3 Online Efficient Market 12 16 13

7/24/2019 3 Online Efficient Market 12 16 13

1/31

1

Q

P

DConsumer surpluscomes from the notion that demand curves

represent maximum prices that consumers are willing & ableto purchase specific quantities of goods & services.

For example, consumers may be willing, at most, to pay $4

per unit for 8 units of the above product (thus spending $32),

but they would of course prefer to pay less per unit (e.g.,

spending $24 on 8 units at $3 per unit).

8

$4

3

10

Total welfare in a market is the sum of the welfare of consumers

(consumer surplus) and the welfare of producers (producersurplus).

efficient markets

Efficient Markets


2/31

2

P

Q

D

$5

6

$30

Here, the consumer is willing to pay no more than $5 for 6 units.

The $30 then represents the maximum they would pay when

purchasing 6 units all at once. The area defined in the above

rectangle equals $30, or $5 times 6 units.

If the consumer in this example was offered to

purchase at $6 per unit, the consumer would notchoose 6 units. Rather, they would choose the

quantity that coincided with $6 per unit on their

demand curve; less than 6 units.

6

efficient markets


3/31

efficient markets3

Q

DIn theory, the entire area under the demand

curve represents the maximum revenues or

expenditures that may be collected.

P

In practice, however, sellers rarely have the ability to price each added quantity at a different

(maximum) price.

So, the next step is to contrast the above case with the more common case whereby only one price

per unit is charged.

In effect, each maximum price could be extracted from the consumer for each added quantity by

walking the consumer down their demand curve. This activity is surely not preferred by the

consumer, but consumers are willing to play-along in the sense that they are not being asked to pay

more than their maximum price for each added quantity. Consumers are just not receiving any

break or surplus value in the sense that they pay less than their maximum price for any quantity.

Consumer surplus considers the difference between what consumers actually pay and what their

maximum payment would be. This difference is a surplus because it reflects a gain in welfare for

the consumer. If Mary is willing to pay $3 for another bagel but only pays $2 her surplus is $1.

Sincetotal expenditure equals price times quantity, the area under the demand curve up to the totalquantity purchased equals total expenditures extracted when maximum prices are charged.


4/31

4

Consumer Surplusis defined as the difference between what consumers are at most willing to

pay and what they actually pay for goods and services. Lets evaluate consumer surplus at

quantity d.

Q

Dwhatthey

pay

CS

0

a

b

c

d

Area 0bcd is the maximum expenditure & area 0acd

is the actual payment when only one price per unit

is charged. Consumer surplus then is area abc, the

difference in these two expenditures.

efficient markets


5/31

efficient markets 5

Consumer Surplus rises (falls) as price falls (rises) thus demonstrating that consumers

are better-off (higher welfare) with lower prices.

P

P

QQ

CS CS

D

D

P

P

what

theypay

what they pay


6/31

efficient markets 6

Consumer Surplus Rises with a Price Fall

D

P

P1

P2

Q1 Q2

A

B

C

E

F

Consumer surplus at (P1,Q1) is area A

Consumer surplus at (P2,Q2) is A+B+E

The rise in consumer surplus from a lower price is B+E here.

The gain in consumer welfare is therefore measured in dollars.


7/31

7

Q

P S

Supply representsminimum pricesproducers are

willing to accept for various quantities.

Here, sellers are willing to receive $3 per unit for 8units ($24 total revenue) and $5 per unit for 10 units

($50 total revenue).

Of course, they would prefer to receive more than $3

per unit for 8 units; e.g., $4, but they are willing toreceive $3 at a minimum payment per unit for 8 units.

8

$5

3

10

efficient markets


8/31

8

In effect, producers could charge each minimum price for each possible quantity by walking upthe supply curve.

The area under the supply curve then represents the minimum payment sellers are willing to take.

Q

PS

efficient markets


9/31

efficient markets 9

P

Q

S

$5

6

A

B

Producer Surplus is defined as the difference

between what producers receive and the

minimum payments they would have been

willing to receive.

