Efficiency Consumer, Producer and Markets. Efficiency Defined Overall: Greatest human satisfaction...

Efficiency

Consumer, Producer and Markets

Efficiency Defined

• Overall: Greatest human satisfaction from scarce resources.

• Allocative Efficiency – resources are dedicated to the combination of goods and services that best satisfy consumer wants

• Production Efficiency – goods and services are produced using the least cost combination of resources and technology

• Dynamic Efficiency – how the economy over time promotes allocative and productive efficiency

Efficiency: Positive versus Normative Perspectives

• Positive – an objective analysis of how economic variables are related

• Normative – a prescriptive analysis to help determine what ought to be.

• Welfare economics – the study of how the allocation of resources affects economic well-being.

Problem of Revealed Preference

• Economic agents, unlike many variables in other sciences, are not passive. Therefore, it is difficult to measure willingness to pay.

• Normal Auction – Ascending price with sale to the highest bidder. May yield the person who most highly values the item, but does not measure their maximum willingness to pay.

• Dutch Auction – Descending Price with sale to first bidder. May yield the person who most highly values the good and the maximum willingness to pay.

Measuring Economic Welfare: Consumer Surplus

• So far, we have demonstrated that people maximize total net benefits from an activity at the point where MB=MC

• Marginal benefits are equal to the (max.) willingness to pay and decline as quantity demanded increase because of the law of diminishing marginal utility (jelly bean example).

• Since consumer as price takers in competitive markets, the price equals the marginal costs to consumers.

• Consumer surplus equals willingness to pay minus the price, which is the same as net benefits we have discussed before.

• Using the demand curve to measure consumer surplus

• Before: giving a price and finding the corresponding quantity demanded

• Now: giving the quantity and finding the amount people are willing to pay for a good or go without it

• MB=MC occurs where price intersects the demand curve and total net benefits=consumer surplus is

maximized. Cool, no!

Figure 2 Measuring Consumer Surplus with the Demand Curve

Copyright©2003 Southwestern/Thomson Learning

(a) Price = $80

Price ofAlbum

50

70

80

0

$100

Demand

1 2 3 4 Quantity ofAlbums

John’s consumer surplus ($20)

Figure 2 Measuring Consumer Surplus with the Demand Curve


(b) Price = $70Price of

Album

50

70

80

0

$100

Demand

1 2 3 4

Totalconsumersurplus ($40)

Quantity ofAlbums

John’s consumer surplus ($30)

Paul’s consumersurplus ($10)

Figure 3 How the Price Affects Consumer Surplus


Consumersurplus

Quantity

(a) Consumer Surplus at Price P

Price

0

Demand

P1

Q1

B

A

C

Figure 3 How the Price Affects Consumer Surplus


Initialconsumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D EF

P1

Q1

P2

Q2

Consumer surplusto new consumers

Additional consumersurplus to initial consumers

Producer Surplus

• Consumer surplus measures the difference between the (max.) willingness to pay and the price.

• Producer surplus measure the difference between the (min.) needed to be willing to sell and the price.

• Remember, the Law of Diminishing Marginal Returns causes marginal costs to rise in the short-run as output increases.– As more the the variable input is added to the fixed

input, its marginal product eventually begins to diminish (production exercise in class).

– If all workers are paid the same wage, the LDMR implies that the extra (marginal) costs of producing extra (marginal) outputs increases.

• If the seller is a price taker, they receive the same price for very output sold. So the difference between the price and the marginal cost (the willingness to sell) is the:

Producer Surplus

Figure 4 The Supply Schedule and the Supply Curve

Figure 5 Measuring Producer Surplus with the Supply Curve


Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(a) Price = $600

Supply

Grandma’s producersurplus ($100)

Figure 5 Measuring Producer Surplus with the Supply Curve


Quantity ofHouses Painted

Price ofHouse

Painting

500

800

$900

0

600

1 2 3 4

(b) Price = $800

Georgia’s producersurplus ($200)

Totalproducersurplus ($500)

Grandma’s producersurplus ($300)

Supply

Figure 6 How the Price Affects Producer Surplus


Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q1

P1

Figure 6 How the Price Affects Producer Surplus


Quantity

(b) Producer Surplus at Price P

Price

0

P1B

C

Supply

A

Initialproducersurplus

Q1

P2

Q2

Producer surplusto new producers

Additional producersurplus to initialproducers

D EF

Competitive Markets and Efficiency

• Assume competitive markets (many buyers and sellers, identical products, free entry and exit, price takers, etc.)

• Assume that consumer surplus measures consumers economic well-being and producer surplus that of sellers.

• So, MB = willingness to pay by consumers and MC = willingness to sell to producers

MB=MC

Occurs where the demand and supply curve intersect, and

Total Well-being is Maximized

Figure 7 Consumer and Producer Surplus in the Market Equilibrium


Producersurplus

Consumersurplus

Price

0 Quantity

Equilibriumprice

Equilibriumquantity

Supply

Demand

A

C

B

D

E

Figure 8 The Efficiency of the Equilibrium Quantity


Quantity

Price

0

Supply

Demand

Costto

sellers

Costto

sellers

Valueto

buyers

Valueto

buyers

Value to buyers is greaterthan cost to sellers.

Value to buyers is lessthan cost to sellers.

