Download EFFICIENCY OF MARKETS

EFFICIENCY OF MARKETS
ECO 2023
Principles of Microeconomics
Dr. McCaleb
Efficiency of Markets
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TOPIC OUTLINE
I.
Consumer and Producer Surplus
II. Efficiency of Competitive Markets
III. Markets, Prices, and Efficiency
IV. Prices and Markets
V.
Tax Incidence
Efficiency of Markets
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Consumer and Producer Surplus
Efficiency of Markets
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CONSUMER AND PRODUCER SURPLUS
 Consumer Surplus
Definition
Consumer surplus is the difference between consumers’ marginal
benefit, measured by their willingness to pay for a good, and the
price they actually pay.
Consumer Surplus=MB-P
Consumer surplus is the difference between what consumers gain
from having the good and what they must give up to get it, a measure
of how much better off they are from having the good.
Efficiency of Markets
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CONSUMER AND PRODUCER SURPLUS
Consumer Surplus:
Illustration
The vertical distance to the demand
curve shows the marginal benefit,
measured by the maximum price the
buyer would be willing to pay for
each unit of the good.
Consumer surplus is the difference
between this MB and the P.
In the diagram, consumer surplus is
the green triangle, the area below
the demand curve and above the
price. It equals $10.
Efficiency of Markets
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CONSUMER AND PRODUCER SURPLUS
 Producer Surplus
Definition
Producer surplus is the difference between the price actually
received by sellers for a unit of the good and the minimum price they
at which they would be willing to sell it. The minimum price at
which they would be willing to sell equals the marginal cost.
Producer Surplus=P-MC
Producer surplus is the difference between what the sellers’ gain from
selling the good and their opportunity cost. Their opportunity cost is
what they would gain if they used their resources to produce or sell
the next best alternative good.
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CONSUMER AND PRODUCER SURPLUS
Producer Surplus:
Illustration
The vertical distance to the supply
curve shows the marginal cost,
equal to the minimum price sellers
are willing to accept for the good.
Producer surplus is the difference
between the P and this MC.
In the diagram, producer surplus is
the blue triangle, the area below the
price and above the supply curve. It
equals $400.
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Consumer surplus is measured by the area
1.
between the demand curve and the supply curve.
2. between the MB curve and the MC curve.
3.
between the MB curve and the price line.
4.
under the supply curve
5.
between the price line and the MC curve.
6.
above the demand curve.
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True (T) or false (F): Producer surplus is the difference
between what the sellers’ gain from selling the good and their
opportunity cost.
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Efficiency of Competitive Markets
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EFFICIENCY OF COMPETITIVE MARKETS
 Economic Efficiency
Definition
A situation in which the quantities of goods and services produced
are those that people value most highly.
Resource use is efficient when we cannot have more of one good
without giving up some of another good that has greater value.
Economic efficiency occurs where marginal benefit equals marginal
cost.
Efficient quantity: Where MB=MC
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EFFICIENCY OF COMPETITIVE MARKETS
The Efficient Quantity
If the marginal benefit of the current
quantity exceeds the marginal cost
(as at 5), the efficient quantity is
greater than the current quantity.
If the marginal cost of the current
quantity exceeds the marginal
benefit (as at 15), the efficient
quantity is smaller than the current
quantity.
When marginal benefit equals
marginal cost (as at 10), the
quantity is efficient.
Efficiency of Markets
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EFFICIENCY OF COMPETITIVE MARKETS
 Market Equilibrium
Definition
A situation in which neither buyers nor sellers have any incentive to
change their behavior.
Market prices adjust up or down to bring about an equilibrium. At
equilibrium, there are no forces causing either quantity or price to
change.
Market equilibrium occurs when quantity demanded=quantity
supplied:
Equilibrium Q: Where QD=QS
Efficiency of Markets
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EFFICIENCY OF COMPETITIVE MARKETS
 Efficiency of Competitive Equilibrium
Fundamental Principle:
Equilibrium in a competitive market is efficient
The equilibrium quantity in any market is the quantity at which
quantity demanded=quantity supplied.
The efficient quantity is the quantity where marginal benefit equals
marginal cost.
