Efficiency and Exchange

Efficiency and Exchange
MB MC
MB MC
Learning Objectives
1.
2.
3.
4.
Define efficiency Analyze how surplus and efficiency are affected by policies Examine the ways taxes affect efficiency and economic surplus SKIP MC pricing of public services
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 7: Efficiency and Exchange
Slide 2
MB MC
Market Equilibrium and Efficiency
When we say a market equilibrium is efficient we mean that

if price and quantity take anything other than their equilibrium values, a transaction that will make at least some people better off without harming others can always be found. Concept of Pareto Efficiency (a 19th C Italian economist) - A situation is efficient if no change is possible that will make some people better off without making anyone worse off.
Slide 3
MB MC
A standard market demand supply equilibrium is Pareto Efficient. Whenever the market is out of equilibrium it is possible to construct exchanges that will help some without harming others. Consider the market for milk. Suppose the current price of milk is $1/gallon. Sellers offer 2000 gallons/day
Slide 4
MB MC
Market for Milk in Which Price Is Below the Equilibrium Level

S
2.50
Price ($/gallon)
2.00
1.50 1.00 .50
If P = $1 then QS = 2,000 gallons/day. Excess Demand of 2,000 gallons a day. At 2,000 gallons the consumer is willing to pay $2 and the MC = $1
D
1 2 3 4 5
Quantity (1,000s of gallons/day)

Slide 5
MB MC
How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction Supply Constrained
Suppose the seller offers an additional gallon for $1.25. 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 D At $1, the market is not efficient
S
2.50
Price ($/gallon)
2.00
1.50 1.25 1.00 .50

Slide 6
MB MC
How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction
S
2.50
Demand Constrained
If P = $2 then Ex-Ss= 2,000 gallons/day Additional output costs only $1; Marginal buyer willing to pay $2. If the seller sells one extra gallon at $1.75, the buyer gains an economic surplus of D $0.25 and the seller gains an economic surplus of $0.75
Slide 7
Price ($/gallon)
2.00
1.75 1.50 1.00 .50

MB MC
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 in equilibrium will the economic surplus be maximized.
Slide 8
MB MC
Markets will be efficient when:

Buyers and sellers are well informed. Markets are perfectly competitive. Supply measures all relevant (private and social) costs. Demand measures all relevant (private and social) benefits.
Slide 9
MB MC
Efficiency is an important goal because it allows for maximum economic surplus (implying maximum resources to do other things), assuming peoples incomes and attributes remain at their current levels. Markets, by themselves, cannot change the distribution of income and automatically make it more equitable.
Slide 10
MB MC
The Cost of Preventing Price Adjustments Price Ceilings
Price Ceilings: Do They Help the Poor? Example: A Price Ceiling for Home Heating Oil The Mid-east oil crisis in the late 1970s doubled the price of home heating oil. Concern over the hardship to poor families, especially in the northern states, the government imposed a price ceiling in the market for home heating oil.
Slide 11
MB MC
Economic Surplus in an Unregulated Market for Home Heating Oil

2.00
1.80 1.60 1.40 Price ($/gallon) 1.20 1.00 .80
Consumer surplus = $900/day
Producer surplus = $900/day D
Without price controls: Equilibrium Price = $1.40 Consumer surplus = (1/2)(3,000)(.6) = $900/day Producer surplus = (1/2)(3,000)(.6) = 900/day Economic surplus = $1,800/day

Slide 12
MB MC
The Waste Caused by Price Controls

2.00
1.80 1.60 1.40 Price ($/gallon) 1.20 1.00 .80
Price Ceiling set at $1.00

Consumer surplus = (1/2)(1,000)(.20) + (0.8)(1000) = $900/day
Lost economic surplus = $800/day

D
Producer surplus = (1/2)(1,000)(.20) = $100/day With price controls: Economic surplus = $1,000 or a loss of $800/day
Slide 13

MB MC
The Cost of Preventing Price Adjustments
The reduction in economic surplus of $800 is likely to be an underestimate of the waste caused by the price ceiling because:
The model assumes that consumers who value oil the most (MB above $1.80) receive the product when it is being rationed. In reality however, anyone willing to pay more than $1 can and will buy oil. Consumers take costly actions to enhance their chances of being served (like arriving early to be in the front of the line); and yet when all consumers incur the higher cost, no one is likely to get any more oil than before.
Slide 14
MB MC
Question
What program could be used to help the poor get heating oil that would be more efficient than a price ceiling? Give them higher incomes with which to buy heating oil. Lump sum transfers are often better (leads to less resource waste) than fixing prices that change marginal costs and benefits.
Slide 15
MB MC
When the Pie Is Larger, Everyone Can Have a Bigger Slice

Surplus with income transfers and no price controls
Surplus with price controls
R
P
P
With price ceiling = $1.00 the economic surplus is 1,000/day R = economic surplus of rich P = economic surplus of poor
Without price controls & with income transfers economic surplus is $1,800/day; R & P have the same share and a much larger economic surplus
Slide 16
MB MC
The Cost of Preventing Price Adjustments Price Subsidies
Price Subsidies: Do They Help the Poor?

