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Markets and Incentives: Theory

Markets and Incentives: Theory. Hadi Yektas The University of Melbourne. Outline. WTP (valuation) and WTA (cost) Total surplus and efficiency Price formation and division of surplus Trading institutions: decentralized bargaining, auctions, markets

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Markets and Incentives: Theory

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  1. Markets and Incentives: Theory Hadi Yektas The University of Melbourne

  2. Outline • WTP (valuation) and WTA (cost) • Total surplus and efficiency • Price formation and division of surplus • Trading institutions: • decentralized bargaining, auctions, markets • Consumer’s surplus and producer’s surplus • Incentives • Government interventions and deadweight loss • Price controls, taxes, subsidies, quotas • Credence goods • Inability to determine/calculate valuations / costs • Many people • on one side • on both sides

  3. WTP: valuation and WTA: cost WTP: Willingness to Pay WTA: Willingness to Accept • Consider a buyer • whose valuation is $50 • and a seller • whose prod. cost is $20 • who are matched via a trading institution such as • bargaining, • auction / procurement, • competitive market. $50 $20

  4. Total Surplus and Efficiency • The difference between • the buyer’s valuation and • the seller’s production cost is called total surplus and it represents the benefit from a potential trade. • A surplus is realized only if the trade takes place. • It is efficient for a trade • to take place if valuation > production cost and • NOT to take place if valuation < production cost. $50 Benefit from trade $30 $20

  5. Efficiency as a Performance Measure Performance of Trading Institutions • Note, we haven’t specified a price, yet! • The price and • the allocation / matches • we took as given are determined by the trading institution. • Efficiency of • the trading institution / the policy is judged on the basis of whether it • enables trades with positive total surplus and • rules out those with negative total surplus . • Efficiency • of the trade of a good increases with the size of the total surplus. $50 Benefit from trade $30 $20

  6. Price formation and division of surplus Bargaining, auctions, markets • Now, suppose that the trading institution leads to a price of $40. • Then, • the buyer’s surplus is valuation minus price, • namely, $50-$40=$10, and • the seller’s surplus is price minus cost, • namely, $40-$20=$20. $50 Buyer’s Surplus $10 $40 Seller’s Surplus $20 $20

  7. Price formation and division of surplus Bargaining, auctions, markets • As the price goes down • the buyer’s surplusincreases, whereas • theseller’s surplusdecreases. while • the total surplusstays the same. $50 Buyer’s Surplus $10 $40 Seller’s Surplus $20 $20

  8. Price formation and division of surplus Bargaining, auctions, markets • As the price goes down • the buyer’s surplusincreases, whereas • theseller’s surplusdecreases. while • the total surplusstays the same. $50 Buyer’s Surplus $20 $30 Seller’s Surplus $10 $20

  9. Buyer’s Incentive Incentives • A buyer has an incentive • to engage in a trade such that • price < valuation. Given that he is already engaged in such a trade, • he also has an incentive • to lower the price so as to • increase his surplus at the expense of the seller. $50 Buyer’s Surplus $20 $30 Seller’s Surplus $10 $20

  10. Seller’s Incentive Incentives • A seller has an incentive • to engage in a trade such that • price > production cost. Given that she is already engaged in such a trade, • she also has an incentive • to increase the price so as to • increase her surplus at the expense of the buyer. $50 Buyer’s Surplus $20 $30 Seller’s Surplus $10 $20

  11. Price Floor and Deadweight Loss(DWL) Government Intervention • If the price floor is • above the buyer’s valuation, then • it will rule out the trade and • create a DWL. • If it is • between the pre-floor price and the buyer’s valuation, then • it will affect the division of the surplus • but will not create a DWL • Otherwise, it will not affect the outcome. $50 $40 $20

  12. Price Floor and Deadweight Loss(DWL) Government Intervention • If the price floor is • above the buyer’s valuation, then • it will rule out the trade and • create a DWL. • If it is • between the pre-floor price and the buyer’s valuation, then • it will affect the division of the surplus • but will not create a DWL • Otherwise, it will not affect the outcome. $60 Price Floor $50 $40 $20

  13. Price Floor and Deadweight Loss(DWL) Government Intervention • If the price floor is • above the buyer’s valuation, then • it will rule out the trade and • create a DWL. • If it is • between the pre-floor price and the buyer’s valuation, then • it will affect the division of the surplus • but will not create a DWL • Otherwise, it will not affect the outcome. $50 $45 Price Floor $40 $20

