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EEP 101 ECON 125

Lecture 2

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When is a Market Socially Optimal?

Markets have nearly miraculousabilitiesto determine value and allocate

resourcesStill, they have many imperfections

Markets can do most of the work in

todays world, yetThere are many important reasons toassert the public interest in private

transactions

http://en.wikipedia.org/wiki/Invisible_handhttp://en.wikipedia.org/wiki/Invisible_hand

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Basic Definitions

Competitive Economy: An economy comprised of manysmall economic units, each with no market power.

Pareto Optimal: A resource allocation such that youcannot improve any individuals welfare without hurting

at least one other individual. Socially efficient allocation.The Main Theorem of Welfare Economics: A competitiveeconomy will achieve Pareto optimal resource allocationwhen:

- Full information exists- No externalities exist

- There are no increasing returns to scale intechnology

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Potential Reasons for GovernmentIntervention in the Market

1. Facilitate information creation and access

2. Manage externalities

3. Provide public goods/services

4. Adjust income distribution

5. Manage non-competitive behavior

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Facilitate informationcreation and access

Education and extension

Public supported media

(infrastructure, standards, andcontent)

Collection and distribution of priceand other economic data

Labeling requirements (truth-in-advertising policies)

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Manage externalities

Externalities: when activities of one agentaffect preferences/technologies of other agents. Negativeexternalities reduce utility or productivity

(pollution). PositiveExternalities increase utility or productivity

(orchard and apiary - trees and bees).

ProductionExternalities: when productivity ofan individual is affected by activities of others

(smokestacklaundry, irrigation - fishery).ConsumptionExternalities: when welfare ofsome individuals is affected by the consumptionactivities of other individuals (loud music,smoking).

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Provide public goods/services

Public Goods and Services are characterized by twofeatures:

1) Nonrivalry: Goods can be consumedconcurrently by more than one individual

2) Nonexcludability: Goods can be accessedfreelyExamples

-Knowledge from education and public

research-National Security-Legal system, treaties-Infrastructure, such as roads, bridges, etc.

-Environmental amenities, such as clean air

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Adjust income distribution

Transfer Policies: Policies designed tochange the distribution of wealth in society.

Examples of transfer policies:

- Income taxes

- Inheritance taxes

- Social Security

- Medicare, Medicaid, and AFDC- Tax breaks for corporations

- Subsidized loans for education or homebuying

- Agricultural subsidies

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Manage non-competitive behavior

Noncompetitive behavior can arise inmany contexts, including

1)Monopoly: One agent controlssupply of a good.

2) Monopsony: One agent controls

demand for a good.3) Middleman: One agent buys the

product from the supplier and sells it

others.

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Overview of Welfare Economics

Welfare analysis:A systematic method ofevaluating economic implications of alternativeallocations. It addresses the following questions:

1. Is a given resource allocation efficient?2. Who gains and who loses under variousresource allocations, and by how much?

Welfare economics: A methodological approach

to assess resource allocations, estimate privatecosts and benefits, and establish criteria for publicintervention.

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The Role of Markets

Markets are institutions that exist toreconcile social values (willingness to

pay) with resource costs (scarcity).The primary mechanism for this isexchange of goods and services for

money.This combines complex behavior withsimple metrics, prices and quantities.

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General Analysis Overview

Welfare analysisis a systematic method ofevaluating economic implications of alternativeallocations. It answers the following questions:

1.Is a given resource allocation efficient?

2. Who gains and who loses under variousresource allocations? By how much?

Welfare economics: A methodological approach

to assess resource allocations and establish criteriafor government intervention.

Partial analysis: Evaluates outcomes in a subsetof markets assuming efficiency in others.

