Efficiency Consumer, Producer and Markets

Efficiency Defined Overall: Greatest human satisfaction from scarce resources. Allocative Efficiency – resources are dedicated to the combination of goods and services that best satisfy consumer wants Production Efficiency – goods and services are produced using the least cost combination of resources and technology Dynamic Efficiency – how the economy over time promotes allocative and productive efficiency

Efficiency: Positive versus Normative Perspectives Positive – an objective analysis of how economic variables are related Normative – a prescriptive analysis to help determine what ought to be. Welfare economics – the study of how the allocation of resources affects economic well-being.

Problem of Revealed Preference Economic agents, unlike many variables in other sciences, are not passive. Therefore, it is difficult to measure willingness to pay. Normal Auction – Ascending price with sale to the highest bidder. May yield the person who most highly values the item, but does not measure their maximum willingness to pay. Dutch Auction – Descending Price with sale to first bidder. May yield the person who most highly values the good and the maximum willingness to pay.

Measuring Economic Welfare: Consumer Surplus So far, we have demonstrated that people maximize total net benefits from an activity at the point where MB=MC Marginal benefits are equal to the (max.) willingness to pay and decline as quantity demanded increase because of the law of diminishing marginal utility (jelly bean example). Since consumer as price takers in competitive markets, the price equals the marginal costs to consumers. Consumer surplus equals willingness to pay minus the price, which is the same as net benefits we have discussed before.

Using the demand curve to measure consumer surplus Before: giving a price and finding the corresponding quantity demanded Now: giving the quantity and finding the amount people are willing to pay for a good or go without it MB=MC occurs where price intersects the demand curve and total net benefits=consumer surplus is maximized. Cool, no!

Figure 2 Measuring Consumer Surplus with the Demand Curve Copyright©2003 Southwestern/Thomson Learning (a) Price = $80 Price of Album $100 Demand 1234 Quantity of Albums John’s consumer surplus ($20)

Figure 2 Measuring Consumer Surplus with the Demand Curve Copyright©2003 Southwestern/Thomson Learning (b) Price = $70 Price of Album $100 Demand 1234 Total consumer surplus ($40) Quantity of Albums John’s consumer surplus ($30) Paul’s consumer surplus ($10)

Figure 3 How the Price Affects Consumer Surplus Copyright©2003 Southwestern/Thomson Learning Consumer surplus Quantity (a) Consumer Surplus at Price P Price 0 Demand P1P1 Q1Q1 B A C

Figure 3 How the Price Affects Consumer Surplus Copyright©2003 Southwestern/Thomson Learning Initial consumer surplus Quantity (b) Consumer Surplus at Price P Price 0 Demand A B C DE F P1P1 Q1Q1 P2P2 Q2Q2 Consumer surplus to new consumers Additional consumer surplus to initial consumers

Producer Surplus Consumer surplus measures the difference between the (max.) willingness to pay and the price. Producer surplus measure the difference between the (min.) needed to be willing to sell and the price.

Remember, the Law of Diminishing Marginal Returns causes marginal costs to rise in the short- run as output increases. –As more the the variable input is added to the fixed input, its marginal product eventually begins to diminish (production exercise in class). –If all workers are paid the same wage, the LDMR implies that the extra (marginal) costs of producing extra (marginal) outputs increases.

If the seller is a price taker, they receive the same price for very output sold. So the difference between the price and the marginal cost (the willingness to sell) is the: Producer Surplus

Figure 4 The Supply Schedule and the Supply Curve

Figure 5 Measuring Producer Surplus with the Supply Curve Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting $ (a) Price = $600 Supply Grandma’s producer surplus ($100)

Figure 5 Measuring Producer Surplus with the Supply Curve Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting $ (b) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Grandma’s producer surplus ($300) Supply

Figure 6 How the Price Affects Producer Surplus Copyright©2003 Southwestern/Thomson Learning Producer surplus Quantity (a) Producer Surplus at Price P Price 0 Supply B A C Q1Q1 P1P1

Figure 6 How the Price Affects Producer Surplus Copyright©2003 Southwestern/Thomson Learning Quantity (b) Producer Surplus at Price P Price 0 P1P1 B C Supply A Initial producer surplus Q1Q1 P2P2 Q2Q2 Producer surplus to new producers Additional producer surplus to initial producers D E F

Competitive Markets and Efficiency Assume competitive markets (many buyers and sellers, identical products, free entry and exit, price takers, etc.) Assume that consumer surplus measures consumers economic well-being and producer surplus that of sellers. So, MB = willingness to pay by consumers and MC = willingness to sell to producers

MB=MC Occurs where the demand and supply curve intersect, and Total Well-being is Maximized

Figure 7 Consumer and Producer Surplus in the Market Equilibrium Copyright©2003 Southwestern/Thomson Learning Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E

Figure 8 The Efficiency of the Equilibrium Quantity Copyright©2003 Southwestern/Thomson Learning Quantity Price 0 Supply Demand Cost to sellers Cost to sellers Value to buyers Value to buyers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. Equilibrium quantity

Efficiency Competitive markets result in the combination of goods and services that maximize consumer well-being (allocative efficiency) and produce goods at least possible cost (production efficiency). Over time, competitive forces will move to promote allocative and production efficiency (dynamic efficiency).

