Markets and Efficiency

Dr. Divya Gupta

Economics I

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References

Neva Goodwin: Chapters 4 and 6

Mankiw: Chapters 4, 6, 7, 8

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Market

What is a market?
- Institutions where potential buyers and sellers meet for exchange of
goods and services (such as via e-markets as well).
What forces drive their actions?
- The forces of demand (buyers) and supply (sellers) drive the market
mechanism.
How do these actors of the market communicate with each other?
- Via Prices.
What ensures the stability or equilibrium in these markets/ or in this
free-market model?
- The price mechanism or the free-market model.

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Free Market Model

The foundation of free market model can be found in the works of

Adam Smith - who propounded the role of ‘invisible hand’ in guiding
the economy to reach an equilibrium.
A more formal model of microeconomics was laid out in neo-classical
theories.
An implicit assumption of this model is that the market structure is
‘perfectly competitive’ (this is something that we will discuss in detail
in a later module).
There does exist various other forms of market structures as well like
monopoly, monopolistic competition, oligopoly.
But first we understand the functioning of a market in a perfectly
competitive (the ideal) scenario and then we will analyse the
departures from this ideal scenario (in the forms of other market
structures).
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Free Market Model (contd.)

But, for now, it’s enough to know that a perfectly competitive market
structure is one where there are:
many buyers
many sellers
homogeneous products - goods and services
no barriers to entry and exit
perfect information between buyer and seller; and perfect mobility
no government intervention and no lobbies
Implications of a perfectly competitive market structure:
No single buyer and seller has any influence over the price.
Examples: agricultural markets, like, wheat market, onion market, etc.
QUESTION: How does this market work?

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Free Market Model (contd.)

Taking the assumption of a perfectly competitive market forward,

there are two sides to understand the working of this market:
Theory of Demand
Theory of Supply

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Theory of Demand

Quantity demanded of any good is the amount that the buyers are
willing to buy at the given price level.
As the price level increases, the quantity demanded falls, that is, there
exist an inverse relationship between the quantity demanded of a
good and the price of the good, other things being staying the same.
Also known as the LAW OF DEMAND.
There are two ways to depict this inverse relation - tabular (called
demand schedule) and graphical (called demand curve).
Demand schedule is the tabular representation that shows the quantity
demanded at each price.
The demand curve is the one that graphs the demand schedule,
illustrates how the quantity demanded of the good changes as its price
varies.
Because a higher price reduces the quantity demanded, the demand
curve slopes downwards.

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Demand Schedule and Demand Curve

Demand Schedule Demand Curve

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Market Demand versus Individual Demand

Individual demand is the quantity of a good or service demanded by

an individual, at a given price level.
Market demand is the sum of the quantities demanded by all buyers
at each price.
Thus, the market demand curve is found by adding horizontally the
individual demand curves, as shown in graph below:

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Movement along the Demand Curve
As discussed earlier, a demand curve shows relation between the price of a
good and its quantity demanded.
On the graph, one of these variables is on the x-axis (quantity demanded)
and the other on the y-axis (price).
Therefore, if there is a change in price (on y-axis), then its effect on the
quantity demanded (on x-axis) will be shown by moving along the
demand curve.
Example: As shown in figure below, if govt. imposes a tax on price of
cigarettes, then price of cigarettes increases, causing a fall in its demand.
This effect is shown by moving along the demand curve - from point A to
point B.

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Shift in Demand Curve
The demand curve shows how price affects quantity demanded, other factors
being held constant.
These “other factors” are the non-price determinants of demand, e.g.
consumer’s tastes, habits, income etc.
While a change in price of a good leads to movement along the demand
curve (shown earlier), changes in these non-price factors will shift the
demand curve.
A favourable change will cause a parallel shift to dd curve outwards; and a
unfavourable change will cause a parallel shift inwards.
Since the change in demand is happening without any change in price,
therefore, at the same price, an increase or decrease in quantity of demand
can be shown by a parallel shift (see figure below).

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Shift in Demand Curve: Factors
The various non-price factors that can affect the demand, causing a shift
in the demand curve are:
Number of buyers: an increase (decrease) in the number of buyers
causes a rightward (leftward) shift in the demand curve of the
commodity.
Income: an increase will shift the demand curve to the right and
vice-versa
Tastes and preferences: a favourable change in the tastes of
consumers will lead to rightward shift in the demand curve; and
vice-versa in case of unfavourable change.
Expectations: Expectations about future prices can lead to changes in
present demand. Example, an upcoming sale on Flipkart will induce
buyers to buy in the future and reduce the demand at present,
shifting the demand curve towards left.