But demand shows consumers’ marginal benefit and supply shows
sellers’ marginal cost. Therefore, in a competitive market, the
equilibrium quantity is the same as the efficient quantity.
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EFFICIENCY OF COMPETITIVE MARKETS
An Efficient Pizza Market
The equilibrium price is $10 and the
equilibrium quantity is 10,000
pizzas per day.
The equilibrium quantity is the
efficient quantity because at this
quantity marginal benefit equals
marginal cost.
At the efficient quantity, the sum of
consumer surplus and producer
surplus is greater than at any other
quantity. The efficient quantity
maximizes the sum of consumer
and producer surplus.
Efficiency of Markets
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EFFICIENCY OF COMPETITIVE MARKETS
 When A Market Is Inefficient
Deadweight loss from underproduction or
overproduction
If the quantity of a good is either less than the efficient quantity
(underproduction) or greater than the efficient quantity
(overproduction), consumer and producer surplus are not maximized.
We say that there is a deadweight loss.
The deadweight loss is the reduction in the sum of consumer and
producer surplus that results when the quantity is inefficient.
It is a net social loss.
Efficiency of Markets
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EFFICIENCY OF COMPETITIVE MARKETS
 When A Market Is Inefficient
Sources of market inefficiency
• Taxes and subsidies
• Regulated prices and quantities (price ceilings, price floors, quotas)
• Positive and negative externalities
• Monopoly and other limits to competition
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The competitive equilibrium quantity is defined as the
quantity at which
1.
Demand equals supply
2.
Quantity demanded equals quantity supplied
3.
Marginal benefit equals marginal cost
4.
Price equals quantity
Efficiency of Markets
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The efficient quantity is defined as the quantity at which
1.
Demand equals supply
2.
Quantity demanded equals quantity supplied
3.
Marginal benefit equals marginal cost
4.
Price equals quantity
Efficiency of Markets
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True (T) or false (F): The demand curve shows the buyers’
marginal benefit.The supply curve shows the sellers’ marginal
cost. Therefore, at the competitive equilibrium quantity
demanded equals quantity supplied, marginal benefit also
equals marginal cost, and the equilibrium quantity is also the
efficient quantity.
Efficiency of Markets
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Inefficiency of Taxes and Subsidies
Efficiency of Markets
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Suppose a tax is imposed on DVD recorder/players. Because
of the tax, the price is so high that no one buys DVD
recorder/players. Instead, they buy only VCR’s.
1.
How much revenue does the tax raise?
2.
Is anyone worse off because of the tax?
Efficiency of Markets
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INEFFICIENCY OF TAXES AND SUBSIDIES
 Taxes
Taxes are economically inefficient
A tax places a wedge between buyers’ marginal benefit and sellers’
marginal cost. Because of the tax, at the equilibrium quantity
MB>MC.
The equilibrium quantity of a taxed good is less than the efficient
quantity. The good is underproduced.
There is a loss in consumer and producer surplus. This is the
deadweight loss or excess burden of a tax.
Efficiency of Markets
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INEFFICIENCY OF TAXES AND SUBSIDIES
Inefficiency of a Tax
A $10 tax shifts the supply curve to
S + tax. The equilibrium quantity is
now 2000 instead of 5000. At the
new equilibrium, MB>MC.
Consumer surplus and producer
surplus are less than without the tax.
The loss in the sum of consumer
and producer surplus is the
deadweight loss or excess burden of
the tax.
Efficiency of Markets
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INEFFICIENCY OF TAXES AND SUBSIDIES
 Subsidies
Subsidies are economically inefficient
Subsidies are essentially negative taxes. Like a tax, a subsidy places a
wedge between buyers’ marginal benefit and sellers’ marginal cost,
but with a subsidy, at the equilibrium quantity MB<MC.
The equilibrium quantity of a subsidized good is greater than the
efficient quantity. The good is overproduced.
Because of the overproduction, there is a loss in consumer and
producer surplus. This is the deadweight loss of the subsidy.
Efficiency of Markets
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INEFFICIENCY OF TAXES AND SUBSIDIES
Inefficiency of a Subsidy
A $5 subsidy shifts the supply curve
to S - subsidy. The equilibrium
quantity is now 15,000 instead of
10,000. At the new equilibrium,
MB<MC.
