MBMC Efficiency and Exchange

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 2 Market Equilibrium and Efficiency What do you think? Are markets always efficient and equitable?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 3 Market Equilibrium and Efficiency A market equilibrium is efficient… …if price and quantity take any other than their equilibrium values, a transaction that will make at least some people better off without harming others can always be found.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 4 A Market in Which Price Is Below the Equilibrium Level 2.50 Quantity (1,000s of gallons/day) Price ($/gallon) D S

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 5 How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction 2.50 Quantity (1,000s of gallons/day) Price ($/gallon) D S If P = $1 then Q S = 2,000 gallons/day At 2,000 gallons the consumer is willing to pay $2 and the MC = $1 If the buyer pays $1.25 for an extra gallon, producer is $.25 better off, and the consumer is $.75 better off, or economic surplus increases by $1.00 At $1, the market is not efficient

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 6 How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction Quantity (1,000s of gallons/day) Price ($/gallon) D S If P = $2 then Q D = 2,000 gallons/day Additional output costs only $1 This is $1 less than a buyer would pay If the buyer pays the seller $1.75, the buyer gains an economic surplus of $0.25 then the seller gains an economic surplus of $0.75

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 7 Market Equilibrium and Efficiency Observations on Efficiency When price is above or below the equilibrium, the quantity exchanged will be below the equilibrium. The vertical value on the demand curve (marginal benefit) is greater than the vertical value on the supply curve (MC). Only the equilibrium will maximize economic surplus.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 8 Market Equilibrium and Efficiency Markets will be efficient when: Buyers and sellers are well informed. Markets are perfectly competitive. Supply measures all relevant costs. Demand measures all relevant benefits.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 9 Market Equilibrium and Efficiency What do you think? Is efficiency the only goal? Why should efficiency be the first goal?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 10 The Cost of Preventing Price Adjustments Price Ceilings: Do They Help the Poor? An Example  A Price Ceiling for Home Heating Oil

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 11 Producer surplus = $900/day Consumer surplus = $900/day D S Economic Surplus in an Unregulated Market for Home Heating Oil 2.00 Quantity (1,000s of gallons/day) Price ($/gallon) Without price controls: Equilibrium Price = $1.40 Consumer surplus = (1/2)(3,000)(.60) = $900/day Producer surplus = (1/2)(3,000)(.6) = 900/day Economic surplus = $1,800/day

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 12 Producer surplus = $100/day Lost economic surplus = $800/day Consumer surplus = $900/day The Waste Caused by Price Controls 2.00 Quantity (1,000s of gallons/day) D S Price ($/gallon) With price controls: Producer surplus = (1/2)(1,000)(.20) = $100/day or a loss of $800/day Economic surplus = $1,000 or a loss of $800/day Price Ceiling set at $1.00

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 13 The Cost of Preventing Price Adjustments The reduction in economic surplus from a price ceiling will be underestimated when The consumers who receive the product are not the consumers who value it the most. Consumers take costly actions to enhance their chances of being served.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 14 The Cost of Preventing Price Adjustments Question What program could be used to help the poor get heating oil that would be more efficient than a price ceiling?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 15 When the Pie Is Larger, Everyone Can Have a Bigger Slice R P R P Surplus with price controlsSurplus with income transfers and no price controls With price controls set at $1.00 the economic surplus is $1,000/day *R = economic surplus received by rich people *P = economic surplus received by poor people Without price controls & with income transfers economic surplus is $1,800/day *R & P have the same share and a much larger economic surplus

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 16 The Cost of Preventing Price Adjustments Question What would be a potential cost of income transfers?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 17 The Cost of Preventing Price Adjustments Price Subsidies: Do They Help the Poor? By how much do subsidies reduce total economic surplus in the market for bread? Assume a small nation imports all its bread at the world price of $2.00

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 18 Consumer surplus = $4,000,000/month Economic surplus maximized where MC($2) = MB($2) at 4 million loaves Economic Surplus in a Bread Market Without Subsidy Quantity (millions of loaves/month Price of bread ($/loaf) D S 2.00 World price = $

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 19 Assume a $1/loaf subsidy Consumers buy 6 million loaves Consumer surplus will increase to $9 million Economic surplus will fall by $1 million The Reduction in Economic Surplus from a Subsidy

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 20 Consumer surplus = $9,000/month Reduction in total economic surplus = $1,000,000/month Domestic price with subsidy The Reduction in Economic Surplus from a Subsidy Quantity (millions of loaves/month Price of bread ($/loaf) World price = $ D S The cost of the tax = $6 million The benefit of the subsidy = $5 million Loss of economic surplus = $1 million

