Applications and Extensions of Supply and Demand Analysis

Market Efficiency and Government Price Controls

Chapter 6: pages 118-122

Chapter 3: pages 57 - 60

Competitive Markets and Efficiency

Demand and Marginal Benefit

l   A demand curve is a marginal benefit curve

Consumer Surplus

l   Consumer surplus is the net benefit (net gain) consumers receive from the market exchange.

  When the price they pay to buy the good is less than what they are willing to pay for it (MB).

 

Graphically: Consumer Surplus

Graphically: Consumer Surplus

Graphically: Consumer Surplus

Graphically: Consumer Surplus

Consumer Surplus and Market Price

l   The area below the demand curve and above the market price measures the consumer surplus in the market.

l   Therefore,

  A lower market price will increase market consumer surplus.

  A higher market price will reduce market consumer surplus.

Solved Problem

l   Refer to Table 6.5. If the six people listed in the table are the only consumers in the market and the equilibrium price is $11, how much consumer surplus will the market generate?

Solved Problem (cont.)

How the Price Affects Consumer Surplus

Marginal Cost and Supply Curve

l   The supply curve is the marginal cost curve

 

Producer Surplus

l   Producer surplus is the net benefit producers receive from the market exchange.

  When they receive more from producing the good than what it costs to produce it

Graphically: Producer Surplus

Graphically: Producer Surplus

Graphically: Producer Surplus

Graphically: Producer Surplus

How the Price Affects Producer Surplus

Producer Surplus and Market Price

l   The area above the supply curve and below the market price measures the producer surplus in the market.

l   Therefore,

  A lower market price will decrease market producer surplus.

  A higher market price will increase market producer surplus.

Solved Problem

l   Refer to Table 6.6. If the six people listed in the table are the only producers in the market and the equilibrium price is $6, how much producer surplus will the market generate?

Solved Problem (cont.)

Total Surplus and Efficiency of the Market

l   Total surplus is the sum of consumer and producer surplus.

 

Market Equilibrium and Maximization of Total Surplus

Market Efficiency

Market For Pizzas
Equilibrium

 

Market For Pizzas
Underproduction

Market For Pizzas
Overproduction

Market Inefficiency

Deadweight Loss

l   Deadweight loss is a loss for the entire society due to inefficiency of the market.

  Total surplus is not maximized

   Consumer surplus and producer surplus decrease

   MB > MC Underproduction (quantity produced is less than the efficient quantity)

   MB < MC Overproduction (quantity produced exceeds the efficient quantity)

 

Solved Problem

l   Using a supply and demand graph show the impact that an increase in supply will have on consumer surplus (assume the demand curve is given)

Solved Problem

l          Use the graph to answer the following questions:

           Calculate the consumer surplus of the 3rd unit purchased?

           Calculate the consumer surplus of the 5th unit purchased?

           Calculate the consumer surplus of the market?

 

 

Application Sources of Market Inefficiency: Government Price Controls

l   Supply and demand determine the market equilibrium price and quantity, but not everyone is happy with this outcome.

l   Lobby the government to set limits to the price of the product (input).

A Price Ceiling

l    Maximum legal price at which a product or resource can be exchanged in the market.

l    A price ceiling set below the equilibrium price

   It is a binding constraint on equilibrium price

   It will create a shortage of the product

    Quantity demanded exceeds quantity supplied

Should the Government Control Apartment Rents?

Price Ceilings: Inefficiency of Rent Controls

Inefficiency of a Price Ceiling

l   Underproduction and deadweight loss

  The amount available in the market is determined by the supply

   It is less than the efficient amount at the quantity produced, MB > MC

   Both, producer and consumer surplus shrink total surplus decreases

   A deadweight loss arises

Inefficiency of a Price Ceiling (cont.)

l   Misallocation of resources and goods

  Goods are not allocated to those who value them most highly and are willing to pay a high price

 

 

A Price Floor

l    Minimum legal price at which a product (resource) can be exchanged in the market

l    A price floor set above the equilibrium price

   It is binding.

   It creates a surplus of the product (resource)

    Quantity supplied exceeds quantity demanded at the set price.

 

Price Floors: Inefficiency of an Agricultural Price Support

 

Inefficiencies of a Price Floor

l    Overproduction and a deadweight loss arises

   The government may buy the surplus output at the set price

   or pay the farmers not to produce in excess at all

l    How does the government dispose of the unwanted surplus in the case of price supports?

    Give it as a foreign aid to poor countries

    Give it away to the poor

    Destroy it

Government Price Controls

Summarizing:

l    Effective government price controls lead to:

   permanent shortages or surpluses

   undesirable rationing mechanisms

   Misallocation of resources and products

   Total surplus is reduced and a deadweight loss is created

Results of Government Intervention: Winners, Losers, and Inefficiency

l   When the government imposes price floors or price ceilings, three important results occur:

  Some people win.

  Some people lose.

  There is a loss of economic efficiency.

The End

l   Practice doing exercises at the end of the chapters:

l   Chapter 3: Key question 14

l   Chapter 6: Questions 12 14 and Key question 15