Area B represents the minimum payment for 6

units.However, when they receive $5 per unit, they

receive A+B (=$30).

Producer surplus then is A, the difference between what they receive (A+B) and the

minimum they would take (B).


10/31

efficient markets 10

Q Q

PPS S

P

P

CS

CS

Producer surplus rises with price as demonstrated below.


11/31

11

In market equilibrium, the consumer surplus (PAE) and producer surplus (CPE) are shown below.

Total surplus or welfare is the sum of these two surpluses & equals area CAE.

P

Pe

0 Qe

E

Consumer

surplus

Producer

surplus

S

D

C

A

Notice equilibrium occurs where we

have the largest quantity & lowest

price where both buyers & sellers

can reach agreement. Equilibrium

price is where the lowest price

producers are willing to take justequals the maximum price

consumers are willing to pay.

Notice that equilibrium occurs

where total surplus is maximized,

thus demonstrating that private

markets maximize welfare of both

buyers & sellers when allowed to setprices & quantities.

efficient markets

Total Surplus at Market Equilibrium


12/31


Multiple Choice

1. Which of the following best explains the source of consumer surplus for good A?

a. Many consumers would be willing to pay more than the market price for good A.

b. Many consumers pay prices that are greater than the equilibrium price of good A.

c. Many consumers think the market price of good A is greater than its cost.

d. Many consumers think the price elasticity of demand for good A is unit elastic.

2. Suppose a market now has a large increase in the number of sellers of groceries, ceteris paribus. Which of the

following would you predict would also arise following the change in market price?

a. consumer surplus will remain the same. b. consumer surplus will increase.

c. it is not possible to predict the change in consumer surplus. d. consumer surplus will decrease

3. Suppose a market now has a large increase in the number of demanders of groceries, ceteris paribus. Which of the

following would you predict would also arise following the change in market price?

a. producer surplus will remain the same. b. producer surplus will increase.

c. it is not possible to predict the change in producer surplus. d. producer surplus will decrease

4. Suppose that in the wine market, consumer surplus equals $500 and producer surplus equals $400. Which of the

following is correct?

a. total surplus equals $100 b. total surplus equals $20,000

c. total surplus equals $500 d. total surplus equals $900

5. Suppose that in the wine market, consumer surplus equals $5,000 and producer surplus equals $3,000. Suppose

that in the beer market, consumer surplus equals $1,000 and producer surplus equals $8,000. Which of the following

is correct?

a. total surplus is highest in the wine market b. total surplus is highest in the beer market

c. total surplus is equal in the two markets d. we cannot cross-compare in the two markets.


13/31

13

Pc is an example of a price ceiling dictated by government. Here price may go no higher than Pc

(hence the word ceiling), although the private market would set the equilibrium price at Pe.

Q

P S

D

Qe

Pe

Pc

A price ceiling is generally rationalized by

the belief that the private market would set

the price too high and therefore a priceceiling is warranted to protect consumers.

What are Price Ceilings & Price Floors?

Markets set prices by the interactions of consumers (demand) & suppliers (supply).

Price ceilings and floors dictate various limits on which prices are allowed to be charged.

efficient markets


14/31


Pf is an example of a price floor dictated by government.

Q

PS

D

Qe

Pe

Pf

Here price may go no lower than Pf (hence the word floor), although the market would set theequilibrium price at Pe.

A price floor is generally rationalized by the belief that the private market would set the price too

low and therefore a price ceiling is warranted to protect sellers.


15/31

15

Shortages are Symptoms of Price Ceilings & Surpluses are Symptoms of Price Floors.

Private markets eliminate shortages andsurpluses through their ability to raise or

lower prices.

Surpluses and shortages therefore are

absent whenever private markets are

allowed to set prices at equilibrium levels.

P

Q

S

D

Qe=Qs=Qd

Pe

no shortages or surpluses possible when price

is set at equilibrium Pe.

efficient markets


16/31


A price ceiling such as Pc mandates that prices may go no higher than Pc.

