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MB MC
MB MC
Learning Objectives
1.
2.
3.
4.
Define efficiency Analyze how surplus and efficiency are affected by policies Examine the ways taxes affect efficiency and economic surplus SKIP MC pricing of public services
Slide 2
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A standard market demand supply equilibrium is Pareto Efficient. Whenever the market is out of equilibrium it is possible to construct exchanges that will help some without harming others. Consider the market for milk. Suppose the current price of milk is $1/gallon. Sellers offer 2000 gallons/day
Slide 4
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Price ($/gallon)
2.00
1.50 1.00 .50
If P = $1 then QS = 2,000 gallons/day. Excess Demand of 2,000 gallons a day. At 2,000 gallons the consumer is willing to pay $2 and the MC = $1
D
1 2 3 4 5
Slide 5
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How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction Supply Constrained
Suppose the seller offers an additional gallon for $1.25. If the buyer pays $1.25 for an extra gallon, producer is $.25 better off, and the consumer is $.75 better off, or economic surplus increases by $1.00 D At $1, the market is not efficient
S
2.50
Price ($/gallon)
2.00
1.50 1.25 1.00 .50
Slide 6
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S
2.50
Demand Constrained
If P = $2 then Ex-Ss= 2,000 gallons/day Additional output costs only $1; Marginal buyer willing to pay $2. If the seller sells one extra gallon at $1.75, the buyer gains an economic surplus of D $0.25 and the seller gains an economic surplus of $0.75
Slide 7
Price ($/gallon)
2.00
1.75 1.50 1.00 .50
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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 in equilibrium will the economic surplus be maximized.
Slide 8
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Slide 9
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Efficiency is an important goal because it allows for maximum economic surplus (implying maximum resources to do other things), assuming peoples incomes and attributes remain at their current levels. Markets, by themselves, cannot change the distribution of income and automatically make it more equitable.
Slide 10
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Price Ceilings: Do They Help the Poor? Example: A Price Ceiling for Home Heating Oil The Mid-east oil crisis in the late 1970s doubled the price of home heating oil. Concern over the hardship to poor families, especially in the northern states, the government imposed a price ceiling in the market for home heating oil.
Slide 11
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Without price controls: Equilibrium Price = $1.40 Consumer surplus = (1/2)(3,000)(.6) = $900/day Producer surplus = (1/2)(3,000)(.6) = 900/day Economic surplus = $1,800/day
Slide 12
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Producer surplus = (1/2)(1,000)(.20) = $100/day With price controls: Economic surplus = $1,000 or a loss of $800/day
Slide 13
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The reduction in economic surplus of $800 is likely to be an underestimate of the waste caused by the price ceiling because:
The model assumes that consumers who value oil the most (MB above $1.80) receive the product when it is being rationed. In reality however, anyone willing to pay more than $1 can and will buy oil. Consumers take costly actions to enhance their chances of being served (like arriving early to be in the front of the line); and yet when all consumers incur the higher cost, no one is likely to get any more oil than before.
Slide 14
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Question
What program could be used to help the poor get heating oil that would be more efficient than a price ceiling? Give them higher incomes with which to buy heating oil. Lump sum transfers are often better (leads to less resource waste) than fixing prices that change marginal costs and benefits.
Slide 15
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R
P
P
With price ceiling = $1.00 the economic surplus is 1,000/day R = economic surplus of rich P = economic surplus of poor
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Without price controls & with income transfers economic surplus is $1,800/day; R & P have the same share and a much larger economic surplus
Slide 16
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Assume a small nation imports all its bread at the world price of $2.00; no bread is produced domestically.
Chapter 7: Efficiency and Exchange Slide 17
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5.00
4.00
3.00
$4m
World price = $2.00
1.00
D
2 4 6 8 Quantity (millions of loaves/month
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
MB MC
Slide 19
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5.00
4.00
3.00
$4m $5m
1.00
$1m
S
Domestic price with subsidy
D
2 4 6 8
Slide 20
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Price Subsidies
How could we provide assistance to low income consumers more efficiently? Again, giving incomes to low income families to buy bread would work better. Given that bread subsidies primarily benefit the poor and are financed by taxing the rich, the poor probably come out ahead. But we could accomplish the same objective with less waste using income transfers rather than a price subsidy.
Slide 21
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First-Come, First-Served Policies In 1978 airlines abandoned their first come first served policy of serving overbooked flights. Instead they started offering compensation to volunteers who were willing to wait for the next flight. How is the latter policy an improvement?
