Lecture 02 Chapter 2 – Efficiency, Markets, and Government

Positive vs. Normative Analysis Positive Analysis:

concerned with what

is. They are factual

Statements ◦ Useful to the normative

approach

◦ Normative needs to

understand the facts of

human behavior in order

to achieve outcomes

believed to be desirable

Example: How much will

health care reform cost?

Normative Analysis:

concerned with what

ought to be. They are

Opinion, Value

Judgments

◦ Useful to the positive

approach

◦ Normative side defines

relevant issues

Example: We should try

to reform health care so

that everyone is covered

Positive vs. Normative Analysis Positive Analysis:

concerned with what

is. They are factual

Statements

Normative Analysis:

concerned with what

ought to be. They are

Opinion, Value

Judgments Examples: Normative or Positive?

1. An increase in the minimum wage will cause a decrease in

the employment among the least skilled.

•Ans: Positive, it can be compared to fact.

2. The income Gains from a higher minimum wage are

worth more than any slight reductions in employment.

•Ans: Normative –“worth” expresses a value judgment

3. State governments should be allowed to collect from

tobacco companies the costs of treating smoking-related

illness among the poor.

•Ans: Normative – “should” expresses a value judgment

Establishing the Baseline

Markets and welfare

When do markets work to maximize

welfare?

What criteria do we have to judge over

all welfare?

Economic Surplus: An Introduction

Economists like markets. WHY?

◦ Operations of markets make people better off

◦ Because people are better off, society is better off

Economists use “surplus” to describe the “better-off-

ness” of society

Efficiency is when surplus is as large as possible

Example:

◦ Please share when you got a good deal on something

Willingness to pay above market price is called Consumer Surplus

Commercial Illustrating this idea

Need two things: (1) How much you are willing to pay and (2) Price

◦ Ebay – Please share when you sold something for more than you

were expecting

Received more for a good than the minimum you would have

accepted Producer Surplus

A Market

•Whose behavior is represented by the demand curve?

•Consumers

•Whose behavior is represented by the supply curve?

•Producers/Firms

Consumer Surplus

•How Many cups would

be Sold at a Price of

$3.50?

• 3, Tim does not value

tea more than $3

•Does Each person have

to pay their willingness

to pay?

•No, each person pays

the market price

•Key Point: The demand

curve can be thought of

as the marginal

benefit curve

Consumer Surplus •Consumer Surplus:

The difference

between the highest

price a consumer is

willing to pay and the

price the consumer

actually pays

•Example: New chair

•Measures the net

benefits from

participating in the

market (ie – what you

would pay minus what

it actually costs.

Consumer Surplus for an Entire

Market.

$3.50

Producer Surplus When will a producer supply a cup of tea?

◦ When the producer receives more than the cost to

produce that cup (that is, when Price > Marginal Cost)

1.75

Why isn’t this area part of

the Producer’s Surplus?

Ans: Because it represents the cost the

producer must incur to produce

For each unit, the area below the supply curve represents the marginal (or

extra) cost of production

Surplus

Producer Surplus: Difference between

the price a firm receives and the lowest

amount it would be willing to accept

◦ Measures the net benefit to producers of

participating in the market (i.e. Amount Firms

receive from consumers – costs)

Economic Surplus Economic surplus The sum of consumer

surplus and producer surplus.

CS: Area Below Demand Curve and above price.

PS: Above Supply Curve, Below Price

Blue area + Red Area =

Economic Surplus

Your Turn 1. True, False, or Uncertain? Explain

When a market is in equilibrium, there is no consumer

surplus. We know this because in equilibrium, the

market price is equal to the price consumes are

willing to pay for the good.

Terms to help us understand

Efficiency Marginal social benefit – the extra benefit by

making one more unit of that good available in a given time period ◦ Downward sloping

◦ Think Demand Curve

Marginal social cost – minimum sum required to compensate the owners of inputs used for making an extra unit of the good available ◦ Upward sloping

◦ Think Supply curve

Economic Efficiency and Deadweight Loss When Surplus (our measure of better-off-ness) is as big as

possible Economic Efficiency

◦ Marginal Benefit =Marginal Cost

◦ Equilibrium

Deadweight Loss

◦ Def: The surplus

lost from the

market not

being at the

best point.