But, at Pc, quantity demanded exceeds quantity supply, and thus a shortage arises.

P

Q

S

D

Pe

Pc

Q1 Q2

shortage

In other words, a law mandating a price

ceiling is a law that indirectly mandates a

shortage.

Notice the shortage grows as the price

ceiling is set farther away from Pe.

AtPc, quantity demanded of Q2 arises and

quantity supplied of Q1 arises, thus

generating a shortage equal to distance

Q1Q2.


17/31


A price floor such as Pf is a law mandating that prices may go no lower than Pf.

But, at Pf, quantity supplied exceeds quantity demanded, and thus a surplus arises.

Q

S

D

Pe

Pf

Q1 Q2

surplus

In other words, a law mandating a price floor

is a law (indirectly) mandating a surplus.

Notice that the surplus grows as the price floor

is set farther away from Pe.

At Pf, quantity demanded of Q1 arises andquantity supplied of Q2 arises, thus generatinga surplus equal to distance Q1Q2.


18/31

18

Costs are more difficult to assess and require a command of supply and demand analysis.Consider a price ceiling of $5 per pizza, when equilibrium is $10 (see nearby graph).

The price ceiling creates a shortage of distance Q1Q2 because quantity demanded Q2 exceeds

quantity supplied Q1.

Q

PS

D

$10

5

Q1 Q2

Distinguish Between Costs & Benefits of Price Ceilings

and Price Floors.

Economists list costs and benefits of policies as a methodby which to appraise the desirability of public policies.

The greater that benefits outweigh costs, the more

desirable public policies are.

Benefits of price ceilings and floors are fairly obvious.

A priceceiling imposed on gasoline of $1 per gallon,

when the equilibrium price is $2, allows consumers to

purchase the product at half of equilibrium price.

A pricefloorof $2 per orange, when the equilibrium

price is $1, allows sellers to receive double the

equilibrium price.

efficient markets


19/31

19

Q

PS

D

$10

5

Q1 Q2

This is a cost because a shortage means that not all

consumers may purchase as many pizzas as they want

(= Q2).

They may purchase only the quantity supplied of Q1.

So some consumers will be unsatisfied.

Another cost is that product quality will tend to

diminish; e.g., pizzas may be become smaller or

otherwise of lower quality.

Sellers may also start charging for boxes or delivery,

thus in effect raising prices.

The price ceiling may also cause sellers to choose who receives available pizzas, and who do not, on

the basis of race, gender, or some other characteristic.

Sellers may also choose to provide on the basis who pays the highest bribes.

The point here is that sellers must decide on some basis who receives available pizzas.

This issue, however, does not come up when prices are allowed to equilibrate because a shortage

never arises at the equilibrium price.

efficient markets


20/31

20

Q

P S

D

$10

5

Suppliers do not like to have their hands tied

behind their backsby price ceilings and, over

time, suppliers will leave this market for markets

without price ceilings.

Suppliers leaving this market causes the supply

curve to shift left from S to S.

Notice, that as the supply curve shifts leftward,

the shortage grows to distance Q3Q2.

Q1 Q2

S

Q3

$11

Also, the price will jump to $11, a price above the initial equilibrium of $10, when the price

ceiling is lifted. (However, over time the price will eventually fall back to $10 if no other changes in

the market have taken place).

The point here is that shortages will tend to grow over time and (in the short run) equilibrium prices

will rise over time, as long as price ceilings remain in place.

A long-standing price ceiling is also likely to foster an exodus out of the market by suppliers.

