Market Efficiency

1. ECON1000 S2 2016, Lecture 4Chapter 4Economic EfficiencyIs efficient?

2. Market Efficiency • Is the market efficient? • Does the market equilibrium maximise the total welfare of buyers and sellers? • How is the welfare of consumers and producers get affected by changes in market prices?

3. L4 Outline– Learning Outcomes • Understand the concepts of consumer surplusand producer surplus. • Understand the concept of economic efficiency. • Demonstrating that economic efficiency is achieved at equilibrium. • Use D and S graphs to analyse the economic impact of price ceilingsand price floors. • Use D and S graphs to analyse the economic impact of taxes.

4. 1a. Consumer Surplus – Demand, WTP, MB • Your willingness to pay (WTP) for something equals the marginal benefit (MB) – the maximum pricethat a person is willing to pay for a good. • A demand (D) curve is a MB curve – the area under the D curve represents the total benefits from consumption.

5. Consumer Surplus Consumer Surplus is the difference between the highest price that a consumer is willing to pay and the price the consumer actually pays. • Consumer surplus measures the net benefits from consumption. • If consumer surplus increases, then consumers are better off.

6. Benefits and D Curve Area underneath the D curve captures the total benefits to consumers. Consumer surplus is the area below the demand curve and above the market price. P P Qd 10 1 9 2 8 3 7 4 6 5 5 6 4 7 10 6 D reflects the maximum price consumers are WTP D 5 Q

7. Benefits to consumers P(willing to pay) Qd Price (actually paid) Consumer surplus 10 1 6 4 9 2 6 3 8 3 6 2 7 4 6 1 6 5 6 0

8. Consumer Surplus P Consumer surplus: area below the D curve and above the market price 6 Amount paid = $6 x 5 = $30 D Q 5

9. How a change in price affects consumer surplus (as supply shifts to the right) Price A S1 S2 Initial consumer surplus Increase in Consumer surplus, area BCDE C P1 B E P2 D Demand 0 Q1 Q2 Quantity

10. 1b. Producer Surplus – Supply, MC • Producer surplus is the difference between the lowest price a firm would have been willing to accept and the price it actually receives. • The cost of one more unit of a good or service is its marginal cost, which reflects the minimum price that a firm is willing to accept. • A supply curve is a marginal cost (MC) curve.

11. Supply & Producer Surplus P P Qs 1 0 2 1 3 2 4 3 5 4 6 5 7 6 S 6 5 Q

12. Supply & Producer Surplus Price Producer P Qs Received Surplus 1 0 - - 2 1 6 4 3 2 6 3 4 3 6 2 5 4 6 1 6 5 6 0

13. Supply & Producer Surplus • Producer surplusis the price of a good minus the marginal cost of producing it • Producer surplus is measured by the area below the priceand above the supply curve

14. Supply & Producer Surplus P Producer receives $30 (PxQ) area below price and above supply curve is the producer surplus S 6 area below supply curve is the cost of production 5 Q

15. How a change in price affects producer surplus (as D curve shifts towards right) Price Increase in producer surplus, area DEBC Supply D E P2 B C P1 Initial producer surplus D2 D1 A 0 Q1 Q2 Quantity

16. 1c. Market Efficiency • The “economic well-being” of a society is measured as the sum of consumer surplus and producer surplus – total (economic) surplus. • Market efficiencyis attained when the allocation of resources maximises total surplus. • At the equilibrium quantity, MB = MC, so the quantity is the efficient quantity.

17. Market Equilibrium and Efficiency • Equilibrium in a competitive market results in the economically efficient level of output, where MB = MC • Is the Competitive Market Efficient? • Yes • Quantity: Efficient • Consumer Surplus/ Producer Surplus: Maximum • Any inefficiency leads to deadweight loss.

