ECON 111 Introductory Microeconomics Chapter 7 Lectures Notes PDF

ECON 111 Introductory Microeconomics Chapter 7: Welfare Economics: Evaluating Market Efficiency and Market Failure Instructor: Mumtaz Ahmad These notes are summaries o...

ECON 111 Introductory Microeconomics Chapter 7: Welfare Economics: Evaluating Market Efficiency and Market Failure Instructor: Mumtaz Ahmad These notes are summaries of the materials discussed in classes. They should be used as a complement to, rather than a substitute for, attending classes. Reproduction of the relevant materials in these notes as the answer to an exam question will not necessarily get you full marks for the question. Chapter 7 Welfare 1. Evaluating Public Policies Economics: 2. Measuring Economic Surplus Evaluating 3. Market Efficiency Market 4. Market Failure and Deadweight Efficiency and Loss 5. Beyond Economic Efficiency Market Failure Chapter 7 (1 of 6) Define and differentiate 1. Evaluating Public positive and Policies normative analysis 2. Measuring Economic Surplus Efficiency and Equity: how big is the 3. Market Efficiency economic pie and how 4. Market Failure and Deadweight Loss is it sliced 5. Beyond Economic Efficiency Positive versus Normative Policy Analysis Positive Analysis: Describes what is happening, explaining why, or predicting what will happen. ⮚ What is going to happen if we adopt this policy? ⮚ Objective analysis that describes and forecasts the effect of the policy. Normative Analysis: Prescribes what should happen, which involves value judgments. ⮚ Which is the better outcome, and what policy should the government adopt? ⮚ Each person reaches their own conclusion based on their 4  Positive Analysis: Normative Analysis: Minimum Minimum Wage Wage Question: What are the Question: Should minimum consequences of raising minimum wage be raised or not? Is the wage? policy worth enacting? Use the supply-and-demand Use your values to weigh the framework to forecast… benefits and the costs of the ⮚ the number of people who will policy: get a pay raise. ⮚ Do the gains to some people ⮚ how much their pay will increase. outweigh the losses to others? ⮚ how businesses’ profitability will ⮚ This answer will differ change. depending on who you ask ⮚ how many jobs employers will because people have eliminate due to higher wages. different values. 5 Efficiency: A way of evaluating policies We want a way to determine how a policy affects people’s welfare. ⮚ People’s happiness, well-being, or prosperity. Economic efficiency: An outcome is more economically efficient if it yields more economic surplus. RECALL economic surplus: The total benefits minus total costs flowing from a decision. ⮚ It measures how much a decision has improved your well-being. Efficiency outcome: The efficiency outcome yields the largest possible economic surplus. ⮚ Economic surplus measures the size of the economic pie. 6 ⮚ Efficiency outcome yields the largest economic pie. Efficiency and Equity: Assess the size of the economic pie, and how it’s sliced! Not everyone will be happy with an efficient outcome. ⮚ Economic efficiency merely assesses whether economic surplus rises overall. ⮚ Most policies help some people but harm others, and the people who are harmed will not be happy. Uber Example: The laws that allow Uber to operate in your city likely raise economic surplus because the benefits to Uber drivers and passengers outweigh the harm suffered by taxi drivers. ⮚ But the taxi drivers are still upset with this outcome. Efficient outcomes hold the potential to make everyone better off. ⮚ Those who benefit could compensate those who were harmed (rarely done in practice). 