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Efficiency and Exchange

Efficiency and Exchange. Market Equilibrium and Efficiency. What do you think? Are markets always efficient and equitable?. Market Equilibrium and Efficiency. A market equilibrium is efficient…

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Efficiency and Exchange

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  1. Efficiency and Exchange

  2. Market Equilibrium and Efficiency • What do you think? • Are markets always efficient and equitable? Chapter 7: Efficiency and Exchange

  3. Market Equilibrium and Efficiency • 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. Chapter 7: Efficiency and Exchange

  4. S D A Market in Which Price Is Below the Equilibrium Level 2.50 2.00 1.50 Price ($/gallon) 1.00 .50 1 2 3 4 5 Quantity (1,000s of gallons/day) Chapter 7: Efficiency and Exchange

  5. S 2.50 • 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 $1, the market is not efficient 2.00 1.50 Price ($/gallon) 1.25 1.00 .50 D 1 2 3 4 5 Quantity (1,000s of gallons/day) How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction Chapter 7: Efficiency and Exchange

  6. S 2.50 • 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 $0.75 2.00 1.75 1.50 Price ($/gallon) 1.00 .50 D 1 2 3 4 5 Quantity (1,000s of gallons/day) How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction Chapter 7: Efficiency and Exchange

  7. Market Equilibrium and Efficiency • Observations on Efficiency • When 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. Chapter 7: Efficiency and Exchange

  8. Market Equilibrium and Efficiency • 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. Chapter 7: Efficiency and Exchange

  9. Market Equilibrium and Efficiency • What do you think? • Is efficiency the only goal? • Why should efficiency be the first goal? Chapter 7: Efficiency and Exchange

  10. The Cost of PreventingPrice Adjustments • Price Ceilings: Do They Help the Poor? • An Example • A Price Ceiling for Home Heating Oil Chapter 7: Efficiency and Exchange

  11. Consumer surplus = $900/day S Producer surplus = $900/day D Economic Surplus in an Unregulated Market for Home Heating Oil 2.00 1.80 1.60 1.40 1.20 1.00 • 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 = $1,800/day Price ($/gallon) .80 1 2 3 4 5 8 Quantity (1,000s of gallons/day) Chapter 7: Efficiency and Exchange

  12. Consumer surplus = $900/day Lost economic surplus = $800/day Producer surplus = $100/day The Waste Caused by Price Controls Price Ceiling set at $1.00 S 2.00 1.80 1.60 1.40 1.20 1.00 D Price ($/gallon) .80 • 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 1 2 3 4 5 8 Quantity (1,000s of gallons/day) Chapter 7: Efficiency and Exchange

  13. The Cost of PreventingPrice Adjustments • 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. Chapter 7: Efficiency and Exchange

  14. The Cost of PreventingPrice Adjustments • Question • What program could be used to help the poor get heating oil that would be more efficient than a price ceiling? Chapter 7: Efficiency and Exchange

  15. Surplus with price controls Surplus with income transfers and no price controls R R P P 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 When the Pie Is Larger, Everyone Can Have a Bigger Slice Chapter 7: Efficiency and Exchange

  16. The Cost of PreventingPrice Adjustments • Question • What would be a potential cost of income transfers? Chapter 7: Efficiency and Exchange

  17. The Cost of PreventingPrice Adjustments • 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 Chapter 7: Efficiency and Exchange

  18. Economic surplus maximized where MC($2) = MB($2) at 4 million loaves Consumer surplus = $4,000,000/month S 2.00 World price = $ D Economic Surplus in a Bread Market Without Subsidy 5.00 Price of bread ($/loaf) 4.00 3.00 1.00 2 4 6 8 Quantity (millions of loaves/month Chapter 7: Efficiency and Exchange

  19. The Reduction in EconomicSurplus from a Subsidy • Assume a $1/loaf subsidy • Consumers buy 6 million loaves • Consumer surplus will increase to $9 million • Economic surplus will fall by $1 million Chapter 7: Efficiency and Exchange

  20. Consumer surplus = $9,000/month Reduction in total economic surplus = $1,000,000/month S Domestic price with subsidy D The Reduction in EconomicSurplus from a Subsidy • The cost of the tax = $6 million • The benefit of the subsidy = $5 million • Loss of economic surplus = $1 million 5.00 4.00 Price of bread ($/loaf) 3.00 2.00 World price = $ 1.00 2 4 6 8 Quantity (millions of loaves/month Chapter 7: Efficiency and Exchange

  21. The Cost of PreventingPrice Adjustments • Price Subsidies • How could we provide assistance to low income consumers more efficiently? Chapter 7: Efficiency and Exchange

  22. The Cost of PreventingPrice Adjustments • Economic Naturalist • First-Come, First-Served Policies • Why does no one complain any longer about being bumped from an overbooked flight? Chapter 7: Efficiency and Exchange

  23. Demand for remaining on the flight Supply of seats 60 24 33 37 Equilibrium in the Market for Seats on Oversold Flights Price ($/seat) Seats Chapter 7: Efficiency and Exchange

  24. First-come, First-served • Reservation prices = (60+59+…+24)/37 = $42/passenger • 4 bumped @ $42 each or $168 loss in economic surplus Supply of seats 60 27 Price ($/seat) 24 33 37 Seats Equilibrium in the Market for Seats on Oversold Flights Chapter 7: Efficiency and Exchange

