1. The Idealized Competitive Model
Weimer and Vining Ch.4 & 5

2. Objectives: The model: The concept of a perfectly competitive economy
The virtues and limits of the competitive market model
Utility and “consumer behavior”
The concept(s) of efficiency
Indifference Maps
Pareto Optimality
Potential Pareto Optimality
Competitive Markets and Efficiency

3. Some Basic Concepts Collective Action
What is it? Define it for a policy analyst.
How is collective action related to “public policy”?
What is the rationale for government intervention in private choice?
W&V approach: begins with the concept of the perfectly competitive economy.
Collective action: what is it? Voluntary agreements among people –families, private organizations. The policy analyst, however deals primarily with collective action involving the legitimate coercive action of the government
Public policy encourages, discourages, prohibits or prescribes private actions.

4. *efficient: it would not be possible to change the patterns in such a way, so as to make some person better off without making some other person worse off.
The Rationale…
Consider the properties of idealized economies involving large numbers of profit maximizing firms and utility maximizing consumers.
Under certain assumptions, the self-motivated behaviors of these economic actors lead to patterns of consumption and production that are efficient*
Economists recognize several commonly occurring circumstances of private choice that violate the assumptions of the idealized model and interfere with efficiency in consumption or production
Define for me: profit maximizing and utility maximizing

5. The Rationale… These violations are called market failures.
Traditional market failures, provide widely accepted rationales for such public policies as the provision of goods and the regulation of markets by government agencies.
Is efficiency the only important social value?
others: human dignity, economic opportunity, political participation are values that deserve consideration.
On occasion, public decision makers or ourselves as members of society, may wish to give up some economic efficiency to protect human life, make the final distribution of goods more equitable, or promote fairness in the distribution process.
As analysts we have the responsibility to confront these multiple values and the potential conflicts among them.

6. Modeling Social Value
Policy analysts have a conception of the “good” that is to be pursued in policy
Derived from utility theory and individualism
Individuals assumed to define their own lives
Value is a function of an individual’s values, preferences, choices and outcomes -- a life.
Avoidance of paternalism
Social value is the aggregation of individual values
Differences from alternative definitions?
We start with efficiency.

7. Modeling Social Value The nature of models
Simplification, abstraction, essentials
The model of the competitive economy
Why use it?
Ideal-type of voluntary exchange
Results in “efficient” outcomes
No additional exchanges will lead to improvements for anyone without hurting someone else
Hence, no additional voluntary trades will be made
Model indicates where efficiency is not achieved

8. The Competitive Market Model
Model components
Consumers, consumption and utility
Producers, production and pricing
Budgets and choices
The central idea is simple:
Given values (preferences), resources, and technologies, how can society arrange things to produce the maximum value at least cost?

9. Modeling Consumer Behavior
Some key assumptions
People have identifiable (to them) bundles of utilities, translatable into preferences
Ceteris paribus*, the greater the quantity of a good, the greater the value to the consumer
But consumption in aggregate is subject to diminishing marginal value
Consumption of hamburgers
Information and search costs
Preservation of wilderness
* All else being equal

10. Consumer Behavior, Continued
Consumers enter into market exchange with budgets made up of
Income -- selling labor (including ideas…)
Endowments -- initial capital, savings, inheritance
These are not assumed to be equal!
Consumers trade money for the things they value
Idealized competitive market assumes no significant market failure (externalities, market power, etc.)

11. Some Thought Experiments
What would you be “willing to pay” for
A loaf of really fresh bread
A front-row seat at the Beatles’ last concert
Prices people are willing to pay express trade-off they make
What are you willing to forego to get the good?
You give up the other things the money could have purchased.
Money is the “medium” of the trade-off.
Surprisingly, we usually get things for less than we’d have been willing to pay (why?!)

