IV. Is the Competitive Market
Fair?
Eciency is a positive term,
while equity is a normative
term. Not everyone can agree
upon what is fair.
There are two general ways of
dening fairness: “It’s not fair if
the results aren’t fair” and “It’s
not fair if the rules aren’t fair.”
It’s Not Fair If the Result Isn’t Fair
Utilitarianism adopts this view. Utilitarianism is a principle that states that we
should strive to achieve “the greatest happiness for the greatest number.” This
principle argues that fairness requires equality of incomes, which requires that
incomes be redistributed.
Numerical example: If Lawrence makes $50,000 per year and Sylvia makes $60,000,
then the marginal benet of an additional dollar is greater for Lawrence than for Sylvia.
Let’s say the marginal benet of an additional dollar to Lawrence is equal to 8 units of
“happiness,” while the marginal benet of an additional dollar to Sylvia is only 3 units of
happiness. (You may want to introduce the concept of “utility” as the economist’s proxy for
“happiness.” The concept of utility will be more fully developed in Chapter 8.) If $1 of
income is transferred from Sylvia to Lawrence, Sylvia will lose 3 units of happiness, but
Lawrence will gain 8 units of happiness. Although Sylvia is worse o7 individually, the
overall level of “happiness” in the economy has increased by 5 units. This process of
transferring income from Sylvia to Lawrence can be repeated as long as Sylvia’s marginal
benet of an additional dollar is still less than Lawrence’s marginal benet of an additional
dollar.
Redistribution leads to the big tradeof, the tradeo7 between eciency and
fairness. The tradeo7 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.
John Rawls argued that redistribution should strive to make the poorest as well o7 as
possible which may mean a smaller piece of a bigger pie, rather than an equal
piece, to keep incentives in place.
It’s Not Fair If the Rules Aren’t Fair
This perspective relies on the symmetry principle—the requirement that people in
similar situations should be treated similarly. In economics, this means equality of
economic opportunity rather than equality of economic outcomes.
Robert Nozick suggests government 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 none of the obstacles to eciency listed before exist,
then according to Nozick, the competitive market is fair.
What’s a “fair” grade in this class? Students generally expect to be graded based on
their performance in a class. This scheme is a “fair rules” view of fairness. Discuss this
observation with the class, and then ask if it would be fairer to grant everyone an A—a
“fair results” view. Many students (especially ones who wouldn’t usually expect an A in a
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5EFFICIENCY AND
EQUITY
E F F I C I E N C Y A N D E Q U I T Y 4 7
course) will nd the guarantee of an A for everyone completely “fair.” Other students who
know they work hard for their grades are likely to say this is “unfair.” Ask the question
again, but this time consider automatically giving every student a D—or even an F. Would
this be fair? Most students would agree that automatically failing everyone would not be
“fair.” If automatically giving students an A is fair, why isn’t it equally fair to automatically
give each student an F? Or, suppose on the nal day of class, the rules of the course are
changed so that regardless of a student’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?
Focus again on what’s a fair “result” as opposed to a fair “rule.”
At Issue: Price Gouging
This section considers the case of Price Gouging. The legal argument and the economist’s
counter argument are considered in light of a case against selling generators at twice the
normal price in the aftermath of Hurricane Katrina.
Economics in the News: Making Tra.c Flow E.ciently
Solving Trac Congestion
Recent research on how to make trac How more eciently has shown the benet of
adding capacity is only temporary. Trac expands to the natural rate of high congestion.
Mass transit projects somewhat astoundingly do not reduce trac. What does reduce
trac is congestion pricing, charging a (higher) price for driving in congested areas or at
congested times..
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4 8 C H A P T E R 5
A d d i t i o n a l P r o b l e m s
1. The table gives the demand
and supply schedules for
spring water.
a. What is the maximum price
that consumers are willing
to pay for the 30th bottle?
b. What is the minimum price
that producers are willing
to accept for the 30th
bottle?
c. Are 30 bottles a day less
than or greater than the
ecient quantity?
d. What is the consumer
surplus if the ecient quantity of spring water is produced?
e. What is the producer surplus if the ecient quantity is of spring water is
produced?
f. What is the deadweight loss if 30 bottles are produced?
