ECON 160ECON 160

Week 07March 08-10, 2011

Efficiency & Government Policies

Market Efficiency

Chapter 7

2

$ 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

3

Allocation Efficiency: Price allocates the goods to highest valued users

A B C Market

$ P $ P $ P

$ P

Q/T

DD

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.

Pe Pe

4

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.

Pe

5

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

Pe

Qe

Marginal Value

MarginalCost

6

MVx

Qtyx / T

$ 10

$ 9

$ 8

$ 7

$ 6

$ 5

$ 4

$ 3

$ 2

$ 11 2 3 4 5 6 7 8 9 10

MVx = Dx

Demand = Marginal Value

Exchange Value

Pe

Qe

Consumer Surplus Value (MV – Price)

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

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

Supply Reflects Marginal Cost

Pe

Qe

Producer Surplus ValuePrice – Marginal Cost

8

$ 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 Trade

Pe

Qe

C.S V.

P.S.V.

9

$ 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

10

$ 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

11

Market Outcome is Efficient

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

• Producing less Efficiency loss• Producing more Efficiency Loss

12

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)

13

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

14

$ Rent

Units/Month

SupplySupply

D0

$ 1400

DD11

1000 1500

$ 2000

LR new SupplyLR new Supply

$ 1600

New LR Equilibrium

15

$ Rent

Units/Month

SupplySupply

D0

$ 1400

DD11

1000 1500

Price Ceiling

Short

16

Implications Price Ceiling below Equilibrium

• Increased Transaction Costs to Buyers & Sellers

• Increase in Non-Market rationing: Discrimination

• Decrease in Quality• Decrease in Supply

17

Price Floor above Equilibrium

• How does the labor Market work?• What happens when you place the Minimum

Wage above Equilibrium wage ?

18

$ Wage

Qty/T

Demand Supply of Labor

Wage E

QE

Min. Wage

Qd Qs

Surplus : UnemploymentSurplus : Unemployment

Unskilled Labor Market

19

The Minimum Wage: A Price Floor

$Wage

Qty / T

D

S

Pe

Qd Qs

D

Qe

Minimum Wage

20

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

21

Taxes & Price Effects

22

Sales Tax on Buyers

$ Price x

Qty x /T

Dx

Sx

$Pe

Qe

Dx’

$Pb

$PsTax Revenue

Qt

23

Tax on Sellers$ Price x

Qty x /T

Dx

Sx

$Pe

Qe

$Pb

$PsTax Revenue

Qt

Sx’

24

Who bares the burden of a tax?

• The distribution of the tax burden is identical for either a sales tax on buyers or an excise tax on sellers.

• When the price to buyers including the tax rises, consumers lose consumer surplus

• When the price to sellers after the tax falls, sellers lose previous revenue.

25

Tax Burden: Inelastic Demand

$ Price x

Qty x /T

Dx

Sx$Pe

Qe

$Pb

$Ps

Qt

Tax

26

Tax Burden: Inelastic Supply

$ Price x

Qty x /T

Dx

Sx

$Pe

Qe

$Pb

$Ps

Qt

Tax

27

Tax Burden: Fixed Supply$ Price x

Qty x /T

Dx

Sx

$800

Qe

$900

$700

Tax $100

Lost Revenue

Qd

Tax $100

28

Tax Burden & Relative Elasticity

• The burden of a tax (either sales or excise) depends on the relative elasticity of demand and supply.

• If demand is more inelastic then supply Buyers bare a larger portion of the burden.

• Is supply is more inelastic than demand, sellers bare a larger portion of the burden.

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