Economic efficiency Who gains and who loses when prices change? 1

The Efficiency of Competitive Markets Economic efficiency A market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production, and in which the sum of consumer surplus and producer surplus is at a maximum. Economic Surplus and Economic Efficiency 2

Consumer surplus measures the net benefit to consumers from participating in a market rather than the total benefit. The net benefit equals the total benefit received by consumers minus the total amount they must pay to buy the good. Similarly, producer surplus measures the net benefit received by producers from participating in a market, or the total amount firms receive from consumers minus the cost of producing the good. What Consumer Surplus and Producer Surplus Measure Consumer Surplus and Producer Surplus 3

Assumes Competitive Markets 1.Remember that our Supply & Demand Model is designed to describe what happens in competitive markets. 2.A competitive market is one where there are many buyers and sellers. No individual buyer or seller can influence the market on their own. 3.Our analysis of price controls ASSUMES that the market in question is competitive. 4

Consumer surplus The difference between the highest price a consumer is willing to pay and the price the consumer actually pays. Consumer Surplus 5

The Consumer Surplus from Satellite Television Consumer surplus allows us to measure the benefit consumers receive in excess of the price they paid to purchase a product. Making the Connection 6

Consumer Surplus Deriving the Demand Curve for Chai Tea 7

Consumer Surplus Measuring Consumer Surplus 8

Producer Surplus Producer surplus The difference between the lowest price a firm would have been willing to accept and the price it actually receives. 9

Calculating Producer Surplus Producer Surplus 10

Hockey stick example 11

The Efficiency of Competitive Markets Economic Surplus Equals the Sum of Consumer Surplus and Producer Surplus Economic surplus The sum of consumer surplus and producer surplus. 12

The Efficiency of Competitive Markets Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium Marginal Benefit Equals Marginal Cost in Competitive Equilibrium 13

The Efficiency of Competitive Markets When a Market Is Not in Equilibrium There is a Deadweight Loss Deadweight Loss Deadweight loss The reduction in economic surplus resulting from a market not being in competitive equilibrium. 14

Price Controls What is a Price Control? Price Controls: legal restriction on how high or low a market price may go. Why would governments enact price controls? Political pressures from both buyers and sellers. i.e. minimum wage, agriculture 15

Price Ceilings Price Ceiling: A maximum price sellers are allowed to charge for a good or service. Effective Price Ceilings: In order for a price ceiling to have any effect on a market, the price ceiling must be set BELOW the equilibrium price. 16

Government Intervention in the Market: Price Floors And Price Ceilings The Economic Effect of a Rent Ceiling Price Ceilings: Government Rent Control Policy in Housing Markets Don’t Let This Happen to YOU! Don’t Confuse “Scarcity” with a “Shortage” 17

Problems With Price Ceilings So what if there is a slight shortage - at least people are getting cheap rent! Right? An economy is efficient if it takes all opportunities to make some people better off without making anyone else worse off. Was anyone made worse off by Rent Controls? 18

Price Ceilings Lead to Inefficiency An economy is inefficient if there are missed opportunities to make people better off without making others worse off. Price Ceilings Inefficiencies: – Inefficient Allocation to Consumers – Wasted Resources – Inefficient Low Quality – Black Markets 19

Inefficient Allocation to Consumers How are apartments inefficiently allocated under Rent Controls? – Some people who are willing to pay a higher price are unable to find an apartment. – Some people who are only willing to pay a low price do get the apartment. – Luck and personal connections determine allocation of the apartments as opposed to “willingness to pay” 20

Wasted Resources: Price Ceiling How could rent controls cause some resources to be wasted? – Shortages make it more difficult to find an apartment! – TIME IS MONEY! 21

Inefficiently Low Quality Why would Rent Controls lead to Low Quality? – Required Rate of Return (Bonds vs. Apts) – How do you upgrade and make repairs without losing money? 22

Illegal Activities: Black Markets What is a Black Market? Apt. Black Market? Black Market: Market where goods or services are sold illegally – either because it is illegal or because of the incentives created by price controls. i.e. Drugs, Bribes etc. Consequences: Disrespect for rule of law, hurt those who obey the law. Black Market prices many times higher than the free market price. 23

Real World Example: Zimbabwe A couple years ago in Zimbabwe in an effort to fight inflation the Government passed a law which forced all sellers to cut their prices by 50% compared to the market prices. Can you guess what happened? 24

Real World Example: Zimbabwe Police forcing people to sell inventory below cost, jailing offenders. Massive shortages due to lower prices. Goods only available on the Black Market at prices 7 times higher than the original market price. Sellers closing their stores because the cost is higher than the prices they are allowed to charge. 25

Price Floors Price Floor: A minimum price sellers are allowed to charge for a good or service. Effective Price Floors: In order for a price floor to have any effect on a market, the price floor must be set ABOVE the equilibrium price. 26

Minimum Wage Is A Price Floor 27

Price Floor on Butter What would happen if the price floor was set at or below $1.00? Answer: There would be no effect on the market! 28

Problems With Price Floors So what if there is a slight surplus - at least farmers and workers are earning higher prices and higher wages. Right? Was anyone made worse off by Price Floor on Butter or the Minimum Wage? 29

Price Floors Lead to Inefficiency Recall: An economy is inefficient if there are missed opportunities to make people better off without making others worse off. Price Floors Inefficiencies: – Inefficient Allocation of Sales – Wasted Resources – Inefficient High Quality – Illegal Activity 30

Inefficient Allocation of Sales How would butter sales be inefficiently allocated between sellers with a price floor? – Some sellers who are willing to sell at a lower price are unable to do so because it is illegal, and thus may not always be the one to make the sale. – How does this idea apply to the minimum wage? Answer: Even if you are willing to work at a wage below the minimum wage, it is illegal for you to do so! 31

Wasted Resources: Price Floor How could price floors and the minimum wage cause some resources to be wasted? – Cause surpluses that the Government may purchase and destroy, or dump on the market as “foreign aid” (i.e. WTO) – Fewer jobs available (mainly for young people and unskilled labor). Waste time searching for a job. 32

Inefficiently High Quality Why would price floors lead to High Quality? Why might High Quality be Inefficient? – Higher price may lead sellers to provide a higher quality even though consumers would prefer lower price, and are willing to accept lower quality. – Price may be more important than quality. 33

Illegal Activities: Black Markets What kind of Black Markets would be created by price floors and minimum wages? “Black (off the books) Labor” in Europe. Bribery and Corruption 34

Why Do Price Floors Exist? Government officials disregard supply and demand because they think there is more to it for a particular market. Politicians don’t understand the model. Politicians have other incentives at play. Benefits go to highly organized, vocal and influential buyer/seller groups. 35

Quantitative Demand and Supply Analysis Calculating the Economic Effect of Rent Controls Appendix CONSUMER SURPLUSPRODUCER SURPLUSDEADWEIGHT LOSS COMPETITIVE EQUILIBRIUM$1,125$865.50$0 RENT CONTROL$1,338.75$278$