  14. Price Floor and Deadweight Loss(DWL) Government Intervention • If the price floor is • above the buyer’s valuation, then • it will rule out the trade and • create a DWL. • If it is • between the pre-floor price and the buyer’s valuation, then • it will affect the division of the surplus • but will not create a DWL • Otherwise, it will not affect the outcome. $50 $40 $30 Price Floor $20

  15. Price Ceiling and Deadweight Loss Government Intervention • If the price ceiling is • below the seller’s cost, then • it will rule out the trade and • create a DWL. • If it is • between the pre-ceiling price and the seller’s cost, then • it will affect the division of the surplus • but will not create a DWL • Otherwise, it will not affect the outcome. $50 $40 $20

  16. Price Ceiling and Deadweight Loss Government Intervention • If the price ceiling is • below the seller’s cost, then • it will rule out the trade and • create a DWL. • If it is • between the pre-ceiling price and the seller’s cost, then • it will affect the division of the surplus • but will not create a DWL • Otherwise, it will not affect the outcome. $50 $40 $20 $10 Price Ceiling

  17. Price Ceiling and Deadweight Loss Government Intervention • If the price ceiling is • below the seller’s cost, then • it will rule out the trade and • create a DWL. • If it is • between the pre-ceiling price and the seller’s cost, then • it will affect the division of the surplus • but will not create a DWL • Otherwise, it will not affect the outcome. $50 $40 $30 Price Ceiling $20

  18. Price Ceiling and Deadweight Loss Government Intervention • If the price ceiling is • below the seller’s cost, then • it will rule out the trade and • create a DWL. • If it is • between the pre-ceiling price and the seller’s cost, then • it will affect the division of the surplus • but will not create a DWL • Otherwise, it will not affect the outcome. $50 $45 Price Ceiling $40 $20

  19. Taxes and Deadweight Loss Government Intervention • Ignore the price for now and • consider a tax of $10/unit on the seller. Then, • if it does not rule out a trade, • then it will shrink the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well rule out some potentially beneficial trades • and thus create a DWL. Before Tax $50 $20

  20. Taxes and Deadweight Loss Government Intervention • Ignore the price for now and • consider a tax of $10/unit on the seller. Then, • if it does not rule out a trade, • then it will shrink the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well rule out some potentially beneficial trades • and thus create a DWL. Before Tax $50 $30 BS + SS = TS $20

  21. Taxes and Deadweight Loss Government Intervention • Ignore the price for now and • consider a tax of $10/unit on the seller. Then, • if it does not rule out a trade, • then it will shrink the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well rule out some potentially beneficial trades • and thus create a DWL. After Tax $50 $30 $20

  22. Taxes and Deadweight Loss Government Intervention • Ignore the price for now and • consider a tax of $10/unit on the seller. Then, • if it does not rule out a trade, • then it will shrink the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well rule out some potentially beneficial trades • and thus create a DWL. After Tax $50 $20 BS + SS $30 $10 Tax Revenue $20

  23. Taxes and Deadweight Loss Government Intervention • Ignore the price for now and • consider a tax of $10/unit on the seller. Then, • if it does not rule out a trade, • then it will shrink the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well rule out some potentially beneficial trades • and thus create a DWL. Before Tax $25 Potential benefit from trade: $5 $20

  24. Taxes and Deadweight Loss Government Intervention • Ignore the price for now and • consider a tax of $10/unit on the seller. Then, • if it does not rule out a trade, • then it will shrink the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well rule out some potentially beneficial trades • and thus create a DWL. After Tax $30 $25 DWL: $5 $20

  25. Subsidies and Deadweight Loss Government Intervention • Ignore the price for now and • consider a subsidy of $10/unit to the seller. Then, • if a trade is already possible without a subsidy, • then it will increase the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well enable some trades that are not beneficial • and thus create a DWL. Before Subsidy $50 $30

  26. Subsidies and Deadweight Loss Government Intervention • Ignore the price for now and • consider a subsidy of $10/unit to the seller. Then, • if a trade is already possible without a subsidy, • then it will increase the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well enable some trades that are not beneficial • and thus create a DWL. Before Subsidy $50 $20 BS + SS $30