14,000

=

MSC

= MSB

LOST

Deadweight Loss At 14,000 cups, there is surplus that society could be

enjoying, but they are not.

◦ Extra Benefits = $2.20

◦ Extra Costs = $1.80

◦ Should society consume the 14,000th unit? A good

Deal?

Yes, Society

could be

better off

by $0.40

If not

produced/consumed,

that surplus will

be lost 14,000

=

MSC

= MSB

$2.20

$1.80

LOST

Deadweight Loss 16,000 cups is too much!

◦ Extra Benefits = $1.80

◦ Extra Costs = $2.20

◦ Should society consume the 16,000th unit? A good deal

No, Society

would be

worse off

by $0.40

If

produced/consumed,

that surplus will

be lost

The lost triangle is

subtracted from surplus

16,000

=

MSC

= MSB

LOST

$2.20

$1.80

Efficiency Criterion

Way to judge if a resource allocation is in everyone’s welfare.

◦ This is our foundation for evaluating markets and the role of government

Definition: Resources are allocated efficiently when it is impossible to increase the well being of another person without reducing the well-being of another person.

Example: Allocating three pieces of pizza to everyone in the class.

•At Q1, the output is inefficient because suppliers can be made better off

without harming any consumers.

•The flip side: At Q1, if sellers made the bread available for $1, the buyers

would be better off without harming the sellers.

•Marginal conditions for efficiency MSB = MSC

Mutually Beneficial Trade

Even when production is accomplished

with out waste, additional gains are

usually possible through mutually

agreeable exchanges.

Ticket Trading Example

Discussion: Markets for Organs

◦ Take home point: Efficiency is not the only

criterion by which society judges outcomes.

Example

At lunch, a friend of yours named Ryan stands up

to buy an ice cream. You ask him if he would

buy you a cookie. He does and when he gives it

to you, you offer him the dollar it cost. You

friend refuses the dollar and you feel very guilty.

Another friend, Tom, offers to take the dollar

and so you give it to him. Is this an example of

an efficiency enhancing transaction?

More Terms:

Total Social benefit: The total benefit to

society of enjoyed through the

consumption of an economic good.

Total Social Cost: Cost (or value) of all

resources necessary to make a given

amount of an economic good.

Total Costs and Total Benefits Graphically

•Moving from Marginal

quantities to Total Quantities

•When we thinking about

being well off, do we want

total benefit to be way above

total costs, or equal to total

costs?

Marginals, Totals, and Efficiency

When MSB = MSC,

surplus is maximize

Efficiency

When no more

beneficial trades can

take place

Efficiency

When TSB is as far

above TSC as possible

Efficiency

Question for Review

Draw the Market For iPads. Label

completely

Identify the efficient quantity. Label the

Point Q*

◦ At the efficient point, What is the marginal net

benefit of iPads?

Note, marginal net benefit = MSB - MSC

Below the market for iPads, Draw the

Total Benefit and Total Cost Curves. In

this new graph, identify the efficient

quantity. Label the quantity Q*

Assumptions of the Model of

Perfect Competition

In a perfectly competitive market:

1. All productive resources are privately owned. ◦ Why does this matter?

Fishing Example

Elephant in Africa Example

◦ ANS:

◦ All firms are selling identical products. ◦ Example: Wheat, Film Development, lawn care

2. There are many buyers and sellers such that no single entity can influence

◦ Why can’t any one buyer or seller influence Price? Examples by contrast:

Can WalMart as a buyer influence price?

Can Microsoft influence price?

Assumptions of the Model of

Perfect Competition (continued) 4. All relevant information is available to

buyers and sellers. ◦ What are the implications?

5. Resources are mobile and may be freely employed in any enterprise.

◦ Often thought of as free entry and free exit assumption.

Implicit assumption in economics: Economics agents seek to maximize their own utility (well being)

Can you think of any examples of markets that satisfy the assumptions of perfect competition?

