1 Efficiency §Principles of Microeconomic Theory, ECO 284 §John Eastwood §CBA 213 § § address:

2 Learning Objectives §Distinguish between value and price §Define consumer surplus §Distinguish between cost and price §Define producer surplus §Explain why consumer surplus and producer surplus are the gains from trade

3 Learning Objectives (cont.) §Explain why competitive markets move resources to their highest-valued uses §Explain the sources of inefficiency in our economy

4 Learning Objectives §Distinguish between value and price §Define consumer surplus §Distinguish between cost and price §Define producer surplus §Explain why consumer surplus and producer surplus are the gains from trade

5 Efficiency: A Refresher §According to economists, efficiency means the resources have been used to produce the goods and services that people value the most.

6 Efficiency: A Refresher §Marginal benefit is the benefit that a person receives from consuming one more unit of a good or service l measured as the maximum amount that a person is willing to give up for one additional unit §Principle of decreasing marginal benefit l marginal benefit decreases as consumption increases

7 Efficiency: A Refresher §Marginal cost is the opportunity cost of producing one more unit of a good or service. l measured as the value of the best alternative foregone §Principle of increasing marginal cost l marginal cost increases as the quantity produced increases

8 The Efficient Quantity of Pizza Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services)

9 The Efficient Quantity of Pizza MB Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services)

10 The Efficient Quantity of Pizza Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services) MB MC

11 The Efficient Quantity of Pizza Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services) MB MC Pizza valued more highly than it costs: Increase production Pizza costs more than it is valued: Decrease production

12 The Efficient Quantity of Pizza Quantity (thousands of pizzas per day) Marginal cost and marginal benefit (dollars worth of goods and services) MB MC Efficient quantity of pizza

13 Imagine Six Buyers & Six Sellers

14 Learning Objectives §Distinguish between value and price §Define consumer surplus §Distinguish between cost and price §Define producer surplus §Explain why consumer surplus and producer surplus are the gains from trade

15 Value, Price, and Consumer Surplus §What is meant by “Value”? l Value of an item is the same thing as its marginal benefit l Marginal benefit - the maximum price people are willing to pay for an additional unit l Willingness determines demand

16 Demand, Willingness to Pay, and Marginal Benefit Quantity (thousands of pizzas per day) Price (dollars per pizza) Price determines quantity demanded D

17 Demand, Willingness to Pay, and Marginal Benefit Quantity (thousands of pizzas per day) Price (dollars per pizza) Price determines quantity demanded Quantity of pizzas demanded at $15 a pizza D

18 Demand, Willingness to Pay, and Marginal Benefit Quantity (thousands of pizzas per day) Price (dollars per pizza) Quantity determines willingness to pay D

19 Demand, Willingness to Pay, and Marginal Benefit Quantity (thousands of pizzas per day) Price (dollars per pizza) D=MB Maximum price willingly paid for the 10,000th pizza Quantity determines willingness to pay

20 Consumer Surplus §Consumer surplus is the value of a good minus the price paid for it. l if a person buys something for less than they are willing to pay for it, a consumer surplus exists

21 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) D

22 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) Market price D

23 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) Market price Amount paid D

24 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) Market price Amount paid Lisa’s consumer surplus from the 10th pizza D

25 A Consumer’s Demand and Consumer Surplus Quantity (slices of pizzas per week) Price (dollars per slice) Market price Amount paid Lisa’s consumer surplus from the 10th pizza Consumer surplus D

26 Demand Curves Measure Willingness-to-Pay §The Demand Price represents the value of the next unit to consumers. §The area under the demand curve to the left of a quantity, Q, equals the total value of that level of output to consumers. §It is the maximum amount they would be willing to pay for Q.

27 Consumers’ Surplus §Consumers’ Surplus is the difference between consumers’ maximum willingness-to-pay and the amount they actually paid. §The amount actually paid equals TR=PQ. §Graphically, Consumers’ Surplus (CS) is the area under the demand curve above P e.

28 Computing CS l CS is the area under the demand curve above P e =$10. l Area (of a right triangle) =(1/2)bh l CS=

29 Computing CS l CS is the area under the demand curve above P e =$10. l Area (of a right triangle) =(0.5)bh l CS=(0.5)10(10) l CS=50 $/day

30 Learning Objectives §Distinguish between value and price §Define consumer surplus §Distinguish between cost and price §Define producer surplus §Explain why consumer surplus and producer surplus are the gains from trade

31 Cost, Price, and Producer Surplus §Cost vs. Price l Cost is what the producer gives up. l Price is what the producer receives. §Marginal cost is the cost of producing one more unit.

32 Supply, Minimum Supply-Price, and Marginal Cost Quantity (thousands of pizzas per day) Price (dollars per pizza) S Price determines quantity supplied.