7 Chapter 7 (2 of 6) Define and differentiate positive and 1. Evaluating Public Policies normative analysis 2. Measuring Economic Surplus Efficiency and Equity: 3. Market Efficiency how big is the 4. Market Failure and economic pie and how Deadweight Loss is it sliced 5. Beyond Economic Efficiency  Key Definition (1 of 4) Diving into the Definition Shopping Scenario: You see a sweater you like so you try it on and Consumer surplus: The economic surplus you get from buying think about how much you are something. willing to pay for the sweater. ⮚ Suppose you are willing to pay Consumer surplus = marginal benefit – price $40. You check the price tag: $35 RECALL: Your marginal benefit is your willingness to pay for that item. ⮚ Yay! The price is below what you were willing to pay. Consumer surplus describes the gain from buying something at a price Consumer surplus = marginal benefit below the highest price you were – price willing to pay. Consumer surplus = $40 - $35 = $5 9  Consumer Surplus of Rihanna’s Song Pric e “Work” $3.2 Consumer surplus for a single 9 transaction: Suppose you are the 5th million person to $2 buy her song. Suppose you were willing to $0.7 pay up to $2 for the song. Your consumer 1 surplus is $0.71, the difference between $1.2 Pric your marginal benefit and the price: 9 e Consumer surplus for your unit = $2 – Total consumer $1.29 = $0.71surplus across all Demand ( = marginal transactions in the benefit) market is the triangular area under 5 10 Quantity (millions of the demand curve and million songs) above the price, $10 10 million. Consumer surplus and the Rational Rule for Buyers RECALL: the Rational Rule for Buyers says you should keep buying something until the marginal benefit of that last unit is equal to the price of that unit. Sock Scenario: Suppose you want to buy socks, and the price is $1.00 per pair. You are willing to pay… Buy it! The marginal benefit exceeds the price, and you get $2 of $3 for the first pair consumer surplus. $2 for the second pair Buy it! The marginal benefit exceeds the price, and you get $1 of consumer surplus. $1 for the third pair Buy it! The marginal benefit equals the price, and you don’t get any consumer surplus. Take-away: You earn consumer surplus on all but your last purchase. 11  Key Definition (2 of Diving into the Definition 4) Tutoring Scenario: The student you are Producer surplus: The economic tutoring asks for another hour of your surplus you get from selling time. What is the marginal cost of providing your services for another something. hour? Producer surplus = price – marginal ⮚ What do you give up if you spend cost another hour tutoring? You conclude you need at least $25 in return for this RECALL: Marginal cost is the extra hour. extra cost from one extra unit. The student offers to pay $35. Producer surplus describes the ⮚ Yay! The price is above what you were gain from selling something at a minimally willing to accept. price above the marginal cost Producer surplus = price – marginal cost you incur from producing that Producer surplus = $35 – $25 = $10 good or service. 12  Producer Surplus of Levi’s Jeans Pric Producer surplus for a single e transaction: Supply Suppose you are selling your 100th pair of ( = marginal jeans. The marginal cost of producing that cost) pair of jeans is $35, reflecting the additional material and labor costs. Your $50 Pric producer surplus is $15, the difference $1 e between the price and the marginal cost: $3 5 Producer surplus for this unit = $50 – 5 Total producer surplus $10 $35 = $15 across all transactions in the market is the triangular area under the 100 200 Quantity price and above the supply (pairs of curve, $4,000. jeans) 13 Producer surplus and the Rational Rule for Sellers RECALL: the Rational Rule for Sellers in a competitive market says you should keep selling until the marginal cost equals the price. Sock Scenario: Suppose you are selling socks, and the price is $1.00 per pair. You are willing to sell socks Sell it!for The a minimum price of… exceeds the marginal cost, and you get $0.75 of producer surplus. $0.25 for the first pair Sell it! The price exceeds the marginal cost, and you get $0.25 of producer surplus. Sell it! The price equals the marginal cost, and you don’t get any producer surplus. $0.75 for the second pair $1 for the third pair Take-away: You earn producer surplus on all but your last sale. 14  Key Definition (3 of Diving into the Definition 4) Voluntary exchange: Buyers and Sock Scenario Revisited: Recall the sellers exchange money for goods price of a pair of socks was $1.00. only if they both want to. For the first pair of socks… Consumer Perspective: Trade is a win-win situation that ⮚ Willing to pay $3 for the first pair. creates both consumer and producer surplus ⮚ Consumer surplus = $2 for first pair. (or at least neither is made worse off). Supplier Perspective: ⮚ Both buyers and sellers gain ⮚ Minimally willing to accept $0.25 for from trade. the first pair. Voluntary exchange does not ⮚ Producer surplus = $0.75 for first guarantee that buyers and sellers pair. share equally in the gains from Take-away: Buyers and sellers both trade. gain from this exchange! 