The Idealized Competitive Model

Weimer and Vining Ch.4 & 5

Objectives:

The model: The concept of a perfectly competitive economy

The virtues and limits of the competitive market model

Utility and “consumer behavior” The concept(s) of efficiency

– Indifference Maps– Pareto Optimality– Potential Pareto Optimality

Competitive Markets and Efficiency

Some Basic Concepts

Collective Action– What is it? Define it for a policy analyst.

How is collective action related to “public policy”?

What is the rationale for government intervention in private choice?

W&V approach: begins with the concept of the perfectly competitive economy.

The Rationale…

Consider the properties of idealized economies involving large numbers of profit maximizing firms and utility maximizing consumers.

Under certain assumptions, the self-motivated behaviors of these economic actors lead to patterns of consumption and production that are efficient*

Economists recognize several commonly occurring circumstances of private choice that violate the assumptions of the idealized model and interfere with efficiency in consumption or production

*efficient: it would not be possible to change the patterns in such a way, so as to make some person better off without making some other person worse off.

The Rationale…

These violations are called market failures. Traditional market failures, provide widely

accepted rationales for such public policies as the provision of goods and the regulation of markets by government agencies.

Is efficiency the only important social value?

Modeling Social Value

Policy analysts have a conception of the “good” that is to be pursued in policy– Derived from utility theory and individualism– Individuals assumed to define their own lives

Value is a function of an individual’s values, preferences, choices and outcomes -- a life.

Avoidance of paternalism

– Social value is the aggregation of individual values Differences from alternative definitions?

Modeling Social Value

The nature of models– Simplification, abstraction, essentials

The model of the competitive economy– Why use it?

Ideal-type of voluntary exchange Results in “efficient” outcomes

– No additional exchanges will lead to improvements for anyone without hurting someone else

– Hence, no additional voluntary trades will be made– Model indicates where efficiency is not achieved

The Competitive Market Model

Model components– Consumers, consumption and utility– Producers, production and pricing– Budgets and choices

The central idea is simple:– Given values (preferences), resources, and

technologies, how can society arrange things to produce the maximum value at least cost?

Modeling Consumer Behavior

Some key assumptions– People have identifiable (to them) bundles of

utilities, translatable into preferences– Ceteris paribus*, the greater the quantity of a good,

the greater the value to the consumer– But consumption in aggregate is subject to

diminishing marginal value Consumption of hamburgers Information and search costs Preservation of wilderness * All else being equal

Consumer Behavior, Continued

Consumers enter into market exchange with budgets made up of

Income -- selling labor (including ideas…) Endowments -- initial capital, savings, inheritance

– These are not assumed to be equal!

Consumers trade money for the things they value

Idealized competitive market assumes no significant market failure (externalities, market power, etc.)

Some Thought Experiments

What would you be “willing to pay” for– A loaf of really fresh bread– A front-row seat at the Beatles’ last concert

Prices people are willing to pay express trade-off they make– What are you willing to forego to get the good?

You give up the other things the money could have purchased.

Money is the “medium” of the trade-off.

Surprisingly, we usually get things for less than we’d have been willing to pay (why?!)

Price, Quantity and Value:The Essentials

Assuming no “price discrimination”, all consumers pay the marginal price -- P0

$(Price)

Q (Quantity)

P0

Marginal valuation schedule

Value to individual i

Q0= Quantity purchased at price P0

Q0

P1

Q1= Quantity purchased at price P1

Q1

Recalling the Basics of Consumer Demand…

Consumer demand is a measure of willingness to pay. consumers often value each additional unit consumed less that

previous units (i.e., the concept of diminishing marginal utility) Give me an example…

So, what is consumer surplus and how is it related to demand?

Consumer Values and Surpluses

When analyzing changes to a consumer optimum given changes in the market price of a particular commodity, we often speak of the consumer being better or worse off.

One method used to measure these welfare changes is through the use of a concept known as Consumer Surplus.

This method compares the value of each unit of a commodity consumed against the price of that commodity.

Stated differently, consumer surplus measures the difference between what is person is willing to pay for a commodity and the amount he/she actually is required to pay.

Assume a market price = $4.00/gal then, quantity demanded = to 6 gallons

the total value of consumption is $39.00 ($9 + 8 + 7 + 6 + 5 + 4).

Part of this value is given up in the form of total expenditure equal to $24.00 ($4 x 6gal) as shown by the gray-shaded area in the right diagram.

The difference of $15.00 ($39.00-$24.00) represents consumer surplus as shown by the cross-hatched colored bars in the right diagram.

Consumer Surplus These measures of total

expenditure and consumer surplus can be neatly defined as geometric areas below a given demand curve.

We can use this measures to quantify the welfare effects of a change in market price by examining the corresponding changes in consumer surplus.

Consumer Surplus: An Example

For example, suppose that the market price increases to $6.00 due to an increase in excise taxes.

At this higher price, the consumer would be willing to purchase only 4 units of this product.

In purchasing these 4 units, the consumer receives $30.00 worth of value ($9.00, $8.00, $7.00, $6.00) and spends $24.00 ($6.00 x 4 units).

What is the new level of consumer surplus?

Example, (cont.) By measuring the change in consumer surplus,

we can begin to quantify the change in consumer welfare from the increase in gasoline prices:

CS before = $15.00CS after    = $6.00ΔCS       = -$9.00

The $2.00 increase in the price of gasoline has led to a $9.00 reduction in consumer welfare.

Analyzing Effects of a Tax

P1 = P0 + Tax

$(Price)

Q (Quantity)

P0

Q0

P1

Q1

Size of tax

Reduction inConsumption

= Q0 - Q1

Tax Revenue

Lost RevenueTo producers

DeadweightLoss in Consumer Surplus

Remaining ConsumerSurplus

Status check…

Now, using the tools of indifference curve analysis, we can demonstrate that in increase in market price indeed makes the consumer worse off – Edgeworth Box

Recall that by measuring the changes in consumer surplus, we can define how much worse off the consumer has become - a useful empirical tool for policy analysis.

The Edgeworth Box: Indifference Mapping

For example, a trade such that these two individuals move to point 'R' in the diagram below would make person 'B' better-off with out harm to 'A'

Any trade that puts these two individuals into, or on the border of, the shaded area will make one or both individuals better off. This is known as a Pareto Improvement.

As long as any Pareto Improvements remain, an incentive for trade exists between these two agents.

An optimal allocation of commodities is determined by the concept of Pareto optimality.

A Pareto optimal allocation of commodities is that allocation where it is not possible to make one person better off without making any other person worse off.

Concepts of Efficiency Pareto Optimality:

– The strict criterion of efficiency is met when a system allocates resources in such a way that no further reallocation of goods can increase any individual's utility without diminishing the utility of others. A given policy is efficient in this strict sense if it increases the well-being of at least one individual without diminishing that of others.

The Kaldor-Hicks Criterion:– The Kaldor-Hicks criterion allows redistributions that

increase net welfare such that those who gain from the distribution could compensate those who lose, restoring the losers to their prior level of well-being, while the winners retain enough of their gains to be better-off than they would have been without the redistribution.

Competitive Markets and Efficiency

It can be demonstrated that an idealized competitive market (ICM) would maximize consumer (and producer) surplus such that any externally induced change will not be Pareto efficient

But many elements of the model change– Tastes and preferences– Technologies

The idea is that the ICM is always moving toward an efficient allocation of goods

Next Time Producer Behavior Producer Surplus Market Failures

Tutorial on consumer surplus: http://www.digitaleconomist.com/cs_tutorial.html

Discussion paper will be assigned this week, for next week.