Part 3Markets and Efficiency

• Concept of economic (allocative) efficiency introduced previously

• Decreasing marginal benefits and increasing marginal costs

• Efficient allocation where MB = MC• This assumes all costs and benefits

are included (including environmental costs)

• Do competitive markets produce efficient outcomes?

Demand and Marginal Benefit

• People value many different goods and services

• The total benefit (value) of a good to a person is the benefit gained from the whole of the amount of the good consumed

• The marginal benefit (value) of a good to a person is the additional benefit that consuming the last unit provides

• A person’s relative valuation of a good is expressed in their willingness to pay

Willingness to Pay

• People have a limited budget so that purchasing one thing for $5 means not purchasing the other things that $5 could have bought

• If I pay $5 for a unit of a good it means I value that unit of that good at least as much as (and maybe more than) the other things I could have bought for $5

• My willingness to pay for the last unit I purchase is a measure of its marginal benefit to me

Willingness to Pay

• Willingness to pay for additional units of a good declines with quantity for each individual

• People vary in their willingness to pay depending on their incomes and preferences

• At the level of the market will find willingness to pay will decline with quantity.

Willingness to Pay and Demand Curves

• Under most circumstances (small or zero income effects from price changes) a demand curve can also be thought of as a marginal benefit curve or as a marginal willingness to pay curve

• The area under the demand curve to the left of the last unit purchased can be thought of as measuring total benefit or total willingness to pay

Willingness to Pay and Demand Curves

P

Q

Total benefit or total WTP for Q1

Q1

P1P1 = MB or marginal WTPat Q1

(green shaded area)

D

Consumers’ Surplus

P

Q

Consumers’ Surplus: excessof total WPT over amount actually paid

Q1

P1P1 = MB or marginal WTPat Q1

Amount actually paid (P1 x Q1)

Given a price of P1 consumers purchase up to Q1. They pay P1 for all units although previous units are valued more

D

Supply and Marginal Cost

• The cost of production of a good is its opportunity cost--the other goods that could have been produced instead with the resources used

• Provided all productive resources are priced in competitive markets, the opportunity cost of producing something will be reflected in the cost of production (cost of the productive resources used)

Supply and Marginal Cost

• The marginal cost of production is the opportunity cost of producing one more unit of the good

• Marginal opportunity costs tend to rise with output

• Producers will only produce up to the point where the price they receive equals the marginal cost of production (profit max)

• The supply curve is a marginal cost curve

Supply and Marginal Cost

MC=S

10

Marginal opportunity costOf the 10th unit = $15

15

P

Q

Firm will supply the 10th unit if the price is$15. This is the minimum price that producerswill accept for that unit of production

Producers’ Surplus

S=MC

15

P

Q10

Producers’ Surplus

Cost of production

Producer would have been willing to Produce units 1-9 for less than $15 but Receives the same price for all units

Is the Competitive Market Efficient?

S=MC

D=MB

15

P

10 Q

CS

PS

At E the Social Surplus is maximized.Maximum of total benefit over the total opportunity cost.

E Sum of CS andPs is the Social Surplus

Is the Market Always Efficient?

• Markets may not result in economic efficiency for a number of reasons - Price floors and ceilings- Taxes, subsidies, quotas- Monopoly- Public goods- External costs or benefits

• These barriers to efficiency are very widespread

Inefficiencies: Underproduction and

OverproductionP

S

D

Q

Deadweight loss

Deadweight loss

Q’

Q’

S

D

P

Q

Underproduction

Overproduction

Q*

Q*

Efficiency and Equity

• Efficiency is an allocation of resources where MB=MC

• An efficient allocation can only be defined given some initial allocation of resources between individuals

• Willingness to pay is budget constrained

• Efficient markets may well result in very unequal distributions of income

Markets with Price or Quantity Regulation

• Housing markets and rent ceilings

Shortage

Qs Qd

Rc

Rb

Deadweight loss

S

Q

Rent

D

Markets with Price or Quantity Regulation

• Labour Markets with minimum wages

Qd Qs

WminS

Q

Wage

D

Unemployment

W*

Q*

Markets with Price or Quantity Regulation

• Agricultural markets--problems of price and income instability due to supply fluctuations and inelastic demand

• Markets in inventories and price stabilization

• Attempts to raise farm incomes

- Price floors

- Quotas

- Subsidy programs

Agricultural Price Floors and Quotas

P

Q

D

S

Q*Q’

Q’ = quota amount

P*

P’

Surplus at P’

Q”

P’ = price floor

Agricultural Subsidies

D

S

S-subsidy

Q* Q’

P*P’

P’+sub

Subsidy

P

Q

Sales Taxes and Prices

• The incidence of a sales tax

• Incidence and the elasticity of demand and supply

Per unit tax

P*

P’+ tax

P’

S + tax

S

D

P

Q

Taxrevenue

Q*Q’

Sales Taxes and Efficiency

Tax revenueP’

Q’

Consumers’ surplus

Producers’ surplus

Deadweight loss

D

S

S+tax

P

Q