 Reading Assignment:

Ch.6 6.1, 6.2, 6.3, 6.4

(Exclude: (i) Market Failure & related exercises and (ii) 6.5)

 Indicative contents
The concepts of efficiency in Economics.

 After studying this topic, you will be able to:

1. Understand the key methods of allocating scarce resources
and define and explain the features of an efficient allocation
2. Distinguish between value and price and define consumer
surplus.
3. Distinguish between cost and price and define producer
surplus.
4. Understand the condition of maximizing total surplus and the
concept of efficiency.
 Tutorial exercises
Bring the tutorial pre-task exercises along for this lecture. Students are required to complete the whole
set of exercises before attending the tutorial meeting assigned for this topic.
 Study Guide
Complete the exercises for topic 3
Copyright © 2020 by PolyU-HKCC. Some copyright materials are from Pearson with
authorization to be posted on the e-learning platform of PolyU-HKCC.

BHMH 2002, Introduction to Economics 1

3.1 ALLOCATION METHODS AND EFFICIENCY
 Because resources are scarce, they must be allocated among their competing uses.

 Resource Allocation Methods

Scare resources might be allocated by one or some combination of the following
methods:
 Price Competition
 Command
 First-come, first-served
 By Draw (Lottery)

BHMH 2002, Introduction to Economics 2

Price Competition
 When a market allocates a scarce resource, the people who get the resource are those who
are willing and able to pay the market price .
 People who do not value the resource as highly as the market price or are unable to pay the
market price will not compete for the resource under the price competition.
 The market could achieve efficiency with the market structure of perfect competition
theoretically.

Illustration
The market price is $15 in the DVD
market. Can a buyer get a DVD if he
is willing to pay $10 for one? How
about if he is willing to pay $20?
3.1 ALLOCATION METHODS AND EFFICIENCY
Non-price competition: other allocation methods
Command
 Command system allocates resources by the order (command) of someone in authority.
 A command system works well in organizations with clear lines of authority but badly in an entire
economy. North Korea and Cuba are the only remaining command economies.

First-Come, First-Served (Waiting in line)

 A first-come, first-served allocates resources to those who are first in line.
 Time cost is involved. The one with lower time cost will be in a better position for competition.
However, it does not mean that they are the highest valued user of the resource.
 First-come, first-served is usually observed to work with the price competition in the market
economy. Economists argue that this is a way to save the transaction (menu) cost of resource
allocation in the real world situation.

By Draw (Lottery)(by luck)

 Using draw to allocate resources to those with the winning number, draw the lucky cards, or
come up lucky.
 For example, the apartments under the Home Ownership Scheme are allocated by draw to those
qualified applicants.
 Draws work well when there is no effective way to distinguish among potential users of a scarce
resource. However, the efficiency of resource allocation is in doubt.

BHMH 2002, Introduction to Economics 4

3.2 MARGINAL BENEFIT, VALUE, AND PRICE

Marginal Benefit
 Marginal benefit is an economic concept to represent the TB
benefit that a person receives from consuming one more MB 
QOutput
unit of a good or service. It is not directly observable.

 Conceptually, the marginal benefit from a good is what

people are willing to forgo to get one more unit of the good.

 People’s preferences determine marginal benefit.

 Marginal benefit is asserted to decrease as the quantity of

the good increases according to the principle of decreasing
marginal benefit.

  the Marginal benefit (MB) curve is downward sloping.

To facilitate making comparison,

marginal benefit and value can
be measured in dollar term.

BHMH 2002, Introduction to Economics 5

3.2 MARGINAL BENEFIT, VALUE, AND PRICE
Demand and Marginal Benefit
 The demand curve shows the quantity demanded at each price, other things remaining the
same. Price is what the consumer pays. (consumer’s cost)
 The demand curve shows the maximum price willingly paid for the last pizza available. Value is
what the consumer gets. (consumer’s benefit)
 Value can be interpreted as marginal benefit which can be measured as the maximum price
that people are willing to pay for another unit of the good or service. Thus, the marginal
benefit of the last unit purchased by a consumer can be revealed by price.
 Deductively, a demand curve is also a marginal benefit curve.

D=

 Consumer’s decision rule:

The consumer will buy one more unit of a good or service if its price is less than or equal to the
value the consumer places on it.
For maximization, the consumer is expected to consume to the last unit at which its price equal
marginal benefit (value at the margin).
BHMH 2002, Introduction to Economics 6
 3.2 MARGINAL COST AND PRICE
Marginal Cost
 Conceptually, marginal cost (MC) is the opportunity cost one must give up to produce one
more unit of a good or service.
 To facilitate making comparison, the marginal cost can be measured in dollar term.
 The marginal cost of producing a good is asserted to increase as more of the good is
produced according to the principle of increasing marginal cost.
 The marginal cost curve is upward sloping.

Supply and Marginal Cost TC

MC 
 Cost is what a seller must give up to produce the good. The cost of producing QOutput
one more unit of a good or service is its marginal cost.
 Price is what a seller receives when the good is sold. (Seller’s Revenue)
 It is just worth producing one more unit of a good or service if the price for
which it can be sold equals marginal cost.
S=
 General speaking, a supply curve is a marginal cost curve. (S = MC)

Producer’s/Seller’s decision rule:

The seller will produce one more unit of a good or service if the
price for which it can be sold exceeds or equals its marginal cost.
For maximization, the seller is expected to produce to the last unit
at which its unit price equal marginal cost.