  25. Equilibrium in the Market for Seats on Oversold Flights • 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 = $102 Supply of seats 60 27 Price ($/seat) 24 33 37 Seats Chapter 7: Efficiency and Exchange

  26. The Cost of PreventingPrice Adjustments • Example • How should a tennis pro handle an overbooking problem? Chapter 7: Efficiency and Exchange

  27. Player Arrival time Reservation price 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 The Cost of PreventingPrice Adjustments • 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 Chapter 7: Efficiency and Exchange

  28. The Cost of PreventingPrice Adjustments • What do you think? • Why offer compensation when the cost of first-come, first-served to the seller is zero? Chapter 7: Efficiency and Exchange

  29. The Marginal Cost Pricing of Public Services • Example • How much should a city charge for water, electricity, or some other service? Chapter 7: Efficiency and Exchange

  30. Ocean 4.0 Lake Spring 0.8 0.2 1 3 The Marginal Cost Curve for Water • Three sources of water • Spring: 1 million gallons/day .02 cents/gallon • Lake: 2 million gallons/day @ .08 cents/gallon • Ocean: 4 cents/gallon Cost (cents/gallon) Water supplied (millions of gallons/day) Chapter 7: Efficiency and Exchange

  31. The Marginal Cost Curve for Water • Example • How much should a city charge for water? Chapter 7: Efficiency and Exchange

  32. Ocean 4.0 Lake Spring 0.8 0.2 1 3 The Marginal Cost Curve for Water • Assume • If P = 4 cents/gallon, Q = 4 million gallons • Question • Why should all residents pay 4 cents per gallon Cost (cents/gallon) Water supplied (millions of gallons/day) Chapter 7: Efficiency and Exchange

  33. Taxes and Efficiency • Question • Who Pays A Tax Imposed On Sellers of a Good? Chapter 7: Efficiency and Exchange

  34. Without a tax P = $3/lb and Q = 3 million lbs/month S + tax S • 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 $3.50/lb 3.50 3 2.50 D 2.5 The Effect of a Tax on the Equilibrium Quantity and Price of Avocados 6 5 4 Price ($/pound) 2 1 1 2 3 4 5 Quantity (millions of pounds/month) Chapter 7: Efficiency and Exchange

  35. Taxes and Efficiency • Question • How will a tax on cars affect their prices in the long run? Chapter 7: Efficiency and Exchange

  36. S + $100 $20,100 S $20,000 • Supply shifts to $20,100 • The burden of the tax falls entirely on the consumer D 1.9 2.0 The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply Assume a tax levy of $100 tax/car Price ($/car) Quantity (millions of cars/month) Chapter 7: Efficiency and Exchange

  37. Taxes and Efficiency • Who Pays a Tax? • When supply is perfectly elastic, the tax burden will fall entirely on the consumer. Chapter 7: Efficiency and Exchange

  38. S Total economic surplus = $9 million/month How a tax collected for a seller affects economic surplus D The Market for Avocados Without Taxes 6 5 4 Price ($/pound) 3 2 1 1 2 3 4 5 Quantity (millions of pounds/month) Chapter 7: Efficiency and Exchange

  39. S + tax S 6 5 How a tax collected from a seller affects economic surplus 4 3.50 Price ($/pound) 3 2.50 2 1 D 1 2 3 4 5 2.5 Quantity (millions of pounds/month) The Effect of a $1 perPound Tax on Avocados Chapter 7: Efficiency and Exchange

  40. Taxes and Efficiency • Deadweight Loss • The reduction in total economic surplus that results from the adoption of a policy Chapter 7: Efficiency and Exchange

  41. S + tax Deadweight loss caused by tax 3.50 2.50 2.5 The Deadweight Loss Caused by a Tax S 6 5 4 Price ($/pound) 3 2 1 D 1 2 3 4 5 Quantity (millions of pounds/month) Chapter 7: Efficiency and Exchange

  42. Taxes and Efficiency • Question • How would you determine the economic feasibility of a tax? Chapter 7: Efficiency and Exchange

  43. Deadweight loss Deadweight loss S + T S + T 2.60 S S 2.40 2.00 2.00 1.60 1.40 D1 D2 19 24 21 24 Elasticity of Demand and the Deadweight Loss from a Tax Price ($/unit) Price ($/unit) Quantity (units/day) Quantity (units/day) The greater the elasticity of demand, the greater the deadweight loss from a tax Chapter 7: Efficiency and Exchange

  44. Deadweight Loss Deadweight Loss S2 + T S1 + T S2 2.65 S1 2.35 2.00 2.00 1.65 1.35 D D 57 72 63 72 Elasticity of Supply and the Deadweight Loss from a Tax Price ($/unit) Price ($/unit) Quantity (units/day) Quantity (units/day) The greater the elasticity of supply, the greater the deadweight loss from a tax Chapter 7: Efficiency and Exchange

  45. Taxes and Efficiency • What do you think? • Why would a tax on land be efficient? • Would a tax on pollution increase economic surplus? Chapter 7: Efficiency and Exchange

  46. End of Chapter

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