18. Economic Surplus/ Total Surplus = Consumer surplus + producer surplus Price c.s. Supply Equilibrium price p.s. Demand 0 Quantity Equilibrium quantity

19. Deadweight Loss (DWL)The decrease in total (economic) surplus that results from a market not being in competitive equilibrium. Price Deadweight loss Supply underproduction overproduction Demand 0 Quantity Qe

20. Other Sources of Inefficiency • Price & quantity restrictions • Taxes & subsidies • Monopoly – market power • Externalities, Public goods, Asymmetric information etc. …tackled in next lecture, L5

21. Review Lucky n’ Lovely Ludovica decides that she would pay as much as $1200 for a new laptop computer. She buys the computer and realises a consumer surplus of $800. How much did Ludovica pay for her computer? A. $400 B. $800 C. $1200 D. $2000 Cute Kerry is in love with Ben and is willing to pay $30 to see the highly anticipated 2016 box office film “Batman v Superman: Dawn of Justice”. She finds a cinema showing an advance screening of film for $20. Kerry’s consumer surplus is: • $50 • $30 • $20 • $10

22. Review The Health Ministry announces that eating chocolate improves your health, especially if you’re expecting! As a result, the equilibrium market price of chocolate __________, and producer surplus ___________. A. increases, decreases B. increases, increases C. decreases, decreases D. decreases, increases

23. Review What area represents the decrease in producer surplus when the market price fall from P2to P1? A. A + C + E B. C + E C. A + B D. B + D

24. 2. Price Ceilings & Price Floors 2A. Price Ceiling (activity 1 in lecture) 2B. Price Floor (activity 2 for homework) • A legally established __________ price at which a good can be sold.

25. Regulated Prices : Price Ceilings & Price Floors • Regulated prices: prices get determined/fixed by govt. and not by market forces • Price Ceiling A legally established maximum price at which a good can be sold. • rent ceilings • ceilings on petrol prices • Price Floor A legally established minimum price at which a good can be sold. • agricultural prices • minimum wage laws

26. 2A. Housing Markets and Rent Ceilings • Imagine that a tropical cyclone destroys much of the city’s homes… • How would the housing market cope with such a devastating reduction in the supply of housing? • You should be able to explain the diagram that is linked to this scenario.

27. A Housing Market After a Cyclone After the cyclone Safter cyclone 900 SBefore 700 Should rents be capped at $500? Rent (dollars per unit per month) 500 D 0 20 30 40 60 Quantity (thousands of units per month)

28. Housing Markets and Rent Ceilings • When a price ceiling is applied to a housing market, it is called a rent ceiling. • If the rent ceiling is set above the equilibrium rent, it has no effect. • But if the rent ceiling is set below the equilibrium rent, it creates a shortage.

29. Rent ceiling Housing shortage A Rent Ceiling Snew 900 700 Rent (dollars per unit per month) 500 D 0 20 30 40 Quantity(thousands of units per month)

30. Economic Effect of a Rent Ceiling • Rent ceiling can lead to shortage which can further result in black market. • A black market is an illegal market in which the price exceeds the legally imposed price ceiling • A shortage creates a black market. • Illegal arrangements are made between renters and landlords at rents above the rent ceiling

31. Housing Markets and Rent Ceilings • Are rent ceilings efficient? • Not always………. • Consumer surplus may be reduced & producer surplus may be increased if apartments are being rented at prices above the legal price ceiling • Some consumers miss out on housing • Some consumers pay lower rent but may have higher search costs • A black market results • Overall, there is a loss of efficiency (‘DWL’)

32. A Rent Ceiling – changes in consumer and producer surplus Snew a 900 b c 700 e Rent (dollars per unit per month) d Rent Ceiling 500 f D 0 20 30 40 Quantity(thousands of units per month)

33. Answers Consumer Surplus (before and after P ceiling) Before: After: Producer Surplus (before and after P ceiling) Before: After: Deadweight loss (DWL)?

34. 2B. Price Floors (for homework) • A price floor is a regulation that makes it illegal to sell at a price lower than a specified level. • Usually producers with vested interests advocate this. • If the minimum price is set below the equilibrium price, it has no effect. • If the minimum price is set above the equilibrium, there will be excess supply –a surplus.

35. Price Floors • Price floors are common in agricultural markets e.g. minimum wool price. • Price floors create surplusesbecause Qs> Qd… Price is higher ($12, not $8). • Taxpayers may fund the purchase of the surplus output (we talk about this in one of the tutorial questions). • Price floors are inefficient (they create a deadweight loss).