How Goods & Services are Rationed When Prices are not Allowed to Reach Equilibrium. This was

explained above in reference to how sellers must determine who receives the available pizzas and who

do not when the price ceiling results in a shortage. Sellers may decide to allocate available pizzas

based on eye colors of consumers, or national origin, gender, zip code or hair color. They could also

choose randomly or on the basis of which consumers offer the best bribes.

efficient markets

A minimum wage law is a price floor because it mandates that employers must pay workers at least


21/31

21

A minimum wage law is a price floor because it mandates that employers must pay workers at least

the defined minimum. The nearby chart shows a minimum wage at $7 per hour, although the

private market sets $5 as equilibrium wage.

workers

wage S

D

$5

$7

A minimum wage of $7 per hour creates unemployment

because it causes a surplus of labor.

At $7 per hour, quantity demanded (by employers) of labor

is Q1, quantity supplied (by workers) is Q2, and thus

distance Q1Q2 is the surplus, or unemployment.

Q1 Q2Unemployment

(surplus)

Unemployment created by a minimum wage law can be broken

down into 2 components.

1. Q1A = workers who used to work, but no longer do. A =

workers hired at equilibrium price $5, and some of them losetheir jobs because employers cut back on hiring by walking

up their demand for labor curve to $7.

2.AQ2 = workers who did not previously want to work at $5, but

now want to work at $7. This movement is shown by going

upward along the supply of labor curve. The minimum wageentices these workers to want to work, but unfortunately they are

unable to find work because, at $7, employers only hire Q1

workers.

efficient markets

W k C d O B th E i I id f Mi i W L Mi i


22/31

22

Workers, Consumers and Owners Bear the Economic Incidence of Minimum Wage Laws. Minimum

wage laws create unemployment and have the potential for raising prices and output levels. These

effects carry the potential for passing on costs of minimum wage laws to different parties. A minimum

wage law raises the costs of production to sellers and thus causes the supply curve to shift left, as

shown in the nearby chart.

S (initial)

S (under min. wage)

D

milk shakes

P

P

P

QQ

While workers who remain employed receive

higher wages (benefit from law), there are also

costs to the policy. There are 4 potential groups

of losers.

1. Workers lose when output falls (from Q to

Q) and therefore fewer workers are needed.

2. Consumers lose because they now payhigher prices (from P to P).

3. Businesses lose because their costs of

production go up thus lowering profits.

4. Governments lose when tax revenues drop iffirms sell less and/or go out of business.

efficient markets


23/31

efficient markets23

6. Suppose a minimum wage is set a level above the equilibrium wage. Which of the following describes the

unemployment created associated with movement along the demand curve for labor?

a. workers who used to work, but are laid off

b. individuals who did not previously seek work, but now do at the higher wage

c. none of the above d. all of the above

7. Suppose a minimum wage is set a level above the equilibrium wage. Which of the following describes the

unemployment created associated with movement along the supply curve of labor?

a. workers who used to work, but no longer can find employment

b. individuals who did not previously seek work, but now do at the higher wage

c. none of the above d. all of the above

8. Suppose a price ceiling is set above equilibrium price in the apple market. Which best describes what will

happen?

a. a shortage will develop b. a surplus will develop

c. the market will stay at equilibrium d. both a shortage and a surplus will develop

9. Suppose a price ceiling is set below the equilibrium price in the apple market. Which of the following best

describes what will happen?

a. a shortage will develop b. a surplus will develop

c. the market will stay at equilibrium d. both a shortage and a surplus will develop

10. Increases in both the supply and demand for caviar will:

(a) affect price in an indeterminate way and increase the quantity exchanged.

(b) increase price and increase the quantity exchanged.

(c) affect quantity in an indeterminate way while reducing the price.

(d) decrease price and decrease the quantity exchanged.

(e) affect price in an indeterminate way and decrease the quantity exchanged.

QU. QU.


24/31

efficient markets

24

PRICE

QU.

SUPPLIED

QU.

