Pricing and Efficiency in Competitive Markets Market Interventions & Institutions Dr. Nikos Nikiforakis The University of Melbourne

Overview The purpose of this talk: Part I: To show how we can utilize theoretical tools to evaluate the effect of different policies. Part II: To show the importance of experiments in evaluating different institutions Ultimately, the goal is to let you know some of the policy analysis that is out there and importance of experiments

Pricing and Efficiency in Competitive Markets Part I: Market Interventions

Introduction Earlier on we saw that… In a competitive market the equilibrium price (p*) will be the one where quantity demanded will equal quantity supplied. p* is the price that maximizes efficiency as all gains from trade are exhausted What happens to p* and q* as the economic environment changes?

Introduction We will discuss two types of policy: 1. Taxes 2. Price controls “Comparative statics”: change in equilibrium outcomes as a result of a change in economic environment.

Imposition of tax Different taxes (direct-indirect, value- quantity, progressive-regressive etc.) We will consider effects of a quantity tax on sellers (for further discussion see Stiglitz (2000)) Quantity tax – a tax levied per unit of quantity bought or sold For simplicity let’s consider that there exist many buyers and sellers That is, demand and supply curves are straight lines

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 q0q0 p0p0 Example 1: Tax imposed to sellers

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 q0q0 p0p0 Example 1: Tax imposed to sellers

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 e1e1 q0q0 q1q1 p1p1 p0p0 Example 1: Tax imposed to sellers

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 e1e1 q0q0 q1q1 p1p1 p0p0 Example 1: Tax imposed to sellers p 1- p 0 < t

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 e1e1 q0q0 q1q1 p1p1 p0p0 Example 1: Tax imposed to sellers psps p 1- p 0 < t

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 e1e1 q0q0 q1q1 pbpb p0p0 Example 1: Tax imposed to sellers psps Consumer surplus p 1- p 0 < t

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 e1e1 q0q0 q1q1 pbpb p0p0 Example 1: Tax imposed to sellers psps Consumer surplus Producer surplus p 1- p 0 < t

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 e1e1 q0q0 q1q1 pbpb p0p0 Example 1: Tax imposed to sellers Tax revenue psps Consumer surplus Producer surplus p 1- p 0 < t

Imposition of tax quantity price Demand curve Supply curve before tax e0e0 e1e1 q0q0 q1q1 pbpb p0p0 Example 1: Tax imposed to sellers Tax revenue psps Consumer surplus Producer surplus Deadweight loss

Tax in the first experiments

A Perfectly Inelastic Supply quantity price Demand curve Supply curve e0e0 q0q0 p0p0 Supply cannot increase or decrease (at least in the short-run). That is, supply curve won’t be shifted and market price (p 0 ) will remain the same. Therefore, all the tax will be paid by the suppliers.

A Perfectly Inelastic Supply quantity price Demand curve Supply curve e0e0 q0q0 p0p0 Supply cannot increase or decrease (at least in the short-run). That is, supply curve won’t be shifted and market price (p 0 ) will remain the same. Therefore, all the tax will be paid by the suppliers. p 0 - t

A Perfectly Inelastic Demand quantity price Demand curve Supply curve e0e0 q0q0 p0p0 Demand will not react to price changes (important drugs, cigarettes) As a result sellers will pass along all the tax to the buyers.

A Perfectly Inelastic Demand quantity price Demand curve Supply curve e0e0 q0q0 p0p0 p 0 + t Demand will not react to price changes (important drugs, cigarettes) As a result sellers will pass along all the tax to the buyers.

Tax Liability-Side Equivalence

p0p0 pbpb psps Demand curve Supply curve before tax TLSE says that it is irrelevant who is responsible for paying the tax – the equilibrium price facing buyers and sellers will be the same as the tax will be passed on. quantity price

Tax Liability-Side Equivalence p0p0 p1p1 p2p2 Demand curve Supply curve before tax Demand curve before tax Supply curve TLSE says that it is irrelevant who is responsible for paying the tax – the equilibrium price facing buyers and sellers will be the same as the tax will be passed on. quantity price quantity price

Tax Liability-Side Equivalence Experimental evidence support TLSE (Borck et al., 2001; Ruffle, 2004) TLSE might not be clearly understood by some policy makers and civilians who confuse statutory with economic incidence. One explanation is that there is confusion between gross and net earnings. (See Ruffle (2004) for Canadian Conservative Party shift from a manufacturer to a consumer tax and Krugman (2000) discussion on Bush’s gasoline tax cuts. Special cases: if demand/supply are perfectly inelastic/elastic, i.e. if one of the curves is horizontal/vertical, then only one side will pay the tax.

