1. The Interaction of People in Markets
Chapter Seven
The Interaction of People in Markets

2. Interaction of People in Markets
Invisible hand – The idea that free interaction of people in a market economy leads to a desirable social outcome; the term was coined by Adam Smith.
Competitive equilibrium model – A model that assumes utility maximization on the part of consumers and profit maximization on the part of firms, along with competitive markets and freely determined prices.
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3. Interaction of People in Markets (cont’d)
In earlier chapters, we learn that the horizontal summation of the individual supply and demand curves form the market supply and demand curves, respectively. From chapter 3, we learned that the intersection of the market supply and market demand curve determines the equilibrium price.
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4. Interaction of People in Markets (cont’d)
Figure 7.2 shows how the interaction of sellers and buyers in the market leads to the determination of the market equilibrium price.
Equilibrium price – the price at which the quantity supplied equals the quantity demanded.
In Figure 7.2, the equilibrium price is $0.90.
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5. Interaction of People in Markets (cont’d) Figure 7.2
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6. Interaction of People in Markets (cont’d)
Surplus (excess supply) – The situation in which quantity supplied is greater than quantity demanded.
Shortage (excess demand) – The situation in which quantity demanded is greater than quantity supplied.
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7. Interaction of People in Markets (cont’d)
Adjustment to equilibrium price:
If the going price in the market is below the equilibrium price, then the market will experience a shortage, i.e., the quantity demanded at that price is greater than the quantity supplied. Buyers will try to outbid each other to get the good. As a result, there is a tendency for the going price to increase.
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8. Interaction of People in Markets (cont’d)
If the going price in the market is above the equilibrium price, then the market will experience a surplus, i.e., the quantity supplied at that price is greater than the quantity demanded. Since there are more for sale than what consumers are buying, sellers will try to sell more by lowering prices. As a result, there is a tendency for the going price in the market to decrease.
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9. Double Auction Market
Double Auction Market – A market in which several buyers and several sellers state prices at which they are willing to buy or sell a good.
Examples: The New York Stock Exchange, the commodity exchange markets in Chicago, etc.
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10. Double Auction Market (cont’d)
In a double auction market, buyers may purchase as many items as they want, but bid on one item at a time. Once a seller who is willing to sell at an agreed price is found, the item is successfully purchased, and the buyer may choose to buy another one.
A buyer will always seek out the lowest cost, and will never bid higher than his marginal benefit.
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11. Double Auction Market (cont’d)
In a double auction market, sellers may sell as many items as they want, but can ask for a price of only one item at a time. Once a buyer who is willing to buy at an agreed price is found, the item is successfully sold, and the seller may choose to sell another one.
A seller will always seek out the highest price, and will never sell below the marginal cost.
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12. Double Auction Market (cont’d)
Consumer Surplus – The difference between what a person is willing to pay for an additional unit of a good (or the marginal benefit) and the market price for the good.
Producer Surplus – The difference between the price received by the firm for an additional item sold, and marginal cost of producing the additional unit of a good.
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13. Double Auction Market (cont’d)
We look at a sample buyer and seller sheet shown in Table 7.1.
The top table in Table 7.1 shows the buyer’s sheet, which lists the marginal benefit (expressed in dollars) of consuming additional units of a good.
The bottom table in Table 7.1 shows the seller’s sheet, which lists the marginal cost (expressed in dollars) of producing additional units of a good.
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14. Double Auction Market (cont’d)
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15. Double Auction Market (cont’d)
Looking at the buyer’s sheet in Table 7.1, if the buyer were able to pay $15 for the first item, and $10 for the second item, the buyer’s total consumer surplus is:
CS = ($25-15) + ($20-10) = $20
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16. Double Auction Market (cont’d)
Looking at the seller’s sheet in Table 7.1, if a seller was able to sell the first item at $15 (marginal cost = $1), and $10 for the second item (marginal cost = $6), the seller’s total producer surplus is:
PS = ($15-1) + ($10-6) = $18
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17. Constructing the Model: The Demand Curve
Figure 7.3 shows how the demand side of a double auction model is constructed. Five buyers’ individual demand curves are summed together to construct a market demand curve. Note that the market demand curve is flatter than any of the individual demand curves.
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18. Constructing the Model: the Demand Curve (cont’d) Figure 7.3
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19. Constructing the Model: the Supply Curve (cont’d)
Figure 7.4 shows how the supply side of a double auction model is constructed. Five sellers’ individual supply curves are summed together to construct a market supply curve. Note that the market supply curve is flatter than any of the individual supply curves.
