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Market Interventions & Institutions Dr. Nikos Nikiforakis The University of Melbourne Pricing and Efficiency in Competitive Markets Overview The purpose of this talk: Part I: To show how we can utilize theoretical tools to evaluate the effect of different policies. Part II: To show the importance of experiments in evaluating different institutions Ultimately, the goal is to let you know some of the policy analysis that is out there and importance of experiments Part I: Market Interventions Pricing and Efficiency in Competitive Markets Introduction Earlier on we saw that… In a competitive market the equilibrium price (p*) will be the one where quantity demanded will equal quantity supplied. p* is the price that maximizes efficiency as all gains from trade are exhausted What happens to p* and q* as the economic environment changes? Introduction We will discuss two types of policy: 1. 2. Taxes Price controls “Comparative statics”: change in equilibrium outcomes as a result of a change in economic environment. Imposition of tax Different taxes (direct-indirect, valuequantity, progressive-regressive etc.) We will consider effects of a quantity tax on sellers (for further discussion see Stiglitz (2000)) Quantity tax – a tax levied per unit of quantity bought or sold For simplicity let’s consider that there exist many buyers and sellers That is, demand and supply curves are straight lines Imposition of tax price Supply curve before tax Demand curve e0 p0 q0 Example 1: Tax imposed to sellers quantity Imposition of tax price Supply curve before tax Demand curve e0 p0 q0 quantity Example 1: Tax imposed to sellers Imposition of tax price Supply curve before tax Demand curve e1 p1 e0 p0 q1 q0 quantity Example 1: Tax imposed to sellers Imposition of tax price Supply curve before tax Demand curve e1 p1 p e0 0 q1 q0 p1- p0< t quantity Example 1: Tax imposed to sellers Imposition of tax price Supply curve before tax Demand curve e1 p1 p e0 0 p1- p0< t ps q1 q0 quantity Example 1: Tax imposed to sellers Imposition of tax price Supply curve before tax Demand curve Consumer surplus e1 pb e0 p0 p1- p0< t ps q1 q0 quantity Example 1: Tax imposed to sellers Imposition of tax price Supply curve before tax Demand curve Consumer surplus e1 pb e0 p0 p1- p0< t ps Producer surplus q1 q0 quantity Example 1: Tax imposed to sellers Imposition of tax price Consumer surplus e1 pb p0 Supply curve before tax Demand curve e0 Tax revenue p1- p0< t ps Producer surplus q1 q0 quantity Example 1: Tax imposed to sellers Imposition of tax price Consumer surplus e1 pb p0 Supply curve before tax Demand curve e0 Tax revenue Deadweight loss ps Producer surplus q1 q0 quantity Example 1: Tax imposed to sellers Tax in the first experiments A Perfectly Inelastic Supply Demand curve price Supply curve p 0 e0 q0 quantity Supply cannot increase or decrease (at least in the short-run). That is, supply curve won’t be shifted and market price (p0) will remain the same. Therefore, all the tax will be paid by the suppliers. A Perfectly Inelastic Supply Demand curve price Supply curve p 0 e0 p0 - t q0 quantity Supply cannot increase or decrease (at least in the short-run). That is, supply curve won’t be shifted and market price (p0) will remain the same. Therefore, all the tax will be paid by the suppliers. A Perfectly Inelastic Demand price Demand curve Supply curve p0 e0 q0 quantity Demand will not react to price changes (important drugs, cigarettes) As a result sellers will pass along all the tax to the buyers. A Perfectly Inelastic Demand price Demand curve Supply curve p0 + t p0 e0 q0 quantity Demand will not react to price changes (important drugs, cigarettes) As a result sellers will pass along all the tax to the buyers. Tax Liability-Side Equivalence Tax Liability-Side Equivalence price Demand curve Supply curve before tax pb p0 ps quantity TLSE says that it is irrelevant who is responsible for paying the tax – the equilibrium price facing buyers and sellers will be the same as the tax will be passed on. Tax Liability-Side Equivalence price price Demand curve Supply curve before tax Demand curve before tax Supply curve p1 p0 p2 quantity quantity TLSE says that it is irrelevant who is responsible for paying the tax – the equilibrium price facing buyers and sellers will be the same as the tax will be passed on. Tax Liability-Side Equivalence Experimental evidence support TLSE (Borck et al., 2001; Ruffle, 2004) TLSE