15  Understanding economic surplus The economic surplus generated by a transaction is the sum of the consumer surplus enjoyed by the buyer and the producer surplus enjoyed by the seller. ⮚ Bring everything together! Economic surplus = consumer surplus + producer surplus = marginal benefit – price + price – marginal cost = marginal benefit – marginal cost 16  Economic Surplus Pric of Levi’s Jeans e Economic surplus for a single $12 transaction: 0 Let’s examine the 100th pair of jeans. Supply Economic surplus is the marginal benefit $8 ( = marginal less the marginal cost. 0 cost) $4 EconomicsTotal economic surplus surplus for 100th unit = $80 $50 5 Pric across all transactions in - $35 = $45 e the market is the triangular $3 area under the demand 5 Demand curve and above the supply $10 ( = marginal curve, $11,000. benefit) Consumer surplus 100 200 Quantity + (pairs of = Producer surplus jeans) 17  Key take-aways: Economic surplus Consumer Surplus The economic surplus you get from buying something when your marginal benefit is above the price. Producer Surplus The economic surplus you get from selling something when the price is above the marginal cost. Economic Surplus The consumer surplus and producer surplus added together. ⮚ The difference between marginal benefit and marginal 18 cost Chapter 7 (3 of 6) Assess the efficiency of 1. Evaluating Public Policies markets: 2. Measuring Economic 1. Who makes what? Surplus 2. Who gets what? 3. Market Efficiency 3. How much is bought 4. Market Failure and and sold? Deadweight Loss 5. Beyond Economic Efficiency  Market Efficiency (1 of 3) Recall, an efficient outcome yields the largest possible economic surplus. Market-based economics yield more efficient outcomes than centrally planned economies. Efficient production: Producing a given quantity of Markets determine… output at the lowest possible 1. Who makes what? cost. 2. Who gets what? ⮚ Requires producing each unit at the lowest marginal cost. 3. How much gets bought and sold? 20  1. Who makes what? (1 of 3) Marginal Scenario A cost ($ per Harris When the price is $2, kilogram) Sisters Big Red ⮚ Harris Sisters supplies 3 million marginal marginal kilograms cost cost ⮚ Big Red supplies 7 million kilograms. $2. 50$ Alternative way to produce 10 million Pric kilograms of tomatoes: $1.2 e 80 Scenario B ⮚ Harris Sisters supplies 4 million kilograms ⮚ It costs Harris Sisters MORE than $2 per kilogram to produce those extra tomatoes. 3 4 6 7 Quantity ⮚ Big Red supplies 6 million kilograms. (millions of kilograms) ⮚ It costs Big Red LESS than $2 per kilogram to produce those extra 21  1. Who makes what? Marginal (2 of 3) cost Scenario A ($ per Harris When the price is $2, kilogram) Sisters Big Red ⮚ Harris Sisters supplies 3 million marginal marginal cost cost kilograms $2. ⮚ Big Red supplies 7 million 20 $ Pric kilograms. 2 e Alternative way to produce 10 million $1. kilograms of tomatoes: 50 Scenario C ⮚ Harris Sisters supplies 2 million kilograms ⮚ It costs Harris Sisters LESS than 2 3 7 8 Quantity $2 per kilogram to produce those (millions of extra tomatoes. kilograms) ⮚ Big Red supplies 8 million 22 kilograms.  1. Who makes what? Marginal (3 of 3) cost Scenario A ($ per Harris When the price is $2, kilogram) Sisters Big Red ⮚ Harris Sisters supplies 3 million marginal marginal kilograms cost cost ⮚ Big Red supplies 7 million kilograms. $ Pric Scenario A represents efficient 2 e production. ⮚ There is no way to produce 10 million kilograms of tomatoes at a lower cost. Take-away: Markets distribute production across firms in a way that minimizes costs. ⮚ Competitive markets ensure each 2 3 4 6 7 8 Quantity unit is being produced by the (millions of supplier who can do so at the kilograms) lowest possible marginal cost. 23  Market Efficiency (2 of 3) Recall, an efficient outcome yields the largest possible economic surplus. Market-based economics yield more efficient outcomes than centrally planned economies. Efficient allocation: Allocating Markets determine… goods to create the largest economic surplus. 