© pearson education, 2005 efficiency and markets lubs1940: topic 3

© Pearson Education, 2005

Efficiency and Markets

LUBS1940: Topic 3


Objectives

After studying this topic, you will able to: Define efficiency

Distinguish between value and price and define consumer surplus

Distinguish between cost and price and define producer surplus

Explain the conditions under which markets move resources to their highest-valued uses and the sources of inefficiency in our economy

Explain the main ideas about fairness and evaluate claims that markets result in unfair outcomes {Self-learning}

Explain how housing markets work and how price ceilings create housing shortages and inefficiency {Self-learning}

Explain how labour markets work and how minimum wage laws create unemployment and inefficiency

Explain the effects of a tax

Explain why farm prices and farm revenues fluctuate and how subsidies, production quotas and price supports influence farm production, costs and prices

Explain how markets for illegal goods work {Self-learning}


Efficiency and Social Interest

Allocative efficiency is one aspect of the social interest and the aspect about which economists have most to say.

Resources are allocated efficiently when it is not possible to produce more of a good or service without giving up some other good or service that is valued more highly.

Efficiency is based on value and people’s preferences determine value.



Marginal BenefitMarginal benefit is the benefit a person receives from consuming one more unit of a good or service.

We can measure the marginal benefit from a good or service by the pound value of other goods and services that a person is willing to give up to get one more unit of it.

Marginal CostMarginal cost is the opportunity cost of producing one more unit of a good or service. The measure of marginal cost is the value of the best alternative forgone to obtain the last unit of the good.

We can measure the marginal cost of a good or service by the pound value of other goods and services that a person is must give up to get one more unit of it.


Efficiency and InefficiencyIf the marginal benefit from a good exceeds its marginal cost, producing and consuming more of the good uses resources more efficiently.

If the marginal cost of a good exceeds its marginal benefit, producing and consuming less of the good uses resources more efficiently.

If the marginal cost of a good equals its marginal benefit, resources are being use efficiently.



Cost, Price and Producer Surplus

Consumer SurplusConsumer surplus is the value of a good minus the price paid for it, summed over the quantity bought.

It is measured by the area under the demand curve and above the price paid, up to the quantity bought.

Producer SurplusProducer surplus is the price of a good minus the marginal cost of producing it, summed over the quantity sold.

Producer surplus is measured by the area below the price and above the supply curve, up to the quantity sold.


Value, Price and Consumer Surplus

Consumer Surplus

The consumer surplus on the 10th slice is the £1.20 that the consumer is willing to pay minus the £1.00 that she does pay, which is £0.20 a slice.


Cost, Price and Producer Surplus

Producer Surplus

The producer surplus on the 50th pizza is the £10 that the producer receives minus the £8 that it cost to produce, which is £2 a pizza.


Is the Competitive Market Efficient?

Efficiency of Competitive Equilibrium

The figure shows that a competitive market creates an efficient allocation of resources at equilibrium.

At the equilibrium quantity, the sum of consumer and producer surplus is maximized.



The marginal benefit of the entire society is marginal social benefit.

The marginal cost to the entire society is marginal social cost.

At the equilibrium quantity, marginal social benefit equals marginal social cost, so it is the efficient quantity.

The sum of consumer.



The Invisible Hand

Adam Smith’s “invisible hand” idea in the Wealth of Nations implied that competitive markets send resources to their highest valued use in society.

Consumers and producers pursue their own self-interest and interact in markets.

Market transactions generate an efficient—highest valued—use of resources.


Obstacles to Efficiency

Markets are not always efficient and the obstacles to efficiency are:

Price ceilings and price floors {This Topic}Taxes, subsidies and quotas {This Topic}Monopoly {Topic 5}External costs and external benefits {Topic 8}Public goods and common resources {Topic 8}




Underproduction and Overproduction

Obstacles to efficiency lead to underproduction or overproduction and create a deadweight loss—a decrease in consumer and producer surplus.


As more people compete for scarce land, house prices and rents rise. {Self-Learning}

As new technologies replace low-skilled labour, the demand for low-skilled workers falls. {Self-Learning}

Can governments control prices and wages?

How do taxes affect prices and quantities and who pays the tax: the buyer or the seller?

How are farm prices and incomes affected by fluctuations in harvests?