Equilibriumquantity

Efficiency

• Competitive markets result in the combination of goods and services that maximize consumer well-being (allocative efficiency) and produce goods at least possible cost (production efficiency).

• Over time, competitive forces will move to promote allocative and production efficiency (dynamic efficiency).

Economic Efficiency and the Liberal Revolution

• Adam Smith, building on the work of other philosophers, was the first to develop a comprehensive argument for the efficiency of markets.

• Mankiw points out the markets are “generally good ways to organize economic activity”.

• The efficiency of markets has proven a powerful force in altering historical perspectives on effective ways humans can interact.

• The revolutionary idea that the pursuit of self-interest, tempered by competition, promotes social interest is the basis for the tremendous economic growth of the last century.

Efficiency, a Second Look

• If markets are not competitive, efficiency might not be guaranteed.

• In some cases, consumer surplus might not be considered a good measure of consumer well-being (drugs or externalities), or producer surplus might not be a good measure of producer well-being (externalities orinefficiency due to monopoly).

Discriminating Monopolists• Perfectly Discriminating – able to charge each consumer

their maximum willingness to pay for each unit they consume. They convert all the consumer surplus to producer surplus. However, they produce where MB=MC so they are efficient, although some think it is inequitable.

• Imperfectly Discriminating – charge different prices based on willingness to pay. A good example are prices charged for better seats at ball games and for first-class/business-class airline tickets. They may or may not be efficient depending upon if the produce output where MB=MC.

Case Studies

• A market for transplantable organs– Current price is zero and there is a shortage of

transplantable organs– Allowing companies to contract with

individuals to donate organs for a price would likely increase the supply of organs

– Positive versus normative considerations

• Pilgrims, communal agriculture, and starvation

• Is a tuition cap a price control?– NPR presentation

http://www.npr.org/features/feature.php?wfId=1474621– Who pays the cost of a college education?– Why are the costs of a college education rising?

• Demand side• Supply side

– What are the likely effects of tuition caps?– Increased financial aid as an alternative to price

controls.

Costs of Taxation

• Taxes create a wedge between the price buyers pay and sellers receive and result in a reduction in quantity bought and sold.

• The reduction in quantity leaves production at a point where MB>MC and consumer surplus and producer surplus is not maximized.

• The consumer and producer surplus that is lost from not producing where MB=MC is call the Deadweight Welfare Loss (DWL).

• DWL is the economic cost of taxation.

Figure 1 The Effects of a Tax

Copyright © 2004 South-Western

Size of tax

Quantity0

Price

Price buyerspay

Price sellersreceive

Demand

Supply

Pricewithout tax

Quantitywithout tax

Quantitywith tax

Figure 2 Tax Revenue


Taxrevenue (T × Q)

Size of tax (T)

Quantitysold (Q)

Quantity0

Price

Demand

Supply

Quantitywithout tax

Quantitywith tax

Price buyerspay

Price sellersreceive

Figure 3 How a Tax Effects Welfare


A

F

B

D

C

E

Quantity0

Price

Demand

Supply

= PB

Q2

= PS

Pricebuyers

pay

Pricesellers

receive

= P1

Q1

Pricewithout tax

How a Tax Affects Welfare

How Large is the DWL?

• As in the case of tax incidence, the key to understanding the extent of DWL are the elasticities of demand and supply.

• When demand and supply are more elastic or responsive, the greater will be the decline in equilibrium quantity for any tax increase.

• The greater the tax, the larger the deadweight welfare loss.

Figure 5 Tax Distortions and Elasticities


(a) Inelastic Supply

Price

0 Quantity

Demand

Supply

Size of tax

When supply isrelatively inelastic,the deadweight lossof a tax is small.



(b) Elastic Supply

Price

0 Quantity

Demand

SupplySizeoftax

When supply is relativelyelastic, the deadweightloss of a tax is large.



Demand

Supply

(c) Inelastic Demand

Price

0 Quantity

Size of taxWhen demand isrelatively inelastic,the deadweight lossof a tax is small.



(d) Elastic Demand

Price

0 Quantity

Sizeoftax Demand

Supply

When demand is relativelyelastic, the deadweightloss of a tax is large.

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes


Tax revenue

Demand

Supply

Quantity0

Price

Q1

(a) Small Tax

Deadweightloss

PB

Q2

PS

Figure 6 Deadweight Loss and Tax Revenue from Three Taxes of Different Sizes


Tax

rev

enue

Demand

Supply

Quantity0

Price

Q1

(c) Large Tax

PB

Q2

PS

Deadweightloss

Case Studies of DWL

• Taxes on labor (federal income tax, social security, medicare) add up to about a 50% marginal tax on labor for many US workers.

• DWL and the labor market– Elastic or inelastic labor supply?– Full time work regardless of wage or is labor responsive

to wages?– Overtime, second earners, retirement, indergrond

economy (barter and illegal activity)– Laffer curve and supply side economics – large tax rates

create a disincentive to work and invest.

• The land tax and Henry George– Promoting equity while minimizing tax shifting

and DWL– Is land in inelastic or elastic supply?

• Raw land versus improvements

– A tax for today?

Efficiency Consumer, Producer and Markets. Efficiency Defined Overall: Greatest human satisfaction...

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