1. Market equilibrium

2. Chapter 7: Efficiency and Exchange
Announcement
I somehow got one lecture ahead of schedule
Will modify syllabus
Chapter 7: Efficiency and Exchange

3. Economic Surplus in the Market for Milk
Quantity (1,000s of gallons/day)
Price ($/gallon) 1
.50
1.00
1.50
2.00
2.50
3.00 2 3 4 5 6 7 8 9 10 11 12
Producer surplus
= $4,000/day S D
Consumer surplus=$2000/day
Economic surplus = consumer surplus + producer surplus
Chapter 7: Efficiency and Exchange

4. Market Equilibrium and Efficiency
In theory, market equilibriums maximize economic surplus
What do you think?
Is maximizing economic surplus an appropriate desirable end? Is it the sole desirable end?
Is maximizing surplus equitable? Demand=preferences weighted by income
Do markets move toward equilibrium?
Chapter 7: Efficiency and Exchange

5. Chapter 7: Efficiency and Exchange
Chapter 7: Efficiency and Exchange

6. Housing prices: Equilibrium?
Chapter 7: Efficiency and Exchange

7. Chapter 7: Efficiency and Exchange
What is efficiency?
Are markets efficient?
Measures of efficiency for food systems
What is the desirable end?
What is the input?
Chapter 7: Efficiency and Exchange

8. Chapter 7: Efficiency and Exchange
What is efficiency?
The Economists view: Pareto efficiency
A situation in which there are no transactions available that would make at least one person better off without making anyone else worse off.
Also called Pareto optimality
Different from productive efficiency, i.e. attaining a point on the PPF
Pareto efficiency implies productive efficiency, but not vice versa
Chapter 7: Efficiency and Exchange

9. Chapter 7: Efficiency and Exchange
Think about it:
Would it be efficient if Bill Gates owned everything in the world?
Would it be optimal?
Chapter 7: Efficiency and Exchange

10. Chapter 7: Efficiency and Exchange
Efficiency and equity
Pareto efficiency and Diminishing marginal utility
What’s worth more, $1000 to a rich person or a poor person?
300 calories to a Zambian or an American?
What makes a greater contribution to happiness? To social welfare?
Should society value an increase in wealth for the poor more than an equal increase for the rich?
What’s actually been happening?
Chapter 7: Efficiency and Exchange

11. Market Equilibrium and Efficiency
A market equilibrium is Pareto efficient
If price and quantity take any other than their equilibrium values, a transaction that will make at least some people better off without harming others can always be found.
1st fundamental theorem of welfare economics: Any market equilibrium is Pareto efficient
Chapter 7: Efficiency and Exchange

12. Market Equilibrium and Efficiency
A market equilibrium is Pareto efficient
BUT prices are determined by demand, and demand is preferences weighted by wealth and income
There is a different Pareto efficient outcome for every initial distribution of wealth and income
The desirability of the outcome is determined by the desirability of the distribution that gave rise to it.
2nd fundamental theorem of welfare economics: we can achieve any Pareto equilibrium through lump sum transfers
Chapter 7: Efficiency and Exchange

13. How do we choose between Pareto efficient outcomes?
TWO NEOCLASSICAL ANSWERS:
We don’t
in which case the efficient market equilibrium is no more optimal than the distribution of resources that produced it.
Potential Pareto Optimality
We choose the outcome which could be a Pareto optimum if the winners compensated the losers, i.e. whatever produces most wealth
Chapter 7: Efficiency and Exchange

14. How do we choose between Pareto efficient outcomes?
ONE EE ANSWER:
We solve the distribution problem before we let markets allocate
Just distribution takes precedence over efficient allocation
Chapter 7: Efficiency and Exchange

15. A Market in Which Price Is Below the Equilibrium LevelD S
2.50
2.00
1.50
Price ($/gallon)
1.00
.50 1 2 3 4 5
Quantity (1,000s of gallons/day)
Chapter 7: Efficiency and Exchange