33 Quantity (thousands of pizzas per day) Price (dollars per pizza) Price determines quantity supplied. S Quantity of pizzas supplied at $15 a pizza Supply, Minimum Supply-Price, and Marginal Cost

34 Quantity (thousands of pizzas per day) Price (dollars per pizza) S Quantity determines minimum supply- price. Supply, Minimum Supply-Price, and Marginal Cost

35 Quantity (thousands of pizzas per day) Price (dollars per pizza) Minimum supply- price for 10,000th pizza Quantity determines minimum supply- price. S=MC Supply, Minimum Supply-Price, and Marginal Cost

36 Learning Objectives §Distinguish between value and price §Define consumer surplus §Distinguish between cost and price §Define producer surplus §Explain why consumer surplus and producer surplus are the gains from trade

37 Producer Surplus §Producer surplus is the value of a good minus the opportunity cost of producing it. l if a firm sells something for more that it costs to produce, a producer surplus exists

38 A Producers Supply and Producer Surplus Quantity (pizzas per day) Price (dollars per pizza) Price determines quantity supplied S

Price (dollars per pizza) S Quantity (pizzas per day) Market price A Producers Supply and Producer Surplus

Price (dollars per pizza) S Quantity (pizzas per day) Market price Cost of Production Max’s producer surplus from the 50th pizza A Producers Supply and Producer Surplus

Price (dollars per pizza) S Quantity (pizzas per day) Market price Cost of Production Max’s producer surplus from the 50th pizza Producer surplus A Producers Supply and Producer Surplus

Price (dollars per pizza) S Quantity (pizzas per day) Market price Cost of Production Producer surplus equals profit A Producers Supply and Producer Surplus

43 Supply Curves Measure Costs §Under competitive conditions, the supply curve represents the cost of producing the next unit.

44 Producers’ Surplus §... is the difference between the amount producers receive, and the minimum amount they would have been willing to accept. §Producers receive TR =PQ. §Graphically, Producers’ Surplus (PS) is the area under the price line, and above Supply.

45 Computing PS l Producers’ Surplus (PS) is the area under the Pe, and above Supply. l Area =(0.5)bh l PS= l CS+PS=

46 Computing PS l Producers’ Surplus (PS) is the area under the Pe, and above Supply. l Area =(0.5)bh l PS=(0.5)10(5) l PS=25 $/day l CS+PS=75 $/day

47 Learning Objectives §Distinguish between value and price §Define consumer surplus §Distinguish between cost and price §Define producer surplus §Explain why consumer surplus and producer surplus are the gains from trade

48 Is the Competitive Market Efficient? §Recall l Supply and demand will force the price toward the equilibrium price Question: Is this the efficient quantity of pizza?

49 An Efficient Market for Pizza Quantity (thousands of pizzas per day) Price (dollars per pizza) S Marginal cost-- opportunity cost --of pizza Marginal benefit-- value--of pizza Efficient quantity of pizzas D

50 Is the Competitive Market Efficient? §At Competitive Equilibrium l Resources are being used efficiently l The sum of consumer surplus and producer surplus is maximized

51 Quantity (thousands of pizzas per day) Price (dollars per pizza) S D An Efficient Market for Pizza

52 Quantity (thousands of pizzas per day) Price (dollars per pizza) S Producer surplus D An Efficient Market for Pizza

53 Quantity (thousands of pizzas per day) Price (dollars per pizza) S Producer surplus Consumer surplus D An Efficient Market for Pizza

54 At P e, both surpluses are greatest. §At a price below Pe, fewer units are sold. l CS may be larger, but PS is smaller. l Some surplus is transferred from producers to consumers. l Some surplus is lost. § At a price above Pe, fewer units are sold. l PS may be larger, but CS is smaller. l Some surplus is transferred from producers to consumers. l Some surplus is lost.

55 Learning Objectives (cont.) §Explain why competitive markets move resources to their highest-valued uses §Explain the sources of inefficiency in our economy

56 The Invisible Hand §Adam Smith - Wealth of Nations in 1776 l Participants in a competitive market is “led by an invisible hand to promote an end (the efficient use of resources) which was not part of his intention.”

57 Learning Objectives (cont.) §Explain why competitive markets move resources to their highest-valued uses §Explain the sources of inefficiency in our economy

58 Sources of Inefficiency §Price ceilings and floors §Taxes, subsidies, and quotas §Monopoly §Public goods §External costs and benefits These lead to underproduction or overproduction.