1. Who makes what? ⮚ Requires that each good goes to 2. Who gets what? the person who will get the highest marginal benefit from it. 3. How much gets bought and sold? 24  2. Who gets what? Marginal (1 of 3) benefit Scenario A ($ per When the price is $2, Gabrielle’s kilogram) ⮚ Gabrielle buys 3 kilograms of marginal tomatoes. benefit ⮚ Peter buys 7 kilograms of tomatoes. Alternative way to allocate 10 kilograms of tomatoes. $2. Scenario B 🡪 give Gabrielle some of 20$ Pric Peter’s tomatoes. 2 e $1. Peter’s ⮚ Gabrielle gets 4 kilograms marginal 50 ⮚ Her marginal benefit from the benefit extra tomatoes is LESS than $2. ⮚ Peter gets only 6 kilograms. 3 4 6 7 Quanti ⮚ He forgoes tomatoes from which ty he gets a marginal benefit of (kilogra 25 MORE than $2. ms)  2. Who gets what? (2 of 3) Marginal benefit Scenario A ($ per When the price is $2, Gabrielle’s kilogram) ⮚ Gabrielle buys 3 kilograms of marginal tomatoes. benefit ⮚ Peter buys 7 kilograms of tomatoes. Alternative way to allocate 10 kilograms $2. of tomatoes. 50 $ Pric Scenario C 🡪 give Peter some of 2 $1. e Gabrielle’s tomatoes. Peter’s 80 ⮚ Gabrielle gets 2 kilograms marginal benefit ⮚ She forgoes tomatoes from which she gets a marginal benefit of MORE than $2. 2 3 7 8 Quanti ⮚ Peter gets only 8 kilograms. ty ⮚ His marginal benefit from the extra (kilogra 26 ms) tomatoes is LESS than $2.  2. Who gets what? (3 of 3) Marginal benefit Scenario A ($ per When the price is $2, Gabrielle’s kilogram) ⮚ Gabrielle buys 3 kilograms of marginal tomatoes. benefit ⮚ Peter buys 7 kilograms of tomatoes. Scenario A is an efficient allocation. $ ⮚ Each tomato ends up being sold to Pric 2 e the person who gets the highest marginal benefit from it. Peter’s marginal Take-away: Markets allocate goods benefit to those with the highest marginal benefit. ⮚ This ensures the market allocates 2 3 4 6 7 8 tomatoes in such a way as to Quanti generate the largest economic ty surplus. (kilogra 27 ms)  Market Efficiency (3 of 3) Recall, an efficient outcome yields the largest possible economic surplus. Market-based economics yield more efficient outcomes than centrally planned economies. Efficient quantity: The Markets determine… quantity that produces the largest possible economic 1. Who makes what? surplus. 2. Who gets what? Rational rule for markets: 3. How much gets bought and sold? Produce more of a good if its marginal benefit is greater than 28 (or equal to) the marginal cost.  3. How much gets bought and sold? Price When production is… Supply less than the equilibrium quantity, (= marginal the marginal benefit exceeds the cost) marginal cost. ⮚ Increase economic surplus by ↑ Q Economic more than the equilibrium quantity, surplus the marginal cost exceeds the marginal benefit. ⮚ Increase economic surplus by ↓ Q Demand Take-away: The supply-equals-demand (= marginal equilibrium, Q*, produces the surplus- benefit) Quanti maximizing quantity Q ty ⮚ where marginal benefit equals Produce * Produce less marginal cost. more 29  Key take-aways: Market efficiency 1. Who makes what? The forces of the competitive market ensure efficient production. ⮚ Each unit of output is produced at the lowest possible cost. 2. Who gets what? The forces of the competitive market ensure efficient allocation. ⮚ Each unit goes to the buyer who will get the highest marginal benefit. 3. How much gets bought and sold? 30 Chapter 7 (4 of 6) Measuring the costs of market failure: 1. Evaluating Public Policies ⮚ Deadweight loss from 2. Measuring Economic underproduction Surplus 3. Market Efficiency ⮚ Deadweight loss from overproduction 4. Market Failure and Deadweight Loss ⮚ Government failure 5. Beyond Economic Efficiency  Market Failure Thus far, competitive markets have led to efficient production and efficient Five main sources of market allocation. failure: But what if… ⮚ supply and demand curves do NOT 1. Market power represent well-informed buyers and sellers? 