Consumer surplus and producer
surplus are less than without the
subsidy.
S - subsidy
The loss in the sum of consumer
and producer surplus is the
deadweight loss from the subsidy.
Efficiency of Markets
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A tax is inefficient because it results in _____ and a subsidy is
inefficient because it results in _____.
1. Overproduction; overproduction
2. Overproduction; underproduction
3. Underproduction; overproduction
4. Underproduction; underproduction
Efficiency of Markets
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Markets and Prices
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MARKETS,
PRICES,
AND
EFFICIENCY
MARKETS
AND
PRICES
 The Invisible Hand Principle
Free markets and prices allocate resources efficiently
When prices are determined by the market forces of consumer
demand and producer supply, consumers get the quantity of each
good or service that they value most highly and are willing to pay for.
Prices provide incentives for producers to supply the efficient
quantity of each good. Market determined prices ensure that the sum
of consumer and producer surplus is maximized.
Efficiency of Markets
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MARKETS AND PRICES
 The Invisible Hand Principle
Underproduction
Prices provide incentives for producers to allocate more resources to
those goods that are underproduced because they are in excess
demand. The price consumers are willing to pay for additional
(marginal) units is greater than the cost to produce those units.
Overproduction
Prices provide incentives for producers to allocate fewer resources to
those goods that are overproduced because they are in excess supply.
The price consumers are willing to pay for additional (marginal) units
is less than the cost to produce those units.
Efficiency of Markets
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MARKETS AND PRICES
 Three Great Myths about Prices
• Prices ration goods to high income people.
• Lower prices always benefit consumers, especially
low income consumers.
• Lower prices mean lower costs for consumers.
Efficiency of Markets
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MARKETS AND PRICES
 Three Truths about Prices
Prices do not necessarily ration goods and services to
high income people
Having more of one good means giving up some of other goods.
Prices ration goods to those who are willing to give up the most other
goods.
Therefore, using prices to ration a good favors those individuals who
place the highest value on the good relative to other goods. High
income or wealthy individuals do not always place the highest value
on a good.
Efficiency of Markets
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MARKETS AND PRICES
 Three Truths about Prices
Low prices do not necessarily benefit consumers
People, including low income people, are not necessarily better off
with lower prices. If prices are held below the market equilibrium
price, the good will be underproduced creating an excess demand.
A low price is of no benefit if you can’t get as much of the good as
you would like or if you incur significant time and money costs
searching for the good or if you have to make “side payments” such
as bribes to get the good.
Efficiency of Markets
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MARKETS AND PRICES
 Three Truths about Prices
Lower prices do not necessarily mean lower costs
Lower prices do not necessarily mean lower opportunity costs.
With prices below equilibrium, opportunity costs often increase, and
may increase more for low income people than for higher income
people. It is even possible that opportunity costs rise for everyone so
that everyone is worse off with prices below equilibrium.
Efficiency of Markets
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Tax Incidence
Efficiency of Markets
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When Oregon increased the excise tax on cigarettes, who was
legally responsible for paying the tax to the government?
On whom did the real economic burden of Oregon’s cigarette
tax rest?
Is the real economic burden of a tax always on the same
economic agents?
Efficiency of Markets
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Who Pays the U.S. Income Tax?
Share of 2001 Individual Income Tax Liabilities
Income Quintile
Share of Taxes
Share of Income
Lowest
-2.3%
4.2%
Second
3.0%
9.2%
Middle
5.2%
14.2%
Fourth
14.3%
20.7%
Highest
82.5%
52.4%
Top 10%
67.7%
37.6%
Top 5%
55.2%
27.5%
Top 1%
34.4%
14.8%
Source: U.S. Congressional Budget Office
Efficiency of Markets
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Who Bears How Much of the Tax Burden?
2001 Tax Shares
Income All Federal Individual
Quintile
Taxes
Income Tax
Payroll
Tax
Corporate
Income Tax
Excise
Taxes
Lowest
1.1%
-2.3%
4.2%
0.8%
11.1%
Second
5.0%
3.0%
10.3%
2.1%
14.6%
Middle
10.0%
5.2%
16.0%
5.4%
18.0%
Fourth
18.5%
14.3%
25.6%
7.7%
22.0%
Highest
65.3%
82.5%
43.9%
82.6%
33.9%
Source: U.S. Congressional Budget Office
Efficiency of Markets
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TAX INCIDENCE
 Tax Incidence
Definition
The division of the burden of a tax between the buyer and the seller.