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Shift in Demand Curve: Factors (contd.)

Price of related goods:

What are related goods? - There are two types of related goods:
substitutes and complements.
Complementary goods are those that are consumed together, such as a
pair of shoes or petrol with an automobile or a computer and software,
etc.
Substitute goods are those that can be consumed in place of each
other to satisfy the given want. For example, tea and coffee or a
subway and a McD’s burger.
If two goods are complements, then an increase in the price of one
good will result in a fall in the demand of the other good as well.
Therefore, leading to a leftward shift in the demand curve.
Alternatively, if the two goods are substitutes then an increase in the
price of one good will result in an increase in the demand of the other
good, that is a rightward shift in the demand curve.

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Theory of Supply
Analogous to the theory of demand, there is theory of supply from the
perspective of the sellers.
Quantity of supply is the amount that the sellers are willing to supply
or sell to the market, at a given price level.
Law of supply: the claim that, other factors held constant, the
quantity supplied of a good rises when the price of the good rises,
that is, there is a direct relationship between the price of a good and
its quantity supplied.
Again, there are two ways to depict this direct relation - tabular
(called supply schedule) and graphical (called supply curve).
Supply schedule is a table that shows the quantity supplied at each
price.
The supply curve is the one which graphs the supply schedule,
illustrates how the quantity supplied of the good changes as its price
varies.
Because a higher price increases the quantity supplied, the supply curve
slopes upward.
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Supply Schedule and Supply Curve

Supply Schedule Supply Curve

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Market versus Individual Supply

Individual supply is the quantity of a good or service supplied by an

individual seller, at a given price level.
Market supply curve is the sum of the quantities supplied by all the
sellers at each price. (see figure below)

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Shift in Supply Curve
Analogous to the shifts in demand curve, a shift in the supply curve
(rightward or leftward) is caused by factors other than price affecting
quantity supplied.
Since the price remains the same, at the same price, these factors will
lead to an increase or decrease in quantity supplied, leading to an
outward or inward shift in the supply curve, respectively (see figure
below).

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Shift in Supply Curve: Factors

Input prices: fall in input prices makes production more profitable at

each output price, so firms supply a larger quantity at each price, and
supply curve shifts to the right, and vice-versa.
Technology : technological advancement reducing the cost of
production will raise the supply, shifting the supply curve to the right,
and vice-versa when a technology wears down or becomes obsolete.
Number of sellers : increase in the number of sellers increases the
quantity supplied at each price, shifting the supply curve to the right.
Expectations: If price of the good a seller sells is expected to rise in
the future, the firm may reduce the supply now, to save some of its
inventory to sell later at the higher price. This would shift the supply
curve leftward, and vice-versa when the price is expected to fall in the
future.

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Demand and Supply together: Equilibrium
When we bring the buyers and sellers together in the market, then the point
at which their demand and supply curves intersect is called as the market
equilibrium.
Equilibrium price: The price that equates quantity supplied with quantity
demanded (at 2 dollars in the figure below).
Equilibrium quantity: where quantity supplied and demanded equates (7
ice-cream cones in the figure below), at the equilibrium price.
Therefore, equilibrium tells us that the buyers and sellers, finally,
trade/exchange the equilibrium quantity at equilibrium price.

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Adjustment process: Excess Supply/ Surplus
What happens if the market price is such that the quantity supplied
of a good is not equal to its quantity demanded?
Such situations are called situations of disequilibrium and can create
either a surplus in the market, or a shortage.
Surplus: when quantity supplied is more than quantity demanded,
that is, there exists excess supply in the market (see figure below).
The adjustment process will start causing the prices to fall (why?).
Prices continue to fall until the equality in quantity demanded and
quantity supplied is restored.

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Adjustment process: Excess Demand/ Shortage

Shortage: when quantity demanded exceeds quantity supplied, that

is there exists excess demand in the market, (see figure below).
The adjustment process will start, causing prices to rise (why?).
Prices continue to rise until the equality in quantity demanded and
quantity supplied is restored.

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Disequilibrium to Equilibrium

Suppose the market starts with a situation of equilibrium.