might not be clearly understood by some policy makers and civilians who confuse statutory with economic incidence. One explanation is that there is confusion between gross and net earnings. (See Ruffle (2004) for Canadian Conservative Party shift from a manufacturer to a consumer tax and Krugman (2000) discussion on Bush’s gasoline tax cuts. Special cases: if demand/supply are perfectly inelastic/elastic, i.e. if one of the curves is horizontal/vertical, then only one side will pay the tax. Price Controls Term ‘price controls’ refers to the imposition of a price floor, i.e. minimum price, or a price ceiling, i.e. maximum price. Recent example in Australia minimum wages in the labour market. What is the effect of such a policy? Price Controls We saw that competitive markets maximize efficiency by exhausting all gains from trade. A price floor (like a price ceiling) will prohibit some of the trades and thus lower efficiency. Price Controls price Demand curve Supply curve e0 p0 q0 quantity Price Controls price Demand curve pmin Supply curve e0 p0 qb q0 qs quantity Price Controls price Demand curve Supply curve Consumer surplus pmin e0 p0 qb q0 qs quantity Efficiency losses not only due to prohibition of trades, but also due to ‘anchoring effects’ (Falk et al., 2006). Price Controls price Demand curve Supply curve Consumer surplus pmin e0 p0 Producer surplus qb q0 qs quantity Efficiency losses not only due to prohibition of trades, but also due to ‘anchoring effects’ (Falk et al., 2006). Price Controls price Demand curve Supply curve Consumer surplus pmin e0 p0 Deadweight loss Producer surplus qb q0 qs quantity Efficiency losses not only due to prohibition of trades, but also due to ‘anchoring effects’ (Falk et al., 2006). Market Predictions Market Predictions Market Predictions Market Predictions Consumer surplus Market Predictions Consumer surplus Producer surplus Market Predictions Consumer surplus Producer surplus Deadweight loss Experimental Results 50 Price 40 30 20 10 0 1 2 3 4 Period 5 6 Experimental Results Summary (Part I) We saw how economic theory can help us predict the impact of imposing taxes and price controls. Experiments indicate that theory predicts well actual behaviour. Removing the price control does not necessarily improve efficiency due to anchoring effects (see Isaac and Plott (1981) for anchoring effects after price controls). Part II Institutions Pricing and Efficiency in Competitive Markets Introduction The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2002 Vernon Smith: “for the use of laboratory experiments as a tool in empirical economic analysis, in particular, for the study of different market mechanisms”. Institution: Rules of the game Feasible actions Sequence of actions Information conditions Introduction Does it matter if only sellers can post prices (like in retail markets)? Many institutions: Double auction markets, English Auctions, Dutch Auctions, government grants. How can we compare performance: Experiments Posted Offer Markets Most retail markets in western countries Sellers quote prices on a take-it-orleave-it basis Sometimes due to government regulation (shipping, alcoholic beverages) Double Auction Double Auction Posted Offer Posted Offer Summary (Part II) Institutions are important Experiments ideal in helping us evaluate which institution is optimal for each situation … and to convince decision makers!! AND NOW … Before we decide which experiment will decide your payments you get to vote … Average payoffs: Experiment 1: $ 37.17 Votes: Experiment 2: $ 35.29 Votes: Experiment 3: $ 22.00 Votes: Further reading Borck, R., Engelmann, D., Müller, W., Normann, H.T. (2001) Tax Liability-Side Equivalence in Experimental Posted-Offer Markets, Southern Economic Journal, 68:3, 672-692. Falk, A., Fehr, E., Zehnder, C. (2006) Fairness Perceptions and Reservations Wages - The Behavioral Impact of Minimum Wage Laws, forthcoming in Quarterly Journal of Economics. Isaac, M., Plott, C. (1981) Price Controls and the Behavior of Auction Markets, American Economic Review, 71, 448-459. Ruffle, Bradley J. (2005) "Tax and Subsidy Incidence Equivalence Theories: Experimental Evidence from Competitive Markets", Journal of Public Economics, 89:8, 1519-1542. Stiglitz, Joseph. (2000) Economics of the public sector, Norton & Co. Ketcham, J., Smith, V., Williams, A. (1984) A Comparison of PostedOffer and Double-Auction Pricing Institutions, The Review of Economic Studies, 51:4, 595-614.