16. Quantity (1,000s of gallons/day)
How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction
2.50
Quantity (1,000s of gallons/day)
Price ($/gallon) D S 1 2 3 4 5
2.00
1.50
1.00
.50
1.25
If P = $1 then QS = 2,000 gallons/day
At 2,000 gallons the consumer is willing to pay $2 and the MC = $1
If the buyer pays $1.25 for an extra gallon, producer is $.25 better off, and the consumer is $.75 better off, or economic surplus increases by $1.00
At $1, the market is not efficient
Chapter 7: Efficiency and Exchange

17. Quantity (1,000s of gallons/day)
How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction
Quantity (1,000s of gallons/day)
Price ($/gallon) D S 1 2 3 4 5
2.50
2.00
1.50
1.00
.50
1.75
If P = $2 then QD = 2,000 gallons/day
Additional output costs only $1
This is $1 less than a buyer would pay
If the buyer pays the seller $1.75, the buyer gains an economic surplus of $0.25 then the seller gains an economic surplus of $0.75
Chapter 7: Efficiency and Exchange

18. Chapter 7: Efficiency and Exchange
If the price of a resource is above or below the equilibrium quantity, which of the following is true?
The quantity exchanged will be less than the equilibrium quantity
There is an opportunity to increase economic surplus
The value on the demand curve (MB) is greater than the value on the supply curve (MC) at that quantity.
Pareto improvements are possible
All of the above
Chapter 7: Efficiency and Exchange

19. Markets will only be efficient when
Buyers and sellers are well informed.
How often is this the case?
NYT: Banks That Bundled Bad Debt Also Bet Against It
What happens as the number of goods proliferates?
Markets are perfectly competitive
Vs. too big to fail
Chapter 7: Efficiency and Exchange

20. Markets will only be efficient when
Supply measures all relevant costs and benefits.
Laws of thermodynamics
Outsourcing
How do we measure these costs?
Demand measures all relevant benefits and costs.
NYT Income Inequality: Too Big to Ignore by R. Frank
“The rich have been spending more simply because they have so much extra money. Their spending shifts the frame of reference...[which make] it substantially more expensive for middle-class families to achieve basic financial goals”
Chapter 7: Efficiency and Exchange

21. Market Equilibrium and Efficiency
What do you think?
Is efficiency the only goal?
Should efficiency be the first goal?
Is efficiency possible?
Most textbooks explicitly state that efficiency is the desirable end
Chapter 7: Efficiency and Exchange

22. The Cost of Preventing Price Adjustments
Price Ceilings: Do They Help the Poor?
An Example: a Price Ceiling for Home Heating Oil
Chapter 7: Efficiency and Exchange

23. Economic Surplus in an Unregulated Market for Home Heating Oil
Producer surplus = $900/day
Consumer surplus = $900/day
2.00 D S
1.80
1.60
1.40
1.20
1.00
Without price controls:
Equilibrium Price = $1.40
Consumer surplus = (1/2)(3,000)(.60) = $900/day
Producer surplus = (1/2)(3,000)(.6) = 900/day
Economic surplus = $1,800/day
Price ($/gallon)
.80 1 2 3 4 5 8
Quantity (1,000s of gallons/day)
Chapter 7: Efficiency and Exchange

24. The Waste Caused by Price Controls
Price Ceiling set at $1.00 S
2.00
Consumer surplus = $900/day
1.80
Lost economic surplus = $800/day
1.60
1.40
1.20
1.00
Producer surplus = $100/day D
Price ($/gallon)
.80
With price controls:
Producer surplus = (1/2)(1,000)(.20) = $100/day or a loss of $800/day
Economic surplus = $1,000 or a loss of $800/day 1 2 3 4 5 8
Quantity (1,000s of gallons/day)
Chapter 7: Efficiency and Exchange

25. The Cost of Preventing Price Adjustments
Conventional economists say the reduction in economic surplus from a price ceiling will be underestimated when
The consumers who receive the product are not the consumers who value it the most.
BUT demand is most inelastic for the wealthiest consumers
Consumers take costly actions to enhance their chances of being served.
Chapter 7: Efficiency and Exchange

26. The Cost of Preventing Price Adjustments
Question
What programs could be used to help the poor get heating oil that would be more efficient than a price ceiling?
Chapter 7: Efficiency and Exchange