At this equilibrium quantity and price, there is no tendency for any
further changes and the market settles.
However, the market can soon go into disequilibrium if there are any
changes in non-price factors that affect demand or supply or both -
causing shifts in demand curve or supply curve or both.
In such cases, the free market model argues that such situations of
disequilibrium - further causing surpluses or shortages, are only
temporary and the market will be back to equilibrium through the
adjustment mechanism discussed earlier.

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Disequilibrium to Equilibrium: An Example
As shown in figure below, suppose the market for ice-cream cones starts at an
equilibrium, with price = 2$ and quantity exchanged = 7 cones.
Now, suppose there is a sudden increase in heat waves in the city leading to
extreme hot weathers further leading to an increase in demand for ice-cream cones.
Since this is a non-price factor, this increase in demand will be reflected by a
parallel shift in the demand curve, from D1 to D2 .
At the existing price of 2$, now there is a disequilibrium because quantity
demanded is more than quantity supplied, hence, creating a shortage.
This puts pressure on the prices to rise; and hence, the new equilibrium is reached
at price increasing to = 2.5$ and the quantity exchanged increasing to = 10 cones.

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Free Market Mechanism

The crux of the free market mechanism, thus, is that even if any
situation leads to disequilibrium (caused by shifts in demand curve
and/or in supply curve), the free markets will automatically adjust to
restore the equilibrium.
Buyers and sellers are ‘free’ to act in their self-interests to maximise
their utilities and profits, respectively.
Thus, let the markets be and they will achieve an equilibrium
outcome - which will be the most ‘efficient’ outcome.

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Welfare Economics: Efficiency

Welfare economics is the study of how the allocation of resources affects

economic well-being.
So far we discussed how a free market mechanism allocates resources, based
on an equilibrium quantity and price.
Before we analyse whether this free market allocation is indeed an efficient
outcome or not, we need to first define how to measure efficiency, or, in
other words, how to define social welfare.
Since the free market model describes the society to be comprising of only
two agents - consumers and producers; social welfare (as per free market
ideas) is simply defined as net benefits to the consumers and producers.
Next, we will define and measure net benefits to consumers and producers,
respectively.
Then, we will analyse how a free market allocation is the one which
maximises the total of net benefits of consumers and producers, that is,
maximises social welfare.

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Consumer Surplus
Consumer Surplus can be defined as the net benefits to consumers obtained from
the consumption of a particular commodity.
It is the difference between a consumer’s willingness to pay (WTP) for a
commodity minus the actual price paid by them.
A buyer’s willingness to pay for a good is the maximum amount that a buyer
is willing to pay for that good.
WTP measures how much the buyer values the good.
WTP and Demand Curve: At any quantity level, the height of the demand
curve, thus, reflects the willingness to pay of the marginal buyer, the one
who would leave the market if the price would be any higher.
Example below shows WTP of four different consumers for the same
commodity, as well as, their position on a typical demand curve.

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Consumer Surplus (contd.)
If the market price is even slightly higher a consumer’s WTP, that consumer
will not consume that commodity. Hence, based on the previous example,
we can say the following:

Consumer Surplus (CS) is, thus, the difference between the price that the
consumer / buyer is willing to pay and the one they actually pay, that is: CS
= WTP- Price
Therefore, based on the example, the CS of different consumers will be
diagrammatically calculated as shown below:

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Consumer Surplus (contd.)

More generally, when a demand prices will lead to changes in CS.

curve shows endless number of A decrease in price, thus,
consumers, CS be defined as the increases CS, as shown below:
area below the demand curve and
above the price line, as shown
below:

As price reduces from P1 to P2 ,

the CS increases from ∆AP1 C to
Since for every consumer, their ∆AP2 F .
WTP is given, based on their The new CS, thus, includes areas
tastes and preferences, changes in of BCDE + ∆CEF .

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Producer Surplus
Analogously, Producer Surplus can be defined as the net benefits to producers
obtained from selling a particular commodity.
It is the difference between the price a producer gets by selling a particular
commodity and the cost of producing that commodity.
Cost includes the value of everything that the seller must give up or has to
incur (their time and expenses for all the raw materials, etc.) to produce a
good.
Therefore, cost also reflects the minimum price at which the seller would be
willing to sell.
The seller will only produce a good if the price they receive is at least as
much their cost or willingness to sell.
Example below shows the costs to different sellers, of producing one unit of
the same commodity, as well as, their positioning on a typical supply curve.