2. Externalities ⮚ we do NOT have a well-functioning market? 3. Information problems ⮚ we do NOT have perfect competition? 4. Irrationality Result 🡪 We will NOT have an efficient outcome. 5. Government regulations Market failure: When market forces of supply and demand lead to an inefficient outcome. 32  Five Main Sources of Market Failure (1 of 5) Market power undermines competitive pressure. 1. Market power If a market does NOT have many sellers, selling identical products 2. Externalities then… 3. Information problems ⮚ sellers can exploit the limited competition by charging higher 4. Irrationality prices. ⮚ Consumers buy smaller 5. Government quantities. regulations Overall result: Less than the efficient quantity is produced (i.e., underproduction). ⮚ How much less depends on how much market power they have. 33  Five Main Sources of Market Failure (2 of 5) Externalities create side effects. 1. Market power Externalities arise whenever the choices that buyers and sellers make 2. Externalities have side effects on others. 3. Information problems Example: If someone decides to smoke a cigarette near you, then you 4. Irrationality experience the annoying side effect of second-hand smoke. 5. Government When these negative side effects are not regulations taken into consideration, more than the efficient quantity ends up getting bought and sold (i.e., overproduction). 34  Five Main Sources of Market Failure (3 of 5) Information problems 1. Market power undermine trust. 2. Externalities Private information: Information that one party has but the other 3. Information does not. problems Example: If a seller knows more 4. Irrationality about the quality of a used car than you do, you might wonder 5. Government regulations why they’re selling it. Your concerns about what might be wrong with it could lead you to not buy the car even if there is nothing wrong with it. 35  Five Main Sources of Market Failure (4 of 5) Irrationality leads to bad decisions. 1. Market power Sometimes people make decisions that are not in their best interests. 2. Externalities ⮚ If buyers don’t follow the Rational Rule for Buyers… 3. Information ⮚ then their demand may no longer reflect problems their marginal benefits. ⮚ Result: unlikely to achieve efficient 4. Irrationality allocation ⮚ If sellers don’t follow the Rational Rule for 5. Government Sellers… regulations ⮚ then their supply decisions may not be driven by their marginal costs. ⮚ Result: unlikely to achieve efficient production 36  Five Main Sources of Market Failure (5 of 5) Governments can impede market forces. 1. Market power Taxes lead to lower quantities being bought and sold. 2. Externalities Price ceilings and price floors can 3. Information problems also lead to lower quantities being bought and sold. 4. Irrationality Quantity regulations change the 5. Government quantity being bought and sold. regulations Sometimes these government regulations: ⮚ correct a market failure. ⮚ other times, they create their own market failure. 37  Key Definition (4 of Diving into the Definition 4) Deadweight loss: How far Deadweight loss arises anytime economic surplus falls below the we are not at the efficient efficient outcome. quantity. ⮚ Deadweight loss abbreviated DWL ⮚ Overproduction generates DWL. DWL = economic surplus at efficient ⮚ Underproduction generates outcome − actual economic DWL. surplus Deadweight loss allows us to Deadweight loss essentially measure the extent of the market measures how far off the “efficient failure, and the associated costs. mark” we find ourselves. ⮚ How far away are we from the efficient point? 