EEP 101 ECON 125

Lecture 2

When is a Market Socially Optimal?

Markets have nearly miraculous abilities to determine value and allocate resources Still, they have many imperfections Markets can do most of the work in todays world, yet There are many important reasons to assert the public interest in private transactions

Basic Definitions
Competitive Economy: An economy comprised of many
small economic units, each with no market power. Pareto Optimal: A resource allocation such that you cannot improve any individuals welfare without hurting at least one other individual. Socially efficient allocation. The Main Theorem of Welfare Economics: A competitive economy will achieve Pareto optimal resource allocation when: - Full information exists - No externalities exist - There are no increasing returns to scale in technology

Potential Reasons for Government Intervention in the Market

1. 2. 3. 4. 5. Facilitate information creation and access Manage externalities Provide public goods/services Adjust income distribution Manage non-competitive behavior

Facilitate information creation and access

Education and extension Public supported media (infrastructure, standards, and content) Collection and distribution of price and other economic data Labeling requirements (truth-inadvertising policies)

Manage externalities
Externalities: when activities of one agent affect preferences/technologies of other agents.

Production Externalities: when productivity of an individual is affected by activities of others (smokestack laundry, irrigation - fishery). Consumption Externalities: when welfare of some individuals is affected by the consumption activities of other individuals (loud music, smoking).

Negative externalities reduce utility or productivity (pollution). Positive Externalities increase utility or productivity (orchard and apiary - trees and bees).

Provide public goods/services

Public Goods and Services are characterized by two features: 1) Nonrivalry: Goods can be consumed concurrently by more than one individual 2) Nonexcludability: Goods can be accessed freely

Examples

-Knowledge from education and public research -National Security -Legal system, treaties -Infrastructure, such as roads, bridges, etc. -Environmental amenities, such as clean air

Adjust income distribution

Transfer Policies: Policies designed to change the distribution of wealth in society. Examples of transfer policies: - Income taxes - Inheritance taxes - Social Security - Medicare, Medicaid, and AFDC - Tax breaks for corporations - Subsidized loans for education or home buying - Agricultural subsidies

Manage non-competitive behavior

Noncompetitive behavior can arise in many contexts, including 1) Monopoly: One agent controls supply of a good. 2) Monopsony: One agent controls demand for a good. 3) Middleman: One agent buys the product from the supplier and sells it others.

Overview of Welfare Economics

Welfare analysis: A systematic method of evaluating economic implications of alternative allocations. It addresses the following questions: 1. Is a given resource allocation efficient? 2. Who gains and who loses under various resource allocations, and by how much? Welfare economics: A methodological approach to assess resource allocations, estimate private costs and benefits, and establish criteria for public intervention.

The Role of Markets

Markets are institutions that exist to reconcile social values (willingness to pay) with resource costs (scarcity). The primary mechanism for this is exchange of goods and services for money. This combines complex behavior with simple metrics, prices and quantities.

General Analysis Overview

Welfare analysis is a systematic method of evaluating economic implications of alternative allocations. It answers the following questions: 1. Is a given resource allocation efficient? 2. Who gains and who loses under various resource allocations? By how much? Welfare economics: A methodological approach to assess resource allocations and establish criteria for government intervention. Partial analysis: Evaluates outcomes in a subset of markets assuming efficiency in others.

Chapter 2: Welfare Economics

General Analysis Overview Welfare under Monopoly Welfare under Monopsony Welfare under Middlemen

Markets: The circular flow of resources and value

Supply: Resources embodied in goods and services

Profit = Revenue Cost

(Pricing power, Scarcity)

Producers

Behavior/Incentives

Consumers

Willingness to Pay
(Taste, Wealth)

Demand: Payments for value received

Market Allocation Example: Cal Basketball Tickets

Value of Tickets to Potential Consumers
Peter Paul Mary Jack Jill $200 $150 $100 $50 $50
200 Peter Z

Price

150

Paul

Value of Tickets to Potential Suppliers:

Professor Professor Professor Professor Professor V W X Y Z $50 $50 $100 $150 $200

Mary 100 X Jack and Jill

50

V and W

Tickets

Equilibrium
Equilibrium Price = $100 Peter, Paul and Mary buy tickets from Professors V, W and X. If they all trade at the equilibrium price, does it matter who buys from whom? No Gains: Peter Paul Mary V W X Total Gain: $250

Price
Consumer Surplus
200 Peter Z

150

Paul

= = = = = =

$200 $150 $100 $100 $100 $100 -

$100 = $100 $100 = $50 $100 = $0 $50 = $50 $50 = $50 $100 = $0

Mary 100 X Jack and Jill

50

V and W

Producer Surplus

Tickets

Demand and Consumer Surplus

Price
Consumer Surplus

Maximum Willingness to Pay for Qo

Po

What is paid

D = Willingness to Pay
Qo

Quantity

Supply and Resource Cost

Price

Producer Surplus Po What is paid

Minimum Amount Needed to Supply Qo Qo

Quantity

Market Equilibrium in Theory: Efficiency

Price
Consumer Surplus

Po

Producer Surplus

D
Qo

Quantity

Price Increase
Price
Remaining Consumer Surplus PH Po New Producer Surplus Lost Producer Surplus: Deadweight Lost Consumer Surplus: Transfer Lost Consumer Surplus: Deadweight

D
QL Qo

Quantity

Welfare under Monopoly

A monopoly is the only seller in a market. The basic condition for a monopoly is Maximizes P(Q) Q - C (Q) Q P C Optimality occurs where: P + Q - = 0 Q Q MR(Q)-MC(Q)=0, where MR=marginal revenue and MC=marginal cost

Monopoly
P

Qc, Pc=under competition Qm,Pm=under monopoly

C A

Pm

C
Pc

B MR

Monopoly produces too little and charges too much. Welfare loss under monopoly is DABC .
D
Q

Qm

Qc

Linear Example of Monopoly-1

Inverse demand= P(Q) =a - bQ Revenue = (a - bQ)Q = aQ-bQ2 Supply = c + dQ Competitive outcome is where Demand=supply a - bQ = c + dQ
Qc = a-c b+ d ba - bc b+d

P c = a -

P c =

ad + bc . b+d

Linear Example of Monopoly-2

Under monopoly, MR=MC a - 2bQ = c + dQ

a-c QM = 2b + d

b(a - c ) P M = a 2b + d a( b + d ) + bc = 2b + d

Welfare under Monopsony

A monopsony is the only buyer in a market.
P MO MC

Pc
Pmn

Qc, Pc=under Competition Qmn,Pmn=under Monopsony

D

Qmn

Qc

Calculation of monopsony
B(Q) - QMC (Q) Maximization equation: Maximize Q Q Area: B(Q) = P( z)dz = area under demand.
0

Optimality condition:

B MC =Q + MC(Q) Q Q

Price paid by monopsony:

MC MO = marginal outlay = MC(Q) + Q

Summary of monopoly and monopsony

Monopolist: Underbuys and oversells. Monopsonist:Underbuys and underpays.

Welfare under Middlemen

A middleman is the only buyer and seller of product. MO
P S

Pmmb

C E

Pmms MR Qmm

Qmm=middlemen output Pmms=price paid by middlemen to supplier Pmmb=price paid to middlemen by buyer
D Q

Profits under Middlemen

P MO S

Pmmb

Profits PmmbCEPmms

Pmms

E
MR Qmm D Q