Chapter Seven The Interaction of People in Markets

Copyright © by Houghton Mifflin Company, Inc. All rights reserved7 - 2 Intro Invisible Hand: Adam Smith, Wealth of Nations (1776). “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest….he is led by an invisible hand to promote an end which was no part of his intention….By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

Copyright © by Houghton Mifflin Company, Inc. All rights reserved7 - 3 Individual Consumers and Firms in a Market Information, Coordination, Motivation –What consumers are willing to buy and what producers are willing to make are all different All occurs in the MARKET –Sometimes buyers and sellers never even see each other

Copyright © by Houghton Mifflin Company, Inc. All rights reserved7 - 4 Figure 7.1: The Market Interaction and the Model to Explain It

Copyright © by Houghton Mifflin Company, Inc. All rights reserved7 - 5 Figure 7.1: The Market Interaction and the Model to Explain It (cont’d)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved7 - 6 Figure 7.1: The Market Interaction and the Model to Explain It (cont’d)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved7 - 7 Competitive Equilibrium Model Each individual demand curve depends on the marginal benefit the individual gets from consuming the goods Each individual supply curve depends on the marginal cost. The competitive equilibrium model is the supply and demand model with the behavior of consumers and firms (in a competitive economy)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved7 - 8 Individual Production and Consumption Decisions A price will emerge where quantity supplied equals quantity demanded (Equilibrium Price) Can look at individual curves to determine market demand (even though curves are different) Can look at individual curves to determine market supply (even though curves are different)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved7 - 9 Figure 7.2: Price and Quantity Determination (Review Shortage and Surplus)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.3: Modeling the Demand Side of the Double-Auction Market

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.4: Modeling the Supply Side of the Double-Auction Market

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.5: Predicted Price and Quantity in the Double-Auction Market

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Are Competitive Markets Efficient? Inefficient Outcome = Outcome that wastes scarce resources Efficient Outcome = Outcome that does not waste scarce resources The possibility of transferring a good from one person to another, thereby making someone better off at the expense of someone else, is not an indication that an economic situation is inefficient or wasteful A situation in which it is possible to change consumption or production in a way that would make someone better off without hurting someone else is INEFFICIENT.

Copyright © by Houghton Mifflin Company, Inc. All rights reserved The Meaning of Efficient Pareto Efficient = An outcome where it is not possible to make someone better off without hurting someone else Three Requirements: –The marginal benefit must equal the marginal cost of the last item produced (MB = MC) –The marginal cost of a good should be equal for every producer Only when MC are the same is there no way to increase production without cost –The marginal benefit of consuming the same good should be equal for all consumers If MB are not equal, there there could be a gain for some people with no loss for anyone else

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Is the market efficient? A consumer chooses a quantity of a good such that PRICE = MARGINAL BENEFIT A firm produces a quantity of a good such that PRICE = MARGINAL COST If P = MB and P = MC then MB = MC The First Theorem of Welfare Economics: The conclusion that a competitive market results in an efficient outcome; “Invisible Hand Theorem”; Definition of Pareto Efficiency

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.6: The Efficiency of the Market: Marginal Benefit Equals Marginal Cost

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Efficiency and Income Inequality Another goal of an economic system: Income Equality –Income Equality is NOT the same as efficiency –Income Inequality = Disparity in levels of income among individuals in the economy –Some suggest price controls to help with income equality, but it interferes with the competitive market –Instead, use taxes and supplement income of poor

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Measuring Waste from Inefficiency Consumer and producer surplus are measures of how much consumers and producers gain from buying and selling in a market. The larger these two surpluses are, the better off people are. Competitive markets maximize the sum of consumer and producer surpluses Producer surplus = Area above the supply curve and below the market price line Consumer surplus = Area below the demand curve and above the market price line

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Deadweight Loss: Loss in producer and consumer surplus due to an inefficient level of production

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.7: Measuring Economic Loss (cont’d…consumer & producer surpluses are maximized

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.7: Measuring Economic Loss (cont’d)

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Price controls and deadweight loss in the milk industry In 1930’s, Federal Government intervened in the milk market to stabilize prices and provide income protection to farmers –Food and Agriculture Act of 1977 aimed at keeping dairy prices high to benefit farmers –These price controls led to deadweight loss

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.8: Price and Quantity Effects of a Price Floor

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Milk Industry Price floor (which is higher than competitive equilibrium price) creates incentive for farmers to produce more and decreases demand, creating excess supply. The government bought excess supply, at a cost of about $2 billion per year. –Also, to keep production down, government taxed farmers who increased their production

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.9: Deadweight Loss from a Price Floor

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Milk Industry Federal Agricultural Improvement and Reform (FAIR) Act of 1996 eliminated the price floor. 2002, President Bush created legislation reinstating the price floor and using the milk market of the Boston area as the market price In conclusion, price floors hurt consumers and benefit producers, creating a loss to society

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Deadweight loss from taxation A tax on sales is a payment that must be made to the government by the seller of the product. If it is a percentage of the dollar value spent on the product sold, it is called an ad valorem tax (like sales tax). If it is proportional to the number of items sold, it is called a specific tax (like tax on a gallon of gas or a pack of cigarettes). Immediate impact is felt on marginal cost, so it will shift the supply curve.

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Figure 7.10: Deadweight Loss from a Tax

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Informational Efficiency Another characteristic of a competitive market is that it processes information efficiently. –In double-auction, would be impossible to obtain ALL marginal benefits and marginal costs. Informational efficiency is different than Pareto efficiency Lack of informational efficiency is a key reason why central planning does not work well –A production process where exact timing is essential will e poorly coordinated through prices. Firms or organizations form and replace market transactions.

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Conclusion – key points Interaction of producers and consumers in a market can be explained by the competitive equilibrium model Processing information and coordinating millions of consumption and production decisions is difficult, but the market is a device that can do the job well (double-auction) An outcome is Pareto efficient if it is not possible to change production or consumption in a way that will make one person better off without hurting someone else

Copyright © by Houghton Mifflin Company, Inc. All rights reserved Conclusion – key points A competitive market is Pareto efficient In a competitive market, marginal benefit equals marginal cost for the last item produced, and the sum of consumer and producer surpluses is maximized Deviations from Pareto efficient outcome create a loss to society called DEADWEIGHT LOSS –Deadweight loss is caused by a tax that reduces the quantity produced Market system is informational efficient, even though there are no general theorems to prove this.