Download At P*MKT

Efficiency and Exchange
1
The Domain of Markets
Free markets promote efficiency
But, markets cannot be expected to solve
every problem (e.g., market economies do
not guarantee a fair income distribution)
Realizing that markets cannot solve
every problem has led some critics to
falsely conclude
that markets cannot solve any problem
2
Market Equilibrium and
Efficiency
Pareto efficient (or just efficient)
Is a situation where there is no change
possible that will help some people without
harming others
Exists when an economy has reached a
point where reallocating resources must
harm one in order to help another
Occurs at equilibrium of perfectly
competitive markets
3
Market Equilibrium and
Efficiency
 When a market is not in equilibrium:
1. P > P* = surplus -- QS > QD
2. P < P* = shortage -- QD > QS
In either case, the quantity exchanged is always
LESS THAN the true equilibrium quantity.
Hence, if a market is not in equilibrium, further
benefit-enhancing transactions are always
possible.
4
Fig. 7.2
How Excess Demand Creates an
Opportunity for a Surplus-Enhancing
Transaction
5
Fig. 7.3
How Excess Supply Creates an
Opportunity for a Surplus-Enhancing
Transaction
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Economic Surplus
Total economic surplus
The sum of all the individual economic
surpluses gained by buyers and sellers
participating in the market
Consumer Surplus
Producer Surplus
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Surplus
Consumer Surplus
Economic surplus gained by the buyers of a
product
Measured by the difference between their
reservation price and the price they pay
Producer Surplus
Economic surplus gained by the sellers of a
product
Measured by the difference between the price
they receive and their reservation price
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Fig. 7.7
Total Economic Surplus in the
Market for Milk
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Surplus and Efficiency
Equilibrium price and quantity
maximize the total economic surplus
Total economic surplus would be lower at
any other price and quantity combination
I.E., “waste” or unrealized gain occurs at
any other price and quantity combination
10
Other Goals
Efficiency is not the only goal
An equitable income distribution is a
desirable goal for many
Why efficiency should be the first Goal
Efficiency enables us to achieve all other
goals to the fullest possible extent
Efficiency minimizes waste
11
The Costs of Price Controls
Price ceilings and price floors cause
markets to be in permanent
disequilibrium.
Price controls are therefore inefficient.
12
Price Ceilings
Price Ceiling
It is a law or regulation that prevents sellers from
charging more than a specified amount
It keeps price low
It reduces total economic surplus
It would allow some poor families to buy the good
at the reduced price. [However, the same objective
could have been accomplished with less waste.]
13
Fig. 7.8
Economic Surplus in an Unregulated
Market for Home Heating Oil
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Fig. 7.9
The Waste Caused by Price Controls
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Fig. 7.10
When the Pie is Larger, Everyone Can
Have a Bigger Slice
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Price Floors
Price Floor
It is a law or regulation that prevents
buyers from paying less than a specified
amount
It keeps prices high
It reduces total economic surplus
It would allow some poor families to buy
the good at the reduced price. [However,
the same objective could have been
accomplished with less waste.]
17
Fig. 7.13
Equilibrium in an Unregulated
Wheat Market
18
Fig. 7.14
Lost Surplus from Price Supports
for Wheat
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Taxes and Efficiency
What happens to the price of a good
when the government imposes a tax on
it?
Most people believe that the price of the
item will rise by the amount of the tax
However, this may not be the case
Who pays the tax depends upon the
elasticities of supply and demand
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Taxes and Efficiency
Who physically pays the tax?
The supplier of the taxed good is the one who
sends the tax money to the gov’t. (Imagine if
the consumer had to write a check to the
gov’t for the gas tax each time they filled up).
So, the firm’s marginal cost of providing the
good simply increases by the amount of the
tax.
 How would this affect supply and demand?
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Fig. 7.16
The Effect of a $1 per unit Tax on the
Equilibrium Quantity and Price of
Potatoes
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Taxes and Efficiency
Even though the vertical distance
between the two supply curves is the
amount of the tax, because of the
relative slopes of the supply and
demand curves, the consumer does not
bear all of the tax burden.
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Taxes and Efficiency
Who will pay a larger percentage of the
tax?
Whoever is less flexible with regard to price.
