is achieved when total surplus is maximized.

• Market failures prevent efficient outcomes and create deadweight loss.

• Government intervention can both correct and cause inefficiencies.

• Equity and fairness are important considerations beyond efficiency.