1 C H A P T E R 6 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Market Efficiency and Government Intervention

2 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Social Interest and the Invisible Hand  Private market equilibrium may be efficient, that is, it may generate the largest possible net benefits for buyers and sellers.  The “invisible hand” is Adam Smith’s description of how individual buyers and sellers, each acting in their own self- interest, frequently promote the social interest.

3 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Social Interest and the Invisible Hand  Markets may not be socially efficient if buyers and sellers acting in their own self-interest generate outcomes that are contrary to the social interest.  To avoid socially inefficient outcomes, four assumptions about markets are necessary: Informed buyers and sellers Perfect Competition No spillover benefits No spillover cost

4 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Consumer Surplus  The price a consumer pays for a good is usually less than the amount he or she is willing to pay. Consumer surplus measures the bonus or surplus received by the consumer.  Consumer surplus is the difference between the maximum amount a consumer is willing to pay for a product and the price the consumer actually pays.

5 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Demand Curve and Consumer Surplus  Market consumer surplus equals the sum of the surpluses earned by all consumers in the market. $30 Market consumer surplus 7Siggy 010 Fivola 31013Forest 61016Thurl 91019Tupak Juan Consumer Surplus Price Paid Willing to Pay

6 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Supply Curve and Producer Surplus  The minimum amount a producer is willing to accept is the marginal cost of producing the product, which includes the cutter’s opportunity cost of his or her time.  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.

7 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Supply Curve and Producer Surplus  Market producer surplus equals the sum of the surpluses earned by all producers in the market. $20 Market producer surplus 12 Efrin 010 Eve Dee Cecil Bea Abe Producer Surplus Price Received Willing to Receive

8 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Market Equilibrium and Efficiency  Market equilibrium is efficient because it generates the highest possible total market value.  An imposed price above or below equilibrium would create inefficiency and reduce total surplus.  At a price of $10, total surplus in the market equals $50 = $30 + $20.

9 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Impact of an Imposed Maximum Price on the Total Surplus of the Market  A government- imposed maximum price is a price below equilibrium, designed to protect consumers.  At a maximum price of $4, the surplus of the first two consumers expands as the surplus of the first two producers drops.  Surpluses for the third and fourth lawns are lost entirely, so the total market value decreases.

10 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Impact of an Imposed Maximum Price on the Total Surplus of the Market  The maximum price of $4 prevents some beneficial transactions.  The third lawn cut would generate a net benefit of $10.  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.

11 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Impact of an Imposed Minimum Price on the Total Surplus of the Market  A government-imposed minimum price is a price above equilibrium. It benefits some producers but lowers the total value of the market.  The surplus of the first two producers expands as the surplus of the first two consumers disappears. Surpluses for the third and fourth lawns are lost entirely.  A price floor turns consumer surplus into producer surplus.

12 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Impact of an Imposed Minimum Price on the Total Surplus of the Market  The minimum price of $19 prevents some beneficial transactions.  The third lawn cut would generate a net benefit of $10.  For example, the third producer is willing to cut lawns at $6 per lawn, and the third consumer is willing to pay $16 for the cut.

13 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Government Intervention: Restricting Quantity  These programs may be intended to protect consumers, but instead create winners and losers and prevent mutually beneficial transactions from taking place.  Licensing programs place limits on the number of producers in a given market.

14 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Market Effects of Taxi Medallions  A medallion policy fixes the number of taxis at 80 and increases the price to $3.60.  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).

15 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Winners and Losers From Medallions  Riders willing to pay between $3.00 and $3.60 per mile for taxi service are prevented from executing mutually beneficial transactions.  The first 80 taxi drivers that obtain medallions from the city for free are the winners of the medallion policy.  The medallion policy reduces both consumer surplus and producer surplus.

16 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Import Restrictions  With free trade, equilibrium in the sugar market occurs at 12 cents per pound and 360 million pounds (point i ).  Domestic producers do not participate in the market since they must receive more than 26 cents to begin producing (point m).

17 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Import Restrictions  A ban on imports of sugar brings equilibrium to point d.  The ban creates domestic producer surplus, but the gain by domestic producers is less than the loss to domestic consumers.

18 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin 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 the good are not confined to the person or organization that decides how much of the good to produce or consume.

19 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin 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.

20 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Tradeoffs From Producing Less  When production drops to 40 tons, consumer and producer surplus decline.  The reduction in cardboard production reduces producer and consumer surplus, but also reduces the cost of pollution.  Since the savings from pollution (blue square) are greater than the loss of surplus (triangle), output reduction is good news.

21 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Determining the Optimal Amount of Pollution  To decide by how much to reduce cardboard production to coincide with the socially efficient amount, we can use the marginal principle. Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.  Marginal benefit: pollution savings per additional ton.  Marginal cost: loss of consumer and producer surplus per additional ton of cardboard produced.

22 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Tradeoffs From Producing Less  When output is reduced from 40 to 39 tons, the loss of consumer surplus equals $5 ($35-$30), and the loss of producer surplus equals $2 ($30 - $28).  The marginal cost of cutting production from 40 to 39 tons equals $7.  The vertical distance between supply and demand at a given quantity shows the marginal cost of reducing output, or loss of surplus.

23 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Finding the Socially Optimal Amount of Output  At 36 tons of cardboard, marginal benefit equals marginal cost and the quantity of cardboard is socially optimal.  When the vertical distance between supply and demand at a given quantity equals the $10 savings from pollution, the quantity of cardboard is optimal.

24 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Market Effects of 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.  A pollution tax of $2 per gallon of waste increases the marginal cost of producing cardboard by $10 ($2 x 5 gallons per ton).  The tax forces firms to bear the full cost of production, including the cost of pollution.