Governments sometimes wish to help the poor by subsidizing essential goods and services, like say bread (France, Russia) 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; no bread is produced domestically.
Chapter 7: Efficiency and Exchange Slide 17
MB MC
Economic Surplus in a Bread Market Without Subsidy

Price of bread ($/loaf)
5.00
4.00
Consumer surplus = $4,000,000 per month
3.00
$4m
World price = $2.00
Economic surplus maximized where MC($2) = MB($2) at 4 million loaves

S
1.00
D
2 4 6 8 Quantity (millions of loaves/month
There are no domestic producers; so producers surplus = 0

Slide 18
MB MC
The Reduction in Economic Surplus from a Subsidy
Assume a $1/loaf subsidy

Consumers buy 6 million loaves per month Total subsidy = $6 million per month Total tax burden = $6 million per month Consumer surplus will increase by $5 million (from $4 million to $9 million) per month Economic surplus will fall by $1 million per month (true MC=$2, but MB for consumption beyond 4 million loaves fall from $2 to $1).
Slide 19
MB MC
The Reduction in Economic Surplus from a Subsidy

The cost of the tax = $6 million The benefit of the subsidy = $5 million Loss of economic surplus = $1 million Consumer surplus = $9,000,000/month Reduction in total economic surplus = $1,000,000/month
Price of bread ($/loaf)
5.00
4.00
3.00
$4m $5m
1.00
$1m
S
Domestic price with subsidy
World price = $2.00
D
2 4 6 8
Quantity (millions of loaves/month

Slide 20
MB MC
The Cost of Preventing Price Adjustments Price Subsidies
Price Subsidies
How could we provide assistance to low income consumers more efficiently? Again, giving incomes to low income families to buy bread would work better. Given that bread subsidies primarily benefit the poor and are financed by taxing the rich, the poor probably come out ahead. But we could accomplish the same objective with less waste using income transfers rather than a price subsidy.
Slide 21
MB MC
First-Come, First-Served Policies In 1978 airlines abandoned their first come first served policy of serving overbooked flights. Instead they started offering compensation to volunteers who were willing to wait for the next flight. How is the latter policy an improvement?
Slide 22
MB MC
First Come First Served Policy
Suppose 37 people show up for a flight with only 33 seats. The demand curve for remaining on the flight is given on the next graph. Assume that the highest bidder would pay $60 not to miss the flight; the next highest reservation price is $59; the next $58 and so on until the 37th person will be willing to pay $24. The average reservation price is $(60 + 59 + 58 + + 24)/37 = $42 Assume people get randomly bumped off under a FCFS policy. So consumers surplus lost = $42x4 = $168
Slide 23
MB MC
Compensation Policy
Suppose airlines decide to provide compensation to ticket holders if they are bumped off a flight. Assume that they conduct auctions where they offer cash compensation in $1 increments.. For $24, the person with the lowest RP will agree to get bumped off the flight; for $25, two people will agree to stay back and so on, until for $27 the airline will have the necessary 4 takers. The compensation total of $27x4 = $108 is a transfer from the producers to the consumers and hence cancel each other. Consumers surplus lost = $27 + $26 + $25 + $24 = $102; a $66 saving on economic surplus over the FCFS policy.
MB MC
Equilibrium in the Market for Seats on Oversold Flights

Demand for remaining on the flight
60 Supply of seats Price ($/seat)
24
33
37
Seats
Slide 25
MB MC
Equilibrium in the Market for Seats on Oversold Flights

Compensation Policy Consumers surplus lost = $6 + $96 = $102
60 Supply of seats Price ($/seat) 27 24
$6
$96
37
Seats
33
Slide 26
MB MC
Why offer compensation when the cost of firstcome, first-served to the seller is zero? Because with increased efficiency the total size of the pie is bigger and so everyone can have a bigger slice. The airline can offer compensation to elicit volunteers; they can recover their cost with slightly higher prices. Travelers are willing to pay slightly higher prices in return for a promise of not to be involuntarily bumped without compensation.
MB MC
Taxes and Efficiency
Who Pays A Tax Imposed On Sellers of a Good? For downward sloping demand curves and upward sloping supply curves, the buyer and the seller share the burden of the tax. All else remaining constant, the greater the elasticity of supply, the smaller the share of the burden on the sellers.
Slide 28
MB MC
The Effect of a Tax on the Equilibrium Quantity and Price of Avocados

