1 Efficiency and Exchange. 2 The Domain of Markets Free markets promote efficiency But, markets cannot be expected to solve every problem (e.g., market.

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Efficiency and ExchangeEfficiency and Exchange

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The Domain of MarketsThe Domain of Markets

Free markets promote efficiencyBut, markets cannot be expected to solve

every problem (e.g., market economies do not guarantee a fair income distribution)

Realizing that markets cannot solve every problem has led some critics to falsely concludethat markets cannot solve any problem

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Market Equilibrium and Efficiency

Market Equilibrium and Efficiency

Pareto efficient (or just efficient)Is a situation where there is no change

possible that will help some people without harming others

Exists when an economy has reached a point where reallocating resources must harm one in order to help another

Occurs at equilibrium of perfectly competitive markets

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Market Equilibrium and Efficiency

Market Equilibrium and Efficiency

When a market is not in equilibrium:1. P > P* = surplus -- QS > QD

2. P < P* = shortage -- QD > QS

In either case, the quantity exchanged is always LESS THAN the true equilibrium quantity.

Hence, if a market is not in equilibrium, further benefit-enhancing transactions are always possible.

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Fig. 7.2How Excess Demand Creates an

Opportunity for a Surplus-Enhancing Transaction

Fig. 7.2How Excess Demand Creates an

Opportunity for a Surplus-Enhancing Transaction

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Fig. 7.3How Excess Supply Creates an

Opportunity for a Surplus-Enhancing Transaction

Fig. 7.3How Excess Supply Creates an

Opportunity for a Surplus-Enhancing Transaction

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Economic SurplusEconomic Surplus

Total economic surplusThe sum of all the individual economic

surpluses gained by buyers and sellers participating in the market

Consumer SurplusProducer Surplus

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SurplusSurplus

Consumer SurplusEconomic surplus gained by the buyers of a

productMeasured by the difference between their

reservation price and the price they payProducer Surplus

Economic surplus gained by the sellers of a product

Measured by the difference between the price they receive and their reservation price

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Fig. 7.7Total Economic Surplus in the

Market for Milk

Fig. 7.7Total Economic Surplus in the

Market for Milk

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Surplus and EfficiencySurplus and Efficiency

Equilibrium price and quantity maximize the total economic surplusTotal economic surplus would be lower at

any other price and quantity combinationI.E., “waste” or unrealized gain occurs at

any other price and quantity combination

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Other GoalsOther Goals

Efficiency is not the only goalAn equitable income distribution is a

desirable goal for many

Why efficiency should be the first GoalEfficiency enables us to achieve all other

goals to the fullest possible extentEfficiency minimizes waste

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The Costs of Price ControlsThe Costs of Price Controls

Price ceilings and price floors cause markets to be in permanent disequilibrium.

Price controls are therefore inefficient.

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Price CeilingsPrice Ceilings

Price CeilingIt is a law or regulation that prevents sellers from

charging more than a specified amountIt keeps price lowIt reduces total economic surplusIt would allow some poor families to buy the good

at the reduced price. [However, the same objective could have been accomplished with less waste.]

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Fig. 7.8Economic Surplus in an Unregulated

Market for Home Heating Oil

Fig. 7.8Economic Surplus in an Unregulated

Market for Home Heating Oil

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Fig. 7.9The Waste Caused by Price Controls

Fig. 7.9The Waste Caused by Price Controls

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Fig. 7.10When the Pie is Larger, Everyone Can

Have a Bigger Slice

Fig. 7.10When the Pie is Larger, Everyone Can

Have a Bigger Slice

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Price FloorsPrice FloorsPrice Floor

It is a law or regulation that prevents buyers from paying less than a specified amount

It keeps prices highIt reduces total economic surplusIt would allow some poor families to buy

the good at the reduced price. [However, the same objective could have been accomplished with less waste.]

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Fig. 7.13Equilibrium in an Unregulated

Wheat Market

Fig. 7.13Equilibrium in an Unregulated

Wheat Market

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Fig. 7.14Lost Surplus from Price Supports

for Wheat

Fig. 7.14Lost Surplus from Price Supports

for Wheat

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Taxes and EfficiencyTaxes and Efficiency

What happens to the price of a good when the government imposes a tax on it?Most people believe that the price of the

item will rise by the amount of the tax

However, this may not be the caseWho pays the tax depends upon the

elasticities of supply and demand

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Taxes and EfficiencyTaxes and EfficiencyWho physically pays the tax?The supplier of the taxed good is the one who

sends the tax money to the gov’t. (Imagine if the consumer had to write a check to the gov’t for the gas tax each time they filled up).

So, the firm’s marginal cost of providing the good simply increases by the amount of the tax.

How would this affect supply and demand?

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Fig. 7.16The Effect of a $1 per unit Tax on the

Equilibrium Quantity and Price of Potatoes

Fig. 7.16The Effect of a $1 per unit Tax on the

Equilibrium Quantity and Price of Potatoes

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Taxes and EfficiencyTaxes and Efficiency

Even though the vertical distance between the two supply curves is the amount of the tax, because of the relative slopes of the supply and demand curves, the consumer does not bear all of the tax burden.