• If the price rises by the full amount of the tax, then the burden
of the tax falls entirely on the buyer.
• If the price doesn’t change, then the burden of the tax falls
entirely on the seller.
• If the price rises by a lesser amount than the tax, then the
burden of the tax falls partly on the buyer and partly on the
seller.
Efficiency of Markets
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TAX INCIDENCE
 Two Types of Tax Incidence
Legal incidence and economic incidence
Legal incidence: Who is legally liable for payment of the tax. The
legal incidence is determined by the tax law.
Economic incidence: Who ultimately bears the real economic burden
of the tax. The economic incidence is determined by the market
forces of demand and supply. It is unrelated to the legal incidence.
Efficiency of Markets
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TAX INCIDENCE
Economic Incidence of a
Tax on CD Players (1)
With no tax, the price of a CD
player is $100 and 5,000 CD
players a week are bought.
A $10 tax per CD player legally
imposed on sellers of CD players
shifts the supply curve to S + tax.
Efficiency of Markets
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TAX INCIDENCE
Economic Incidence of a
Tax on CD Players (2)
The equilibrium price rises to
$105—an increase of $5 a CD
player. The equilibrium quantity
decreases to 2,000 CD players a
week.
Sellers receive $95 after payment of
the tax—a decrease of $5 per CD
player.
Efficiency of Markets
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TAX INCIDENCE
Economic Incidence of a
Tax on CD Players (3)
The government collects tax
revenue of $20,000 a week—the
purple rectangle.
The burden of the tax is split
equally between the buyer and the
seller—each pays $5 per CD player.
Efficiency of Markets
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Because the law specifies that sellers of cigarettes in Oregon
are responsible for paying the tax to the government, the
_____ incidence of the cigarette tax is on the _____.
1.
Legal; buyers
2.
Legal; sellers
3.
Economic; buyers
4.
Economic; sellers
Efficiency of Markets
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Because the price of cigarettes in Oregon increased by the full
amount of the cigarette tax, the _____ incidence of the tax is
on the _____.
1.
Legal; buyers
2.
Legal; sellers
3.
Economic; buyers
4.
Economic; sellers
Efficiency of Markets
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TAX INCIDENCE
 Tax Incidence and Elasticity
Economic incidence depends on elasticities of demand
and supply
The division of the real tax burden between buyers and sellers--the
economic incidence of the tax--depends on the relative price
elasticities of demand and supply.
If demand is more elastic (less inelastic), the price increase is smaller
and the buyers bear the smaller share of the tax. If supply is more
elastic (less inelastic), the price increase is larger and the buyers bear
the larger share of the tax.
Efficiency of Markets
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TAX INCIDENCE
Tax Incidence in a Market
with Perfectly Elastic
Supply—The Market for
Sand
A tax of 1¢ a pound increases the
price by 1¢ a pound, and the buyer
pays all the tax.
Efficiency of Markets
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TAX INCIDENCE
Tax Incidence in a Market
with Perfectly Inelastic
Demand—The Market for
Insulin
A tax of 20¢ a dose raises the price
by 20¢, and the buyer pays all the
tax.
Efficiency of Markets
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TAX INCIDENCE
Tax Incidence in a Market
with Perfectly Elastic
Demand—The Market for
Pink Marker Pens
A tax of 10¢ a pen lowers the price
received by the seller by 10¢, and
the seller pays all the tax.
Efficiency of Markets
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TAX INCIDENCE
Tax Incidence in a Market
with Perfectly Inelastic
Supply—The Market for
Spring Water
A tax of 5¢ a bottle lowers the price
received by the seller by 5¢, and the
seller pays all the tax.
Efficiency of Markets
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The entire economic incidence of a tax is on the buyers if
either demand is perfectly _____ or supply is perfectly _____.
1.
Elastic; elastic
2.
Elastic; inelastic
3.
Inelastic; elastic
4.
