MBMC Efficiency and Exchange. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights...

MB MC

Efficiency and Exchange

Efficiency and Exchange

Chapter 7: Efficiency and Exchange Slide 2

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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.

Market Equilibrium and Efficiency

What do you think?Are markets always efficient and

equitable?


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A market equilibrium is efficient……if price and quantity take any other than

their equilibrium values, a transaction that will make at least some people better off without harming others can always be found.


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A Market in Which Price Is Below the Equilibrium Level

2.50

Quantity (1,000s of gallons/day)

Pri

ce (

$/g

allo

n)

1 2 3 4 5

2.00

1.50

1.00

.50

D

S


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How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction

2.50


Pri

ce (

$/g

allo

n)

D

S

1 2 3 4 5

2.00

1.50

1.00

.50

1.25

• If P = $1 then QS = 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


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How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction


Pri

ce (

$/g

allo

n)

D

S

1 2 3 4 5

2.50

2.00

1.50

1.00

.50

1.75

•If P = $2 then QD = 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


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Observations on EfficiencyWhen 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).

Only the equilibrium will maximize economic surplus.


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


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What do you think?Is efficiency the only goal?Why should efficiency be the first goal?


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The Cost of PreventingPrice Adjustments

Price Ceilings: Do They Help the Poor?An Example

A Price Ceiling for Home Heating Oil


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Producer surplus = $900/day

Consumer surplus = $900/day

D

S

Economic Surplus in an Unregulated Market for Home Heating Oil

2.00


Pri

ce (

$/g

allo

n)

1 2 3 4 5

1.60

1.20

1.00

.80

1.80

1.40

8

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


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Producer surplus = $100/day

Lost economic surplus = $800/day

Consumer surplus = $900/day

The Waste Caused by Price Controls

2.00


D

S

1 2 3 4 5

1.60

1.20

1.00

.80

1.80

1.40

8

Pri

ce (

$/g

allo

n)

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


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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.

Consumers take costly actions to enhance their chances of being served.


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QuestionWhat program could be used to help the

poor get heating oil that would be more efficient than a price ceiling?


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When the Pie Is Larger, Everyone Can Have a Bigger Slice

R

P

R

P

Surplus with price controls Surplus 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


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QuestionWhat would be a potential cost of income

transfers?


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Price Subsidies: Do They Help the Poor?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


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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

Pri

ce o

f b

read

($/

loaf

)

2 4 6

3.00

1.00

5.00

4.00

8

D

S2.00World price = $


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Assume a $1/loaf subsidyConsumers buy 6 million loavesConsumer surplus will increase to $9

millionEconomic surplus will fall by $1 million

The Reduction in EconomicSurplus from a Subsidy


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Consumer surplus = $9,000/month

Reduction in total economic surplus = $1,000,000/month

Domestic price with subsidy

The Reduction in EconomicSurplus from a Subsidy

Quantity (millions of loaves/month

Pri

ce o

f b

read

($/

loaf

)

2 4 6

3.00

1.00

5.00

4.00

8

2.00World price = $

D

S

•The cost of the tax = $6 million•The benefit of the subsidy = $5 million•Loss of economic surplus = $1 million


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Price SubsidiesHow could we provide assistance to low

income consumers more efficiently?


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Economic NaturalistFirst-Come, First-Served Policies

Why does no one complain any longer about being bumped from an overbooked flight?


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Equilibrium in the Market for Seats on Oversold Flights

Demand for remaining on the flight

60

24

37Seats

Pri

ce (

$/se

at)

33

Supply of seats


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60

2427

33 37Seats

Pri

ce (

$/se

at)

Supply of seats

First-come, First-served•Reservation prices = (60+59+…+24)/37 = $42/passenger

•4 bumped @ $42 each or $168 loss in economic surplus


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60

2427

33 37Seats

Pri

ce (

$/se

at)

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


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ExampleHow should a tennis pro handle an

overbooking problem?


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Player

Ann 9:50 A.M. $4

Bill 9:52 A.M. 3

Carrie 9:55 A.M. 6

Dana 9:56 A.M. 10

Earl 9:59 A.M. 2

Arrival time Reservation 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



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What do you think?Why offer compensation when the cost of

first-come, first-served to the seller is zero?


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The Marginal Cost Pricing of Public Services

ExampleHow much should a city charge for water,

electricity, or some other service?


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The Marginal Cost Curve for Water

Water supplied (millions of gallons/day)

Co

st (

cen

ts/g

allo

n)

4.0

0.8

0.2

1 3

Spring

Lake

Ocean

Three sources of water•Spring: 1 million gallons/day .02 cents/gallon•Lake: 2 million gallons/day @ .08 cents/gallon•Ocean: 4 cents/gallon


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ExampleHow much should a city charge for water?


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Water supplied (millions of gallons/day)

Co

st (

cen

ts/g

allo

n)

4.0

0.8

0.2

1 3

Spring

Lake

Ocean

Assume•If P = 4 cents/gallon, Q = 4 million gallons

Question•Why should all residents pay 4 cents per gallon


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Taxes and Efficiency

QuestionWho Pays A Tax Imposed On Sellers of a

Good?


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The Effect of a Tax on the Equilibrium Quantity and Price of Avocados

6

Quantity (millions of pounds/month)

Pri

ce (

$/p

ou

nd

)

1 2 3 4 5

5

4

2

1D

S

3

Without a tax P = $3/lband Q = 3 million lbs/month

2.50

3.50

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


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QuestionHow will a tax on cars affect their prices in

the long run?


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The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply

Quantity (millions of cars/month)

Pri

ce (

$/ca

r)

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


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Who Pays a Tax?When supply is perfectly elastic, the tax

burden will fall entirely on the consumer.


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Total economic surplus = $9 million/month

How a tax collected for a seller affects economic surplus

The Market for Avocados Without Taxes

6

1 2 3 4 5

5

4

2

1

3

Pri

ce (

$/p

ou

nd

)


D

S


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The Effect of a $1 perPound Tax on Avocados

6


Pri

ce (

$/p

ou

nd

)

1 2 3 4 5

5

4

2

1

3

2.50

3.50

S + tax

2.5

D

S

How a tax collected from a seller affects economic surplus


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Deadweight LossThe reduction in total economic surplus

that results from the adoption of a policy


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The Deadweight Loss Caused by a Tax

6


Pri

ce (

$/p

ou

nd

)

D

S

1 2 3 4 5

5

4

2

1

3

2.50

3.50

S + tax

2.5

Deadweight loss caused by tax


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QuestionHow would you determine the economic

feasibility of a tax?


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Elasticity of Demand and the Deadweight Loss from a Tax

Quantity (units/day)

Pri

ce (

$/u

nit

)

21

2.60

1.60

S + T

19

2.40

1.40

S + T

Deadweight loss Deadweight loss

Quantity (units/day)

Pri

ce (

$/u

nit

)

D1

S

24

2.00

D2

S

24

2.00

The greater the elasticity of demand, the greater the deadweight loss from a tax


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57

2.65

1.65

S1 + T

63

2.35

1.35

S2 + T

Deadweight Loss Deadweight Loss

Elasticity of Supply and the Deadweight Loss from a Tax

Pri

ce (

$/u

nit

)

Pri

ce (

$/u

nit

)

D

S1

72

2.00

D

S2

72

2.00

The greater the elasticity of supply, the greater the deadweight loss from a tax

Quantity (units/day) Quantity (units/day)


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What do you think?Why would a tax on land be efficient?Would a tax on pollution increase

economic surplus?

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End ofChapterEnd of

Chapter

MBMC Efficiency and Exchange. MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights...

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