1 efficiency §principles of microeconomic theory, eco 284 §john eastwood §cba 213 §523-7353...
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1
EfficiencyPrinciples of
Microeconomic Theory, ECO 284
John EastwoodCBA 213523-7353e-mail address:
2
Learning Objectives
Distinguish between value and price
Define consumer surplus
Distinguish between cost and price
Define producer surplus
Explain why consumer surplus and producer surplus are the gains from trade
3
Learning Objectives (cont.)
Explain why competitive markets move resources to their highest-valued uses
Explain the sources of inefficiency in our economy
4
Learning Objectives
Distinguish between value and price
Define consumer surplus
Distinguish between cost and price
Define producer surplus
Explain why consumer surplus and producer surplus are the gains from trade
5
Efficiency: A Refresher
According to economists, efficiency means the resources have been used to produce the goods and services that people value the most.
6
Efficiency: A Refresher
Marginal benefit is the benefit that a person receives from consuming one more unit of a good or service measured as the maximum amount that a person
is willing to give up for one additional unit
Principle of decreasing marginal benefit marginal benefit decreases as consumption
increases
7
Efficiency: A Refresher
Marginal cost is the opportunity cost of producing one more unit of a good or service. measured as the value of the best alternative
foregone
Principle of increasing marginal cost marginal cost increases as the quantity produced
increases
8
The Efficient Quantity of Pizza
Quantity (thousands of pizzas per day)
Mar
gina
l cos
t and
mar
gina
l ben
efit
(dol
lars
wor
th o
f go
ods
and
serv
ices
)
0 5 10 15 20
5
10
15
20
25
10
The Efficient Quantity of Pizza
0 5 10 15 20
5
10
15
20
25
Quantity (thousands of pizzas per day)
Mar
gina
l cos
t and
mar
gina
l ben
efit
(dol
lars
wor
th o
f go
ods
and
serv
ices
)
MB
MC
11
The Efficient Quantity of Pizza
0 5 10 15 20
5
10
15
20
25
Quantity (thousands of pizzas per day)
Mar
gina
l cos
t and
mar
gina
l ben
efit
(dol
lars
wor
th o
f go
ods
and
serv
ices
)
MB
MC
Pizza valued morehighly than it costs:Increase production
Pizza costs morethan it is valued:Decrease production
12
The Efficient Quantity of Pizza
0 5 10 15 20
5
10
15
20
25
Quantity (thousands of pizzas per day)
Mar
gina
l cos
t and
mar
gina
l ben
efit
(dol
lars
wor
th o
f go
ods
and
serv
ices
)
MB
MCEfficient quantityof pizza
14
Learning Objectives
Distinguish between value and price
Define consumer surplus
Distinguish between cost and price
Define producer surplus
Explain why consumer surplus and producer surplus are the gains from trade
15
Value, Price, and Consumer Surplus
What is meant by “Value”? Value of an item is the same thing as its
marginal benefit
Marginal benefit - the maximum price people
are willing to pay for an additional unit
Willingness determines demand
16
Demand, Willingness to Pay,and Marginal Benefit
Quantity (thousands of pizzas per day)0 5 10 15 20
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
Price determinesquantity demanded
D
17
Demand, Willingness to Pay,and Marginal Benefit
Quantity (thousands of pizzas per day)0 5 10 15 20
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
Price determinesquantity demanded
Quantity of pizzasdemanded at $15a pizza D
18
Demand, Willingness to Pay,and Marginal Benefit
Quantity (thousands of pizzas per day)0 5 10 15 20
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
Quantity determineswillingness to pay
D
19
Demand, Willingness to Pay,and Marginal Benefit
Quantity (thousands of pizzas per day)0 5 10 15 20
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
D=MB
Maximum pricewillingly paid for the 10,000th pizza
Quantity determineswillingness to pay
20
Consumer Surplus
Consumer surplus is the value of a good minus the price paid for it. if a person buys something for less than they
are willing to pay for it, a consumer surplus exists
21
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
D
22
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
Marketprice
D
23
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
Marketprice
Amountpaid D
24
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
Marketprice
Amountpaid
Lisa’s consumersurplus from the10th pizza
D
25
A Consumer’s Demand and Consumer Surplus
Quantity (slices of pizzas per week)0 10 20 30 40
0.50
1.00
1.50
2.00
2.50
Pric
e (d
olla
rs p
er s
lice
)
Marketprice
Amountpaid
Lisa’s consumersurplus from the10th pizza
Consumersurplus
D
26
Demand Curves Measure Willingness-to-PayThe Demand Price represents the value of the next
unit to consumers.The area under the demand curve to the left of a
quantity, Q, equals the total value of that level of output to consumers.