12. Price, Quantity and Value: The Essentials
Value to individual i $
(Price)
Marginal valuation schedule
Q0= Quantity purchased at price P0
Now, back to modeling consumer behavior.
2 axis: Price and quantity.
Dark blue line: marginal valuation schedule: also a demand schedule
Consumer demand is a measure of willingness to pay. As shown in the diagram, consumers often value each additional unit consumed less that previous units (i.e., the concept of diminishing marginal utility). P0
Q1= Quantity purchased at price P1 P1 Q0 Q1
Q (Quantity)
Assuming no “price discrimination”, all consumers pay the marginal price -- P0

13. Recalling the Basics of Consumer Demand…
For example, suppose that the good in question is monthly consumption of gasoline.
Based on the data in the diagram below (left), the consumer would be willing to pay $9 for the first gallon rather than to without. This first gallon would be used for essential driving activities.
Each successive gallon has a value to the consumer of $1 less than previous units (2nd gal = $8.00, 3rd gal. = $7.00, and so on) as needs are met and the consumer engages in driving more for pleasure and sight-seeing.
The value that the consumer places on each gallon (unit) consumed is summarized by the individual Demand curve as shown in the diagram on the right.
Consumer demand is a measure of willingness to pay.
consumers often value each additional unit consumed less that previous units (i.e., the concept of diminishing marginal utility)
Give me an example…

14. So, what is consumer surplus and how is it related to demand?

15. Consumer Values and Surpluses
When analyzing changes to a consumer optimum given changes in the market price of a particular commodity, we often speak of the consumer being better or worse off.
One method used to measure these welfare changes is through the use of a concept known as Consumer Surplus.
This method compares the value of each unit of a commodity consumed against the price of that commodity.
Stated differently, consumer surplus measures the difference between what is person is willing to pay for a commodity and the amount he/she actually is required to pay.
What is missing in this analysis is the ability to quantify changes in individual satisfaction due to these price changes.

16. Assume a market price = $4
Assume a market price = $4.00/gal then, quantity demanded = to 6 gallons
the total value of consumption is $39.00 ($ ).
Part of this value is given up in the form of total expenditure equal to $24.00 ($4 x 6gal) as shown by the gray-shaded area in the right diagram.
The difference of $15.00 ($39.00-$24.00) represents consumer surplus as shown by the cross-hatched colored bars in the right diagram.

17. Consumer Surplus
These measures of total expenditure and consumer surplus can be neatly defined as geometric areas below a given demand curve.
We can use this measures to quantify the welfare effects of a change in market price by examining the corresponding changes in consumer surplus.
In the diagram below, the colored bars have been replaced with shaded areas allowing for divisibilities in consumption.
Rather than restricting the consumer to purchase of 1, 2, 3, ... gallons, we now allow that individual to be able to purchase fractions of a gallon.

18. Consumer Surplus: An Example
For example, suppose that the market price increases to $6.00 due to an increase in excise taxes.
At this higher price, the consumer would be willing to purchase only 4 units of this product.
In purchasing these 4 units, the consumer receives $30.00 worth of value ($9.00, $8.00, $7.00, $6.00) and spends $24.00 ($6.00 x 4 units).
What is the new level of consumer surplus?
30-24=$6

19. Example, (cont.)
By measuring the change in consumer surplus, we can begin to quantify the change in consumer welfare from the increase in gasoline prices:
CS before = $15.00 CS after    = $6.00 ΔCS       = -$9.00
The $2.00 increase in the price of gasoline has led to a $9.00 reduction in consumer welfare.
Powerful.

20. Analyzing Effects of a Tax$
(Price)
Q (Quantity) P0 Q0 P1 Q1
Size of tax
Reduction in
Consumption
= Q0 - Q1
Tax Revenue
Lost Revenue
To producers
Deadweight
Loss in Consumer Surplus
Remaining Consumer
Surplus
P1 = P0 + Tax

21. Status check…
Now, using the tools of indifference curve analysis, we can demonstrate that in increase in market price indeed makes the consumer worse off – Edgeworth Box
Recall that by measuring the changes in consumer surplus, we can define how much worse off the consumer has become - a useful empirical tool for policy analysis.

