1. Week 07 March 02-04, 2010 Efficiency & Government Policies
ECON 160
Week 07
March 02-04, 2010
Efficiency & Government Policies

2. Market Efficiency
Chapter 7

3. Market Interaction $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
Demand
Supply Pe
Exchange Value Dx
Total Revenue = Price x Quantity $6 x 5 = $30
Qtyx /T Qe

4. Allocation Efficiency: Price allocates the goods to highest valued users
Market Demand determines Price. Each buyer responds to price by buying till Marginal Value equals price. No reallocation can generate greater value.
Market A B C
$ P
Demand
Supply
$ P
$ P
$ P D D Pe Pe Pe Pe D Qa Qb Qc Qe
Q/T
Marginal Value A = Marginal Value B = Marginal Value C = Market Price

5. Production Efficiency: Price coordinates the efficient use or resources
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.
Market
Firm 1
Firm 2
Firm 3
$ P
Demand
$ P
$ P
$ P
Supply S2 Pe Pe Pe S1 S3 Qe
Q/T Q1 Q2 Q3
Market Price = Marginal Cost Firm 1 = Marginal Cost Firm 2 = Marginal Cost Firm 3

6. Market is Efficient since at Qe the Marginal Value = Marginal cost
$ P x
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
Demand
Supply Pe Dx
Total Revenue = Price x Quantity $6 x 5 = $30
Marginal
Value
Marginal
Cost
Qtyx /T Qe

7. Demand = Marginal Value
MVx
$ 10
$ 9 $ 8
$ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
Consumer Surplus Value
(MV – Price) Pe
Exchange
Value
MVx = Dx
Qtyx / T Qe

8. Supply Reflects Marginal Cost
$ P x
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
The height reflects the marginal cost of producing an additional unit. Pe
Producer Surplus Value
Price – Marginal Cost
1. At higher prices, sellers are willing to employ resources with higher opportunity cost and increase the amount supplied.
Qtyx /T Qe

9. Market: Gains from Trade
$ P x
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
C.S V.
Demand
Supply Pe
P.S.V. Sx Dx
Total Revenue = Price x Quantity $6 x 5 = $30
Qtyx /T Qe

10. Market Efficiency: Reduced Output
$ P x
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
Demand
Supply
Efficiency Loss Pe Sx Dx
Total Revenue = Price x Quantity $6 x 5 = $30
Qtyx /T Qe

11. Market Efficiency: Increased Output
$ P x
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
Demand
Supply
Efficiency Loss Pe Sx Dx
Total Revenue = Price x Quantity $6 x 5 = $30
Qtyx /T Qe

12. Market Outcome is Efficient
Marginal Value (MV) of last unit produced = Marginal Cost of production (MC)
Producing less  Efficiency loss
Producing more  Efficiency Loss

13. Periods 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)

14. 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

15. $ Rent
Supply
LR new Supply D0
New LR Equilibrium
$ 2000
$ 1600
$ 1400 D1
1000
1500
Units/Month

16. $ Rent
Supply D0
Price Ceiling
$ 1400 D1
Short
1000
1500
Units/Month

17. Implications Price Ceiling below Equilibrium
Increased Transaction Costs to Buyers & Sellers
Increase in Non-Market rationing: Discrimination
Decrease in Quality
Decrease in Supply

18. Price Floor above Equilibrium
How does the labor Market work?
What happens when you place the Minimum Wage above Equilibrium wage ?

19. Unskilled Labor Market
$ Wage
Unskilled Labor Market
Supply of Labor
Demand
Min. Wage
Wage E
Surplus : Unemployment Qd
Qty/T QE Qs

20. The Minimum Wage: A Price FloorD S
Minimum Wage Pe D Qd Qe Qs
Qty / T

21. 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

22. Taxes & Price Effects

23. Sales Tax on Buyers Sx $ Price x $Pb $Pe Tax Revenue $Ps Dx Dx’ Qt Qe
Qty x /T

24. Tax on Sellers $ Price x Sx’ Sx $Pb $Pe Tax Revenue $Ps Dx Qt Qe
Qty x /T

25. 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.

26. Tax Burden: Inelastic Demand
$ Price x
$Pb Sx
$Pe
Tax
$Ps Dx Qt Qe
Qty x /T

27. Tax Burden: Inelastic Supply
$ Price x Sx
$Pb
$Pe
Tax Dx
$Ps Qt Qe
Qty x /T

28. Tax Burden: Fixed Supply
$ Price x Sx
$900
Tax $100
$800
Lost Revenue
Tax $100
$700 Dx Qd Qe
Qty x /T

29. 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.