Chapter 14 Economic Efficiency and the Competitive Ideal ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

2 Economic Efficiency Is achieved when –Cannot rearrange the production or allocation of goods –to make one person better off –without making anybody else worse off Pareto improvement –At least one person is better off, and no one is harmed

3 Economic Efficiency Economic efficiency –achieved when every possible Pareto improvement is exploited. Side payment –action will benefit one group and harm another

4 Economic Efficiency Greater total gains than total losses –Side payment –Transferred from the gainers to the losers –Pareto improvement

5 Competitive Markets and Economic Efficiency Demand curve –The maximum price someone would be willing to pay for each unit –Value of the last unit of the good consumed Supply curve –The minimum price a seller must get in order to supply that unit –Additional cost of each unit of the good supplied

6 Reinterpreting the Demand Curve $25 $23 $21 $19 $17 Demand Flo Flo (again) Joe Bo Zoe Price Number of Lessons per Week While the first lesson is worth $25 to some consumer (Flo)... and the third is worth $21. the second lesson is worth only $23... Figure 1 The Value of Another Guitar Lesson

7 Reinterpreting the Supply Curve The smallest cost for this first lesson is $13... and $17 for the third. but it's $15 for the second $21 $19 $17 $15 $13 McCollum Supply Martin (again) Gibson Martin (again) Martin Price Number of Lessons per Week Figure 2 The Cost of Another Guitar Lesson

8 The Efficient Quantity of a Good Whenever the demand curve is higher than the supply curve –the value of one more unit to some consumer is greater than its additional cost to some producer Efficient quantity of a good –Market demand curve and market supply curve intersect –Automatically achieved in perfect competition at equilibrium

9 The Efficient Quantity of a Good $25 $23 $21 $19 $17 $15 $13 Demand 1.Joe would pay as much as $23 for the second lesson... Flo Joe McCollum Martin Zoe Supply 2.while Martin would offer it for as little as $ Martin Gibson Martin 3.Four lessons is the equilibrium and the efficient quantity. Price Number of Lessons per Week 234 Bo Figure 3 Efficiency In The Market For Guitar Lessons

10 Measuring Market Gains Consumer surplus - difference between –Value of a unit of a good to the buyer –And what the buyer actually pays for it Market consumer surplus –Total consumer surplus enjoyed by all consumers in a market. –Total area under the demand curve, above the market price

11 Consumer surplus $25 $23 $21 $19 $17 Demand The total shaded area is market consumer surplus. Price Number of Lessons per Week 1.When market price is $19, someone (Flo) gets $6 in consumer surplus on the first lesson... 3.and someone (Flo again) gets $2 in consumer surplus on the third. 2.someone (Joe) gets $4 in consumer surplus on the second... Assumed Market Price Figure 4a Consumer Surplus in a Small Market for Guitar Lessons

12 Consumer surplus 4,000 $19 Market Price Number of Lessons per Week In a market with many buyers, market consumer surplus is the entire area under the demand curve and above the market price. Demand Figure 4b Consumer Surplus in a Large Market for Guitar Lessons

13 Measuring Market Gains Producer surplus - difference between –Price the seller gets –And the additional cost of providing it Market producer surplus –Total producer surplus enjoyed by all sellers in a market. –Total area above the supply curve, below the market price

14 Producer surplus 1234 $21 $19 $17 $15 $13 Supply Price Number of Lessons per Week The total shaded area is market producer surplus. 3.and someone (Gibson) gets $2 on the third. 1.When market price is $19, someone (Martin) gets $6 in producer surplus on the first lesson... 2.someone (Martin again) gets $4 in producer surplus on the second... Assumed Market Price 5 Figure 5a Producer Surplus from Selling Guitar Lessons

15 Producer surplus 4,000 $19 In a market with many sellers, market producer surplus is the entire area above the market supply curve and below the market price. Price Number of Lessons per Week Supply Market Price Figure 5b Producer Surplus from Selling Guitar Lessons

16 Total Benefits and Efficiency Total benefits –Sum of consumer surplus and producer surplus Efficient market –Total benefits are maximized Equilibrium quantity –Maximizes total benefits

17 Total Benefits and Efficiency $19 4,000 S D Equilibrium Price Price Figure 6 Total Benefits in a Competitive Market for Guitar Lessons Number of Lessons per Week Equilibrium Quantity