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Chapter 2:Welfare Economics

General Analysis Overview

Welfare under Monopoly

Welfare under Monopsony

Welfare under Middlemen

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r : r u r wresources and value

Supply: Resources embodied in goods and services

Profit = Revenue Cost(Pricing power, Scarcity)

Behavior/Incentives

Willingness to Pay(Taste, Wealth)

Producers

Demand: Payments for value received

Consumers

M k t All ti E l

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Market Allocation Example:Cal Basketball Tickets

Value of Tickets to Potential Consumers

Peter $200

Paul $150

Mary $100

Jack $50

Jill $50

Value of Tickets to Potential Suppliers:

Professor V $50

Professor W $50

Professor X $100

Professor Y $150

Professor Z $200

200

150

100

50

Price

Tickets0 1 2 3 4

5

Mary

Peter

Paul

Jack and Jill

V and W

X

Y

Z

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Equilibrium

Equilibrium Price = $100

Peter, Paul and Mary buy tickets fromProfessors V, W and X. If they all trade at theequilibrium price, does it matter who buys

from whom? No

Gains:

Peter = $200 - $100 = $100

Paul = $150 - $100 = $50

Mary = $100 - $100 = $0

V = $100 - $50 = $50W = $100 - $50 = $50

X = $100 - $100 = $0

Total Gain: $250

200

150

100

50

Price

Tickets0 1 2 3 4

5

Mary

Peter

Paul

Jack and Jill

V and W

X

Y

Z

Consumer Surplus

Producer Surplus

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Demand and ConsumerSurplus

Price

Quantity

D = Willingness to Pay

Po

Qo

Maximum Willingness to Pay for Qo

What is paid

Consumer Surplus

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Supply and Resource Cost

Minimum Amount Needed toSupply Qo

Price

Quantity

Po

Qo

What is paid

Producer Surplus

S

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Market Equilibrium in Theory:

Efficiency

Price

Quantity

Po

Qo

S

Producer Surplus

Consumer

Surplus

D

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Price Increase

Price

Quantity

Po

Qo

S

D

QL

Remaining

ConsumerSurplus

PH

New Producer

Surplus

Lost ConsumerSurplus: Deadweight

Lost Producer Surplus:Deadweight

Lost ConsumerSurplus: Transfer

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Welfare under Monopoly

A monopoly is the only seller in a market.

The basic condition for a monopoly is

Optimality occurs where:

MR(Q)-MC(Q)=0, where MR=marginal

revenue and MC=marginal cost

MaximizesQ P(Q) Q C(Q)P+Q

P

Q

C

Q=0

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MonopolyP

Q

C

D

Pc

Qc

C

MR

Pm

Qm

A

B

Qc, Pc=under competitionQm,Pm=under monopoly

Monopolyproduces too little

and charges

too much. Welfare

loss under

monopoly is .ABC

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Linear Example of Monopoly-1Inverse demand=

P(Q) =a - bQRevenue= (a - bQ)Q =

aQ-bQ2Supply= c + dQCompetitive outcomeis where

Demand=supplya - bQ = c + dQ

Qc =a c

b + d

Pc = aba bcb+ d

Pc =ad+ bc

b + d.

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Linear Example of Monopoly-2

Under monopoly,

MR=MC

a 2bQ= c + dQ

QM=a c

2b+ d

PM=ab a c( )

2b + d

=a b + d( )+ bc

2b+ d

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Welfare under MonopsonyA monopsony is the only buyer in a market.

P

Q

D

MC

Pc

Qc

MO

Pmn

Qmn

Qc, Pc=underCompetitionQmn,Pmn=underMonopsony

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Calculation of monopsonyMaximization equation:

Area:

Optimality condition:

Price paid by monopsony:

MaximizeQ

B(Q) QMC(Q)

B(Q)= P(z)dz=0

Q

area under demand.

B

Q=Q

MC

Q+MC(Q)

MO=marginal outlay= MC(Q)+MC

Q

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Summary of monopoly andmonopsony

Monopolist: Underbuys and oversells.

Monopsonist:Underbuys and

underpays.

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Welfare under Middlemen

A middleman is the only buyer and seller

of product. MOP

Q

D

S

Pmmb

Qmm

C

E

MR

Pmms

Qmm=middlemen outputPmms=price paid bymiddlemen to supplier

Pmmb=price paid tomiddlemen by buyer

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Profits under Middlemen

MOP

Q

D

S

Pmmb

Qmm

C

E

MR

Pmms

Profits PmmbCEPmms