38  Producing less than the HELPFUL HINT: Deadweight loss is shaped like an arrow- efficient quantity creates head, pointing toward the deadweight loss efficient quantity. Price Efficient quantity is where the Actual marginal benefit and marginal cost quantity Margina curves cross. l cost The actual quantity is less than the Actual efficient quantity due to a market econo Deadweig failure. Econom Econom mic ht loss ic ic surplus surplus Deadweight losssurplus = at at - actual Marginal efficien t quantity benefit quantity - Quanti Actual Efficien ty = quantit t 39  Producing more than the HELPFUL HINT: efficient quantity creates Deadweight loss is shaped like an arrow-head, pointing deadweight loss toward the efficient quantity. Efficient quantity is where the Price marginal benefit and marginal cost Actual quantity Margina curves cross. l cost The actual quantity is more than the efficient quantity due to a market failure. Economic surplus at Deadweight Once production exceeds the efficient efficient quantity loss quantity… ⮚ marginal cost exceeds marginal benefit Marginal benefit ⮚ NOT GOOD! Quantit ⮚ This extra production reduced y economic surplus. Efficien Actual t quantit 40 This deadweight loss is the measure of  Market Failures and the Government Market failures point to a potentially positive role for government. ⮚ A well-designed policy can limit or even correct the market failure, thereby reducing or eliminating deadweight loss. Examples: The government taxes smoking and subsidizes flu shots (and COVID shots!). Government failures limit the extent to which we should rely on governments. ⮚ Government failures: When the government policies lead to worse outcomes. ⮚ Politicians and bureaucrats don’t always act in the best interest of society. ⮚ Motivated by reelection, campaign donations, and are overly responsive to those who are politically organized. ⮚ Sprawling and bloating bureaucracy can fail to provide efficient services. 41  Key take-aways: Market failure and DWL Market failures lead to inefficient outcomes. ⮚ Five sources of market failure Deadweight loss ⮚ Occurs anytime we are NOT at the efficient outcome. ⮚ A measure of how far economic surplus falls below the efficient outcome. Government and market failures ⮚ Governments have the potential to correct for market failures. ⮚ But can also make things worse (i.e., a government 42 failure). Chapter 7 (5 of 6) Evaluate the limitations of economic efficiency in 1. Evaluating Public Policies policy analysis. 2. Measuring Economic ⮚ Distributional Surplus consequences 3. Market Efficiency ⮚ Ability to pay 4. Market Failure and ⮚ The ends and the Deadweight Loss means 5. Beyond Economic Efficiency  Critiques of economic efficiency (1 of 3) Economic efficiency tells us to choose the outcome that yields a larger economic surplus. ⮚ Pick the largest possible pie. BUT it’s not just about the size of the pie, but how that pie is sliced. We want to understand the distributional consequences of new policies. ⮚ Distributional consequences: who gets what. ⮚ Assess whether the outcome seems fair or equitable. 44  Critiques of economic efficiency (2 of 3) Recall, economic surplus is the marginal benefits, less the marginal costs. ⮚ Maximizing economic surplus means each good goes to the person with the largest marginal benefit. BUT economists equate marginal benefit with a person’s willingness to pay. The Kim Kardashian Problem: Your willingness to pay partly reflects… Kim has so much money that ⮚ how much you like something her willingness to pay will likely surpass yours for many goods, ⮚ and your ability to pay but should she always get the good instead of you? 45  Critiques of economic efficiency (3 of 3) Economics efficiency leads to a judgment focused on the consequences of a policy, rather than the process that led to that outcome. Some people may think that the process matters more than the outcome. Using the pie example once again… ⮚ Was the process by which you decided how to slice the pie decided democratic or dictatorial? ⮚ If you were the one that made the pie, do you deserve a bigger slice? ⮚ If everyone had the opportunity to make a pie, should those who actually made it be forced to share a cut of that pie with others? (i.e., equality of opportunity rather than outcome) 46 Chapter 7 (6 of 6) 1. Positive versus normative, and economic efficiency 1. Evaluating Public Policies 2. Consumer, producer, and 2. Measuring Economic economic surplus Surplus 3. Who makes what, gets what, and how much is 3. Market Efficiency made? 4. Market failure and 4. Market Failure and deadweight loss Deadweight Loss 5. Critiques of economic 5. Beyond Economic Efficiency efficiency