© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 6 Market Efficiency and Government Intervention

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Metaphor of the Invisible Hand 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.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin 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

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin 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.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.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.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Demand Curve and Consumer Surplus Market consumer surplus equals the sum of the surpluses earned by all consumers in the market.Market consumer surplus equals the sum of the surpluses earned by all consumers in the market. $30 Total consumer surplus $7Siggy $0$10 Fivola $3$10$13Forest $6$10$16Thurl $9$10$19Tupak $12$10$22Juan Consumer Surplus Price Paid Willing to Pay

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin 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.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.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Supply Curve and Producer Surplus Market producer surplus equals the sum of the surpluses earned by all producers in the market.Market producer surplus equals the sum of the surpluses earned by all producers in the market.$20 Market producer surplus Market producer surplus $12 Efrin Efrin $0$10$10 Eve Eve $2$10 $8 $8 Dee Dee $4$10 $6 $6 Cecil Cecil $6$10 $4 $4 Bea $8$10 $2 $2 Abe Abe Producer Surplus Price Received Willing to Receive

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Market Equilibrium and Efficiency Market equilibrium is efficient because it generates the highest possible total market value.Market equilibrium is efficient because it generates the highest possible total market value. An imposed price, above or below equilibrium, creates inefficiencies and reduces total surplus.An imposed price, above or below equilibrium, creates inefficiencies and reduces total surplus. At a price of $10, total surplus in the market equals $50 = $30 + $20.At a price of $10, total surplus in the market equals $50 = $30 + $20.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Total Surplus Is Lower with a Price Below the Equilibrium Price A maximum price of $4 reduces the total value of the market.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 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.The consumer and producer surplus of the third and fourth lawns are lost entirely.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The maximum price of $4 prevents some beneficial transactions.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.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. Total Surplus Is Lower with a Price Below the Equilibrium Price

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Total Surplus Is Lower with a Price Above the Equilibrium Price A minimum price of $19 reduces the total value of the market.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 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.The consumer and producer surplus of the third and fourth lawns are lost entirely.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The minimum price of $19 prevents some beneficial transactions.The minimum price of $19 prevents some beneficial transactions. For example, the third lawn cut would generate a net benefit of $10.For example, the third lawn cut would generate a net benefit of $10. Total Surplus Is Lower with a Price Above the Equilibrium Price

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin 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.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.Rent control is a policy under which the government specifies a maximum rent that is below the equilibrium rent.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Government Intervention: Controlling Price Rent control is a policy under which the government specifies a maximum rent that is below the equilibrium rent.Rent control is a policy under which the government specifies a maximum rent that is below the equilibrium rent. Rental housing Rental housing Gasoline Gasoline Medical goods and services 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.Both maximum and minimum prices create winners and losers. Because the gains are less than the losses, total market surplus decreases.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Government Intervention: Restricting Quantity Licensing programs place limits on the number of producers in a given market.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.These programs may be intended to protect consumers, but instead create winners and losers and prevent mutually beneficial transactions from taking place.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Market Effects of Taxi Medallions 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.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. 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).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).

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Licensing and Market Efficiency 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.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. The price of a taxi ride increases to $3.60, thus, consumer surplus decreases.The price of a taxi ride increases to $3.60, thus, consumer surplus decreases.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Licensing and Market Efficiency The triangle mse represents a net loss for the city as a whole—less taxi service, at a higher price.The triangle mse represents a net loss for the city as a whole—less taxi service, at a higher price. The first 80 taxis to obtain a medallion are the winners of the policy. The loss of consumer surplus translates into a gain of producer surplus for these taxis.The first 80 taxis to obtain a medallion are the winners of the policy. The loss of consumer surplus translates into a gain of producer surplus for these taxis.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Case of the Cheap Pet Salon The reason for a decrease in the price of grooming services is not that supply has increased—the city has not issued any more licenses, and supply remains constant at 300 pet services per day.The reason for a decrease in the price of grooming services is not that supply has increased—the city has not issued any more licenses, and supply remains constant at 300 pet services per day. A lower price must be explained by a decrease in demand.A lower price must be explained by a decrease in demand.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin With free trade, the total surplus is shown by the shaded areas (consumer and producer surplus.With free trade, the total surplus is shown by the shaded areas (consumer and producer surplus. The price of 12¢ is below the minimum price domestic producers are willing to accept, so domestic firms do not participate in the market. All producer surplus is foreign producer surplus.The price of 12¢ is below the minimum price domestic producers are willing to accept, so domestic firms do not participate in the market. All producer surplus is foreign producer surplus. Import Restrictions

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin If sugar imports are banned, the only supply becomes the domestic (U.S.) supply.If sugar imports are banned, the only supply becomes the domestic (U.S.) supply. Equilibrium price increases and quantity decreases. The ban generates a producer surplus for domestic producers, but their gain is less than the loss to domestic consumers.Equilibrium price increases and quantity decreases. The ban generates a producer surplus for domestic producers, but their gain is less than the loss to domestic consumers. The Effects of an Import Ban

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Spillovers and Market Inefficiency When there are spillover costs, the market equilibrium will be inefficient and government intervention may be beneficial.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.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’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.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.When 50 tons of cardboard are produced, the pollution cost equals $500.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Tradeoffs From Producing Less When production drops to 40 tons, consumer and producer surplus decline.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.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 PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Tradeoffs From Producing Less As long the savings from pollution are greater than the loss of surplus, the good news outweigh the bad news.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?Is the reduction in cardboard production to 40 tons the right amount?

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Determining the Socially Efficient Quantity of Cardboard To determine what is the socially efficient amount of cardboard production, we can use the marginal principle.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. 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 PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin 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.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.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin 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 taxKnowing 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.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.