1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-1 Chapter 7 Efficiency and exchange

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-2 Market equilibrium and efficiency A market equilibrium is efficient –A situation is efficient (or Pareto efficient) if there is no opportunity for exchange or trade that will make at least one person better off without harming others. –When the supply and demand curves for a product capture all the relevant costs and benefits of producing that product, the market equilibrium for that product will be efficient.

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-3 A Pareto-improving transaction where the ruling market price is below its equilibrium level 2.50 Quantity (1000s of litres/day) Price ($/litre) 12345 2.00 1.50 1.00.50 D S

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-4 How excess supply creates an opportunity for a surplus-enhancing transaction when price is above equilibrium Quantity (1000s of litres/day) Price ($/litre) D S 12345 2.50 2.00 1.50 1.00.50 1.75 If P = $2 then Q D = 2000 litres/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.

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-5 Market equilibrium and efficiency What do you think? –Are markets always efficient and equitable?

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-6 Market equilibrium and efficiency Observations on efficiency –When price is above or below the equilibrium, the quantity exchanged will be below the equilibrium. –The vertical value on the demand curve (marginal benefit) is greater than the vertical value on the supply curve (MC). –Only the equilibrium will maximise economic surplus.

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-7 Market equilibrium and efficiency Markets will be efficient when –Buyers and sellers are well informed. –Markets are perfectly competitive. –Supply measures all relevant costs. –Demand measures all relevant benefits.

8. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-8 Market equilibrium and efficiency Efficiency: the first but not the only goal. What do you think? –Is efficiency the only goal? –Why should efficiency be the first goal?

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-9 The cost of preventing price adjustments Price ceilings: Do they help the poor? –An example  How much waste does a price ceiling on milk cause?

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-10 Producer surplus = $900/day Consumer surplus = $900/day D S Economic surplus in an unregulated market for milk 2.00 Quantity (1000s of litres/day) Price ($/litre) 12345 1.60 1.20 1.00.80 1.80 1.40 8 Without price controls: Equilibrium Price = $1.40 Consumer surplus = (1/2)(3000)(.60) = $900/day Producer surplus = (1/2)(3000)(.6) = 900/day Economic surplus = $1800/day

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-11 Producer surplus = $100/day Lost economic surplus = $800/day Consumer surplus = $900/day The loss of economic surplus caused by a price ceiling in the market for milk 2.00 Quantity (1000s of litres/day) D S 12345 1.60 1.20 1.00.80 1.80 1.40 8 Price ($/litre) With price ceiling: Producer surplus = (1/2)(1000)(.20) = $100/day or a loss of $800/day Economic surplus = $1000 or a loss of $800/day Price ceiling set at $1.00

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-12 The cost of preventing price adjustments 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. –Consumers take costly actions to enhance their chances of being served.

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-13 The cost of preventing price adjustments Question –What program could be used to help the poor get milk that would be more efficient than a price ceiling?

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-14 The cost of preventing price adjustments Price subsidies –Government’s involvement in some market takes the form of subsidising either sellers or buyers of a good. –The approach of subsidising the prices of ‘essential’ goods and services assists low-income consumers.

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-15 When the pie is larger, everyone can have a bigger slice R P R P Surplus with price controlsSurplus with income transfers and no price controls With price controls set at $1.00, the economic surplus is $1000/day *R = economic surplus received by rich people *P = economic surplus received by poor people Without price controls & with income transfers, economic surplus is $1800/day *R & P have the same share and a much larger economic surplus

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-16 The cost of preventing price adjustments Question –What would be a potential cost of income transfers?

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-17 The cost of preventing price adjustments Price subsidies: Do they help the poor? –By how much do subsidies reduce total economic surplus in the market for milk? –Assume a small isolated community imports milk for its population at a price of $2 per litre.

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-18 Consumer surplus = $4000/day Economic surplus maximised where MC($2) = MB($2) at 4000 litres Economic surplus in the milk market without a subsidy Quantity (1000s of litre/day Price of milk ($/litre) 246 3.00 1.00 5.00 4.00 8 D S 2.00 World price = $

19. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-19 The loss of economic surplus caused by a price ceiling in the market for milk Assume a $1/litre subsidy –Consumers buy 6000 litres per day. –Consumer surplus will increase to $9000 a day. –Economic surplus will fall by $1000.

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-20 Consumer surplus = $9000/day Reduction in total economic surplus = $1000/day The loss of economic surplus from a price ceiling Quantity (1000s of litres/day Price of milk ($/litre) 246 3.00 1.00 5.00 4.00 8 2.00 World price = $ D S The cost of the tax = $6000 The benefit of the subsidy = $5000 Loss of economic surplus = $1000

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-21 The cost of preventing price adjustments Price subsidies –How could we provide assistance to low-income consumers more efficiently?

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-22 The cost of preventing price adjustments Thinking as an economist –`First come, first served’ policies  Why are passenger complaints about overbooked flights a thing of the past?

23. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-23 Equilibrium in the market for seats on oversold flights Demand for remaining on the flight 60 24 37 Seats Price ($/seat) 33 Supply of seats

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-24 Equilibrium in the market for seats on oversold flights 60 24 27 3337 Seats Price ($/seat) Supply of seats First come, first served Reservation prices = (60 + 59 +…+ 24)/37 = $42/passenger 4 bumped @ $42 each or $168 loss in economic surplus.

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-25 Equilibrium in the market for seats on oversold flights 60 24 27 3337 Seats Price ($/seat) Supply of seats Compensation policy $27 = reservation price (compensation) to get 4 passengers to volunteer to stay The cost of the compensation = 4 x $27 = $108 minus the economic surplus to the passengers of $6 = $102

26. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-26 The cost of preventing price adjustments Example –How should a tennis pro handle an overbooking problem?

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-27 Player Ann9:50 A.M. $4 Bill9:52 A.M. 3 Carrie9:55 A.M.6 Dana9:56 A.M.10 Earl9:59 A.M.3 Arrival timeReservation price 5 bookings for 3 slots. All 5 show up for the lesson. How can the tennis pro minimise the cost of rescheduling two students? HINT: first come, first served or compensation. The cost of preventing price adjustments

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-28 The cost of preventing price adjustments What do you think? –Why offer compensation when the cost of first come, first served to the seller is zero?

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-29 The marginal cost pricing of public services Example –How much should the Water Corporation charge residents of a town for water?

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-30 The marginal cost curve for water Water supplied (gigalitres/day) Cost (cents/litre) 1.5 0.5 0.3 250500 Dam Aquifer Desalination plant Three sources of water Dam: 250 gigalitres/day.03 cents/litre Aquifer: 500 gigalitres/day @.05 cents/litre Desalination plant: 1.5 cents/litre

31. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-31 The marginal cost curve for water Example –How much should the Water Corporation charge for water?

32. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-32 The marginal cost curve for water Water supplied (gigalitres/day) Cost (cents/litre) 1.5 0.5 0.3 250500 Dam Aquifer Desalination plant Assume If P = 1.5 cents/litre, Q = 1000 gigalitres Question Why should all residents pay 1.5 cents per litre?

33. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-33 Taxes and efficiency Question –Who pays a tax imposed on sellers of a good?

34. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-34 The effect of a tax on the equilibrium quantity and price of hamburgers 6 Quantity (1000s of burgers/month) Price ($/burger) 12345 5 4 2 1 D S 3 Without a tax P = $3/burger and Q = 3000 burgers/month 2.50 3.50 S + tax 2.5 With a tax of $1/burger MC increases by $1/burger. Supply shifts up by $1. P = $3.50; Q = 2500. Consumers and producers share the burden of the tax equally. Producers receive $2.50/burger. Consumers pay $3.50/burger.

35. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-35 Taxes and efficiency Question –How will a tax of $100 per car collected from car manufacturers affect the price of cars in the long run, if the elasticity of supply is infinite?

36. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-36 The effect of a tax on sellers of a good with infinite price elasticity of supply Quantity (millions of cars/month) Price ($/car) D S 2.0 $20,000 Assume a tax levy of $100 tax/car 1.9 S + $100 $20,100 Supply shifts to $20,100 The burden of the tax falls entirely on the consumer

37. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-37 Taxes and efficiency Who pays a ‘bed tax’? –When supply is perfectly elastic, the tax burden will fall entirely on the consumer.

38. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-38 Total economic surplus = $9000/month How a tax collected for a seller affects economic surplus The market for hamburger without taxes 6 12345 5 4 2 1 3 Price ($/burger) Quantity (1000s of burgers/month) D S

39. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-39 The effect of a $1 per burger tax on hamburger 6 Quantity (1000s of burgers/month) Price ($/burger) 12345 5 4 2 1 3 2.50 3.50 S + tax 2.5 D S How a tax collected from a seller affects economic surplus

40. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-40 Taxes and efficiency Deadweight loss –The reduction in total economic surplus that results from the adoption of a policy.

41. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-41 The deadweight loss caused by a tax 6 Quantity (1000s of burgers/month) Price ($/burger) D S 12345 5 4 2 1 3 2.50 3.50 S + tax 2.5 Deadweight loss caused by tax

42. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-42 Taxes and efficiency Question –How would you determine the economic feasibility of a tax?

43. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-43 Elasticity of demand and the deadweight loss from a tax Quantity (units/day) Price ($/unit) Quantity (units/day) Price ($/unit) D 1 S 24 2.00 D2D2 S 24 2.00 21 2.60 1.60 S + T 19 2.40 1.40 S + T Deadweight loss The greater the elasticity of demand, the greater the deadweight loss from a tax

44. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-44 Deadweight loss Elasticity of supply and the deadweight loss from a tax Price ($/unit) D S1S1 72 2.00 D S2S2 72 2.00 The greater the elasticity of supply, the greater the deadweight loss from a tax Quantity (units/day) 57 2.65 1.65 S 1 + T 63 2.35 1.35 S 2 + T Deadweight loss Quantity (units/day)

45. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 7-45 Taxes and efficiency What do you think? –Why would a tax on land be efficient? –Would a tax on pollution increase economic surplus?