  27. Subsidies and Deadweight Loss Government Intervention • Ignore the price for now and • consider a subsidy of $10/unit to the seller. Then, • if a trade is already possible without a subsidy, • then it will increase the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well enable some trades that are not beneficial • and thus create a DWL. After Subsidy $50 $30 $20

  28. Subsidies and Deadweight Loss Government Intervention • Ignore the price for now and • consider a subsidy of $10/unit to the seller. Then, • if a trade is already possible without a subsidy, • then it will increase the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well enable some trades that are not beneficial • and thus create a DWL. After Subsidy $50 $20 TS BS + SS $30 $10 Cost of Subsidy $20

  29. Subsidies and Deadweight Loss Government Intervention • Ignore the price for now and • consider a subsidy of $10/unit to the seller. Then, • if a trade is already possible without a subsidy, • then it will increase the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well enable some trades that are not beneficial • and thus create a DWL. Before Subsidy $30 No benefits from trade $25

  30. Subsidies and Deadweight Loss Government Intervention • Ignore the price for now and • consider a subsidy of $10/unit to the seller. Then, • if a trade is already possible without a subsidy, • then it will increase the sum of buyer’s and seller’s surplus. • But the total surplus will stay the same. But • it may as well enable some trades that are not beneficial • and thus create a DWL. After Subsidy $30 DWL $25 $20

  31. Quotas and Deadweight Loss Government Intervention • Consider 2 buyers and 2 sellers that are matched as seen in the figure. • Then the total surplus is ($50-$20)+($30-$25)=$35 • If a quota restricts the number of trades to single unit, then the total surplus can be at most $30. • Thus, the quota would create a DWL that is at least as large as $5. Before Quota $50 $30 $25 $20 2 1

  32. Quotas and Deadweight Loss Government Intervention • Consider 2 buyers and 2 sellers that are matched as seen in the figure. • Then the total surplus is ($50-$20)+($30-$25)=$35 • If a quota restricts the number of trades to single unit, then the total surplus can be at most $30. • Thus, the quota would create a DWL that is at least as large as $5. Before Quota $50 $30 $25 $20 2 1

  33. Quotas and Deadweight Loss Government Intervention • Consider 2 buyers and 2 sellers that are matched as seen in the figure. • Then the total surplus is ($50-$20)+($30-$25)=$35 • If a quota restricts the number of trades to single unit, then the total surplus can be at most $30. • Thus, the quota would create a DWL that is at least as large as $5. After Quota $50 $30 $25 $20 2 1

  34. Quotas and Deadweight Loss Government Intervention • Consider 2 buyers and 2 sellers that are matched as seen in the figure. • Then the total surplus is ($50-$20)+($30-$25)=$35 • If a quota restricts the number of trades to single unit, then the total surplus can be at most $30. • Thus, the quota would create a DWL that is at least as large as $5. After Quota $50 $30 DWL $25 $20 2 1

  35. Credence Goods • It may be that the buyer (the seller) is unable to • determine or • calculate his valuation (her cost) • Then, this uncertainty can preclude trade if • the uncertainty is too big and/or • the seller’s cost is too high (the buyer’s valuation too low). $50 $20

  36. One Seller and Many Buyers • An efficient auction matches the seller with the buyer who has the highest valuations. • Example: Pricing in an English auction $50 $40 $30 $20

  37. One Seller and Many Buyers • An efficient auction matches the seller with the buyer who has the highest valuations. • Example: Pricing in an English auction $50 $40 Total Surplus $30 $20

  38. One Seller and Many Buyers • An efficient auction matches the seller with the buyer who has the highest valuations. • Example: Pricing in an English auction Price = 2nd highest valuation $50 $40 Total Surplus $30 $20

  39. Many Sellers and One Buyer • An efficient procurement matches the buyer with the seller who has the least production cost. • Example: Pricing in an English procurement auction $50 $40 $30 $20

  40. Many Sellers and One Buyer • An efficient procurement matches the buyer with the seller who has the least production cost. • Example: Pricing in an English procurement auction $50 $40 Total Surplus $30 $20

  41. Many Sellers and One Buyer • An efficient procurement matches the buyer with the seller who has the least production cost. • Example: Pricing in an English procurement auction $50 $40 Total Surplus $30 Price = 2nd least cost $20

  42. Many Sellers and Many Buyers • There exist quite many trading institutions that can potentially govern the relationships between • buyers and • sellers of the same good if there are many of each. • Each of these institutions will potentially perform differently. $50 $30 $25 $20 2 1

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