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Producer Surplus (contd.)
If the market price is even slightly lower a seller’s minimum cost, that seller
will not sell that commodity. Hence, based on the previous example, we can
say the following:

Producer Surplus (CS) is, thus, the difference between the price that the
producer/ seller actually receives for a commodity and the one at which they
are willing to sell or their cost of production, that is: PS = Price - Cost
Therefore, based on the example, the PS of different producers will be
diagrammatically calculated as shown below:

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Producer Surplus (contd.)

More generally, when a supply prices will lead to changes in PS.

curve shows endless number of An increase in price, thus,
producers, PS be defined as the increases PS, as shown below:
area above the supply curve and
below the price line, as shown
below:

As price increases from P1 to P2 ,

the PS increases from ∆AP1 C to
Since for every producer, their ∆AP2 F .
cost is given, based on their The new PS, thus, includes areas
modes of production, changes in of BCDE + ∆CEF .

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Market Efficiency
Let’s assume there is a benevolent social planner, who wants to maximize
the well-being of everyone in the society.
How to measure well-being is the question that arises then?
One of the possible methods is to calculate the total surplus.
Total Surplus = Consumer Surplus + Producer Surplus
Recall, Consumer Surplus = Value to buyers - Amount paid by buyers; and
Producer Surplus = Amount received by sellers - cost to sellers
Therefore, Total surplus = Value to buyers - Amount paid by buyers +
Amount received by sellers - cost to sellers
Since in a market equilibrium, amount paid by buyers = amount received by
sellers: Total Surplus = Value to buyers - Cost to sellers
Thus, an allocation of resources is efficient if it maximizes total surplus.
Efficiency means: The goods are being consumed by the buyers who value
them most highly; and the goods are being produced by the producers with
lowest cost.
Raising or lowering the quantity of a good would not increase total surplus.
Additionally, social planner might also care about equality - that is whether
various buyers and sellers have a similar level of economic well-being.
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Free Market Equilibrium: Efficient
As shown in diagram, is this equilibrium, E, allocation of resources efficient?
That is, does it maximize total surplus?
Free markets allocate the supply of goods to the buyers who value the most
highly, as measured by their willingness to pay.
Free markets allocate the demand for goods to the sellers who can produce
them at the lowest cost.
Thus, free markets produce the quantity of goods that maximizes the sum of
consumer and producer surplus. That is to say social planner cannot raise
total economic well-being by increasing or decreasing the quantity of the
good.

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Free Market Equilibrium: Efficient (contd.)
The free market equilibrium, at E, is an efficient outcome. Why?
This is because, as shown in the graph below, at any quantity to the left of
E1 , say, Q1 , the value to buyers > cost to the seller. So, any point on the
left of E is not efficient as the total surplus can be increased by increasing
the quantity further, until E1 .
Similarly, at any point to the right of E1 , say Q2 , value to buyers < cost to
the sellers and is not efficient either. A decrease in quantity can, thus,
increase the total surplus, which will continue until E1 is achieved.
E1 is the only efficient point that maximizes total surplus, and is also the
equilibrium that is being achieved through free market interaction amongst
the buyers and sellers.

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Government Intervention and Inefficiency

Until now, we saw how a free market mechanism leads to an efficient

market outcome.
Government intervention in the form of price controls - price ceilings
and price floors; and taxes can lead to departures from such situation,
hence, leading to inefficiency.
This is the reason why government intervention is often opposed by
free market proponents, as they believe that it leads to inefficiency.

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Price Controls

Price ceiling: a legal maximum imposed by the government on the

price of a good or service.
Example: rent control, maximum retail price.
The market price cannot go higher than this.
The intent of such policies is to protect the interests of the consumers.
Price floor: a legal minimum imposed by the government on the price
of a good or service.
Example: minimum wage.
The market price cannot go lower than this.
The intent of such policies is to protect the interests of the producers.
Taxes: The govt. can also make buyers or sellers pay a specific
amount on each unit bought/sold by imposing a tax, hence, altering
the final price paid by them.

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Price Ceiling: Non-binding
Non-binding price ceiling: A price ceiling is non-binding if it already is above
the market price.
Since the ceiling suggests a maximum and the market price is already lower
than this maximum, such a price ceiling is non-binding in the sense that it
does not impose any restriction on the existing market equilibrium.
As shown below, the market price is at 3$ while the price ceiling is that of
$4.

