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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