Economic Efficiency and the Liberal Revolution Adam Smith, building on the work of other philosophers, was the first to develop a comprehensive argument for the efficiency of markets. Mankiw points out the markets are “generally good ways to organize economic activity”. The efficiency of markets has proven a powerful force in altering historical perspectives on effective ways humans can interact. The revolutionary idea that the pursuit of self-interest, tempered by competition, promotes social interest is the basis for the tremendous economic growth of the last century.

Efficiency, a Second Look If markets are not competitive, efficiency might not be guaranteed. In some cases, consumer surplus might not be considered a good measure of consumer well- being (drugs or externalities), or producer surplus might not be a good measure of producer well- being (externalities orinefficiency due to monopoly).

Discriminating Monopolists Perfectly Discriminating – able to charge each consumer their maximum willingness to pay for each unit they consume. They convert all the consumer surplus to producer surplus. However, they produce where MB=MC so they are efficient, although some think it is inequitable. Imperfectly Discriminating – charge different prices based on willingness to pay. A good example are prices charged for better seats at ball games and for first-class/business-class airline tickets. They may or may not be efficient depending upon if the produce output where MB=MC.

Case Studies A market for transplantable organs –Current price is zero and there is a shortage of transplantable organs –Allowing companies to contract with individuals to donate organs for a price would likely increase the supply of organs –Positive versus normative considerations Pilgrims, communal agriculture, and starvation

Is a tuition cap a price control? –NPR presentation –Who pays the cost of a college education? –Why are the costs of a college education rising? Demand side Supply side –What are the likely effects of tuition caps? –Increased financial aid as an alternative to price controls.

Costs of Taxation Taxes create a wedge between the price buyers pay and sellers receive and result in a reduction in quantity bought and sold. The reduction in quantity leaves production at a point where MB>MC and consumer surplus and producer surplus is not maximized. The consumer and producer surplus that is lost from not producing where MB=MC is call the Deadweight Welfare Loss (DWL). DWL is the economic cost of taxation.

Figure 1 The Effects of a Tax Copyright © 2004 South-Western Size of tax Quantity 0 Price Price buyers pay Price sellers receive Demand Supply Price without tax Quantity without tax Quantity with tax

Figure 2 Tax Revenue Copyright © 2004 South-Western Tax revenue (T × Q) Size of tax (T ) Quantity sold (Q) Quantity 0 Price Demand Supply Quantity without tax Quantity with tax Price buyers pay Price sellers receive

Figure 3 How a Tax Effects Welfare Copyright © 2004 South-Western A F B D C E Quantity 0 Price Demand Supply = PBPB Q2Q2 = PSPS Price buyers pay Price sellers receive = P1P1 Q1Q1 Price without tax

How a Tax Affects Welfare

How Large is the DWL? As in the case of tax incidence, the key to understanding the extent of DWL are the elasticities of demand and supply. When demand and supply are more elastic or responsive, the greater will be the decline in equilibrium quantity for any tax increase. The greater the tax, the larger the deadweight welfare loss.

Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (a) Inelastic Supply Price 0Quantity Demand Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small.

Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (b) Elastic Supply Price 0 Quantity Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large.

Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western Demand Supply (c) Inelastic Demand Price 0 Quantity Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small.

Figure 5 Tax Distortions and Elasticities Copyright © 2004 South-Western (d) Elastic Demand Price 0 Quantity Size of tax Demand Supply When demand is relatively elastic, the deadweight loss of a tax is large.

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (a) Small Tax Deadweight loss PBPB Q2Q2 PSPS

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes Copyright © 2004 South-Western Tax revenue Demand Supply Quantity 0 Price Q1Q1 (c) Large Tax PBPB Q2Q2 PSPS Deadweight loss

Case Studies of DWL Taxes on labor (federal income tax, social security, medicare) add up to about a 50% marginal tax on labor for many US workers. DWL and the labor market –Elastic or inelastic labor supply? –Full time work regardless of wage or is labor responsive to wages? –Overtime, second earners, retirement, indergrond economy (barter and illegal activity) –Laffer curve and supply side economics – large tax rates create a disincentive to work and invest.

The land tax and Henry George –Promoting equity while minimizing tax shifting and DWL –Is land in inelastic or elastic supply? Raw land versus improvements –A tax for today?