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