© 2013 Pearson Should price gouging be illegal? © 2013 Pearson Efficiency and Fairness of Markets CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to Describe the alternative methods of allocating scare resources and define and explain the features of an efficient allocation Distinguish between value and price and define consumer surplus Distinguish between cost and price and define producer surplus © 2013 Pearson When you have completed your study of this chapter, you will be able to Evaluate the efficiency of the alternative methods of allocating scare resources Explain the main ideas about fairness and evaluate the fairness of alternative methods of allocating scarce resources © 2013 Pearson 6.1 ALLOCATION METHODS AND EFFICIENCY  Resource Allocation Methods Scare resources might be allocated by • • • • • • • • • Market price Command Majority rule Contest First-come, first-served Sharing equally Lottery Personal characteristics Force How does each method work? © 2013 Pearson 6.1 ALLOCATION METHODS AND EFFICIENCY Market Price When a market allocates a scarce resource, the people who get the resource are those who are willing to pay the market price Most of the scarce resources that you supply get allocated by market price You sell your labor services in a market, and you buy most of what you consume in markets For most goods and services, the market turns out to a good job © 2013 Pearson 6.1 ALLOCATION METHODS AND EFFICIENCY Command Command system allocates resources by the order (command) of someone in authority For example, if you have a job, most likely someone tells you what to Your labor time is allocated to specific tasks by command A command system works well in organizations with clear lines of authority but badly in an entire economy © 2013 Pearson 6.1 ALLOCATION METHODS AND EFFICIENCY Majority Rule Majority rule allocates resources in the way that a majority of voters choose Societies use majority rule for decisions about tax rates that allocate resources between private and public use and tax dollars between competing uses such as defense and health care Majority rule works well when the decision affects lots of people and self-interest must be suppressed to use resources efficiently © 2013 Pearson 6.1 ALLOCATION METHODS AND EFFICIENCY Contest A contest allocates resources to a winner (or group of winners) The most obvious contests are sporting events but they occur in other arenas: For example, The Oscars are a type of contest Contest works well when the efforts of the “players” are hard to monitor and reward directly © 2013 Pearson 6.1 ALLOCATION METHODS AND EFFICIENCY First-Come, First-Served A first-come, first-served allocates resources to those who are first in line Casual restaurants use first-come, first served to allocate tables Supermarkets use first-come, firstserved at checkout Airlines use first-come, first-served to allocate standby seats First-come, first-served works best when scarce resources can serve just one person at a time in a sequence © 2013 Pearson 6.4 ARE MARKETS EFFICIENT? An apartment owner would provide an external benefit if she installed an smoke detector But she doesn’t consider her neighbor’s marginal benefit and decides not to install the smoke detector The result is underproduction © 2013 Pearson 6.4 ARE MARKETS EFFICIENT? Public Goods and Common Resources A public good benefits everyone and no one can be excluded from its benefits It is in everyone’s self-interest to avoid paying for a public good (called the free-rider problem), which leads to underproduction © 2013 Pearson 6.4 ARE MARKETS EFFICIENT? A common resource is owned by no one but used by everyone It is in everyone’s self interest to ignore the costs of their own use of a common resource that fall on others (called tragedy of the commons), which leads to overproduction © 2013 Pearson 6.4 ARE MARKETS EFFICIENT? Monopoly A monopoly is a firm that is sole provider of a good or service The self-interest of a monopoly is to maximize its profit To so, a monopoly sets a price to achieve its selfinterested goal As a result, a monopoly produces too little and underproduction results © 2013 Pearson 6.4 ARE MARKETS EFFICIENT? High Transactions Costs Transactions costs are the opportunity costs of making trades in a market To use market prices as the allocators of scarce resources, it must be worth bearing the opportunity cost of establishing a market Some markets are just too costly to operate When transactions costs are high, the market might underproduce © 2013 Pearson 6.4 ARE MARKETS EFFICIENT? Alternatives to the Market No one method allocates resources efficiently But supplemented by other methods, markets an amazingly good job Table 6.1 on the next slide shows some possible remedies for market inefficiencies © 2013 Pearson 6.4 ARE MARKETS EFFICIENT? © 2013 Pearson 6.5 ARE MARKETS FAIR? Two broad and generally conflicting views of fairness are: • It’s not fair if the rules aren’t fair • It’s not fair if the result isn’t fair © 2013 Pearson 6.5 ARE MARKETS FAIR? It’s Not Fair if the Rules Aren’t Fair This idea translates into “equality of opportunity.” Harvard philosopher, Robert Nozick, in Anarchy, State, and Utopia (1974), argues that the rules must be fair and must respect two principles: • The state must enforce laws that establish and protect private property • Private property may be transferred from one person to another only by voluntary exchange © 2013 Pearson 6.5 ARE MARKETS FAIR?  It’s Not Fair if the Result Isn’t Fair The fair rules approach is consistent with allocative efficiency, but the distribution might be “too unequal.” Most people recognize that there is no easy answer or principle to guide the amount of equality The fair results approach conflicts with efficiency and leads to what is called the “big tradeoff.” © 2013 Pearson 6.5 ARE MARKETS FAIR? The big tradeoff is a tradeoff between efficiency and fairness that recognizes the cost of making income transfers The tradeoff is between the size of the economic pie and the degree of equality with which it is shared The greater the amount of income redistribution through income taxes, the greater is the inefficiency —the smaller is the economic pie © 2013 Pearson 6.5 ARE MARKETS FAIR? Taking all the costs of income transfers into account, the fair distribution of the economic pie is the one that makes the poorest person as well off as possible The “fair results” ideas require a change in the results after the game is over Some say that this in itself is unfair © 2013 Pearson Should Price Gouging Be Illegal? The figure illustrates the market for camp stoves The supply of stoves is the curve S, and in normal times, the demand for stoves is D0 The price is $20 per stove and the equilibrium quantity is stoves per day © 2013 Pearson Should Price Gouging Be Illegal? Following a hurricane, the demand for camp stoves increases to D1 With no price gouging law, the price jumps to $40 and the quantity increases to stoves per day This outcome is efficient because the marginal cost of a stove equals the marginal benefit from a stove © 2013 Pearson Should Price Gouging Be Illegal? If a strict price gouging law required the price after the hurricane to be $20 a stove, Then the quantity of stoves supplied would remain at per day A deadweight loss shown by the gray triangle arises The price gouging law is inefficient, but is it fair? © 2013 Pearson ... is the opportunity cost of producing one more unit of a good or service and is measured by the slope of the PPF The marginal cost of producing a good increases as more of the good is produced... study of this chapter, you will be able to Evaluate the efficiency of the alternative methods of allocating scare resources Explain the main ideas about fairness and evaluate the fairness of alternative... willing to pay the market price Most of the scarce resources that you supply get allocated by market price You sell your labor services in a market, and you buy most of what you consume in markets