Slide 22
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Suppose 37 people show up for a flight with only 33 seats. The demand curve for remaining on the flight is given on the next graph. Assume that the highest bidder would pay $60 not to miss the flight; the next highest reservation price is $59; the next $58 and so on until the 37th person will be willing to pay $24. The average reservation price is $(60 + 59 + 58 + + 24)/37 = $42 Assume people get randomly bumped off under a FCFS policy. So consumers surplus lost = $42x4 = $168
Slide 23
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Compensation Policy
Suppose airlines decide to provide compensation to ticket holders if they are bumped off a flight. Assume that they conduct auctions where they offer cash compensation in $1 increments.. For $24, the person with the lowest RP will agree to get bumped off the flight; for $25, two people will agree to stay back and so on, until for $27 the airline will have the necessary 4 takers. The compensation total of $27x4 = $108 is a transfer from the producers to the consumers and hence cancel each other. Consumers surplus lost = $27 + $26 + $25 + $24 = $102; a $66 saving on economic surplus over the FCFS policy.
Chapter 7: Efficiency and Exchange Slide 24
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24
33
37
Seats
Slide 25
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$6
$96
37
Seats
33
Slide 26
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Why offer compensation when the cost of firstcome, first-served to the seller is zero? Because with increased efficiency the total size of the pie is bigger and so everyone can have a bigger slice. The airline can offer compensation to elicit volunteers; they can recover their cost with slightly higher prices. Travelers are willing to pay slightly higher prices in return for a promise of not to be involuntarily bumped without compensation.
Chapter 7: Efficiency and Exchange Slide 27
MB MC
Who Pays A Tax Imposed On Sellers of a Good? For downward sloping demand curves and upward sloping supply curves, the buyer and the seller share the burden of the tax. All else remaining constant, the greater the elasticity of supply, the smaller the share of the burden on the sellers.
Slide 28
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With a tax of $1/lb MC increases by $1/lb Supply shifts up by $1 P = $3.50; Q = 2.5 million Consumers and producers share the burden of the tax equally Producers receive $2.50/lb D Consumers pay $3.50/lb
2.5 Quantity (millions of pounds/month)
Slide 29
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Who Pays A Tax Imposed On Consumers of a Good? For downward sloping demand curves and upward sloping supply curves, the buyer and the seller share the burden of the tax. All else remaining constant, the greater the elasticity of demand, the smaller the share of the burden on the buyers. Bottomline: It does not matter who the tax is assessed on.
Chapter 7: Efficiency and Exchange Slide 30
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Given sufficient time, in many markets additional inputs required to produce one extra unit of a good can be acquired at a constant cost. The long run supply curves in these markets are horizontal straight lines. A tax imposed on the seller will be entirely transferred to the buyer. The same is true is demand is perfectly inelastic.
Chapter 7: Efficiency and Exchange Slide 31
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The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply
Assume a tax levy of $100 tax/car
Price ($/car)
$20,100 $20,000
S + $100 S
D
1.9 2.0
Supply shifts to $20,100 The burden of the tax falls entirely on the consumer
Slide 32
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Slide 33
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D
1 2 3 4 5 2.5 Quantity (millions of pounds/month)
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 34
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Deadweight Loss
The reduction in total economic surplus that results from the adoption of a policy
Slide 35
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Taxes reduce output irrespective of who legally pays the tax buyer or the seller. wTOTAL is the wage inclusive if taxes; wNET is wages net of taxes. Producers surplus is area P*; Consumers surplus is Q*; Government Tax collection is area T. Triangle DL is the deadweight loss. Buyers and Sellers share the cost of the tax
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Clearly, no taxes is not good because we would then have no public amenities at all. So the question is how to determine the economic feasibility of a tax? The main problem with a tax is that it makes people pursue too little of the activity. So taxes cause smaller deadweight loss in markets where the equilibrium quantity is not highly sensitive to production costs.
Chapter 7: Efficiency and Exchange Slide 37
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Price ($/unit)
2.00 1.60
D1
D2
19 24 Quantity (units/day)
21 24 Quantity (units/day)
The smaller the elasticity of demand, the Smaller the deadweight loss from a tax
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 38
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2.00 1.65
57 72 Quantity (units/day)
63 72 Quantity (units/day)
The smaller the elasticity of supply, the smaller the deadweight loss from a tax
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Slide 39
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The deadweight loss from a tax imposed on a good whose supply is perfectly inelastic will be zero. This explains why economists favor taxes on land. A tax on a negative externality will actually raise economic surplus while at the same time provide tax resources for useful public services.
Slide 40
End of Chapter
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