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20. Constructing the Model: The Supply Curve (cont’d) Figure 7 .4
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21. Constructing the Model: the Supply and the Demand Curves (cont’d)
Figure 7.5 puts both the demand curve from Figure 7.3 with the supply curve from Figure The intersection of the supply and demand curves is where the market is likely to find equilibrium. The equilibrium in this example is:
P* = $13 and Q* = 13
Where P* and Q* are equilibrium price and quantity , respectively.
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22. Constructing the Model: the Supply and the Demand Curves Figure 7.5
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23. Using Experiments to Find the Equilibrium
Economists conduct experiments to try to see if the outcome of the experiments truly mimic actual operation of markets.
Economists find that even with a small number of participants, outcomes of experiments are very close to what the model predicts.
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24. Are Competitive Markets Efficient?
Pareto Efficient – a situation in which it is not possible to make someone better off without making someone else worse off. This concept of efficiency was named after an Italian economist who developed this concept of efficiency.
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25. Are Competitive Markets Efficient? (cont’d)
Three Conditions for Efficient Outcomes
The marginal benefit must equal marginal cost of the last item produced.
The marginal cost of a good should be equal for every producer.
The marginal benefit of consuming the same good should be equal for all consumers.
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26. Is the Market Efficient?
From Chapter 5, we learned that consumers will consume such that price equals marginal benefit, or P=MB. From Chapter 6, we learned that a firm produces until price equals marginal cost, or P = MC.
Putting both equations together, we have:
P = MB =MC, or simply
MB = MC
The competitive market satisfies the first condition of efficiency.
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27. Is the Market Efficient? (cont’d)
Figure 7.6 illustrates the intersection between the market supply (derived from marginal costs) and market demand (derived from marginal benefit).
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28. Is the Market Efficient? (cont’d) Figure 7.6
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29. Is the Market Efficient? (cont’d)
From Figure 7.6, a point (point D) found to the left of the intersection between MB and MC is not efficient because marginal benefit is greater than marginal cost. Increasing output will result in increased welfare.
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30. Is the Market Efficient? (cont’d)
Similarly, a point (point F) found to the left of the intersection between MB and MC is not efficient because marginal benefit is less than marginal cost. Decreasing output will result in increased welfare.
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31. Is the Market Efficient? (cont’d)
The second condition for efficiency also holds:
All sellers face the same marginal cost because each seller faces the same price (remember: in a competitive market, the seller takes the price, and then sells until P = MC).
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32. Is the Market Efficient? (cont’d)
The third condition for efficiency also holds:
All buyers face the same marginal benefit because each buyer faces the same price (remember: in a competitive market, the buyer takes the price, and then consumes until P = MB).
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33. Is the Market Efficient? (cont’d)
First theorem in welfare economics – The conclusion that a competitive market results in an efficient (specifically, a Pareto efficient) outcome; sometimes called the invisible hand theorem.
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34. Efficiency and Income Inequality
Income Inequality – The disparity in levels of income among individuals in the economy.
Income equality is not the same as efficiency. An efficient outcome can coexist with an unequal outcome.
A solution to improve income equality while still maintaining efficiency is through income transfers.
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35. Measuring Waste from Inefficiency
A competitive market equilibrium maximizes the sum of the consumer and producer surplus. We can use the consumer surplus and producer surplus to measure the waste that stems from not producing at the efficient level of outcome.
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36. Measuring Waste from Inefficiency (cont’d)
Figure 7.7 shows the amount of consumer and producer surplus captured with varying levels of quantity produced.
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37. Measuring Waste from Inefficiency (cont’d)
Figure 7.7
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38. Measuring Waste from Inefficiency (cont’d)
The top graph of Figure 7.7 shows that producing below the efficient level results in a deadweight loss, or loss from inefficient production. The deadweight loss can be calculated as the difference between total (consumer and producer) surplus when the market is producing at the efficient level (the middle graph in Figure 7.7) and the total surplus when the market is not.
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39. Measuring Waste from Inefficiency (cont’d)
Deadweight Loss: The loss in producer and consumer surplus due to an inefficient level of production.
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40. Measuring Waste from Inefficiency (cont’d)
The bottom graph of Figure 7.7 shows that producing above the efficient level also results deadweight loss. The deadweight loss is the sum of the negative producer and consumer surplus resulting from producing a quantity more than the efficient quality.
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41. Deadweight Loss from Taxation
From Chapter 3, we learned that the supply curve will shift up when a tax is imposed.