Price Controls Term ‘price controls’ refers to the imposition of a price floor, i.e. minimum price, or a price ceiling, i.e. maximum price. Recent example in Australia minimum wages in the labour market. What is the effect of such a policy?

Price Controls We saw that competitive markets maximize efficiency by exhausting all gains from trade. A price floor (like a price ceiling) will prohibit some of the trades and thus lower efficiency.

Price Controls quantity price Demand curveSupply curve e0e0 q0q0 p0p0

Price Controls quantity price Demand curveSupply curve e0e0 q0q0 p0p0 p min qbqb qsqs

Price Controls quantity price Demand curveSupply curve e0e0 q0q0 p0p0 p min qbqb qsqs Efficiency losses not only due to prohibition of trades, but also due to ‘anchoring effects’ (Falk et al., 2006). Consumer surplus

Price Controls quantity price Demand curveSupply curve e0e0 q0q0 p0p0 p min qbqb qsqs Efficiency losses not only due to prohibition of trades, but also due to ‘anchoring effects’ (Falk et al., 2006). Consumer surplus Producer surplus

Price Controls quantity price Demand curveSupply curve e0e0 q0q0 p0p0 p min qbqb qsqs Deadweight loss Efficiency losses not only due to prohibition of trades, but also due to ‘anchoring effects’ (Falk et al., 2006). Consumer surplus Producer surplus

Market Predictions

Consumer surplus

Market Predictions Consumer surplus Producer surplus

Market Predictions Deadweight loss Consumer surplus Producer surplus

Experimental Results

Summary (Part I) We saw how economic theory can help us predict the impact of imposing taxes and price controls. Experiments indicate that theory predicts well actual behaviour. Removing the price control does not necessarily improve efficiency due to anchoring effects (see Isaac and Plott (1981) for anchoring effects after price controls).

Pricing and Efficiency in Competitive Markets Part II Institutions

Introduction The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2002 Vernon Smith: “for the use of laboratory experiments as a tool in empirical economic analysis, in particular, for the study of different market mechanisms”. Institution: Rules of the game Feasible actions Sequence of actions Information conditions

Introduction Does it matter if only sellers can post prices (like in retail markets)? Many institutions: Double auction markets, English Auctions, Dutch Auctions, government grants. How can we compare performance: Experiments

Posted Offer Markets Most retail markets in western countries Sellers quote prices on a take-it-or- leave-it basis Sometimes due to government regulation (shipping, alcoholic beverages)

Double Auction

Posted Offer

Summary (Part II) Institutions are important Experiments ideal in helping us evaluate which institution is optimal for each situation … and to convince decision makers!!

AND NOW … Before we decide which experiment will decide your payments you get to vote … Average payoffs: Experiment 1: $ 37.17Votes: Experiment 2: $ 35.29Votes: Experiment 3: $ 22.00Votes:

Further reading Borck, R., Engelmann, D., Müller, W., Normann, H.T. (2001) Tax Liability-Side Equivalence in Experimental Posted-Offer Markets, Southern Economic Journal, 68:3, Falk, A., Fehr, E., Zehnder, C. (2006) Fairness Perceptions and Reservations Wages - The Behavioral Impact of Minimum Wage Laws, forthcoming in Quarterly Journal of Economics. Isaac, M., Plott, C. (1981) Price Controls and the Behavior of Auction Markets, American Economic Review, 71, Ruffle, Bradley J. (2005) "Tax and Subsidy Incidence Equivalence Theories: Experimental Evidence from Competitive Markets", Journal of Public Economics, 89:8, Stiglitz, Joseph. (2000) Economics of the public sector, Norton & Co. Ketcham, J., Smith, V., Williams, A. (1984) A Comparison of Posted-Offer and Double-Auction Pricing Institutions, The Review of Economic Studies, 51:4,