27. When the Pie Is Larger, Everyone Can Have a Bigger Slice
Surplus with price controls
Surplus with income transfers and no price controls
With price controls set at $1.00 the economic surplus is $1,000/day *R = economic surplus received by rich people *P = economic surplus received by poor people
Without price controls & with income transfers economic surplus is $1,800/day *R & P have the same share and a much larger economic surplus
Chapter 7: Efficiency and Exchange

28. Chapter 7: Efficiency and Exchange
Rationing
In WWII, everyone received a coupon for how much heating oil they could consume.
Rationing was the solution Brazil used for it’s recent energy crisis. California just let prices soar.
Coupons could be traded, going to the consumers that valued it most.
Chapter 7: Efficiency and Exchange

29. Other costs of adjustment
Question
How politically feasible are income transfers relative to price ceilings or tradable ration coupons?
Chapter 7: Efficiency and Exchange

30. The Cost of Preventing Price Adjustments
Price Subsidies: Do They Help the Poor? The view from mainstream economics
By how much do subsidies reduce total economic surplus in the market for bread?
Assume a small nation imports all its bread at the world price of $2.00
Chapter 7: Efficiency and Exchange

31. The Reduction in Economic Surplus from a Subsidy
The cost of the subsidy = $6 million
The benefit of the subsidy = $5 million
Loss of economic surplus = $1 million
5.00
Consumer surplus = $9,000,000/month
4.00
Price of bread ($/loaf)
Reduction in total economic surplus = $1,000,000/month
3.00
World price = $
2.00 S
1.00 D 2 4 6 8
Quantity (millions of loaves/month
Chapter 7: Efficiency and Exchange

32. Chapter 7: Efficiency and Exchange
BUT…
What’s the marginal utility of another loaf of bread to a family with malnourished children?
What’s the future productivity of well-nourished children vs. malnourished ones?
Chapter 7: Efficiency and Exchange

33. Chapter 7: Efficiency and Exchange
NYT Headlines:
Ending Famine,
Simply by Ignoring
the Experts
The secret of Malawi’s success: heavy subsidies for fertilizer, farmers say. The World Bank had pressed for their elimination.
Chapter 7: Efficiency and Exchange

34. Pricing of Public Services
Example
How much should a city charge for water, electricity, or some other service essential to life?
Chapter 7: Efficiency and Exchange

35. The Marginal Cost Curve for Water
4.0
0.8
0.2 1 3
Spring
Lake
Ocean
Three sources of water
Spring: 1 million gallons/day .02 cents/gallon
Lake: 2 million .08 cents/gallon
Ocean: 4 cents/gallon
Cost (cents/gallon)
Water supplied (millions of gallons/day)
Chapter 7: Efficiency and Exchange

36. The Marginal Cost Curve for Water
4.0
0.8
0.2 1 3
Spring
Lake
Ocean
Assume
If P = 4 cents/gallon, Q = 4 million gallons
Question
Why should all residents pay 4 cents per gallon?
Cost (cents/gallon)
Water supplied (millions of gallons/day)
Chapter 7: Efficiency and Exchange

37. Chapter 7: Efficiency and Exchange
Mainstream view
Price = marginal cost
If price is less, people will use more, and cost of supplying more is 4 cents/gallon
Chapter 7: Efficiency and Exchange

38. Chapter 7: Efficiency and Exchange
BUT…
In Cochabamba, Bolivia, marginal pricing led to people spending 25% of income on water, rioting, and death.
How much did Bolivia spend defending Bechtel’s profits?
In South Africa, the rich fill their swimming pools, while the poor drink polluted water, and die of cholera
What are the costs of cholera?
Chapter 7: Efficiency and Exchange

39. Commodity or human right?
Conventional economists look at almost everything as a commodity
Can we distinguish by use?
Water used for essential needs is a human right
Water for non-essential uses is a commodity
Chapter 7: Efficiency and Exchange

40. Why not charge by quantity?
Cost of first 50 gallons/week (essential needs) = .02 cents/gallon
Cost of next 100 gallons/week (important needs) =.08 cents/gallon
All else costs 4 cents/gallon
Chapter 7: Efficiency and Exchange