Markets and Efficiency

Purchasers consider their own Marginal Private

Benefit

◦ Purchasers trade until their benefit = what they must

forgo to obtain one more unit of the good.

◦ What must we forgo to obtain one more unit?

◦ Price = MPB = MSB

◦ Notice how “privately owned resources” comes into

play here. If everything is privately owned, then the

extra private benefit = the extra social benefit

◦ MPB = MSB

◦ Sandwich example and private benefits

◦ Pizza Example and price = MPB

Markets and Efficiency

Producers trade until the revenue

obtained from selling one more unit is

equal to the cost of producing the unit

◦ What do producers receive per unit?

◦ Price = MPC = MSC

Notice the use of privately owned resources

Under the assumptions of perfect

competition, are markets efficient?

Ans: Yes …… WHY?

◦ Price = MPB = MSB = MPC = MSC

◦ In other words MB = MC for society

When do markets fail to allocate

efficiently? When one or more of the assumptions of

a well functioning market do not hold.

Taxes and Subsidies

◦ What is the main assumption that is violated?

Price no longer contains perfect information about

the scarcity of resources or the preferences of the

public.

Tax causes the amount of a good or service that is traded to be influenced by tax paid per unit, not only marginal social benefit/cost

Note: We begin to see that any time the marginal social cost or marginal social benefit is not accurately reflected in price, there is a case for efficiency loss

Therefore, the tax distorts decisions of market participants

Occurs in product and factor markets.

What kind of distortion may occur in the market for labor?

Taxes and Efficiency

Surplus and Taxes •Assume the government requires sellers to pay a

dollar tax per pack, what is going to happen to our

graph?

•Supply curve shifts vertically one dollar.

•Why?

•Because sellers

require $1.00 more

to sell the same

quantity.

•Consumers pay

$4.90, How much do

producers receive?

•$3.90, WHY?

•They had to pay a

dollar Tax

•Notice the wedge

between how

consumers value

cigarettes and how

much it costs to

produce them. MSB

> MSC

•When MSB > MSC

the surplus is not as

large as possible.

This causes a

deadweight loss.

Result: Taxes Cause a DWL Loss in

Competitive Markets

Loss of Efficiency Due to Taxes

Efficiency and Subsidies

Is efficiency loss also possible due to subsidies?

◦ Remember: Any time price does not reflect the

marginal social benefits or costs, there is the

possibility for a loss of efficiency.

Supply1 = MSC + Subsidy

When do market fail to allocate

efficiently? When one or more of the assumptions of

a well functioning market do not hold.

Monopoly Power

◦ What is the main assumption that is violated?

Many sellers assumption is violated.

This allows the monopolist to influence the supply

of goods and services.

Does Monopoly Reduce Economic Efficiency?

Comparing Monopoly and Perfect Competition

Monopoly and Surplus (or efficiency) loss

•If this were a perfectly competitive industry, where would the

economic surplus be?

•Since the monopolist does not produce the competitive amount,

what happens to surplus?

•Surplus is reduced

because society does not

get to consume those

units.

•Monopoly is associated

with a deadweight loss

•Note that Price goes

from PC to PM. for a

monopolist. Do you think

this is better for

consumers or producers?

•Producers

•Some of consumer

surplus is transferred to

the monopolist

Figure 2.2 page 63

Efficiency vs. Equity

Many people think that resources should

be allocated according to some measure

of fairness

◦ Any problems with fairness?

Whose opinion of fair?

What if imposing fairness inhibits individual

productivity?

How can we model these ideas?

Utility Possibilities Curve

Definition: a curve presents the maximum

attainable level of well-being (utility) for

one individual, given the utility level of

others in the economy, their tastes,

resource availability, and technology.

Utility Possibility Curve Is E1 Efficient?

Is E2 Efficient?

Is X Efficient?

How Might

Efficiency be

obtained from

X?

Would Anyone

oppose a move

from X to E3?

Could B Convince

A to move from X

to E3?

Utility Possibility Curve

What Relevance does this

Graph have to Public

Policy?

Individuals/Organizations

wanting point X are

content with a larger

share of a smaller pie