1. ECON 160 Week 07 March 08-10, 2011 Efficiency & Government Policies

2. Market Efficiency Chapter 7 2

3. $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T Supply Demand DxDx Market Interaction Pe Qe Exchange Value 3

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

5. Production Efficiency: Price coordinates the efficient use or resources Firm 2Firm 1Firm 3 Market $ P Q/T Demand S1S1 S2S2 Qe Q1Q2Q3 Pe Market Price = Marginal Cost Firm 1 = Marginal Cost Firm 2 = Marginal Cost Firm 3 Supply S3S3 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. Pe 5

6. $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T Supply Demand DxDx Market is Efficient since at Qe the Marginal Value = Marginal cost Pe Qe Marginal Value Marginal Cost 6

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

8. $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T The height reflects the marginal cost of producing an additional unit. Supply Reflects Marginal Cost Pe Qe Producer Surplus Value Price – Marginal Cost 8

9. $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T Supply Demand DxDx SxSx Market: Gains from Trade Pe Qe C.S V. P.S.V. 9

10. $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T Supply Demand DxDx SxSx Market Efficiency: Reduced Output Pe Qe Efficiency Loss 10

11. $ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 1 2 3 4 5 6 7 8 9 10 11 12 Qty x /T Supply Demand DxDx SxSx Market Efficiency: Increased Output Pe Qe Efficiency Loss 11

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 12

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) 13

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 14

15. $ Rent Units/M onth Supply D0D0 $ 1400 D1D1D1D1 10001500 $ 2000 LR new Supply $ 1600 New LR Equilibrium 15

16. $ Rent Units/M onth Supply D0D0 $ 1400 D1D1D1D1 10001500 Price Ceiling Short 16

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

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

19. $ Wage Qty/T Demand Supply of Labor Wage E QEQE Min. Wage QdQd QsQs Surplus : Unemployment Surplus : Unemployment Unskilled Labor Market 19

20. The Minimum Wage: A Price Floor $Wage Qty / T D S PePe QdQs D Qe Minimum Wage 20

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 21

22. Taxes & Price Effects 22

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

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

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. 25

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

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

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

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. 29