2. The table gives the demand
schedules for train travel for
Joe, Jean, and Joy.
a. If the price of train travel is
50 cents a passenger mile,
what is the consumer
surplus of each consumer?
b. Which consumer has the
largest consumer surplus?
Explain why.
c. If the price of train travel
falls to 30 cents a
passenger mile, what is the
change in consumer
surplus of each consumer?
S o l u t i o n s t o A d d i t i o n a l P r o b l e m s
1. a. The maximum price that consumers will pay is $2.50. The demand schedule shows
the maximum price that consumers will pay for each bottle of spring water. The
maximum price that consumers will pay for the 30th bottle is $2.50.
b. The minimum price that producers will accept is $1.50. The supply schedule shows
the minimum price that producers will accept for each bottle of spring water. The
minimum price that produces will accept for the 30th bottle is $1.50.
© 2016 Pearson Education, Inc.
Price
Quantity
demande
d
Quantity
supplied
(dollars per bottle) (bottles per day)
0 80 0
0.50 70 10
1.00 60 20
1.50 50 30
2.00 40 40
2.50 30 50
3.00 20 60
3.50 10 70
4.00 0 80
Price
(cents
per mile)
Quantity demanded
(passenger miles)
Joe Jean Joy
10 50 600 300
20 45 500 250
30 40 400 200
40 35 300 150
50 30 200 100
60 25 100 50
70 20 0 0
80 15 0 0
90 10 0 0
100 5 0 0
110 0 0 0
E F F I C I E N C Y A N D E Q U I T Y 4 9
c. 30 bottles is less than the ecient quantity. The ecient quantity is such that
marginal benet from the last bottle equals the marginal cost of producing it. The
ecient quantity is the equilibrium quantity—40 bottles a day.
d. Consumer surplus is $40. The equilibrium price is $2. The consumer surplus is the
area of the triangle under the demand curve above the price. The area of the
triangle is ½ ($4 $2) 40, which is $40.
e. Producer surplus is $40. The producer surplus is the area of the triangle above the
supply curve below the price. The price is $2. The area of the triangle is ½ ($2
$0) 40, which is $40.
f. The deadweight loss is $5. Deadweight loss is the sum of the consumer surplus and
producer surplus that is lost because the quantity produced is not the ecient
quantity. The deadweight loss equals ½ (40 30) ($2.50 $0.50), which is $5.
2. a. Joe’s consumer surplus is $9. Jean’s consumer surplus is $20, and Joy’s consumer
surplus is $10. Consumer surplus is the area under the demand curve above the
price. At 50 cents, Joe will travel 30 miles, Jean will travel 200 miles, and Joy will
travel 100 miles. Joe’s consumer surplus equals ½ (110¢ 50¢) 30, which
equals $9. Similarly, Jean’s consumer surplus equals ½ (70¢ 50¢) 200, which
equals $20. And Joy’s consumer surplus equals ½ (70¢ 50¢) 100, which equals
$10.
b. Jean’s consumer surplus is the largest because she places a higher value on each
unit of the good than the other two do.
c. Joe’s consumer surplus rises by $7. Jean’s consumer surplus rises by $60, and Joy’s
consumer surplus rises by $30. At 30 cents a mile, Joe travels 40 miles and his
consumer surplus is $16. Joe’s consumer surplus equals ½ (110¢ 30¢) 40,
which equals $16. Joe’s consumer surplus increases from $9 to $16, an increase of
$7. Jean travels 400 miles and her consumer surplus is $80, an increase of $60. Joy
travels 200 miles and her consumer surplus is $40, an increase of $30.
