1 Frank & Bernanke 3 rd edition, 2007 Ch. 7: Efficiency and Exchange

2 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

3 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

4 Market Equilibrium and Efficiency When price is above or below the equilibrium, the quantity exchanged will be below the equilibrium. 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). 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. Only the equilibrium will maximize economic surplus.

5 Market Equilibrium and Efficiency Markets will be efficient when: Markets will be efficient when: Buyers and sellers are well informed. Buyers and sellers are well informed. Markets are perfectly competitive. Markets are perfectly competitive. Supply measures all relevant costs. Supply measures all relevant costs. Demand measures all relevant benefits. Demand measures all relevant benefits.

6 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

7 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

8 The Cost of Preventing Price Adjustments The reduction in economic surplus from a price ceiling will be underestimated when 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. 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. Consumers take costly actions to enhance their chances of being served.

9 The Cost of Preventing Price Adjustments What program could be used to help the poor get heating oil that would be more efficient than a price ceiling? What program could be used to help the poor get heating oil that would be more efficient than a price ceiling?

10 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

11 Question What would be a potential cost of income transfers? What would be a potential cost of income transfers?

12 Price Subsidies: Do They Help the Poor By how much do subsidies reduce total economic surplus in the market for bread? 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 Assume a small nation imports all its bread at the world price of $2.00

13 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 = $

14 Consumer surplus = $4,000,000/month Economic surplus maximized where MC($2) = MB($2) at 4 million loaves Economic Surplus in a Bread Market With $1 Subsidy Quantity (millions of loaves/month Price of bread ($/loaf) D S 2.00 World price = $

15 The Reduction in Economic Surplus from a Subsidy Assume a $1/loaf subsidy Assume a $1/loaf subsidy Consumers buy 6 million loaves Consumers buy 6 million loaves Consumer surplus will increase to $9 million Consumer surplus will increase to $9 million Economic surplus will fall by $1 million Economic surplus will fall by $1 million

16 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

17 The Cost of Preventing Price Adjustments Price Subsidies Price Subsidies How could we provide assistance to low income consumers more efficiently? How could we provide assistance to low income consumers more efficiently?

18 The Cost of Preventing Price Adjustments First-Come, First-Served Policies First-Come, First-Served Policies Why does no one complain any longer about being bumped from an overbooked flight? Why does no one complain any longer about being bumped from an overbooked flight?

19 Equilibrium in the Market for Seats on Oversold Flights Demand for remaining on the flight Seats Price ($/seat) 33 Supply of seats

20 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

21 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

22 Example How should a tennis pro handle an overbooking problem? How should a tennis pro handle an overbooking problem?

23 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

24 The Cost of Preventing Price Adjustments Why offer compensation when the cost of first-come, first-served to the seller is zero? Why offer compensation when the cost of first-come, first-served to the seller is zero?

25 The Marginal Cost Pricing of Public Services How much should a city charge for water, electricity, or some other service? How much should a city charge for water, electricity, or some other service?

26 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

27 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

28 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

29 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

30 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

31 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

32 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

33 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

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)

35 Taxes and Efficiency Why would a tax on land be efficient? Why would a tax on land be efficient? Would a tax on pollution increase economic surplus? Would a tax on pollution increase economic surplus?