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Price Ceiling: Binding

When the govt. imposed price ceiling is below the market clearing price
level, it becomes binding.
As shown in the figure on slide 39, market clearing price is at $3 which is >
the price ceiling of $2.
This means that now the seller cannot sell the product at a price higher than
$2.
At $2, however, demand > supply, leading to excess demand in the market
or shortages.
This is so because the price ceiling has been set at such a low level, that
many suppliers not able to recover their minimum costs would not be willing
to sell at this lower price, hence, sellers would adjust their supply in wake of
lower prices to a lower level of output.
Contrarily, the buyers would adjust their demand to be higher, in wake of
the lower price level.
This results in higher shortages in long-run than in short-run.

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Price Ceiling: Binding

As can be seen in the graph above, due to the binding price ceiling,
the quantity supplied is restricted at 75, while the quantity demanded
has increased to 125.
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Price Ceiling and Inefficiency

As seen previously, a price ceiling, when binding, creates a situation of

shortage, i.e. quantity supplied becomes smaller than quantity demanded.
As shown in the diagram on slide 41, the free market price of 800 equates
the quantity demanded and supplied at 10.
At this price and quantity, CS = areas of A + B + C, while PS = areas of D
+E + F.
Now, a price ceiling of 650 creates a shortage where Qs = 7 and Qd = 12.
Note that in this market, finally, trade will happen for only 7 units of the
commodity.
Due to this, now CS = Areas of A +B + D; while PS = Area of F.
Therefore, in a free market equilibrium, Total Surplus (TS) = A + B + C +
D + E + F; whereas in case of price ceiling, TS = A+ B + D + F.
The TS reduces by the size of area of C + F, which is called as ‘Deadweight
Loss’ or loss of efficiency.

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Price Ceiling and Inefficiency

Recall that a price ceiling was intended to protect the interests of the consumers.
Yet, it ends up hurting those it was trying to help.
CS definitely decreases from A + B + C to only A.
Further, the situation of shortage created by a price ceiling will lead to rationing by
sellers.
More often than not, such rationing mechanisms are discriminatory and inefficient.
Also, for example, price ceilings as rent controls may keep rents low, but it also
discourages landlords from maintaining their buildings and makes housing hard to
find.
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Price Floor: Non-binding
Non-binding price floor: A price floor is non-binding if it already is lower
than the market price.
Since the floor suggests a minimum and the market price is already higher
than this minimum, such a price floor is non-binding in the sense that it
does not impose any restriction on the existing market equilibrium.
As shown below, the market price is at 3$ while the price floor is that of $2.

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Price Floor: Binding
When the price floor is set at a level higher than the market clearing price it
becomes binding, that is it affects the free market outcomes.
As shown in the figure below, price floor is at $4 which is > the market clearing
price of $3.
This means, that a seller has to be paid a minimum of $4 for the good.
At this price, market supply > market demand, there is excess supply or surplus in
the market.
This is so because the price floor has been set at such a high level, that many
buyers are not willing to pay such a high price, hence leading to fall in demand.
Contrarily, because of the high price, more sellers enter the market who are now
able to recover their costs as well, hence leading to increase in supply.

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Price Floor and Inefficiency
As seen previously, a price floor creates a situation of surplus, i.e. quantity
supplied becomes larger than quantity demanded.
As shown in the diagram on slide 45, in the market for labour, the free
market wage rate of 6$ per hour equates the quantity demanded and
supplied of labour at 2.
At this price and quantity, CS = areas of A + B + C, while PS = areas of D
+E.
Now, a price floor, in the form of minimum wage has been imposed, that of
$7.25, which creates a surplus of labour, i.e. where Qs = 2.4 and Qd = 1.7.
Note that in this market, finally, only 1.7 units of labour will be employed
(why?).
Due to this, now CS = Area of A ; while PS = Areas of B + D.
Therefore, in a free market equilibrium, Total Surplus (TS) = A + B + C +
D + E ; whereas in case of price floor/minimum wage, TS = A+ B + D.
The TS reduces by the size of area of C + E, which is called as ‘Deadweight
Loss’ or loss of efficiency.
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Price Floor and Inefficiency

Recall a price floor is intended to help the sellers/producers.

In case of minimum wage laws, the sellers are poor labourers who are selling their
labour.
Thus, we can see that price floor ends up hurting those they are trying to help.
PS (or surplus to labourers) reduces from D + E to D.
Further, while minimum-wage laws may raise the incomes of some workers, but
they also cause other workers to be unemployed.
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 ALL THE BEST!

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