A d d i t i o n a l D i s c u s s i o n Q u e s t i o n s
1. Do price controls help following a natural disaster or emergency? The
text introduces the compelling dilemma of allocating necessary goods
following a natural disaster. (Though this issue is serious, if you want a few
laughs—and perhaps more student engagement—use the idea of a Zombie
disaster as your example.) Engage the students in a careful discussion on this
theme, as it opens their eyes to the complexities involved with trying to
improve upon the competitive market allocation of scarce resources, even
under times of economic duress.
Should “price gouging” and “proteering” be considered criminal
acts? Price controls are often imposed for weeks after the devastating
event occurs. Goods such as bottled drinking water, bags of ice, batteries,
electrical generators, plywood sheets (to seal broken windows), and chain
saws (to remove downed trees from roadways) are typical objects for which
sellers are not allowed to raise their sale price above pre-disaster levels.
Ask students to critically examine the claim that such price restrictions
protect the interests of disaster victims who are trying to get their lives
back to normal as quickly as possible.
What happens to the demand curve for these goods? Ask the
students to use the supply and demand model to reHect changes in the
market for these goods immediately after the disaster has struck. Clearly
the radical change in the local environment causes a rightward shift in the
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5 0 C H A P T E R 5
demand curve, sharply raising equilibrium market price. A price ceiling
results in a heart-wrenching shortage.
What happens to the supply curve for these goods? Emphasize that
the devastation that creates trauma for the consumers also signicantly
increases the cost of replacing the goods sold in a timely fashion.
Replacement of these items needs to be rather quick if the victims want to
minimize any future damage to the community (continued water damage
from damaged homes, illnesses from contaminated drinking water
supplies, etc.). The increase in the opportunity cost of supplying these
goods pushes the supply curve to the left, aggravating the shortage.
Motivate the students to consider how the goods will ultimately be
distributed.
Distribution under price regulation: There is much pain, but is
there any gain (in e$ciency or in fairness)? Often the government
sets and enforces price controls for these goods after a disaster. Point out
to students that in an unregulated market, only those victims who value
the goods at least as much as the unregulated equilibrium price would
receive the scarce goods. Under price controls, it is uncertain how the
goods will be allocated. Consumers with relatively low valuation of the
goods are just as likely end up with the goods as those who have a
relatively high valuation, decreasing total consumer surplus. Also, point out
that if private resale prices are not closely monitored, then those victims
with a relatively low value for their goods would engage in arbitrage by
selling the goods at a high price to victims with a relatively high valuation
for the goods. This simply transfers producer surplus from sellers to low
valuation consumers, the fairness of which would be dicult to justify.
Can price regulation contribute to undesirable seller behavior?
Since the price control erases the opportunity cost that suppliers would
normally face if they fail to sell their scarce goods to the highest bidder,
these sellers may consider any number of non-monetary benets when
they determine who will ultimately receive their goods: Friends and
well-networked acquaintances of the suppliers will likely receive
consideration over strangers who would otherwise be willing to pay a
higher price. In other words, sellers can use a personal characteristics
method of allocation, so they might practice racial, gender, or religious
discrimination when selling their goods.
Can price regulation actually prolong victims’ su&ering? Point out
that for suppliers to quickly replace their depleted inventory they must be
willing to bid away the goods from other areas not devastated by the
disaster. Also, special deliveries of these goods to the disaster area must
be arranged, meaning transportation resources must also be bid away
from their usual employment. Both realities increase the cost of inventory
replacement. Under a price ceiling there is insucient incentive for goods
to be quickly redistributed to where they are needed the most.
2. The big tradeo&: How can economic analysis make us more informed
citizen voters? How to properly address the big tradeof in society is the
heart of continuing debates over proposed changes to the federal income tax
code.
Should tax rates be decreased in order to spur greater economic
activity and increase total production of goods and services in the
economy? Get the students to identify and describe the opportunity cost
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E F F I C I E N C Y A N D E Q U I T Y 5 1
of this proposal. Would income inequality increase? Would the “social
fabric” change?
Should tax rates be increased to reduce the federal budget decit
and outstanding, national debt, or to fund greater government
services and income redistribution programs? This chapter has
shown that the economic pie would decrease if income were redistributed.