I.E. whoever is more inelastic
Consumers will pay 100% if:
Demand is perfectly inelastic
Supply is perfectly elastic
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Fig. 7.17
The Effect of a Tax on Sellers of a Good
with Infinite Price Elasticity of Supply
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Taxes and Economic
Surplus
“Deadweight loss” (DWL)
The reduction in economic surplus that
results from a policy
A tax distorts the signal that free prices
send
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Fig. 7.18
The Market for Potatoes Without Taxes
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Fig. 7.19
The Effect of a $1 Pound Tax
on Potatoes
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Fig. 7.20
The Deadweight Loss Caused by a Tax
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DWL
CS pre-tax = ½ (3)(3,000,000) = $4,500,000
PS pre-tax = ½ (3)(3,000,000) = $4,500,000
CS post-tax = ½ (2.50)(2,500,000) = $3,125,000
PS post-tax = ½ (2.50)(2,500,000) = $3,125,000
Lost PS+CS = $2,750,000
Tax revenue = $1(2,500,000) = $2,500,000
DWL = $250,000
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Taxes, Elasticity, and
Efficiency
Deadweight loss is minimized if taxes
are imposed on goods and services that
have relatively inelastic supply or
relatively inelastic demand.
31
Fig. 7.21
Elasticity of Demand and the
Deadweight Loss from a Tax
32
Fig. 7.22
Elasticity of Supply and the
Deadweight Loss from a Tax
33
Do all taxes decrease economic
efficiency?
Consider a tax on land
Land supply is perfectly inelastic
DWL = $0
What other goods have high tax rates?
Booze
Cigarettes
Gasoline
34
Taxes, External Costs, and
Efficiency
Taxing reduces the equilibrium
quantity
Therefore, taxing activities that people
tend to pursue to excess can actually
increase total economic surplus (e.g.,
activities that cause pollution)
35
External Costs
Consider a market activity that generates
harmful side-effects on a 3rd party …
E.g. Pollution from a plant imposes costs on
anyone who lives near the plant
Does that firm’s supply curve accurately
reflect the full costs of production?
No. without regulation, the firm’s supply curve
only reflects the marginal costs of production.
The external costs are not included in these costs.
What if they were?
36
Market Equilibrium
P
S = MPC
$20 = P*MKT
D = MSB
Q*MKT
Q
At P*MKT QD = QS = Q*MKT
CS + PS are maximized
37
Market Equilibrium
The firm’s supply curve represents “private”
or “market-level” marginal costs of
production (MPC), and is used by the firm to
make pricing and output decisions.
If there are external costs (costs realized
outside of the market), the FULL costs of
production would be represented by a
different curve = MSC
For example, suppose that each unit of
output causes $2 in damage to 3rd parties.
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Social Equilibrium
P
MSC = MPC + 2
S = MPC
$21 = P*SOC
$20 = P*MKT
D = MSB
Q*SOC Q*MKT
Q
39
Social Efficiency
At P*MKT:
MSC > MSB
Q*MKT > Q*SOC the market “overproduces” the good
P*MKT < P*SOC the market “under-prices” the good
Market solution is therefore not efficient from
society’s standpoint
How can this inefficiency be corrected?
40
Social Efficiency
A tax equal to the marginal external
cost ($2.00) would serve to increase the
firm’s MPC so that it is coincident with
the MSC function.
In other words, the tax brings the
external cost into the market.
= “internalizing the externality”
41
Social Equilibrium
P
New MPC = Old MPC + 2
S = MPC
$21 = P*SOC
D = MSB
Q*SOC Q*MKT
Q
42
Can markets create external
benefits?
If markets can create costs on 3rd
parties, can they create benefits?
Sure.
Education.
Lawn care
House maintenance
Text: beekeeper adjacent to apple orchard
Will the market solution be efficient?
43
External Benefits
P
S = MSC
P*MKT
MSB
D = MPB
Q*MKT Q*SOC
Q
44
External Benefits
In the case of external benefits, the
market will under-provide the good
relative to the socially optimal amount.
I.E. at Q*MKT MSB > MSC
How can this inefficiency be corrected?
Recall the solution to negative externality
was a tax…
We should subsidize the positive
externality generating activity.
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Naturalist Questions
Why are gasoline taxes so high (relative
to other goods)?
Why aren’t gasoline taxes higher (as in
other nations)?
Why do communities have zoning
laws?
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Exercises
The more elastic demand is the ______ the burden of the
tax borne by ______.
A. smaller; consumer and producers
B. larger; consumers
C. larger; producers
D. smaller; producers
E. larger; consumers and producers
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Exercises
Which of the following statements expresses the justification for
making efficiency the first goal of economic interaction?
A. Efficiency give the poor an incentive to improve their
economic status.
B. Since consensus on what is a fair distribution of goods is
impossible, efficiency is the next best goal.
C. People are not really concerned about the problems of the
poor.
D. It is too difficult to pursue more than one goal at a time.
E. Efficiency maximizes total economic surplus and thereby
allows other goals to be more fully achieved
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