2 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 concludethat markets cannot solve any problem
3 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 othersExists when an economy has reached a point where reallocating resources must harm one in order to help anotherOccurs at equilibrium of perfectly competitive markets
4 Market Equilibrium and Efficiency When a market is not in equilibrium:P > P* = surplus -- QS > QD2. P < P* = shortage -- QD > QSIn 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.
5 Fig. 7.2 How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction
6 Fig. 7.3 How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction
7 Economic Surplus Total economic surplus The sum of all the individual economic surpluses gained by buyers and sellers participating in the marketConsumer SurplusProducer Surplus
8 Surplus Consumer Surplus Producer Surplus Economic surplus gained by the buyers of a productMeasured by the difference between their reservation price and the price they payProducer SurplusEconomic surplus gained by the sellers of a productMeasured by the difference between the price they receive and their reservation price
9 Fig. 7.7 Total Economic Surplus in the Market for Milk
10 Surplus and Efficiency Equilibrium price and quantity maximize the total economic surplusTotal economic surplus would be lower at any other price and quantity combinationI.E., “waste” or unrealized gain occurs at any other price and quantity combination
11 Other Goals Efficiency is not the only goal An equitable income distribution is a desirable goal for manyWhy efficiency should be the first GoalEfficiency enables us to achieve all other goals to the fullest possible extentEfficiency minimizes waste
12 The Costs of Price Controls Price ceilings and price floors cause markets to be in permanent disequilibrium.Price controls are therefore inefficient.
13 Price Ceilings Price Ceiling It is a law or regulation that prevents sellers from charging more than a specified amountIt keeps price lowIt reduces total economic surplusIt would allow some poor families to buy the good at the reduced price. [However, the same objective could have been accomplished with less waste.]
14 Fig. 7.8 Economic Surplus in an Unregulated Market for Home Heating Oil
16 Fig. 7.10 When the Pie is Larger, Everyone Can Have a Bigger Slice
17 Price Floors Price Floor It is a law or regulation that prevents buyers from paying less than a specified amountIt keeps prices highIt reduces total economic surplusIt would allow some poor families to buy the good at the reduced price. [However, the same objective could have been accomplished with less waste.]
18 Fig. 7.13 Equilibrium in an Unregulated Wheat Market
19 Fig. 7.14 Lost Surplus from Price Supports for Wheat
20 Taxes and EfficiencyWhat 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 taxHowever, this may not be the caseWho pays the tax depends upon the elasticities of supply and demand
21 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?
22 Fig. 7.16 The Effect of a $1 per unit Tax on the Equilibrium Quantity and Price of Potatoes
23 Taxes and EfficiencyEven 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.
24 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 inelasticConsumers will pay 100% if:Demand is perfectly inelasticSupply is perfectly elastic
25 Fig. 7.17 The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply
26 Taxes and Economic Surplus “Deadweight loss” (DWL)The reduction in economic surplus that results from a policyA tax distorts the signal that free prices send
27 Fig. 7.18 The Market for Potatoes Without Taxes
28 Fig. 7.19 The Effect of a $1 Pound Tax on Potatoes
30 DWL CS pre-tax = ½ (3)(3,000,000) = $4,500,000 PS pre-tax = ½ (3)(3,000,000) = $4,500,000CS post-tax = ½ (2.50)(2,500,000) = $3,125,000PS post-tax = ½ (2.50)(2,500,000) = $3,125,000Lost PS+CS = $2,750,000Tax revenue = $1(2,500,000) = $2,500,000DWL = $250,000
31 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.
32 Fig. 7.21 Elasticity of Demand and the Deadweight Loss from a Tax
33 Fig. 7.22 Elasticity of Supply and the Deadweight Loss from a Tax
34 Do all taxes decrease economic efficiency? Consider a tax on landLand supply is perfectly inelasticDWL = $0What other goods have high tax rates?BoozeCigarettesGasoline
35 Taxes, External Costs, and Efficiency Taxing reduces the equilibrium quantityTherefore, taxing activities that people tend to pursue to excess can actually increase total economic surplus (e.g., activities that cause pollution)
36 External CostsConsider 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 plantDoes 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?
37 Market Equilibrium CS + PS are maximized At P*MKT QD = QS = Q*MKT P S = MPC$20 = P*MKTD = MSBAt P*MKT QD = QS = Q*MKTCS + PS are maximizedQ*MKT Q
38 Market EquilibriumThe 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 = MSCFor example, suppose that each unit of output causes $2 in damage to 3rd parties.
39 Social Equilibrium P MSC = MPC + 2 S = MPC D = MSB Q*SOC Q*MKT Q $21 = P*SOC$20 = P*MKTD = MSBQ*SOC Q*MKT Q
40 Social Efficiency At P*MKT: How can this inefficiency be corrected? MSC > MSBQ*MKT > Q*SOC the market “overproduces” the goodP*MKT < P*SOC the market “under-prices” the goodMarket solution is therefore not efficient from society’s standpointHow can this inefficiency be corrected?
41 Social EfficiencyA 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”
42 Social Equilibrium P New MPC = Old MPC + 2 S = MPC D = MSB $21 = P*SOCD = MSBQ*SOC Q*MKT Q
43 Can markets create external benefits? If markets can create costs on 3rd parties, can they create benefits?Sure.Education.Lawn careHouse maintenanceText: beekeeper adjacent to apple orchardWill the market solution be efficient?
45 External BenefitsIn the case of external benefits, the market will under-provide the good relative to the socially optimal amount.I.E. at Q*MKT MSB > MSCHow can this inefficiency be corrected?Recall the solution to negative externality was a tax…We should subsidize the positive externality generating activity.
46 Naturalist QuestionsWhy 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?
47 ExercisesThe 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
48 ExercisesWhich 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