18 Inefficiency and Deadweight Loss Price ceiling –May benefit consumers as a group –Reduces total net benefits in the market Price floor –May benefit producers as a group –Reduces total net benefits in the market Deadweight loss –The loss of potential benefits due to a deviation from the efficient outcome

19 Price Ceiling $19 4,000 S $15 6,0002,000 D Price 1. A price ceiling of $ It also decreases market quantity, taking away some consumer surplus A B C 2.transfers surplus from producers to consumers and some producer surplus, neither of which are transferred to anyone. $23 Figure 7 The Inefficiency of a Price Ceiling deadweight loss Number of Lessons per Week

20 Price Floor 3.It also decreases market quantity, taking away some consumer surplus $19 4,000 S $21 3,000 D Price 1. A price floor of $21... F G H 2.transfers surplus from consumers to producers. $17 5, and some producer surplus, neither of which are transferred to anyone. Figure 8 The Inefficiency of a Price Floor deadweight loss

21 Monopoly and Market Power Monopoly and imperfectly competitive markets –Firms charge a single price on all units –P>MC –Price is too high –Output is too low –Inefficient

22 Monopoly and Market Power Figure 9 The Deadweight Loss from Monopoly Dollars S $8 D 3 E 500,000 Perfectly Competitive Market Monopoly Market Dollars S $8 D 300,000 MR 5 F consumer surplus producer surplus producer surplus consumer surplus deadweight loss 500,000 E

23 Taxes and Deadweight Losses Imposing a tax on an efficient market –Creates a deadweight loss –The loss in benefits to buyers and sellers is greater than the gain in revenue to the government Taxes create smaller deadweight loss –when they are imposed on markets in which demand or supply is relatively inelastic

24 Deadweight Loss From an Excise Tax Figure 10 The Deadweight Loss from an Excise Tax S1S1 S After Tax Price per Ticket Millions of Tickets per Year D Consumer Surplus Deadweight Loss Producer Surplus Government Tax Revenue 300 A $340 B 280

25 D after Tax 3,000,000 S A Tax on Land Figure 11 A Tax on Land Monthly Rent per Acre Number of Acres $800 A 600 B D Government Revenue

26 Externalities By-product of a good or activity Affects someone not immediately involved in the transaction Negative externality –Causes harm to others Positive externality –Creates benefits for others

27 The Private Solution to a Negative Externality Coase theorem –A side payment can be arranged without cost –Market will solve an externality problem on its own Conditions 1.Legal rights are clearly established 2.Legal rights can be easily transferred 3.Number of people involved is very small

28 Externalities The Free Rider Problem –When the efficient outcome requires a side payment –Individual gainers will not contribute

29 Government Solutions A market with a negative externality –Produce more than the efficient quantity –Creates a deadweight loss Correcting negative externalities –Taxes –Regulations –Tradable permits

30 Government Solutions Taxing a Negative Externality –A tax on each unit of a good = external harm it causes –Can correct a negative externality –Bring the market to an efficient output level

31 Taxing a Negative Externality D S $2.00 A MSC C $1.00 B Millions of Gallons per Period Dollars Efficient Quantity Equilibrium Quantity Figure 3a A Tax on Producers to Correct a Negative Externality

32 Taxing a Negative Externality D $2.00 $1.00 B Millions of Gallons per Period Dollars $2.60 $1.60 S S After Tax A Figure 3b A Tax on Producers to Correct a Negative Externality New Equilibrium Quantity with Tax

33 Regulation and Tradable Permits Regulations –Move a market closer to the efficient point Tradable permit –License that allows a company to release a unit of pollution into the environment over some period of time

34 Dealing with a Positive Externality A market with a positive externality –Produce less than the efficient quantity –Creates a deadweight loss Correcting positive externalities –Subsidies A subsidy on each unit of a good = external benefits it creates, Can correct a positive externality Brings the market to an efficient output level

35 Dealing with a Positive Externality D S $400 MSB A $200 Quantity of Devices (thousands) Price B Figure 4a A Subsidy for Consumers to Correct a Positive Externality

36 Dealing with a Positive Externality S B A $200 Quantity of Devices (thousands) Price $ D D After Subsidy Figure 4b A Subsidy for Consumers to Correct a Positive Externality