DEMANDED

$10 600 units 50 units

9 500 100

8 400 200

7 300 3006 200 400

5 100 700

4 0 900

11. Suppose a price ceiling is set where price may not go any higher than $8 per unit. Which of the following is true?

a. There will be a shortage of 200 units b. There will be a surplus of 200 units

c. There will be shortage of 600 units d. There will be no shortage or surplus

12. Suppose a price floor is set where price may not go any lower than $8 per unit. Which of the following is true?

a. There will be a shortage of 200 units b. There will be shortage of 600 units

c. There will be a surplus of 200 units d. There will be a surplus of 600 units e. There will no shortage or surplus

13. Suppose a price ceiling is set where price may not go any higher than $7 per unit. Which of the following is true?

a. There will be a shortage of 200 units b. There will be shortage of 600 units

c. There will be a surplus of 200 units d. There will be a surplus of 600 units e. There will no shortage or surplus

14. Suppose new suppliers enter this market and provide at each price an additional 200 units; e.g., at price $10,quantity supplied becomes 800 units, at price $9 quantity supplied becomes 700 units, etc. Which is true?

a. There will be a shortage of 600 units if there is a price ceiling set at $5

b. There will be shortage of 200 units if there is a price ceiling set at $6

c. There will be a surplus of 200 units if there is price ceiling set at $9

d. There will be no shortage or surplus at a price of $6 e. none of these is true

Use the table to answer the following 4 questions.

Each question is self-contained (i.e., only use

information provided in each question).


25/31


15. Use the graph on the right for the following question. If price falls

from Pa to Pb, which of the following is correct?

a. consumer surplus falls from 1+2+3 to 1+2

b. consumer surplus rises from 1+4 to 4+6c. consumer surplus rises from 1 to 1+2+3

d. consumer surplus rises from 1 to 1+2+4

e. consumer surplus does not change

16. Use the graph on the right for the following question. Which of the

following is correct?a. total expenditure is 3+5 when the price is Pb

b. total expenditure is 1+2+3 when the price is Pa

c. total expenditure is 3+5+6 when the price is Pb

d. total expenditure is 4+5 when the price is Pb

e. none of the above is correct

17. Use the graph below. What is the change in producer surplus as price

falls from P2 to P1?

a. from D+E to A+B b. from A+B to D + E

c. from A + D to A d. from B+E to B e. none of these


26/31


What are Externalities?

Our lives are affected by the actions of many individuals, and as much as would like to control

our lives, some factors are clearly beyond our control. The time we spend commuting to class or

jobs is affected by how many other people decide to leave at the same time. It is easier to fallasleep at night when our neighbors (and their dogs) are quiet. The actions of others may also be

beneficial. Medical scientists who find new cures for illnesses and quite neighbors who keep tidy

lawns exert positive influences on our lives.

Markets can be efficient only when market participants consider all the benefits and costs of theiractions. When individuals do not pay for all the resources that they use,negative externalities, or

external costs, are said to exist. A negative externality may arise, for example, when homeowners

are subjected to the noise created by a nearby factory producing toys. That factory is imposing a

cost (noise) on homeowners that is not paid for by factory owners and therefore allocates too

many resources in this market. That is, too much production of toys occurs.

Positive externalitiesoccur whenever private markets fail to allocate resources on the basis of

social benefits. While all neighbors property values rise because the Smiths keep a tidy lawn,

those neighbors do not have to pay the Smiths for those higher values. The Smiths, however, may

not consider the beneficial effects on others when they make decisions about the quantity of

resources to allocate in maintaining a tidy lawn. Market allocate too few resources to activities

when individuals do not fully take account of the benefits of their actions on others. That is, too

little production of tidy lawns occurs.


27/31

efficient markets27

Negative externalities arise when there is a divergence between private costs and social costs.Private

costsare costs occurred by private parties. Private costs include only those paid by the producer and

therefore do not necessarily include the costs of all resources used in production. In the previous

example, a toy factory that does not pay for the noise pollution it inflicts on nearby homeowners onlyconsider their private costs of production (i.e., labor, tools, electricity, rent, etc.)