Inelastic; inelastic
Efficiency of Markets
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The entire economic incidence of a tax is on the sellers if
either demand is perfectly _____ or supply is perfectly _____.
1.
Elastic; elastic
2.
Elastic; inelastic
3.
Inelastic; elastic
4.
Inelastic; inelastic
Efficiency of Markets
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TAX INCIDENCE
 Example 1: Incidence of the Payroll Tax
Legal Incidence
Social security and Medicare are financed by a payroll tax. The total
tax is 15.3% of an employer’s payroll.
The legal incidence of the payroll tax is divided equally between the
employer and the employee. The employer pays 7.65% of each
worker’s pay and the employee has 7.65% deducted from his or her
pay.
Who really pays the payroll tax?
Efficiency of Markets
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TAX INCIDENCE
 Example 1: Incidence of the Payroll Tax
Economic Incidence
Empirical evidence shows the supply of labor is very inelastic (0.10.2).
With a very inelastic supply, the economic incidence of a tax is
mostly on the sellers. In the labor market, the workers or employees
are the sellers.
Therefore, no matter how the legal incidence is divided between
employers and employees, the economic incidence of the payroll tax
is primarily on workers. The net wage received by workers is
approximately 15.3% lower than it would be if there were no payroll
tax.
Efficiency of Markets
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TAX INCIDENCE
 Example 2: Incidence of Taxes on Business
Legal Incidence
Businesses do not pay taxes in any real economic sense. Only people
pay taxes. All of a business’s revenues are derived from people
(consumers) and ultimately become income to other people
(employees, suppliers of other resources, owners and shareholders).
Even though the legal incidence of a tax may be on business, the
economic incidence must rest on people.
Efficiency of Markets
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TAX INCIDENCE
 Example 2: Incidence of Taxes on Business
Economic Incidence: What Are the Possibilities?
Just because the legal incidence of a tax is on business income or
profits does not necessarily mean that profits are lower by the amount
of the tax. The tax may instead raise prices or reduce wages or lower
the prices paid to other resource suppliers.
Efficiency of Markets
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TAX INCIDENCE
 Example 2: Incidence of Taxes on Business
Consumers
If consumer demand for the goods produced by the business is
relatively inelastic, then consumers pay higher prices than they
would if there were no tax. A share of the real tax burden is shifted
from business owners to consumers.
Because of the higher prices, consumers bear part of the economic
incidence of the tax. The tax business is actually a tax on consumers.
Efficiency of Markets
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TAX INCIDENCE
 Example 2: Incidence of Taxes on Business
Workers
If workers’ supply of labor is relatively inelastic, then workers are
paid lower wages than they would receive if there were no tax. Part
of the real tax burden is shifted to workers.
Because of lower wages, workers bear part of the economic
incidence of the tax. The tax on business is actually a tax on workers.
Efficiency of Markets
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TAX INCIDENCE
 Example 2: Incidence of Taxes on Business
Suppliers of other resources
If the supply of other productive resources used by the business
(physical capital, land) is relatively inelastic, then the suppliers of
those other resources receive lower prices than they would if there
were no tax. Part of the real tax burden is shifted to other resource
suppliers.
Because of lower prices for other resources, suppliers of other
resources bear part of the economic incidence of the tax. The tax on
business is actually a tax on other resource suppliers.
Efficiency of Markets
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TAX INCIDENCE
 Example 2: Incidence of Taxes on Business
Investors, entrepreneurs and suppliers of financial
capital
If the supply of financial capital and entrepreneurship to the business
is relatively inelastic, then part of the economic incidence of a tax on
business rests on the business’s owners and shareholders who supply
these services. The income they earn from their investment in the
business is lower than it would be if there were no tax.
Only in this case is a tax on business really a tax on profits.
Efficiency of Markets
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TAX INCIDENCE
 Example 2: Incidence of Taxes on Business
Who ultimately bears the economic incidence of a tax
on business?
Legislators have no influence over the economic incidence of taxes
on business. Economics, not politics, determines where the ultimate
burden of a tax on business rests.
Because the supply of labor is very inelastic and consumer demand is
often less elastic than the supply of capital or entrepreneurship, a
large part of any tax on business is likely to rest on workers and
consumers, not on owners and shareholders.
Efficiency of Markets
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