How much decrease in economic activity is worth the greater equality?
Greater knowledge of economic analysis lets people weigh these
opportunity costs more carefully and thoughtfully.
3. Does the concept of decreasing marginal benets actually imply that
rich people will lose fewer benets from an income transfer than the
poor will gain? Emphasize to the students that many social policies (both
private and public) that favor the poor at the expense of the rich are justied
on utilitarian grounds. Marginal income tax rates that rise with income provide
one obvious example. A business discount for college students (who are
presumed to be poorer than the general population) is another example. Yet
the students should understand that the ability to make a direct comparison of
benets lost for one person against the benets gained by another is not
implied by the concept of diminishing marginal benets. Explain to them that
the assumption of decreasing marginal benets allows us to compare the
marginal benets across di7erent levels of consumption for the same person,
but it says nothing about comparing the marginal benets across di7erent
people at di7erent consumption levels.
To clarify, ask them the following question: Can we truly measure and
compare the happiness from a rich person’s consumption level to a poor
person’s consumption level for the same good? Have the students assume that
the quantity of income taken away from a rich mother means that she is now
able to send only one, rather than both, of her children to college. Assume also
that the same quantity of income given to a poor mother enables her to send
one of her two children to college when she otherwise couldn’t have a7orded
to send either child to college. Ask the students, “Does this imply that the
happiness, or perceived value, lost by the rich mother is somehow smaller
than the happiness, or perceived value gained by the poor mother?” Ask the
students if anyone can honestly claim to know that one mother’s concern
about providing for her second child is smaller in magnitude than another
mothers’ concern about providing for her rst child. Obviously not! Explain
that if this claim is false for this example, then it is false for all examples
comparing benet gains and losses across people at di7erent levels of in
income.
4. Do “liberals” care more about fairness than “conservatives”? Some
years ago, Jim Tobin told Michael Parkin about a nice test of whether a person
is a liberal or a conservative. It also generates a good classroom discussion.
Here’s how it goes. Give the students the following scenario and question: You
are at an oasis in a large desert and you have some ice cream in an
immovable refrigerator. (Assume, for the sake of the story, that ice cream is
the only food available.) The people in the next oasis some miles away have
no ice cream (and no other food) and are too old and inrm to travel. You have
plenty of ice cream and you can transport it to the next oasis, but on the
journey, some of it will melt. Now the question: How much of the ice cream
would have to survive the journey for it to be worth transporting to the next
oasis?
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5 2 C H A P T E R 5
Your students will not agree (and you may not agree with your students’
conclusions). According to Tobin, the most liberal would transport if only the
smallest percentage survived the journey. The most conservative would want a
large proportion to survive before undertaking the redistribution. You can point
out that di7erent people choose di7erent points on the “big tradeo7.” Be
careful not to support one view over the other as the only correct viewpoint.
The focus here is on understanding the tradeo7 between fairness and
eciency, not the value of one over the other.
You could spend the rest of the course talking about and discussing equity,
fairness, or distributive justice as it is sometimes called. This material is not
standard, and you’ll be hard-pressed to nd it in any other principles text. It is
included here because governments and the news media often make
judgments about what is fair and what is not fair, and students need to know
what criteria are included in those judgments.
5. When is it price gouging and when are prices “just high”? It is common
at events to have extremely high prices for items such as bottled water, beer,
food, prices much higher than would be paid outside the venue. Consider soda
at professional baseball games or bottled water at a theme park. Prices might
be double or triple what they would be outside but it isn’t considered to be
illegal. Have students discuss fairness in this context and in the context of the
aftermath of a disaster. If a bottle of water is selling for $4 in both cases, why
is only one case considered gouging? What do they think the outcome should
have been for the man described in the case that purchased generators and
transported them to the hurricane region to prot? Was he serving himself,
others, or both, as Adam Smith would argue?
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E F F I C I E N C Y A N D E Q U I T Y 5 3