It is the maximum amount they would be willing to pay for Q.
27
Consumers’ Surplus
Consumers’ Surplus is the difference between consumers’ maximum willingness-to-pay and the amount they actually paid.
The amount actually paid equals TR=PQ.Graphically, Consumers’ Surplus (CS) is the area
under the demand curve above Pe.
28
Computing CS
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
Demand
Supply
Quantity (bbl./day)
Pri
ce (
$/b
bl.
) CS is the area under the demand curve above Pe =$10.
Area (of a right triangle) =(1/2)bh
CS= CS=
29
Computing CS
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
Demand
Supply
Quantity (bbl./day)
Pri
ce (
$/b
bl.
) CS is the area under the demand curve above Pe =$10.
Area (of a right triangle) =(0.5)bh
CS=(0.5)10(10) CS=50 $/day
30
Learning Objectives
Distinguish between value and price
Define consumer surplus
Distinguish between cost and price
Define producer surplus
Explain why consumer surplus and producer surplus are the gains from trade
31
Cost, Price, and Producer Surplus
Cost vs. Price Cost is what the producer gives up. Price is what the producer receives.
Marginal cost is the cost of producing one more unit.
32
Supply, Minimum Supply-Price, and Marginal Cost
Quantity (thousands of pizzas per day)0 50 100 150 200
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S
Price determinesquantity supplied.
33Quantity (thousands of pizzas per day)
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
Price determinesquantity supplied.
S
Quantity of pizzassupplied at $15a pizza
0 50 100 150 200
Supply, Minimum Supply-Price, and Marginal Cost
34Quantity (thousands of pizzas per day)
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S
0 50 100 150 200
Quantity determinesminimum supply-price.
Supply, Minimum Supply-Price, and Marginal Cost
35Quantity (thousands of pizzas per day)
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
Minimum supply-price for 10,000thpizza Quantity determines
minimum supply-price.
S=MC
0 50 100 150 200
Supply, Minimum Supply-Price, and Marginal Cost
36
Learning Objectives
Distinguish between value and price
Define consumer surplus
Distinguish between cost and price
Define producer surplus
Explain why consumer surplus and producer surplus are the gains from trade
37
Producer Surplus
Producer surplus is the value of a good minus the opportunity cost of producing it. if a firm sells something for more that it costs
to produce, a producer surplus exists
38
A Producers Supplyand Producer Surplus
Quantity (pizzas per day)
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
Price determinesquantity supplied
S
0 50 100 150 200
39
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S
Quantity (pizzas per day)
Marketprice
0 50 100 150 200
A Producers Supplyand Producer Surplus
40
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S
Quantity (pizzas per day)
Marketprice
Costof Production
Max’s producersurplus from the 50th pizza
0 50 100 150 200
A Producers Supplyand Producer Surplus
41
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S
Quantity (pizzas per day)
Marketprice
Costof Production
Max’s producersurplus from the 50th pizza
Producersurplus
0 50 100 150 200
A Producers Supplyand Producer Surplus
42
5
10
15
20
25
Pric
e (d
olla
rs p
er p
izza
)
S
Quantity (pizzas per day)
Marketprice
Costof Production
Producer surplusequals profit
0 50 100 150 200
A Producers Supplyand Producer Surplus
43
Supply Curves Measure Costs
Under competitive conditions, the supply curve represents the cost of producing the next unit.
44
Producers’ Surplus
. . . is the difference between the amount producers receive, and the minimum amount they would have been willing to accept.
Producers receive TR =PQ.Graphically, Producers’ Surplus (PS) is the area
under the price line, and above Supply.
45
Computing PS
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
Demand
Supply
Quantity (bbl./day)
Pri
ce (
$/b
bl.
) Producers’ Surplus (PS) is the area under the Pe, and above Supply.
Area =(0.5)bh PS= PS= CS+PS=
46
Computing PS
0
5
10
15
20
25
0 2 4 6 8 10 12 14 16 18 20
Demand
Supply
Quantity (bbl./day)
Pri
ce (
$/b
bl.
