Download 2.4 Market Efficiency

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Market Efficiency and
Government Intervention
Prepared by:
Fernando Quijano and Yvonn Quijano
© 2003 Prentice Hall Business Publishing
Economics: Principles and Tools, 3/e
O’Sullivan/Sheffrin
The Metaphor of the Invisible Hand
• The “invisible hand” is Adam Smiths
description of how individual buyers and
sellers, each acting in their own selfinterest, frequently promote the social
interest.
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The Metaphor of the Invisible Hand
• To avoid socially inefficient outcomes,
four assumptions about markets are
necessary:
• Informed buyers and sellers
• Perfect Competition
• No spillover benefits
• No spillover cost
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The Demand Curve and
Consumer Surplus
• Consumer surplus is the difference between
the maximum amount a consumer is willing to
pay for a product and the price that he or she
pays for the product.
• The price of a consumer good is less than or
equal to the amount the consumer is willing to
pay for the good. Consumer surplus measures
the bonus or surplus received by the consumer.
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The Demand Curve and
Consumer Surplus
• Market consumer surplus equals the sum of the
surpluses earned by all consumers in the market.
Juan
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Willing Price Consumer
to Pay
Paid Surplus
$22
$10
$12
Tupak
$19
$10
$9
Thurl
$16
$10
$6
Forest
$13
$10
$3
Fivola
$10
$10
$0
Siggy
$7
Total consumer surplus
$30
Economics: Principles and Tools, 3/e
The Supply Curve and
Producer Surplus
• Producer surplus is the
difference between the
price a producer receives
for a product and the
minimum amount the
producer is willing to
accept for the product.
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The Supply Curve and
Producer Surplus
• Market producer surplus equals the sum of the
surpluses earned by all producers in the market.
Willing to
Receive
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Price
Producer
Received Surplus
Abe
$2
$10
$8
Bea
$4
$10
$6
Cecil
$6
$10
$4
Dee
$8
$10
$2
Eve
$10
$10
$0
Efrin
$12
Market producer surplus
$20
Economics: Principles and Tools, 3/e
Market Equilibrium and Efficiency
• Market equilibrium is
efficient because it
generates the highest
possible total market
value.
• At a price of $10, total
surplus in the market
equals $50 = $30 +
$20.
• An imposed price, above or below equilibrium,
creates inefficiencies and reduces total surplus.
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Total Surplus Is Lower with a Price
Below the Equilibrium Price
• A maximum price of $4
reduces the total value of
the market.
• The first two consumers
gain at the expense of
the first two producers.
• The consumer and
producer surplus of the
third and fourth lawns
are lost entirely.
© 2003 Prentice Hall Business Publishing
Economics: Principles and Tools, 3/e
Total Surplus Is Lower with a Price
Below the Equilibrium Price
• The maximum price of $4
prevents some beneficial
transactions.
• For example, the third
consumer is willing to pay
$16 to have his lawn cut,
and the third producer is
willing to cut it for $6. The
third lawn cut would
generate a net benefit of
$10.
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Economics: Principles and Tools, 3/e
Total Surplus Is Lower with a Price
Above the Equilibrium Price
• A minimum price of $19
reduces the total value of
the market.
• The first two producers
gain at the expense of
the first two consumers.
• The consumer and
producer surplus of the
third and fourth lawns
are lost entirely.
© 2003 Prentice Hall Business Publishing
Economics: Principles and Tools, 3/e
Total Surplus Is Lower with a Price
Above the Equilibrium Price
• The minimum price of $19
prevents some beneficial
transactions.
• For example, the third lawn
cut would generate a net
benefit of $10.
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Economics: Principles and Tools, 3/e
Government Intervention:
Controlling Price
• If a market is perfectly competitive and has no
spillovers, government intervention reduces the
total surplus of the market and thus causes
inefficiency.
• Rent control is a policy under which the
government specifies a maximum rent that is
below the equilibrium rent.