S + tax S
Without a tax P = $3/lb and Q = 3 million lbs/month

6 5 Price ($/pound) 4 3.50 3 2.50 2 1 1 2 3 4 5
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 D Consumers pay $3.50/lb
2.5 Quantity (millions of pounds/month)
Slide 29
MB MC
Who Pays A Tax Imposed On Consumers of a Good? For downward sloping demand curves and upward sloping supply curves, the buyer and the seller share the burden of the tax. All else remaining constant, the greater the elasticity of demand, the smaller the share of the burden on the buyers. Bottomline: It does not matter who the tax is assessed on.
MB MC
Given sufficient time, in many markets additional inputs required to produce one extra unit of a good can be acquired at a constant cost. The long run supply curves in these markets are horizontal straight lines. A tax imposed on the seller will be entirely transferred to the buyer. The same is true is demand is perfectly inelastic.
MB MC
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)
$20,100 $20,000
S + $100 S
D
1.9 2.0
Supply shifts to $20,100 The burden of the tax falls entirely on the consumer
Quantity (millions of cars/month)

Slide 32
MB MC
Taxes and Economic Surplus
Slide 33
MB MC
The Deadweight Loss Caused by a Tax in the Market for Avocados

S + tax
6 5 Price ($/pound) 4 3.50 3 2.50 2 1
Deadweight loss caused by tax
D
1 2 3 4 5 2.5 Quantity (millions of pounds/month)
Slide 34
MB MC
Deadweight Loss
The reduction in total economic surplus that results from the adoption of a policy
Why does the loss occur?

The tax reduces economic surplus because it distorts the equality between MB and MC. At the new equilibrium of 2.5m pounds a month buyers MB=$3.50 and the true resource MC to the seller is $2.50
Slide 35
MB MC
Tax and Deadweight Loss
Taxes reduce output irrespective of who legally pays the tax buyer or the seller. wTOTAL is the wage inclusive if taxes; wNET is wages net of taxes. Producers surplus is area P*; Consumers surplus is Q*; Government Tax collection is area T. Triangle DL is the deadweight loss. Buyers and Sellers share the cost of the tax
MB MC
Clearly, no taxes is not good because we would then have no public amenities at all. So the question is how to determine the economic feasibility of a tax? The main problem with a tax is that it makes people pursue too little of the activity. So taxes cause smaller deadweight loss in markets where the equilibrium quantity is not highly sensitive to production costs.
MB MC
Elasticity of Demand and the Deadweight Loss from a $1 Tax

Deadweight loss S+T Deadweight loss S+T
2.60 Price ($/unit)
Price ($/unit)
2.40 2.00 1.40
2.00 1.60
D1
D2
19 24 Quantity (units/day)
The smaller the elasticity of demand, the Smaller the deadweight loss from a tax
Slide 38
MB MC
Elasticity of Supply and the Deadweight Loss from a Tax

Deadweight Loss S1 + T Deadweight Loss S2 + T S2 S1
Price ($/unit) 2.35 2.00 1.35
2.65 Price ($/unit)
2.00 1.65
The smaller the elasticity of supply, the smaller the deadweight loss from a tax
Slide 39
MB MC
The deadweight loss from a tax imposed on a good whose supply is perfectly inelastic will be zero. This explains why economists favor taxes on land. A tax on a negative externality will actually raise economic surplus while at the same time provide tax resources for useful public services.
Slide 40
End of Chapter
MB MC

Efficiency and Exchange

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Efficiency and Exchange

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

Market Equilibrium and Efficiency

When we say a market equilibrium is efficient we mean that

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

Market Equilibrium and Efficiency

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

Market for Milk in Which Price Is Below the Equilibrium Level

Quantity (1,000s of gallons/day)

Chapter 7: Efficiency and Exchange

Quantity (1,000s of gallons/day)

Chapter 7: Efficiency and Exchange

How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction

Quantity (1,000s of gallons/day)

Chapter 7: Efficiency and Exchange

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

Market Equilibrium and Efficiency

Markets will be efficient when:

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

Market Equilibrium and Efficiency

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

The Cost of Preventing Price Adjustments Price Ceilings

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

Economic Surplus in an Unregulated Market for Home Heating Oil

Consumer surplus = $900/day

Producer surplus = $900/day D

Quantity (1,000s of gallons/day)

Chapter 7: Efficiency and Exchange

The Waste Caused by Price Controls

Price Ceiling set at $1.00

Lost economic surplus = $800/day

Quantity (1,000s of gallons/day)

Chapter 7: Efficiency and Exchange

The Cost of Preventing Price Adjustments

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

The Cost of Preventing Price Adjustments

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

When the Pie Is Larger, Everyone Can Have a Bigger Slice

Surplus with price controls

Chapter 7: Efficiency and Exchange

The Cost of Preventing Price Adjustments Price Subsidies

Price Subsidies: Do They Help the Poor?

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic Surplus in a Bread Market Without Subsidy

Consumer surplus = $4,000,000 per month

Economic surplus maximized where MC($2) = MB($2) at 4 million loaves

There are no domestic producers; so producers surplus = 0

Chapter 7: Efficiency and Exchange

The Reduction in Economic Surplus from a Subsidy

Assume a $1/loaf subsidy

Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 7: Efficiency and Exchange

The Reduction in Economic Surplus from a Subsidy

Price of bread ($/loaf)

World price = $2.00