1. C H A P T E R 7 Prepared by: Fernando and Yvonn Quijano © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. Market Efficiency and Government Intervention

2. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 2 of 19 Market Efficiency and Government Intervention In this chapter, we will take a closer look at the benefits of exchange, examining the experiences of both buyers and sellers. PRINCIPLE of Voluntary Exchange A voluntary exchange between two people makes both people better off.

3. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 3 of 19 The Metaphor of the Invisible Hand A market equilibrium will generate the largest possible surplus and thus be efficient when four conditions are met: No external benefits No external costs Perfect information Perfect competition

4. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 4 of 19 Consumer Surplus and Producer Surplus Your willingness to pay for a product is the maximum amount you are willing to pay for the product. Your consumer surplus is the difference between your willingness to pay and the price you actually pay for it.

5. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 5 of 19 The Demand Curve and Consumer Surplus The market consumer surplus equals the sum of the consumer surpluses obtained by all the consumers in the market. $30 Total consumer surplus $7Siggy $0$10 Fivola $3$10$13Forest $6$10$16Thurl $9$10$19Tupak $12$10$22Juan Consumer Surplus Price Paid Willing to Pay

6. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 6 of 19 The Supply Curve and Producer Surplus A sellers willingness to accept is the minimum amount he or she is willing to accept as payment for a product, and is equal to the marginal cost of production. Producer surplus is the difference between the price a producer receives for a product and the willingness to accept, or the difference between price and marginal cost.

7. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 7 of 19 The Supply Curve and Producer Surplus Market producer surplus equals the sum of the surpluses earned by all producers in the market. $20 Market producer surplus $12 Efrin $0$10 Eve $2$10 $8 Dee $4$10 $6 Cecil $6$10 $4 Bea $8$10 $2 Abe Producer Surplus Price Received Willing to Receive

8. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 8 of 19 Market Equilibrium and Efficiency The total surplus of a market is the sum of consumer surplus and producer surplus. The market equilibrium generates the highest possible total surplus. That’s why we say that the market equilibrium is efficient.

9. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 9 of 19 Total Surplus Is Lower with a Price Below the Equilibrium Price A maximum price of $4 reduces the total surplus of the market because it prevents some mutually beneficial transactions. The first two consumers gain at the expense of the first two producers.The first two consumers gain at the expense of the first two producers. The consumer and producer surplus of the third and fourth lawns are lost entirely.

10. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 10 of 19 Total Surplus Is Lower with a Price Above the Equilibrium Price A minimum price of $19 reduces the total value of the market. The first two producers gain at the expense of the first two consumers.The first two producers gain at the expense of the first two consumers. The consumer and producer surplus of the third and fourth lawns are lost entirely.The consumer and producer surplus of the third and fourth lawns are lost entirely.

11. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 11 of 19 Government Intervention in Markets Market failure is a situation in which markets, if left on their own, will fail to generate socially efficient outcomes. Market failure exists when there is an external benefit, an external cost, imperfect information, or imperfect competition.

12. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 12 of 19 Controlling the Price A maximum price of $300 per apartment decreases the total surplus of the market by the amount of the triangle des. This loss is called a deadweight loss.

13. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 13 of 19 Application: Rent Control The contributions opposing rent control exceed the contributions favoring it by $375. Table 7.1: College Town’s Campaign Contributions BenefitCostContribution Consumers 1 - 700$70,000 = $100 * 700 + $700 = 1% of $70,000 Producers 1 - 700$70,000 = $100 * 700 – $700 = 1% of $70,000 Consumers 701 - 1000$22.500 = ½ ($150*300) – $225 = 1% of 22,500 Producers 701 - 1000$15,000 = ½ (100*300) – $150 = 1% of $15,000 TOTAL$70,000$107,500– $375

14. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 14 of 19 Controlling the Quantity—Licensing and Import Restrictions Application: Taxi Medallions The medallion policy creates an excess demand for taxi service, and decreases the total surplus of the taxi market.

15. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 15 of 19 Restricting Imports An import ban would ultimately decrease the total surplus in the sugar market. It would cause domestic producers to gain at the expense of domestic consumers.

16. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 16 of 19 Who Really Pays Taxes? Revenue Sources for Local, State and Federal Governments

17. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 17 of 19 Tax Shifting: Forward and Backward If demand is inelastic, a tax will increase the market price by a large amount, so consumers will bear a large share of the tax. If demand is elastic, the price will increase by a small amount and consumers will bear a small share of the tax.

18. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 18 of 19 Tax Burden and Deadweight Loss In a constant-cost industry, a tax increases the equilibrium price by the tax ($1 per pound in this example). Consumer surplus decreases by areas R and E. Total tax revenue collected is shown by rectangle R, so the total burden exceeds the tax revenue by triangle E, also known as the deadweight loss or excess burden of the tax.

19. © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 7: Market Efficiency and Government Intervention C H A P T E R 7: Market Efficiency and Government Intervention 19 of 19 Key Terms willingness to pay willingness to pay consumer surplus consumer surplus willingness to accept willingness to accept producer surplus producer surplus total surplus total surplus market failure market failure deadweight loss deadweight loss deadweight loss from taxation deadweight loss from taxation excess burden of a tax excess burden of a tax