) Producers’ Surplus (PS) is the area under the Pe, and above Supply.
Area =(0.5)bh PS=(0.5)10(5) PS=25 $/day
CS+PS=75 $/day
47
Learning Objectives
Distinguish between value and price
Define consumer surplus
Distinguish between cost and price
Define producer surplus
Explain why consumer surplus and producer surplus are the gains from trade
48
Is the CompetitiveMarket Efficient?
Recall Supply and demand will force the price toward
the equilibrium price
Question: Is this the
efficient quantity of pizza?
49
An Efficient Market for Pizza
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S Marginal cost--opportunity cost--of pizza
Marginal benefit--value--of pizza
Efficient quantityof pizzas
5
10
15
20
25
D
50
Is the CompetitiveMarket Efficient?
At Competitive Equilibrium Resources are being used efficiently The sum of consumer surplus and producer
surplus is maximized
51Quantity (thousands of pizzas per day)
0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
An Efficient Market for Pizza
52Quantity (thousands of pizzas per day)
0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
Producersurplus
5
10
15
20
25
D
An Efficient Market for Pizza
53Quantity (thousands of pizzas per day)
0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
Producersurplus
Consumersurplus
5
10
15
20
25
D
An Efficient Market for Pizza
54
At Pe, both surpluses are greatest.
At a price below Pe, fewer units are sold. CS may be larger, but PS is smaller. Some surplus is transferred from producers to
consumers. Some surplus is lost.
At a price above Pe, fewer units are sold. PS may be larger, but CS is smaller. Some surplus is transferred from producers to
consumers. Some surplus is lost.
55
Learning Objectives (cont.)
Explain why competitive markets move resources to their highest-valued uses
Explain the sources of inefficiency in our economy
56
The Invisible Hand
Adam Smith - Wealth of Nations in 1776 Participants in a competitive market is “led by
an invisible hand to promote an end (the
efficient use of resources) which was not part
of his intention.”
57
Learning Objectives (cont.)
Explain why competitive markets move resources to their highest-valued uses
Explain the sources of inefficiency in our economy
58
Sources of Inefficiency
Price ceilings and floors
Taxes, subsidies, and quotas
Monopoly
Public goods
External costs and benefits
These lead to underproduction or overproduction.
59
Sources of Inefficiency
Deadweight Loss The decrease in consumer and producer surplus
that results from an inefficient allocation of resources
60
Underproduction
Quantity (thousands of pizzas per day)0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
61Quantity (thousands of pizzas per day)
0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25Deadweightloss
D
Underproduction
62Quantity (thousands of pizzas per day)
0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
S
5
10
15
20
25
D
Overproduction
63Quantity (thousands of pizzas per day)
0 5 10 15 20
Pric
e (d
olla
rs p
er p
izza
)
D
S
5
10
15
20
25
Deadweightloss
Overproduction
64
Deadweight Loss
The area lost is known as a “deadweight loss” because it benefits no one.
Taxes produce deadweight losses when they reduce the quantity traded.
Price controls produce deadweight losses.
65
Deadweight Loss -- Price Ceiling
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyCeiling
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Area=0.5bh=0.5(4)6
Loss = $__/day
w/o ceiling
CS = $__/day
PS = $__/day
CS+PS = $__/day
With ceiling
CS = $__/day
PS = $__/day
CS+PS = $__/day
66
Deadweight Loss -- Price Ceiling
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyCeiling
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Area=0.5bh=0.5(4)6
Loss = $12/day
w/o ceiling
CS = $50/day
PS = $25/day
CS+PS = $75/day
With ceiling
CS = $54/day
PS = $ 9/day
CS+PS = $63/day
67
Deadweight Loss
Taxes produce deadweight losses when they reduce the quantity traded. Remove the price ceiling Add a $3/bbl tax on oil What is the deadweight loss?
68
Unit Tax as a Decrease in Supply
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyS+Tax
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)Qn = __ bbl./day
Pgross = $__/bbl.
Tax, T = $__/bbl.
Pnet = $__/bbl.Buyers pay Pgross
Firms keep Pnet
Tax rev. = $_/bbl x _ bbl/day)$__/day
69
Unit Tax as a Decrease in Supply
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyS+Tax
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)Qn = 8 bbl./day
Pgross = $12/bbl.
