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Unformatted text preview: PADP 8670 POLICY ANALYSIS I Efficiency Angela Fer7g, Ph.D. Today's plan Pareto Efficiency Measured by social surplus Consumer surplus and demand curve Producer surplus and supply curve Compe;;on leads to Pareto Efficiency Compe;;on vs. Monopoly Price Discrimina;on and Efficiency 1 What is Efficiency? One policy goal among several possible others (equity, human dignity, economic opportunity, etc.) "Best" alloca;on of resources What do we mean by "best"? Pareto Efficiency "Best" alloca;on can mean it is not possible to change the alloca;on to make someone beNer off without making someone else worse off Pareto improvement = a way to make some people beNer off without making anybody else worse off Pareto efficient = reached the point where all Pareto improvements have been made, no more Pareto improvements are possible 2 Pareto Efficiency is measured by Social Surplus Social surplus = CS + PS Consumer surplus (CS) measures consumer welfare: CS is the difference between the maximum amount consumers are willing to pay for a good and the amount they must actually pay Producer surplus (PS) measures producer welfare: PS is the difference between the minimum amount the producer would be willing to sell a good for and the amount she actually sells it for If a policy alterna;ve can raise social surplus rela;ve to the status quo, then it is improving efficiency. Need demand curve to get consumer surplus The demand curve measures the amount that will be purchased at each price The demand curve can also tell us what the price would have to be to get consumers to buy Q units of the good (maximum willingness to pay) PMAX P* Demand Curve Q* Q 3 Graphical Illustra;on of Consumer Surplus CS is the difference between the maximum amount consumers are willing to pay for a good and the amount they must actually pay PMAX CS = 0.5 Q* (PMAX P*) CS P* D Q Q* Need supply curve to get producer surplus Supply curve measures the amount that will be supplied at each price Supply curve also measures what the price would have to be to get the producer to supply Q units of the good (minimum willingness to sell) PMAX Supply Curve P* Q* Q 4 Graphical Illustra;on of Producer Surplus P S P* PS PS = 0.5 Q* P* Q Q* Graphical Illustra;on of Social Surplus P S CS P* PS D Q Q* 5 What would happen to SS if tax on producers imposed? P t Pconsumer P* Pproducer D Q Q* S + t S What would happen to SS if tax on producers imposed? P t CS Pconsumer P* Pproducer Tax revenue PS D DWL S + t S DWL=Dead weight loss, loss in social surplus due to policy Tax Revenue could be redistributed to consumers or producers so part of SS Q Qtax Q* 6 Are taxes Pareto efficient? A situa;on is Pareto efficient if there is no way to make some group of people beNer off without making some other group worse off. No. The tax causes Qtax<Q* at which point there is someone who is willing to supply an extra unit of the good at a price that is less than the price that someone is willing to pay for that unit. If the good were produced and exchanged between these 2 people, they would both be beNer off. Pareto Efficiency Compe;;on There are 2 fundamental results from welfare economics: First Welfare Theorem: Every compe;;ve equilibrium alloca;on of resources is Pareto efficient Second Welfare Theorem: Any Pareto efficient alloca;on of resources can be reached through a compe;;ve market equilibrium Provided that the government has the ability to make "lump sum" transfers of resources between economic agents These welfare theorems mean that Pareto efficient alloca;ons are iden;cal to compe;;ve equilibrium alloca;ons. 7 The Invisible Hand The welfare theorems tell us that a decentralized system of perfectly compe;;ve markets achieves Pareto efficient resource alloca;ons. Efficiency is reached even though all economic agents act only in their own self-interest, not necessarily the broader interests of society. The self-interested ac;ons of individuals and firms result in market exchanges that maximize the overall welfare of society, "as if guided by an invisible hand" (Adam Smith). No direct government interven;on is required for achieving efficiency. It is enough to just "let the market work." Policy Distor;ons If policy moves the market away from the compe;;ve equilibrium, we call this a "policy distor;on". This means that, not only is direct government interven;on unnecessary for achieving efficiency, it is actually harmful to efficiency if markets are perfectly compe;;ve. 8 Many excep;ons Public policy can create Pareto improvements when the structure of the market deviates from perfect compe;;on or when externali;es exist Externali7es are situa;ons where the ac;ons of economic agents impose costs or benefits on the rest of society that are not priced in market transac;ons (talk about this later) Group Exercise 1. Assume that the world market for crude oil is compe;;ve, with an upward-sloping supply curve and a downward-sloping demand curve. Draw a diagram that shows the eqbm world price and quan;ty. Now imagine that one of the major oil expor;ng countries undergoes a revolu;on that shuts down its oil fields. Draw a new supply curve and show the loss in consumer surplus in the world oil market resul;ng from the loss of supply. What assump;ons are you making about the demand for crude oil in your measurement of consumer surplus? Now assume that the US is a net importer of crude oil. (Hint: US demands more than it produces at the given world price does not achieve equilibrium in the US market). Show the impact of the price increase resul;ng from the loss of supply to the world market on social surplus in the US market. Is this new eqbm Pareto efficient? 