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ECON 160ECON 160
Week 07March 08-10, 2011
Efficiency & Government Policies
Market Efficiency
Chapter 7
2
$ P x
$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$ 4
$ 3
$ 2
$ 1
1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T
Supply
Demand
Dx
Market Interaction
Pe
Qe
Exchange Value
3
Allocation Efficiency: Price allocates the goods to highest valued users
A B C Market
$ P $ P $ P
$ P
Q/T
DD
D
Qa Qb Qc Qe
Pe Pe
Marginal Value A = Marginal Value B = Marginal Value C = Market Price
DemandSupply
Market Demand determines Price. Each buyer responds to price by buying till Marginal Value equals price. No reallocation can generate greater value.
Pe Pe
4
Production Efficiency: Price coordinates the efficient use or resources
Firm 2Firm 1 Firm 3Market$ P
$ P $ P $ P
Q/T
Demand
S1
S2
Qe Q1 Q2 Q3
Pe Pe
Market Price = Marginal Cost Firm 1 = Marginal Cost Firm 2 = Marginal Cost Firm 3
Supply
S3
Market Supply is the sum of the industry output at alternative prices. Each firm produces up to the quantity where Price = Marginal Cost. No reallocation of resources will produce at a lower opportunity cost.
Pe
5
$ P x
$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$ 4
$ 3
$ 2
$ 1
1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T
Supply
Demand
Dx
Market is Efficient since at Qe the Marginal Value = Marginal cost
Pe
Qe
Marginal Value
MarginalCost
6
MVx
Qtyx / T
$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$ 4
$ 3
$ 2
$ 11 2 3 4 5 6 7 8 9 10
MVx = Dx
Demand = Marginal Value
Exchange Value
Pe
Qe
Consumer Surplus Value (MV – Price)
7
$ P x
$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$ 4
$ 3
$ 2
$ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T
The height reflects the marginal cost of producing an additional unit.
Supply Reflects Marginal Cost
Pe
Qe
Producer Surplus ValuePrice – Marginal Cost
8
$ P x
$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$ 4
$ 3
$ 2
$ 1
1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T
Supply
Demand
DxSx
Market: Gains from Trade
Pe
Qe
C.S V.
P.S.V.
9
$ P x
$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$ 4
$ 3
$ 2
$ 1
1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T
Supply
Demand
DxSx
Market Efficiency: Reduced Output
Pe
Qe
Efficiency Loss
10
$ P x
$ 10
$ 9
$ 8
$ 7
$ 6
$ 5
$ 4
$ 3
$ 2
$ 1
1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T
Supply
Demand
DxSx
Market Efficiency:Increased Output
Pe
Qe
Efficiency Loss
11
Market Outcome is Efficient
• Marginal Value (MV) of last unit produced = Marginal Cost of production (MC)
• Producing less Efficiency loss• Producing more Efficiency Loss
12
Periods of AnalysisPeriods of Analysis
• Long-Run: All inputs are variable (prospective)• Short-Run: Some inputs fixed, some variable• Market Period: All inputs Fixed Output
Fixed ( vertical supply)
13
Market Analysis
• The Market for Rental apartments• Analyze an increase in demand• Analyze price effects in the market period• Analyze supply and price effects in the long-
run
14
$ Rent
Units/Month
SupplySupply
D0
$ 1400
DD11
1000 1500
$ 2000
LR new SupplyLR new Supply
$ 1600
New LR Equilibrium
15
$ Rent
Units/Month
SupplySupply
D0
$ 1400
DD11
1000 1500
Price Ceiling
Short
16
Implications Price Ceiling below Equilibrium
• Increased Transaction Costs to Buyers & Sellers
• Increase in Non-Market rationing: Discrimination
• Decrease in Quality• Decrease in Supply
17
Price Floor above Equilibrium
• How does the labor Market work?• What happens when you place the Minimum
Wage above Equilibrium wage ?
18
$ Wage
Qty/T
Demand Supply of Labor
Wage E
QE
Min. Wage
Qd Qs
Surplus : UnemploymentSurplus : Unemployment
Unskilled Labor Market
19
The Minimum Wage: A Price Floor
$Wage
Qty / T
D
S
Pe
Qd Qs
D
Qe
Minimum Wage
20
Implications of Price Floor above Equilibrium
• Increase in transaction costs• Increase in non-market rationing
(discrimination)• Increase in quality (not demand driven)• Increase in supply• Wealth transfer: from unemployed to
employed
21
Taxes & Price Effects
22
Sales Tax on Buyers
$ Price x
Qty x /T
Dx
Sx
$Pe
Qe
Dx’
$Pb
$PsTax Revenue
Qt
23
Tax on Sellers$ Price x
Qty x /T
Dx
Sx
$Pe
Qe
$Pb
$PsTax Revenue
Qt
Sx’
24
Who bares the burden of a tax?
• The distribution of the tax burden is identical for either a sales tax on buyers or an excise tax on sellers.
• When the price to buyers including the tax rises, consumers lose consumer surplus
• When the price to sellers after the tax falls, sellers lose previous revenue.
25
Tax Burden: Inelastic Demand
$ Price x
Qty x /T
Dx
Sx$Pe
Qe
$Pb
$Ps
Qt
Tax
26
Tax Burden: Inelastic Supply
$ Price x
Qty x /T
Dx
Sx
$Pe
Qe
$Pb
$Ps
Qt
Tax
27
Tax Burden: Fixed Supply$ Price x
Qty x /T
Dx
Sx
$800
Qe
$900
$700
Tax $100
Lost Revenue
Qd
Tax $100
28
Tax Burden & Relative Elasticity
• The burden of a tax (either sales or excise) depends on the relative elasticity of demand and supply.
• If demand is more inelastic then supply Buyers bare a larger portion of the burden.
• Is supply is more inelastic than demand, sellers bare a larger portion of the burden.
29