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Econ25200F10Mtg6

Econ25200F10Mtg6 - Econ 25200 6th Class Demand and Supply...

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Econ 25200 – 6 th Class Demand and Supply & Market Efficiency (3)
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Recap In an ideal world (price-taking, individual rationality, voluntary transactions, full information, no externalities, no outside intervention), market leads to maximization of MS and efficient outcome for society. But unlikely world is that ideal, or that simple?
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Externalities Suppose each unit of production produces negative effects for non-market participants equal to 3 ($) Additional cost of production that needs to be taken into consideration If no charge for polluting, then producer may ignore such costs
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Externalities Marginal (Social) Cost (MSC) = Marginal Private Cost (MPC) + Marginal External Cost (MEC) Here MSC = [ 2 + (1/2)Q S ] + 3 = 5 + (1/2)Q S
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MSC, MSB Note: MSC, MSB not “socialist concepts” Insist that all individual costs and benefits are included, In that sense are highly “individualistic”
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Free-Market Equilibrium P Q 14 56 0 2 10 16 Q S , MPC Q D , MPB
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Problem At free-market equilibrium, Market-clearing price does not reflect all social costs and benefits at margin Hence giving wrong signal to buyers, sellers
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Efficient Outcome P Q 14 56 0 2 10 16 Q S , MPC Q D , MPB = MSB MSC = MPC + MEC 5 12 P = 11 MPC = 8
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Algebra Efficient outcome when MSB = MSC MSB = MPB = 14 – (1/4)Q MSC = MPC + MEC = [2 + (1/2)Q] + 3 Hence, (3/4)Q = 14 – 5 = 9, so Q = 12
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Price, MPB, MPC At efficient outcome: Q = 12 MPB = 14 – (1/4)Q = 14 – 3 = 11 = P MPC = 2 + (1/2)Q = 2 + 6 = 8 = MSC – MEC = 11 - 3
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Deadweight Loss P Q 14 56 0 2 10 16 Q S , MPC Q D , MPB = MSB MSC = MPC + MEC 5 12 P = 11 MPC = 8
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Laissez-faire No intervention (laissez-faire) leads to DWL = (1/2) x (13 – 10) x (16 – 12) = 6 Wasteful to use resources in production if MSC > MSB
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Overall Surplus (OS)
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