2. 3. 4. 5. 9 Let's show that compe;;on has greater social surplus than monopoly Perfect Compe;;on Perfect compe;;on is a type of market with: Large numbers of buyers and sellers Firms that produce a homogeneous good Free entry and exit Since firms are numerous and all produce the exact same good, no firm has the ability to charge anything but the prevailing market price Each firm is so small compared to the whole market that it cannot affect the market price no maNer how much it produces If any firm tried to charge more than the market price, it would lose all its customers to other firms Firms are "price takers" because they take the market price as given Likewise, each consumer is too small compared to the whole market to affect the market price, so the consumer is also a price- taker 10 Demand curve facing compe;;ve firm Because each firm is a price taker, it views its demand curve as perfectly horizontal P MR=marginal revenue, the amount that revenue goes up if the firm sells one more. For a compe;;ve firm, MR=P*. P* d = MR q Profit maximiza;on for compe;;ve firm To find the profit-maximizing quan;ty, the firm compares MR and MC: P MC MC=marginal cost How did we get MC? P* d=MR q* q 11 Need cost-curves Average Costs (AC) = Average Fixed Costs (AFC) + Average Variable Costs (AVC) AFC decreases and grows flaNer with Q AVC increases with Q because of diminishing marginal product (Q goes up less with each addi;onal worker because of crowding, less produc;ve land, etc.) So, AC is U-shaped MC=AC when moving from Q=0 to 1 When MC is below AC, AC must be falling; when MC is above AC, AC must be rising Marginal Costs (MC) is the change in total costs when Q goes up by 1 Logic by example: If average grade (AG) is 90, and next grade (MG) is 80, what happens to AG? What if MG is 100? Figure 4.5 Average and Marginal Cost Curves MC PS MARGINAL COST (MC) AVERAGE COST (AC) AND PRICE (P) a AC ACS b PL 0 QL QS OUTPUT LEVEL PER UNIT OF TIME 12 Short-run to long-run industry adjustment Assume a perfectly compe;;ve firm earns posi;ve profit in the short-run P MC AC P* d=MR q q* Then, new firms enter the market P Industry S P Firm MC AC d=MR P1 P2 D Q1 Q2 Q q2 q1 Long run competitive equilibrium: q Industry Q increases Firm's q decreases Profit = 0 P = min. AC 13 Monopoly Monopoly is a type of market with: One seller No subs;tutes available for the good Barriers to entry Since there is only one firm, the firm's decisions about quan;ty affect the price of the good If the firm charges a high price, they will only sell a small quan;ty, and vice versa Monopolies are "price se[ers" because their decisions affect the market price We assume, as before, that each consumer is too small compared to the whole market to affect the market price, so the consumer is s;ll a price-taker Demand curve facing monopoly Because a monopoly is the only firm in the market, it views its demand curve as the market demand curve: P d q 14 Marginal revenue for a monopoly Marginal revenue (MR) is defined as the change in total revenue that results from producing an addi;onal unit: MR = TR / Q For a monopoly that can only charge one price: If want to sell one more unit of Q , then must lower P for all units so: TR=P1-Q0(P0-P1) Marginal revenue curve for monopoly P MR d q 15 Profit maximiza;on for monopoly To find the profit-maximizing quan;ty, the firm compares MR and MC (same solu;on, different graph): P MC AC P* 2 1) Find Q* where MR=MC 2) Find P* such that demand would be Q* 1 MR Q* D d=MR q Profit, price, and quan;ty with monopoly Posi;ve profits in the long-run Eqbm monopoly price (P*) > eqbm compe;;ve price (Pc) Eqbm monopoly Q* < eqbm compe;;ve market Qc P MC AC P* Pc D MR Q* Qc Q 16 Show SS is lower for monopoly than compe;;ve firm Back to the original ques;on: There is a deadweight loss rela;ve to compe;;on so SS must be lower under monopoly. P MC P* Pc DWL D MR Q* Qc Q Thus, monopolies are Pareto inefficient There is someone willing to pay more for an extra unit of output than it costs to produce that extra unit there is room for Pareto improvement P MC P* D MR Q* Q 17 Group Exercise Assume that there is a monopoly with the following cost curves. Is long-run level of DWL lower if the government forces the firm to charge the efficient price (P=MC)? P MC AC MR D Q Price Discrimina;on Price discrimina;on is the prac;ce of charging different prices to different consumers of same good It is a tac;c that firms with market power some;mes use in order to increase their profits To be able to prac;ce PD, need: Market power (ability to set the price of your product) Ability to iden;fy and separate customers w/ different marginal benefits Examples of PD: Ability to prevent resale of the good Airlines (business vs. vaca;on travel) Colleges (tui;on discounts based on need/ability) Movies (students vs. non-students) Restaurants (senior ci;zens discounts) Coupons 18 PD increases efficiency If the monopoly can dis;nguish groups of buyers with different marginal benefits, then the firm can reduce DWL firm gets more profit and consumers get some CS P P1 P2 P3 MR Q1 Q2 Q3 CS CS PS CS PS If the monopoly is able to discern every single buyer's marginal benefit, then the firm's MR curve = the consumer's willingness to pay curve (D), and DWL 0, but firm gets all of it as profit, no CS (perfect PD) P PS PS DWL MC D Q Q* D = MR MC Q For next ;me Skim EITC & food stamp handouts Read Simon and Gruber 2008 write one page summary to hand in as part of homework 2 Homework 2 problems 19 ...
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This note was uploaded on 01/18/2012 for the course PADP 8670 taught by Professor Staff during the Fall '10 term at University of Georgia Athens.
- Fall '10