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 à
at the quantity produced, MB > MC
•
Both, producer and consumer surplus shrink à
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