What happens in a market when trading a good is illegal? {Self-Learning}

Turbulent Times


The Labour Market and Minimum Wage

A Minimum WageA price floor is a regulation that makes it illegal to trade at a price lower than a specified level.

When a price floor is applied to labour markets, it is called a minimum wage.

A minimum wage set below the equilibrium wage rate has no effect on how the market works.

A minimum wage set above the equilibrium wage rate has powerful effects.

If the minimum wage is set above the equilibrium wage rate:

1. The quantity of labour supplied by workers exceeds the quantity demanded by employers.

2. There is a surplus of labour.Employers cannot be forced to hire more labour than they wish at the legal wage rate.

Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemployment.


The Labour Market and Minimum Wage

A minimum wage decreases the quantity of labour employed,

shrinks the workers’ surplus and the firms’ surplus by using resources in job search activity,

and creates a deadweight loss.


Taxes

Who really pays these taxes?

You’re going to discover that it isn’t obvious who pays a tax and that lawmakers don’t decide who will pay!

Tax Incidence

Tax incidence is the division of the burden of a tax between the buyer and the seller.


Taxes

A Tax on Sellers

The tax changes the equilibrium price and quantity.

The quantity decreases.

The price paid by the buyer rises to €4 a pack and the price received by the seller falls to €2.50 a pack.

So buyers pay €1 of the tax.

Sellers pay the remaining 50¢.


Taxes

A Tax on Buyers

The quantity decreases.

The price received by the seller falls to €2.50 a pack and the price paid by the buyer rises to €4 a pack.

So, exactly as before when the seller was taxed:

The buyer pays €1 of the tax.

The seller pays the other 50¢ of the tax.


Taxes

Tax Division and Elasticity of DemandTo see the effect of the elasticity of demand on the division of the tax, we look at two extremes:

Perfectly inelastic demand: buyers pay Perfectly elastic demand: sellers pay

The more inelastic the demand, the larger is the buyers’ share of the tax.

Tax Division and Elasticity of SupplyTo see the effect of the elasticity of supply on the division of the tax payment, we again look at two extreme cases.

Perfectly inelastic supply: sellers pay Perfectly elastic supply: buyers pay

The more elastic the supply, the larger is the buyers’ share of the tax.


Taxes

Perfectly Inelastic Demand

In this figure, demand is perfectly inelastic—the demand curve is vertical.

When a tax is imposed on this good, buyers pay the entire tax.


Taxes

Perfectly Inelastic Supply

In this figure, supply is perfectly inelastic—the supply curve is vertical.

When a tax is imposed on this good, sellers pay the entire tax.


Taxes

Taxes in Practice

Taxes usually are levied on goods and services with an inelastic demand or an inelastic supply.

Alcohol, tobacco and petrol have inelastic demand, so the buyers of these items pay most the tax on them.

Labour has a low elasticity of supply, so the seller—the worker—pays most of the income tax and most of the social security contribution.


Taxes

Taxes and Efficiency

The tax revenue takes part of the consumer surplus and producer surplus.

The decreased quantity creates a deadweight loss.


Intervening in Agricultural Markets

Fluctuations in the weather bring big fluctuations in farm output.

How do changes in farm output affect the prices of farm products and farm revenues?

How might farmers be helped by intervention in markets for farm products?


Government Intervention

Intervention in markets for farm products takes three main forms:

Subsidies: A subsidy is a payment made by the government to a producer.Production quotas: A production quota is an upper limit to the quantity of a good that may be produced during a specified period.Price supports: A price support is a government guaranteed minimum price of a good.



Subsidies

The equilibrium quantity increases and the farmers’ cost of producing wheat rises to €50 a tonne .


The equilibrium price falls to €30 a tonne.

The farmer receives more for each tonne produced— €50 a tonne.


Production Quotas

A production quota limits total production to 40 million tonnes a year.


The equilibrium quantity decreases to this amount.

The price rises to €50 a tonne and marginal cost falls to €20 a tonne.


Price Supports

To maintain the price support, the government buys the surplus and the total government subsidy is €540 million a year.


Revenue from the market is €270 million a year.

If the government does not buy the surplus, the price returns to €130 a tonne.

© pearson education, 2005 efficiency and markets lubs1940: topic 3

Documents

marginal cost marginal

measure of marginal

good equals

good uses resources

opportunity cost

price ceilings

pound value

objectives pearson education