Two types of taxes:
Ad valorem tax – A tax that is proportional to the value of the product sold. For example, a 6 percent sales tax is an ad valorem tax.
Specific tax – A tax that is proportional to the quantity of the product sold; a per unit tax. For example, a 50 cent tax per gallon of gasoline is a specific tax.
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42. Federal and State Specific Taxes for Gasoline: Selected States
Federal tax (cents per gallon)
State Tax (cents per gallon)
Alaska
18.4 8
California 18
Colorado 22
Dist. of Columbia 20
Florida
14.5
Louisiana
Note: Additional ad valorem taxes may also be levied (varies by state).
Source: gaspricewatch.com
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43. Federal and State Specific Taxes for Gasoline: Selected States (cont’d)
Federal tax (cents per gallon)
State Tax (cents per gallon)
Maine
18.4
25.2
Maryland
23.5
Massachusetts
New York
31.9
North Dakota 21
Ohio 26
Note: Additional ad valorem taxes may also be levied (varies by state).
Source: gaspricewatch.com
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44. Federal and State Specific Taxes for Gasoline:
Selected States (cont’d)
State
Federal tax (cents per gallon)
State Tax (cents per gallon)
Oregon
18.4 24
Pennsylvania
31.1
Tennessee 20
Texas
Washington 28
Wisconsin
32.1
Note: Additional ad valorem taxes may also be levied (varies by state).
Source: gaspricewatch.com
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45. State Specific Taxes on Cigarettes
TAX RATE (¢ per pack)
RANK
Alabama (1)
42.5 39
Alaska
160 7
Arizona
118 15
Arkansas (2) 59 31
California 87 22
Colorado 84 23
Connecticut
151 8
Delaware 55 34
Florida
33.9 44
Georgia 37 41
Hawaii
140 11
Idaho 57 32
Illinois (1) 98 20
As of January 1, Source: Compiled by the Federation of Tax Administrators
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46. State Specific Taxes on Cigarettes (cont’d)
TAX RATE (¢ per pack)
RANK
Indiana
55.5 33
Iowa 36 42
Kansas 79 26
Kentucky (2) 30 45
Louisiana
Maine
200 4
Maryland
100 18
Massachusetts
151 8
Michigan
Minnesota 48 37
Mississippi 49
Missouri (1) 17 50
Montana
170 6
As of January 1, Source: Compiled by the Federation of Tax Administrators
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47. State Specific Taxes on Cigarettes (cont’d)
TAX RATE (¢ per pack)
RANK
Nebraska       64 29
Nevada 80 24
New Hampshire
New Jersey
240 2
New Mexico           91 21
New York (1)
150 10
North Carolina (3) 30 45
North Dakota 44 38
Ohio
125 13
Oklahoma
103 17
Oregon
118 15
Pennsylvania
135 12
Rhode Island
246 1
As of January 1, Source: Compiled by the Federation of Tax Administrators
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48. State Specific Taxes on Cigarettes (cont’d)
TAX RATE (¢ per pack)
RANK
South Carolina       7 51
South Dakota         53 36
Tennessee (1) (2) 20 48
Texas 41 40
Utah
69.5 28
Vermont
119 14
Virginia (1) 30 45
Washington
202.5 3
West Virginia 55 34
Wisconsin 77 27
Wyoming              60
Dist. of Columbia   
100 18
U. S. Median
79.0
As of January 1, Source: Compiled by the Federation of Tax Administrators
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49. Deadweight Loss from Taxation
Figure 7.10 shows the deadweight loss resulting from a tax. The imposition of the tax shifts the supply curve up by the value of the tax. The intersection between the new supply curve and the demand curve is the new market equilibrium, which has a higher price than the old market equilibrium.
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50. Deadweight Loss from Taxation (cont’d) Figure 7.10
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51. Deadweight Loss from Taxation (cont’d)
The tax also creates a difference between the price that sellers receive, and the price that buyers pay. The difference between the two prices is the value of the tax.
From Figure 7.10, we can also see that imposing the tax results in a new equilibrium quantity lower than the equilibrium quantity before the tax.
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52. Deadweight Loss from Taxation (cont’d)
The lower equilibrium quantity is the source of the deadweight loss, because the fewer quantity sold results in less surplus that is captured by the sellers and buyers.
The dark triangle in Figure 7.10 situated between the old quantity and the new quantity is the deadweight loss from a tax.
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53. Key Points Invisible hand Competitive equilibrium model
Double auction market
Pareto- efficient
First theorem of welfare economics
Income inequality
Deadweight loss
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