BHMH 2002, Introduction to Economics 7

 3.3 Value, Price, and Consumer Surplus
We don’t always have to pay as much as we’re willing to pay. When people buy something for less than
it is worth to them, they receive a consumer surplus.
Consumer surplus (CS) is the excess of marginal
benefit from a good over the price paid for it, consumer surplus per unit
summed over the quantity consumed. = Marginal Benefit – Unit Price

In other word, consumer surplus is the difference

between the total amount that consumers are willing Total consumer surplus
and able to pay for a good or service (indicated by the = Total Benefit – Total Expenditure
demand curve) and the total amount that they actually
do pay (i.e. the market price).
Economists use the concept of consumer surplus to represent and measure the welfare that people
gain from consuming goods and services.

Checkpoint exercise:
= MC
 The quantity of DVDs bought is _________ a day.
 The consumer surplus = ____________________ = ________.
 The amount spent on DVDs = __________= ________.
 The total benefit from DVDs = MB
= total expenditure + consumer surplus = __________ = _____.

Don’t miss out the unit e.g. dollar sign ($)

BHMH 2002, Introduction to Economics 8

3.3 Cost, Price, and Producer Surplus
When the price exceeds marginal cost, the firm obtains a producer surplus.
Producer surplus (PS) is the excess of the price of a Producer surplus per unit
good over the marginal cost of producing it, summed = Unit Price – Marginal Cost
over the quantity produced.
In other words, producer surplus (PS) is the difference between the actual amount a
producer receives and the total opportunity cost of producing that quantity of product.
Producer surplus is a measure of producer Total producer surplus
welfare. = Total Revenue – Total production Cost

Checkpoint exercise:
 The quantity of DVDs sold is 20 a day.
 The producer surplus = ___________________ = _______.
= MC
 The total revenue = ___________________= ________.
 The total cost of producing DVDs
= total revenue - producer surplus
= _______________ = ______. = MB

BHMH 2002, Introduction to Economics 9

 3.4 ARE MARKETS EFFICIENT?
Efficiency of resource allocation is achieved
• when marginal benefit equals marginal cost at the last Figure 6.8 shows an efficient pizza market
unit, and
• when the total surplus is maximized, and
• no deadweight loss.
Total surplus is the sum of consumer surplus and producer
surplus.

Market Efficiency and Perfect Competitive Market:

In a competitive market:
 The demand curve shows buyers’ marginal benefit. The
supply curve shows the sellers’ marginal cost.
 Under a competitive market, marginal benefit equals
marginal cost at the equilibrium .
 Thus, resources allocation is efficient and the competitive
market delivers the efficient quantity.
 The competitive equilibrium maximizes total surplus.
 Market equilibrium: Qd = Qs
 Buyers seek the lowest possible price and sellers seek the
highest possible price.  When marginal cost equals marginal benefit,
 When buyers and sellers pursue their self-interest, the the quantity is efficient.
social interest is served.  +  = Consumer surplus plus producer surplus
which are maximized subject to constraint.
BHMH 2002, Introduction to Economics 10
 3.4 ARE MARKETS EFFICIENT?

 Market failure is a situation in which

the market delivers an inefficient
outcome.

 Inefficiency can occur because of

underproduction or overproduction

 Deadweight loss is the decrease in

total surplus that results from an
inefficient underproduction or
overproduction. It is a social loss.

Checkpoint:
Indicate the area of consumer surplus and
producer surplus in the diagram respectively.

BHMH 2002, Introduction to Economics 11

Reference - Proper way to ‘describe’ and ‘label’ of consumer surplus,
producer surplus and total surplus
Concepts of surpluses are commonly integrated in different analyses such as demand and
supply analysis or impacts of different market structures to illustrate the changes of welfare
among different parties like the ones of consumers, producers and the society.

However, students always encounter problems in

presenting different surpluses accurately. Here is a
‘bad example’!

It is very difficult and unclear describe the original


area of consumer surplus, producer surplus and total
surplus in your written explanation. Even worse, how
to describe the changes of these areas after there is
an increase in the supple of apple in your written
explanation accurately?

BHMH 2002, Introduction to Economics 12

 Correct way of labelling different surpluses for
written explanation
Figure 1  Use the ‘lower case letters’ (i.e. a, b, c, …) to label the intercepts or
any intersection of relevant points.
 The concept of surplus is “an area” on the diagram. The followings
are the proper way to describe the surpluses on the diagram.
• In figure 1, the consumer surplus is the area abP1.
• Area P1bc represents the producer surplus.
• Area abc represents the total surplus.


 “Change” is frequently used in asking question because the
meaning is unclear. Therefore, it is the task of students to
clarify the direction of change.
 When you describe the ‘change’ of surpluses, it is a must
that you need to state clearly whether there is “an increase”
or “a decrease” in the surplus. Don’t use the word “change”
again in your answer. Students are expected to provide clear
direction of change in their answers.
 The common sentence structures are:
“ [types of surplus] increases (decreases) from the area _____ to the area _____. Thus, the [types
of surplus] increases (decreases) by the area ______”

 In figure 1, the consumer surplus increases from the area abP1 to the area aeP2.
 In figure 1, the consumer surplus increases by the area P1beP2.

 In figure 1, the consumer surplus increases by the area P1bP2e. (What is wrong with this statement?)
BHMH 2002, Introduction to Economics 13
 What is wrong with this illustration?

DON’T use the upper case letters! Why?

As a convention in Economics, upper case letter ‘D’ is reserved for ‘demand’ in a demand and supply diagram.

If you use the upper case letters for labels of intersection points on the diagram, probably, the letter ‘D’ will
appear two times. However, it refers to two different positions on the same diagram and two different
meaning. It will lead to ambiguity for the readers and markers. No mark is given for this inconsistency of
labelling.

BHMH 2002, Introduction to Economics 14