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Economics: Principles and Tools, 3/e
Government Intervention:
Controlling Price
• Rent control is a policy under which the
government specifies a maximum rent that is
below the equilibrium rent.
• Rental housing
• Gasoline
• Medical goods and services
• Both maximum and minimum prices create
winners and losers. Because the gains are less
than the losses, total market surplus decreases.
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Winners and Losers
WINNERS
LOSERS
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Government Intervention:
Restricting Quantity
• Licensing programs
place limits on the
number of producers in
a given market.
• These programs may
be intended to protect
consumers, but instead
create winners and
losers and prevent
mutually beneficial
transactions from taking
place.
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The Market Effects of Taxi Medallions
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•
Initially, the market for
taxis is in equilibrium at a
price of $3 per mile and a
quantity of 10,000 miles
per day (100 miles per
taxi).
•
A taxi medallion is a
license to operate a taxi.
In this example, a
medallion policy fixes the
number of taxis at 80, each
providing 100 miles of
service per day.
Economics: Principles and Tools, 3/e
Licensing and Market Efficiency
•
•
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The price of a taxi ride
increases to $3.60, thus,
consumer surplus
decreases.
Riders that were willing to
pay between $3.00 and
$3.60 per mile for taxi
service are now prevented
from executing mutually
beneficial transactions.
Economics: Principles and Tools, 3/e
Spillovers and Market Inefficiency
• When there are spillover costs, the market
equilibrium will be inefficient and government
intervention may be beneficial.
Spillover PRINCIPLE
For some goods the costs or benefits
associated with producing or consuming
those goods are not confined to the person or
organization producing or consuming them.
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Spillovers Costs
• Each ton of cardboard
generates 5 gallons of
waste at a cost of $2 per
gallon. Then, the pollution
cost per ton of cardboard
equals $10.
• When 50 tons of cardboard
are produced, the pollution
cost equals $500.
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Tradeoffs From Producing Less
• When production drops
to 40 tons, consumer
and producer surplus
decline.
• The reduction in
cardboard production
generates good news and
bad news: it reduces the
cost of pollution, but it
also reduces producer
and consumer surplus.
© 2003 Prentice Hall Business Publishing
Economics: Principles and Tools, 3/e
Tradeoffs From Producing Less
• As long the savings from
pollution are greater than
the loss of surplus, the
good news outweigh the
bad news.
• Is the reduction in
cardboard production to 40
tons the right amount?
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Economics: Principles and Tools, 3/e
Determining the Socially Efficient
Quantity of Cardboard
• To determine what is the socially efficient amount of
cardboard production, we can use the marginal principle.
• In this case, the marginal cost is the loss of consumer and
producer surplus per additional ton of cardboard produced, and
the marginal benefit is the pollution savings per additional ton.
Marginal PRINCIPLE
Increase the level of an activity if its marginal benefit
exceeds its marginal cost; reduce the level of an
activity if its marginal cost exceeds its marginal
benefit. If possible, pick the level at which the
activity’s marginal benefit equals its marginal cost.
© 2003 Prentice Hall Business Publishing
Economics: Principles and Tools, 3/e
Determining the Socially Efficient
Quantity of Cardboard
• When the vertical distance
between supply and
demand at a given quantity
equals $10 (or the savings
per unit in treatment costs),
marginal benefit equals
marginal cost and the
quantity of cardboard is
socially optimal. This
occurs at 36 tons of
cardboard.
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Economics: Principles and Tools, 3/e
Market Effects of a Pollution Tax
• Knowing that the efficient
amount of output is 36
tons, the government can
force producers to reduce
output to this amount by
imposing a pollution tax
• The pollution tax shifts the
supply curve up by $10,
and the market settles in
equilibrium at a price of
$37 and 36 tons of
cardboard.
© 2003 Prentice Hall Business Publishing
Economics: Principles and Tools, 3/e