Tax, T = $3/bbl.
Pnet = $9/bbl.Buyers pay Pgross
Firms keep Pnet
Tax rev. = $3/bbl x 8 bbl/day)$24/day Who pays?
70
Unit Tax -- Deadweight Loss
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyS+Tax
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Area=0.5bh=0.5(2)3
Loss = $__/day
CS was = $50/day
PS was = $25/day
CS+PS = $75/day
Tax rev = $24/day
CS = $__/day
PS = $__/day
Tx+CS+PS=$__/day
71
Unit Tax -- Deadweight Loss
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyS+Tax
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Area=0.5bh=0.5(2)3
Loss = $3/day
CS was = $50/day
PS was = $25/day
CS+PS = $75/day
Tax rev = $24/day
CS = $32/day
PS = $16/day
Tx+CS+PS=$72/day
72
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
Demand
Supply
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Compute CS & PS CS= area above
the Pe, and below Demand
PS= area under the Pe, and above Supply.
Area =0.5(b)h CS=
PS=
CS+PS
73
Compute CS & PS
0
5
10
15
20
25
0 2 4 6 8 10 12 14 16 18 20
Demand
Supply
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
CS= area above the Pe, and below Demand
PS= area under the Pe, and above Supply.
Area =0.5(b)h CS= 0.5(10)10 CS= $50/day PS= 0.5(10)5 PS= $25/day CS+PS=$75/day
74
Deadweight Loss -- Subsidy $__/bbl.
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyS-Subsidy
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Area=0.5bh=
Loss =CS =
PS =
Gov. pays the subsidy
Consumers gain or lose?
Producers gain or lose?
Taxpayers?Net benefit
75
Deadweight Loss -- Subsidy $6/bbl.
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyS-Subsidy
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Area=0.5bh=0.5(4)6
Loss = $12/dayCS = 0.5(14)14 = $98/day
PS = 0.5(7)14 = $49/day
Gov. pays the subsidy=($6/bbl)14bbl day = $84/day
Consumers gain = 98-50 = $48/day
Producers gain = 49 - 25 = $24/day
Taxpayers lose $84/day
Net benefit = 72 - 84 = -12
76
Output Restriction (or Quota)
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
Demand
Supply
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Output limit = 8 bbl./day
CS=
PS=
Consumers
Producers
Net Benefit =
77
Output Restriction (or Quota)
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
Demand
Supply
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Output limit = 8 bbl./day Area=0.5bh=0.5(2)3Loss = $3/day
CS = 0.5(8)8 = $32/day
PS=8(3)+0.5(8)4= $40/day
Consumers lose = 50 - 32 = $18/day
Producers gain = 40 - 25 = $15/day
Net Benefit =15-18=-$3
78
Price Floor -- $___/bbl.
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyFloor
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Floor only
CS =
PS =
Gov. pays
Consumers
Producers
Net Benefit =
79
Price Floor -- $12/bbl.
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyFloor
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Floor only
CS = 0.5(8)8 = $32/day
PS = 8(3)+0.5(8)4= $40/day
Consumers lose = 32 - 50 = -18 $/day
Producers gain = 40 - 25 = $15/day
Net Benefit =15-18=-3
WAIT! IF 14 BBL ARE MADE,
THEN . . .
80
Price Floor -- $___/bbl.
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyFloor
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Floor & Gov’t buy excess
CS =
PS =
Gov. pays
Consumers
Producers
Net Benefit =
81
Price Floor -- $12/bbl.
02468
101214161820
0 2 4 6 8 10 12 14 16 18 20
DemandSupplyFloor
Quantity (bbl./day)
Pri
ce (
$/b
bl.
)
Floor & Gov’t buy excess
CS = 0.5(8)8 = $32/day
PS = 0.5(7)14 = $49 /day
Gov. pays=(14-8)12
= $72 to buy 6 bbl/day;
cost to produce = $63
surplus not consumed
Consumers lose = 32 - 50 = -$18/day
Producers gain = 49 - 25 = $24/day
Net Benefit =24 - 18 - 72
Net Benefit = -$66
82
Which policy is “second best”?
Depends on ed and es
Party Quota Subsidy Floor
Consumer&Taxpayer
-18 -36 -90
Producer 15 24 24
Society -3 -12 -66