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 21 The Cost of Preventing Price Adjustments Price Subsidies How could we provide assistance to low income consumers more efficiently?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 22 The Cost of Preventing Price Adjustments Economic Naturalist First-Come, First-Served Policies  Why does no one complain any longer about being bumped from an overbooked flight?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 23 Equilibrium in the Market for Seats on Oversold Flights Demand for remaining on the flight Seats Price ($/seat) 33 Supply of seats

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 24 Equilibrium in the Market for Seats on Oversold Flights Seats Price ($/seat) Supply of seats First-come, First-served Reservation prices = (60+59+…+24)/37 = $42/passenger 4 $42 each or $168 loss in economic surplus

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 25 Equilibrium in the Market for Seats on Oversold Flights Seats Price ($/seat) Supply of seats Compensation Policy $27 = reservation price (compensation) to get 4 passengers to volunteer to stay The cost of the compensation = 4 x $27 = $108 minus the economic surplus to the passengers of $6 = $102

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 26 The Cost of Preventing Price Adjustments Example How should a tennis pro handle an overbooking problem?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 27 Player Ann9:50 A.M. $4 Bill9:52 A.M. 3 Carrie9:55 A.M.6 Dana9:56 A.M.10 Earl9:59 A.M.2 Arrival timeReservation price 5 bookings for 3 slots All 5 show up for the lesson How can the tennis pro minimize the cost of rescheduling two students? HINT: First-come, First-served or compensation The Cost of Preventing Price Adjustments

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 28 The Cost of Preventing Price Adjustments What do you think? Why offer compensation when the cost of first-come, first-served to the seller is zero?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 29 The Marginal Cost Pricing of Public Services Example How much should a city charge for water, electricity, or some other service?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 30 The Marginal Cost Curve for Water Water supplied (millions of gallons/day) Cost (cents/gallon) Spring Lake Ocean Three sources of water Spring: 1 million gallons/day.02 cents/gallon Lake: 2 million cents/gallon Ocean: 4 cents/gallon

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 31 The Marginal Cost Curve for Water Example How much should a city charge for water?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 32 The Marginal Cost Curve for Water Water supplied (millions of gallons/day) Cost (cents/gallon) Spring Lake Ocean Assume If P = 4 cents/gallon, Q = 4 million gallons Question Why should all residents pay 4 cents per gallon

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 33 Taxes and Efficiency Question Who Pays A Tax Imposed On Sellers of a Good?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 34 The Effect of a Tax on the Equilibrium Quantity and Price of Avocados 6 Quantity (millions of pounds/month) Price ($/pound) D S 3 Without a tax P = $3/lb and Q = 3 million lbs/month S + tax 2.5 With a tax of $1/lb MC increases by $1/lb Supply shifts up by $1 P = $3.50; Q = 2.5 million Consumers and producers share the burden of the tax equally Producers receive $2.50/lb Consumers pay $3.50/lb

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 35 Taxes and Efficiency Question How will a tax on cars affect their prices in the long run?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 36 The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply Quantity (millions of cars/month) Price ($/car) D S 2.0 $20,000 Assume a tax levy of $100 tax/car 1.9 S + $100 $20,100 Supply shifts to $20,100 The burden of the tax falls entirely on the consumer

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 37 Taxes and Efficiency Who Pays a Tax? When supply is perfectly elastic, the tax burden will fall entirely on the consumer.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 38 Total economic surplus = $9 million/month How a tax collected for a seller affects economic surplus The Market for Avocados Without Taxes Price ($/pound) Quantity (millions of pounds/month) D S

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 39 The Effect of a $1 per Pound Tax on Avocados 6 Quantity (millions of pounds/month) Price ($/pound) S + tax 2.5 D S How a tax collected from a seller affects economic surplus

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 40 Taxes and Efficiency Deadweight Loss The reduction in total economic surplus that results from the adoption of a policy

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 41 The Deadweight Loss Caused by a Tax 6 Quantity (millions of pounds/month) Price ($/pound) D S S + tax 2.5 Deadweight loss caused by tax

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 42 Taxes and Efficiency Question How would you determine the economic feasibility of a tax?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 43 Elasticity of Demand and the Deadweight Loss from a Tax Quantity (units/day) Price ($/unit) S + T S + T Deadweight loss Quantity (units/day) Price ($/unit) D 1 S D2D2 S The greater the elasticity of demand, the greater the deadweight loss from a tax

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide S 1 + T S 2 + T Deadweight Loss Elasticity of Supply and the Deadweight Loss from a Tax Price ($/unit) D S1S D S2S The greater the elasticity of supply, the greater the deadweight loss from a tax Quantity (units/day)

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 45 Taxes and Efficiency What do you think? Why would a tax on land be efficient? Would a tax on pollution increase economic surplus?

MBMC End of Chapter End of Chapter