Social costsare those incurred by private parties in addition to any other costs borne by other members

of society. In our factory example, the difference between private and social costs is the discomfort that

the factory imposes on homeowners. The negative externality is this difference between private andsocial costs and explains why it is sometimes referred to as an external cost.

toys

$

private costs

social costs

D

The graph shows both private and social costs in

producing toys. Note that social costs lie above

private costs, with the vertical distance between

the two curves reflecting the level of negativeexternality. For example, at market equilibrium

Q1, distance bc measures the negative

externality per unit of production.

An efficient level of production would consider allcosts and occurs at the intersection of demand

and social costs curve at point a.

b

c

Q1

a

Qe

Pe

P1

Markets will produce too much at Q1 and charge too little with P1. An efficient outcome would be

to produce less at Qe and charge a higher price at Pe.

Positive externalities arise when there is a divergence between private benefits and social benefits.


28/31

efficient markets28

g p f f

Positive externalities thus occur whenever markets fail to allocate on the basis of full social benefits.

Immunization against communicable diseases is a common example of a good that produces positive

externalities individuals who do not consume the good benefit because inoculations decrease the

number of individuals who may transmit diseases.

Markets do not take account of the benefits that flow to those who are not inoculated. However, those

benefits, which are external to the market exchange, are part of the benefits that society receives when

resources are allocated to immunization. Private producers do not normally care about non-paying

customers and thus will ignore external benefits to their production thus resulting in too littleproduction from the point of view of society.

inoculations

$

social costs

private benefits

The graph shows both private and social benefits

in producing inoculations. Note that social

benefits lie above private benefits, with the vertical

distance between the two curves reflecting thelevel of positive externality. For example, at

market equilibrium Q1, distance ac measures

the positive externality per unit of production.

An efficient level of production would consider allbenefits and occurs at the intersection of social

benefits and social costs curve at point b.

b

c

Q1

a

Qe

Pe

P1

Markets will produce too little at Q1 and charge too little with P1. An efficient outcome would be to

produce more at Qe and charge a higher price at Pe.

social benefits

True-False


29/31


18. Negative Externalities arise whenever markets fail to allocate resources on the basis of full social cost.

19. Too many resources are allocated in markets with positive externalities.

20. Social costs are larger than private costs in markets characterized by negative externalities.

Multiple Choice

21. Which of the following is most likely to be associated with a positive externality?

a. air pollution b. water pollution

c. inoculations for transmittable diseases d. congestion on a crowded highway

22. When there is a divergence between social and private costs, which of the following arises?

a. positive externality b. negative externality

c. public good d. social good

23. Which of the following is said to occur when a market characterized by social benefits being larger thanprivate benefits?

a. positive externality b. negative externality

c. Pareto equilibrium d. Giffin good

Key Concepts


30/31

efficient markets

30

Key Concepts

Total Welfare

Consumer Surplus

Maximum Price Consumers Willing to PayProducer Surplus

Minimum Prices Sellers are Willing to Accept

Do Not Confuse Consumer Surplus /Producer Surplus with Market Surplus

Walking Consumers Down a Demand Curve

Consumer Surplus Rises (Falls) with Lower (Higher) Prices

Producer Surplus Rises (Falls) as Price Rises (Falls)

Total Expenditure

Total Surplus at Market Equilibrium

Equilibrium as an Efficient Point in a Market

Price Ceiling vs. Price Floor

Shortages as Symptoms of Price Ceilings

Surpluses as Symptoms of Price Floors

Resource Misallocation (Inefficient Resource Allocation)

Deadweight Loss

Law of Unintended Consequences

Costs and Benefits of Price Ceilings/Floors

Minimum Wage Laws

2 Types of Unemployment Created by Minimum Wage Laws

Negative Externalities and Positive Externalities: When Markets are not Efficient

Private Costs vs. Social Costs; Private Benefits vs. Social Benefits.

Resource Misallocation Under Externalities


31/31


1A

2B

3B

4D5B

6A

7B

8C

9A

10A11D

12C

13E

14D

15D

16A

17C.

18T

19F

20T

21C22B

23A

Documents

3 Online Efficient Market 12 16 13