59 Sources of Inefficiency §Deadweight Loss l The decrease in consumer and producer surplus that results from an inefficient allocation of resources

60 Underproduction Quantity (thousands of pizzas per day) Price (dollars per pizza) S D

61 Quantity (thousands of pizzas per day) Price (dollars per pizza) S Deadweight loss D Underproduction

62 Quantity (thousands of pizzas per day) Price (dollars per pizza) S D Overproduction

63 Quantity (thousands of pizzas per day) Price (dollars per pizza) D S Deadweight loss Overproduction

64 Deadweight Loss §The area lost is known as a “deadweight loss” because it benefits no one. §Taxes produce deadweight losses when they reduce the quantity traded. §Price controls produce deadweight losses.

65 Deadweight Loss -- Price Ceiling Area=0.5bh=0.5(4)6 Loss = $__/day w/o ceiling CS = $__/day PS = $__/day CS+PS = $__/day With ceiling CS = $__/day PS = $__/day CS+PS = $__/day

66 Deadweight Loss -- Price Ceiling Area=0.5bh=0.5(4)6 Loss = $12/day w/o ceiling CS = $50/day PS = $25/day CS+PS = $75/day With ceiling CS = $54/day PS = $ 9/day CS+PS = $63/day

67 Deadweight Loss §Taxes produce deadweight losses when they reduce the quantity traded. l Remove the price ceiling l Add a $3/bbl tax on oil l What is the deadweight loss?

68 Unit Tax as a Decrease in Supply Qn = __ bbl./day P gross = $__/bbl. Tax, T = $__/bbl. P net = $__/bbl. Buyers pay P gross Firms keep P net Tax rev. = $_/bbl x _ bbl/day) $__/day

69 Unit Tax as a Decrease in Supply Qn = 8 bbl./day P gross = $12/bbl. Tax, T = $3/bbl. P net = $9/bbl. Buyers pay P gross Firms keep P net Tax rev. = $3/bbl x 8 bbl/day) $24/day Who pays?

70 Unit Tax -- Deadweight Loss Area=0.5bh=0.5(2)3 Loss = $__/day CS was = $50/day PS was = $25/day CS+PS = $75/day Tax rev = $24/day CS = $__/day PS = $__/day Tx+CS+PS=$__/day

71 Unit Tax -- Deadweight Loss Area=0.5bh=0.5(2)3 Loss = $3/day CS was = $50/day PS was = $25/day CS+PS = $75/day Tax rev = $24/day CS = $32/day PS = $16/day Tx+CS+PS=$72/day

72 Compute CS & PS l CS= area above the Pe, and below Demand l PS= area under the Pe, and above Supply. l Area =0.5(b)h l CS= l PS= l CS+PS

73 Compute CS & PS l CS= area above the Pe, and below Demand l PS= area under the Pe, and above Supply. l Area =0.5(b)h l CS= 0.5(10)10 l CS= $50/day l PS= 0.5(10)5 l PS= $25/day l CS+PS=$75/day

74 Deadweight Loss -- Subsidy $__/bbl. Area=0.5bh= Loss = CS = PS = Gov. pays the subsidy Consumers gain or lose? Producers gain or lose? Taxpayers? Net benefit

75 Deadweight Loss -- Subsidy $6/bbl. Area=0.5bh=0.5(4)6 Loss = $12/day CS = 0.5(14)14 = $98/day PS = 0.5(7)14 = $49/day Gov. pays the subsidy =($6/bbl)14bbl day = $84/day Consumers gain = = $48/day Producers gain = = $24/day Taxpayers lose $84/day Net benefit = = -12

76 Output Restriction (or Quota) Output limit = 8 bbl./day CS= PS= Consumers Producers Net Benefit =

77 Output Restriction (or Quota) Output limit = 8 bbl./day Area=0.5bh=0.5(2)3 Loss = $3/day CS = 0.5(8)8 = $32/day PS=8(3)+0.5(8)4= $40/day Consumers lose = = $18/day Producers gain = = $15/day Net Benefit =15-18=-$3

78 Price Floor -- $___/bbl. Floor only CS = PS = Gov. pays Consumers Producers Net Benefit =

79 Price Floor -- $12/bbl. Floor only CS = 0.5(8)8 = $32/day PS = 8(3)+0.5(8)4= $40/day Consumers lose = = -18 $/day Producers gain = = $15/day Net Benefit =15-18=-3 WAIT! IF 14 BBL ARE MADE, THEN...

80 Price Floor -- $___/bbl. Floor & Gov’t buy excess CS = PS = Gov. pays Consumers Producers Net Benefit =

81 Price Floor -- $12/bbl. Floor & Gov’t buy excess CS = 0.5(8)8 = $32/day PS = 0.5(7)14 = $49 /day Gov. pays=(14-8)12 = $72 to buy 6 bbl/day; cost to produce = $63 surplus not consumed Consumers lose = = -$18/day Producers gain = = $24/day Net Benefit = Net Benefit = -$66

82 Which policy is “second best”? Depends on e d and e s