Government Policies & Efficiency

Econ 1

Chapters 7,6

Periods of AnalysisPeriods of Analysis

• Long-Run: All inputs are variable (prospective)

• Short-Run: Some inputs fixed, some variable

• Market Period: All inputs Fixed Output Fixed ( vertical supply)

Market Analysis

• The Market for Rental apartments

• Analyze an increase in demand

• Analyze price effects in the market period

• Analyze supply and price effects in the long-run

$ Rent

Units/Month

SupplySupply

D0

$ 800DD11

1000 1500

$ 1000

LR new SupplyLR new Supply

$ 880

New LR Equilibrium

$ Rent

Units/Month

SupplySupply

D0

$ 800

DD11

1000 1500

Price Ceiling

Short

Implications Price Ceiling below Equilibrium

• Increased Transaction Costs to Buyers & Sellers

• Increase in Non-Market rationing: Discrimination

• Decrease in Quality

• Decrease in Supply

Price Floor above Equilibrium

• How does the labor Market work?

• What happens when you place the Minimum Wage above Equilibrium wage ?

$ Wage

Qty/T

Demand Supply of Labor

Wage E

QE

Min. Wage

Qd Qs

SurplusSurplus

The Minimum Wage: A Price Floor

$Wage

QTY / T

D

S

Pe

Qd Qs

D

Qe

Minimum Wage

Implications of Price Floor above Equilibrium

• Increase in transaction costs

• Increase in non-market rationing (discrimination)

• Increase in quality (not demand driven)

• Increase in supply

• Wealth transfer: from unemployed to employed

ECON 1

Market Efficiency

Chapter 7

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

Supply

Demand

Dx

Market Interaction

Pe

Qe

Exchange Value

Allocation Efficiency: Price allocates the goods to highest valued users

A B C Market

$ P $ P $ P

$ P

Q/T

D D

D

Qa Qb Qc Qe

Pe Pe

Marginal Value A = Marginal Value B = Marginal Value C = Market Price

DemandSupply

Market Demand determines Price. Each buyer responds to price by buying till Marginal Value equals price. No reallocation can generate greater value.

Production Efficiency: Price coordinates the efficient use or resources

Firm 2Firm 1 Firm 3Market$ P

$ P $ P $ P

Q/T

Demand

S1

S2

Qe Q1 Q2 Q3

Pe Pe

Market Price = Marginal Cost Firm 1 = Marginal Cost Firm 2 = Marginal Cost Firm 3

Supply

S3

Market Supply is the sum of the industry output at alternative prices. Each firm produces up to the quantity where Price = Marginal Cost. No reallocation of resources will produce at a lower opportunity cost.

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

SupplyDemand

Dx

Market is Efficient since at Qe the Marginal Value = Marginal cost

Pe

Qe

Marginal Value

MarginalCost

MVx

Qtyx / T

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10

MVx = Dx

Demand = Marginal Value

Exchange Value

Pe

Qe

Consumer Surplus Value (MV – Price)

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

The height reflects the marginal cost of producing an additional unit.

Supply Reflects Marginal Cost

Pe

Qe

Producer Surplus ValuePrice – Marginal Cost

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

Supply

Demand

DxSx

Market: Gains from Market: Gains from TradeTrade

Pe

Qe

C.S V.

P.S.V.

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

Supply

Demand

DxSx

Market Efficiency: Reduced Output

Pe

Qe

Efficiency Loss

$ P x

$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1

1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T

Supply

Demand

DxSx

Market Efficiency:Increased Output

Pe

Qe

Efficiency Loss

Market Outcome is EfficientMarket Outcome is Efficient

• Marginal Value (MV) of last unit produced = Marginal Cost of production (MC)

• Producing less Efficiency loss

• Producing more Efficiency Loss