22. The Edgeworth Box: Indifference Mapping
Usually, we study the behavior of the markets using the traditional supply and demand framework. Through the use of supply and demand, we have determined the equilibrium price and equilibrium quantity in different types of markets. This type of analysis of market conditions is called partial equilibrium analysis where we look at the determinants of price and quantity in a particular market holding all other markets constant.
A natural extension to the above type of analysis is general equilibrium analysis or how demand and supply conditions interact in several markets to determine the price of many goods. A common tool in general equilibrium analysis is the Edgeworth box which allows the study of the interaction of two individuals trading two different commodities. This type of analysis draws on the use of indifference curve analysis to analyze this trading behavior.
The lower left-hand corner represents the origin for consumer 'A' and the upper right-hand corner represents the origin for consumer 'B'.  Person A's preferences (indifference curves) are convex to the origin OA. Person B's preferences are convex to OB. 
Moving to the right means that person 'A' has more of commodity 'X' and person 'B' has less of that commodity. Moving upwards means that person 'A' has more of commodity 'Y' and person 'B' has less. Moving in the northeast direction makes person 'A' better off. Moving in the southwest direction makes person 'B' better off.
Rather than introduce budget lines for the two consumers, the Edgeworth box uses the concept of initial endowments. An initial endowment 'w' represents the amount of commodities X & Y individuals A & B have available before trade. Thus (XA ,YA ) =  wA and (XB , YB ) =  wB where wA and wB represents A's and B's initial endowments (or income). The height of the Edgeworth box represents the total amount of commodity 'Y' available and the width of the Edgeworth box represents the total amount of commodity 'X' available. In the absence of any production, the dimensions of the box remain constant.
One goal of general equilibrium analysis is to determine if it is possible to make individual 'A' and/or individual 'B' better off through the process of exchange given their initial endowments.

23. Any trade that puts these two individuals into, or on the border of, the shaded area will make one or both individuals better off. This is known as a Pareto Improvement.
As long as any Pareto Improvements remain, an incentive for trade exists between these two agents.
For example, a trade such that these two individuals move to point 'R' in the diagram below would make person 'B' better-off with out harm to 'A'

24. An optimal allocation of commodities is determined by the concept of Pareto optimality.
A Pareto optimal allocation of commodities is that allocation where it is not possible to make one person better off without making any other person worse off.
If, for example, the two consumers are at the initial endowment point 'w', it is possible to make person 'B' better off by moving to point 'R' without making person 'A' worse off (a movement along person A's indifference curve).
A second trade could be the movement towards point 'T' which would make person 'A' better off without making person 'B' worse off.  This trade (from w to T) would make both person 'A' and person 'B' better off.

25. Concepts of Efficiency
Pareto Optimality:
The strict criterion of efficiency is met when a system allocates resources in such a way that no further reallocation of goods can increase any individual's utility without diminishing the utility of others. A given policy is efficient in this strict sense if it increases the well-being of at least one individual without diminishing that of others.
The Kaldor-Hicks Criterion:
The Kaldor-Hicks criterion allows redistributions that increase net welfare such that those who gain from the distribution could compensate those who lose, restoring the losers to their prior level of well-being, while the winners retain enough of their gains to be better-off than they would have been without the redistribution.
Unbending application of the strict Pareto optimality criterion would impose rather severe restrictions on government action: no action, no matter how beneficial it might be to the community as a whole, could be taken that diminished the well-being of even one individual.
In the extreme, even an action required to maintain the viability of the community (say, maintenance of law and order) would violate the criterion if any person, on the basis of his or her own assessment of the effect of the action on his or her utility, determined that the action would leave them worse off than would no action at all.
But clearly much of government action does just that: policies of income redistribution, progressive taxation, use of eminent domain for the construction of highways and dams, and price-support programs for agricultural products, to name just a few, improve the lot of some at the expense of others.
The applicable criterion, then, would be one that would allow assessments of the efficiency of policies that do increase the welfare of some at the expense of others.
The solution takes the form of a weak criterion of efficiency, sometimes called "Kaldor-Hicks criterion."
Although the Kaldor-Hicks criterion requires that a policy result in net gains in social well-being, it does not require that the gains actually be redistributed in a manner that offsets the losses of those harmed by redistribution.
The principle requires only that such a compensation could have been made, and that net social gains be left over. It is enough to show that, in the aggregate, sufficient value has been created to more than offset the losses entailed. No guidance is offered by the criterion as to whether or how compensation should be made; such decisions are beyond the scope of efficiency analysis and must be made on the basis of other criteria.
The Kaldor-Hicks criterion is the central normative standard in the policy analysis paradigm. The criterion is applied most widely as the decision rule for benefit-cost analysis.

26. Competitive Markets and Efficiency
It can be demonstrated that an idealized competitive market (ICM) would maximize consumer (and producer) surplus such that any externally induced change will not be Pareto efficient
But many elements of the model change
Tastes and preferences
Technologies
The idea is that the ICM is always moving toward an efficient allocation of goods

27. Next Time Producer Behavior Producer Surplus Market Failures
Tutorial on consumer surplus:
Discussion paper will be assigned this week, for next week.