36. Price Floor - Wool Price per kg S $12 Minimum price $8 D Qty (millions kgs) Qs Qd Qefficient

37. Price Floor - Wool • Who gains & who loses from the price floor? • Producers receive a higher price ($12) but sell less – does their producer surplus increase? • Consumers pay more ($12, instead of $8) and get less – their consumer surplus………

38. Wool Price Floor – effect on producer surplus, consumer surplus and DWL Price per kg S A Surplus $12 Minimum price B C $8 E D D Qty(millions kgs) Qefficient Qfloor

39. Price Floor on Slide 38 (check it out!) • Producer Surplus (before and after P floor) • beforeP floor = D + E • with P floor =D + B • Consumer Surplus (before and after P floor) • before P floor A + B + C • with P floor = A • Deadweight Loss • Total surplus has decreased by C + E

40. 3. Taxes • Governments levy taxes on goods and services to raise revenue for public purposes. • Taxes discourage market activity. • When a good is taxed, the quantity sold is less; the price is higher • A tax creates a wedge between buyer and seller.

41. “Tobacco tax increase flagged as possible revenue option for Federal budget” Eliza Borrello and Louise Yaxley, ABC NEWS, 15th March 2016 Treasurer Scott Morrison says he cannot deliver both company and income tax cuts in one budget at the same time some MPs say they are open to increasing the tax on tobaccoas an income stream. Increase in tobacco excise firms as possibility. … The Opposition has already announced it would have four increases in tobacco excise of 12.5 per cent each, which would raise nearly $4 billion over the forward estimates and around $48 billion over the medium term. ABC News: Nic MacBean Source: http://www.abc.net.au/news/2016-03-15/ashtray-cigarette-packet/7247584

42. Taxes • Taxes can be levied on buyers or sellers • A tax on sellers will decrease supply • A tax on buyers will decrease demand • Example: The govt wants to impose a new tax on beer (say, Tax = $1.50) • Should the tax be imposed on buyers or sellers? • It makes no difference, in terms of the reduction in market quantity sold/purchased from the tax, as we will see.

43. S + tax on sellers Price paid by buyers $1.50 tax Price with no tax Price received by sellers A Tax on Sellers 5.00 4.00 3.00 2.50 2.00 1.00 0 S A tax on sellers shifts the S curve upward by the amount of the tax Price (dollars per bottle) The tax burden on the buyer is one dollar The tax burden on the seller is 50 cents D 50 75 100 125 150 175 200 225 Quantity (millions of bottles per year)

44. Price paid by buyers Price with no tax $1.50 tax Price received by sellers D + tax on buyers A Tax on Buyers 5.00 4.00 3.00 2.50 2.00 1.50 1.00 0 S A tax on buyers shifts the D curve downward by the size of the tax Price (dollars per bottle) D 50 75 100 125 150 175 200 225 Quantity (millions of bottles per year)

45. Taxes • Equivalence of tax on buyers and sellers • A tax on buyers has the same effectas a tax on sellers • In both cases the equilibrium quantity decreases by the same amount and equilibrium P rises by the same amount • Practical problem would be collecting tax from buyers

46. Incidence (or ‘burden’) of Tax • In what proportions is the burden of the tax divided? • Who pays more of the tax, the buyer or the seller? It depends on the elasticityof D and S • incidence of a tax falls more on buyer when D is moreinelasticcompared to S. • incidence of a tax falls more on seller when D is moreelasticcompared to S. • Inelastic D: tax burden more on buyers • Elastic D: more burden on sellers

47. A Tax on Sellers – Inelastic D S + tax on sellers 5.00 4.00 3.00 2.00 1.00 0 S • The tax burden on the buyer is $1 • The tax burden on the seller is 0.50c • D is more inelastic compared to S 2.50 Price (dollars per bottle) D 50 75 100 125 150 175 200 225 Quantity (millions of bottles per year)

48. A Tax on Sellers – ElasticD S + tax on sellers 5.00 4.00 3.00 2.00 1.00 0 S • The tax burden on the buyer is 50c • The tax burden on the seller is $1 • D is more elastic compared to S 3.50 Price (dollars per bottle) D 50 75 100 125 150 175 200 225 Quantity (millions of bottles per year)

49. Taxes and Efficiency • What about the efficiency of a tax? • How does a tax affect consumer & producer surplus? • Will total surplus increase or decrease? • Taxes … • increase the price paid by consumers • decrease the price received by sellers • and decrease quantity purchased/sold.

50. A Tax on Sellers – Inelastic DPrice Buyers Pay, their loss of Consumer Surplus S + tax on sellers 5.00 4.00 3.00 2.00 1.00 0 • After a tax, consumers will pay more ($4, not $3) and consume less (100m bottles instead of 125m) • Consumer surplus will decrease by the shaded area S 2.50 Price (dollars per bottle) D 50 75 100 125 150 175 200 225 Quantity (millions of bottles per year)