Transcript Market Efficiency and Government Intervention

CHAPTER
6
Market Efficiency and
Government Intervention
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
Social Interest and the Invisible
Hand


The “invisible hand” is Adam Smith’s
description of how individual buyers and
sellers, each acting in their own selfinterest, frequently promote the social
interest.
Private market equilibrium may be
efficient, that is, it may generate the
largest possible net benefits for buyers
and sellers.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Social Interest and the Invisible
Hand


Markets may not be socially efficient if buyers
and sellers acting in their own self-interest
generate outcomes that are contrary to the
social interest.
To avoid socially inefficient outcomes, four
assumptions about markets are necessary:




Informed buyers and sellers
Perfect Competition
No spillover benefits
No spillover cost
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Consumer Surplus

Consumer surplus is the difference between
the maximum amount a consumer is willing to
pay for a product and the price the consumer
actually pays.

The price a consumer pays for a good is
usually less than the amount he or she is
willing to pay. Consumer surplus measures
the bonus or surplus received by the
consumer.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Demand Curve and Consumer
Surplus

Market consumer surplus equals the sum of
the surpluses earned by all consumers in the
market.
Willing Price Consumer
to Pay Paid Surplus
Juan
22
10
12
Tupak
19
10
9
Thurl
16
10
6
Forest
13
10
3
Fivola
10
10
0
Siggy
7
Market consumer surplus
$30
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Supply Curve and Producer
Surplus

Producer surplus is the difference between the
price a producer receives for a product and the
minimum amount the producer is willing to
accept for the product.

The minimum amount a producer is willing to
accept is the marginal cost of producing the
product, which includes the cutter’s
opportunity cost of his or her time.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Supply Curve and Producer
Surplus

Market producer surplus equals the sum of
the surpluses earned by all producers in the
market.
Willing to Price
Producer
Receive
Received Surplus
Abe
2
10
8
Bea
4
10
6
Cecil
6
10
4
Dee
8
10
2
Eve
10
10
0
Efrin
12
Market producer surplus
$20
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Market Equilibrium and Efficiency



Market equilibrium is
efficient because it
generates the highest
possible total market
value.
At a price of $10, total
surplus in the market
equals $50 = $30 +
$20.
An imposed price above or below equilibrium would
create inefficiency and reduce total surplus.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Impact of an Imposed Maximum Price
on the Total Surplus of the Market



A governmentimposed maximum
price is a price below
equilibrium, designed
to protect consumers.
At a maximum price of
$4, the surplus of the
first two consumers
expands as the surplus
of the first two
producers drops.
Surpluses for the third and fourth lawns are lost entirely,
so the total market value decreases.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Impact of an Imposed Maximum Price
on the Total Surplus of the Market



The third lawn cut would
generate a net benefit of $10.
The maximum price
of $4 prevents
some beneficial
transactions.
For example, the
third consumer is
willing to pay $16 to
have his lawn cut,
and the third
producer is willing
to cut it for $6.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Impact of an Imposed Minimum Price
on the Total Surplus of the Market


A
price floor turns consumer
surplus into producer surplus.
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
A government-imposed
minimum price is a
price above
equilibrium. It benefits
some producers but
lowers the total value of
the market.
The surplus of the first
two producers expands
as the surplus of the first
two consumers
disappears. Surpluses
for the third and fourth
lawns are lost entirely.
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Impact of an Imposed Minimum Price
on the Total Surplus of the Market



The third lawn cut would
generate a net benefit of $10.
The minimum price
of $19 prevents
some beneficial
transactions.
For example, the
third producer is
willing to cut lawns
at $6 per lawn, and
the third consumer
is willing to pay $16
for the cut.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Government Intervention:
Restricting Quantity

Licensing programs place limits on
the number of producers in a given
market.

These programs may be intended to
protect consumers, but instead
create winners and losers and
prevent mutually beneficial
transactions from taking place.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Market Effects of Taxi
Medallions

Initially, the market for
taxis is in equilibrium at
a price of $3 per mile
and a quantity of
10,000 miles per day
(100 miles per taxi).

A medallion policy fixes
the number of taxis at
80 and increases the
price to $3.60.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Winners and Losers From Medallions

The medallion policy
reduces both consumer
surplus and producer
surplus.

Riders willing to pay
between $3.00 and
$3.60 per mile for taxi
service are prevented
from executing
mutually beneficial
transactions.

The first 80 taxi drivers
that obtain medallions
from the city for free
are the winners of the
medallion policy.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Import Restrictions

With free trade,
equilibrium in the sugar
market occurs at 12
cents per pound and
360 million pounds
(point i ).

Domestic producers do
not participate in the
market since they must
receive more than 26
cents to begin
producing (point m).
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Import Restrictions

A ban on imports of
sugar brings
equilibrium to point d.

The ban creates
domestic producer
surplus, but the gain by
domestic producers is
less than the loss to
domestic consumers.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillovers and Market Inefficiency

When there are spillover costs, the
market equilibrium will be inefficient
and government intervention may be
beneficial.
Spillover PRINCIPLE
For some goods, the costs or benefits associated
with the good are not confined to the person or
organization that decides how much of the good to
produce or consume.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Spillovers Costs

Each ton of cardboard
generates 5 gallons of
waste at a cost of $2
per gallon. Then, the
pollution cost per ton
of cardboard equals
$10.

When 50 tons of
cardboard are
produced, the pollution
cost equals $500.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Tradeoffs From Producing Less



When production drops
to 40 tons, consumer
and producer surplus
decline.
The reduction in
cardboard production
reduces producer and
consumer surplus, but
also reduces the cost
of pollution.
Since the savings from pollution (blue square) are
greater than the loss of surplus (triangle), output
reduction is good news.
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
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Determining the Optimal Amount of
Pollution

To decide by how much to reduce cardboard production
to coincide with the socially efficient amount, we can
use the marginal principle.
Marginal PRINCIPLE
Increase the level of an activity if its marginal benefit
exceeds its marginal cost, but reduce the level if the
marginal cost exceeds the marginal benefit. If
possible, pick the level at which the marginal benefit
equals the marginal cost.

Marginal benefit: pollution savings per additional ton.

Marginal cost: loss of consumer and producer surplus
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per additional ton of cardboard produced.
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Tradeoffs From Producing Less

The marginal cost of cutting
production from 40 to 39 tons
equals $7.
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e

The vertical distance
between supply and
demand at a given
quantity shows the
marginal cost of reducing
output, or loss of surplus.

When output is reduced
from 40 to 39 tons, the
loss of consumer surplus
equals $5 ($35-$30), and
the loss of producer
surplus equals $2 ($30 $28).
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Finding the Socially Optimal Amount
of Output

When the vertical
distance between supply
and demand at a given
quantity equals the $10
savings from pollution,
the quantity of cardboard
is optimal.

At 36 tons of cardboard,
marginal benefit equals
marginal cost and the
quantity of cardboard is
socially optimal.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Market Effects of a Pollution Tax



The tax forces firms to bear
the full cost of production,
including the cost of pollution.
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
A pollution tax of $2 per
gallon of waste increases
the marginal cost of
producing cardboard by
$10 ($2 x 5 gallons per
ton).
The pollution tax shifts
the supply curve up by
$10, and the market
settles in equilibrium at
a price of $37 and 36
tons of cardboard.
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