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Taxes and EfficiencyTaxes and Efficiency

Who will pay a larger percentage of the tax?Whoever is less flexible with regard to price.I.E. whoever is more inelasticConsumers will pay 100% if:

Demand is perfectly inelasticSupply is perfectly elastic

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Fig. 7.17The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply

Fig. 7.17The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply

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Taxes and Economic Surplus

Taxes and Economic Surplus

“Deadweight loss” (DWL)The reduction in economic surplus that

results from a policyA tax distorts the signal that free prices

send

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Fig. 7.18The Market for Potatoes Without Taxes

Fig. 7.18The Market for Potatoes Without Taxes

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Fig. 7.19The Effect of a $1 Pound Tax

on Potatoes

Fig. 7.19The Effect of a $1 Pound Tax

on Potatoes

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Fig. 7.20The Deadweight Loss Caused by a Tax

Fig. 7.20The Deadweight Loss Caused by a Tax

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DWLDWLCS pre-tax = ½ (3)(3,000,000) = $4,500,000PS pre-tax = ½ (3)(3,000,000) = $4,500,000

CS post-tax = ½ (2.50)(2,500,000) = $3,125,000PS post-tax = ½ (2.50)(2,500,000) = $3,125,000Lost PS+CS = $2,750,000Tax revenue = $1(2,500,000) = $2,500,000

DWL = $250,000

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Taxes, Elasticity, and Efficiency

Taxes, Elasticity, and Efficiency

Deadweight loss is minimized if taxes are imposed on goods and services that have relatively inelastic supply or relatively inelastic demand.

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Fig. 7.21Elasticity of Demand and the Deadweight Loss from a Tax

Fig. 7.21Elasticity of Demand and the Deadweight Loss from a Tax

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Fig. 7.22Elasticity of Supply and the Deadweight Loss from a Tax

Fig. 7.22Elasticity of Supply and the Deadweight Loss from a Tax

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Do all taxes decrease economic efficiency? Do all taxes decrease economic efficiency?

Consider a tax on landLand supply is perfectly inelasticDWL = $0

What other goods have high tax rates?BoozeCigarettes Gasoline

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Taxes, External Costs, and Efficiency

Taxes, External Costs, and Efficiency

Taxing reduces the equilibrium quantity

Therefore, taxing activities that people tend to pursue to excess can actually increase total economic surplus (e.g., activities that cause pollution)

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External Costs External Costs Consider a market activity that generates

harmful side-effects on a 3rd party …E.g. Pollution from a plant imposes costs on

anyone who lives near the plantDoes that firm’s supply curve accurately

reflect the full costs of production? No. without regulation, the firm’s supply curve

only reflects the marginal costs of production.The external costs are not included in these costs.What if they were?

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Market EquilibriumMarket Equilibrium

Q*MKT Q

D = MSB

P

At P*MKT QD = QS = Q*MKT

CS + PS are maximized

S = MPC

$20 = P*MKT

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Market EquilibriumMarket Equilibrium

The firm’s supply curve represents “private” or “market-level” marginal costs of production (MPC), and is used by the firm to make pricing and output decisions.

If there are external costs (costs realized outside of the market), the FULL costs of production would be represented by a different curve = MSC

For example, suppose that each unit of output causes $2 in damage to 3rd parties.

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Social EquilibriumSocial Equilibrium

Q*SOC Q*MKT Q

D = MSB

P

$20 = P*MKT

S = MPC

MSC = MPC + 2

$21 = P*SOC

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Social EfficiencySocial Efficiency

At P*MKT:MSC > MSB Q*MKT > Q*SOC the market “overproduces” the goodP*MKT < P*SOC the market “under-prices” the goodMarket solution is therefore not efficient from

society’s standpoint

How can this inefficiency be corrected?

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Social EfficiencySocial Efficiency

A tax equal to the marginal external cost ($2.00) would serve to increase the firm’s MPC so that it is coincident with the MSC function.

In other words, the tax brings the external cost into the market.= “internalizing the externality”

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Social EquilibriumSocial Equilibrium

Q*SOC Q*MKT Q

D = MSB

P

S = MPC

New MPC = Old MPC + 2

$21 = P*SOC

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Can markets create external benefits?

Can markets create external benefits?

If markets can create costs on 3rd parties, can they create benefits?

Sure. Education.Lawn careHouse maintenanceText: beekeeper adjacent to apple orchard

Will the market solution be efficient?

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External BenefitsExternal Benefits

Q*MKT Q*SOC Q

D = MPB

P

S = MSC

P*MKT

MSB

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External BenefitsExternal BenefitsIn the case of external benefits, the

market will under-provide the good relative to the socially optimal amount.I.E. at Q*MKT MSB > MSC

How can this inefficiency be corrected?Recall the solution to negative externality

was a tax… We should subsidize the positive

externality generating activity.

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Naturalist QuestionsNaturalist Questions

Why are gasoline taxes so high (relative to other goods)?

Why aren’t gasoline taxes higher (as in other nations)?

Why do communities have zoning laws?

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ExercisesExercisesThe more elastic demand is the ______ the burden of the

tax borne by ______.

A. smaller; consumer and producers B. larger; consumers C. larger; producers D. smaller; producers E. larger; consumers and producers

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ExercisesExercises

Which of the following statements expresses the justification for making efficiency the first goal of economic interaction?

A. Efficiency give the poor an incentive to improve their economic status. B. Since consensus on what is a fair distribution of goods is impossible, efficiency is the next best goal. C. People are not really concerned about the problems of the poor. D. It is too difficult to pursue more than one goal at a time. E. Efficiency maximizes total economic surplus and thereby allows other goals to be more fully achieved