Topic 2.

Market, State and Welfare.

Topic 2. Market, state and welfare.

1.1. Market equilibrium

1.2. Efficiency and welfare
1.3. State intervention and efficiency
 Price controls (Price ceiling and Price floor)
 Taxes
 Tariffs
1.4. Efficiency vs equity
1.5. Market failures
 Externalities
 Public goods
 Demand function

Q1D = f ( P1 , P2 , Income (m) , Tastes,

expectations, # consumers, ...)

Q1D = f ( P1 )
The Demand Schedule and the Demand Curve
Individual and Market Demand
Supply function

Q1S = f ( P1 , P2 , PINPUTS ,
technology , expectations,
# producers, ... )

Q1S = f ( P1 )
The Supply Schedule and the Supply Curve
 Individual Supply Curve and the
Market Supply Curve
(a) (b) (c)
Mr. Figueroa’s Mr. Bien Pho’s Individual Market Supply Curve
Price of Individual Supply Curve Supply Curve
coffee Price of
coffee Price of
beans (per coffee
pound) beans (per
pound) beans (per
SFigueroa SBien Pho pound) SMarket
$2 $2 $2

1 1 1

0 1 2 3 0 1 2 0 1 2 3 4 5
Quantity of coffee Quantity of coffee Quantity of coffee
beans (pounds) beans (pounds) beans (pounds)
Market Equilibrium
Price Above Its Equilibrium Level
Creates a Surplus
Price Below Its Equilibrium Level
Creates a Shortage
Equilibrium and Shifts of the
Demand Curve
Equilibrium and Shifts of the
Supply Curve
Simultaneous Shifts of the
Demand and Supply Curves
Consumer Surplus
Producer Surplus
Total Surplus
Market equilibrium and Efficiency

◼ Resource allocation in a competitive

equilibrium maximizes total economic
surplus (TS = CS + PS) and, therefore,
the allocation is efficient.

◼ Out of equilibrium allocations are

inefficient.
Inefficient Allocations
 Exercise 1

Supply: 10 P = 50 + 5 QS
Demand : 10P = 200 -10 QD
Calculate:
a) Efficient Equilibrium: PE, QE, CS, PS, TS?
State Intervention

State Intervention

and the

Effect on Welfare
The Market for Apartments in the
Absence of Government Controls
The Effects of a Price Ceiling
Price Ceiling
Price Ceiling
 Exercise 1 (cont’d)

Supply: 10 P = 50 + 5 QS
Demand : 10P = 200 -10 QD
Calculate:
a) Efficient Equilibrium: PE, QE, CS, PS, TS?
b) Price Ceiling: PMAX = 2; New PE, QE, CS, PS, TS, DWL?
Compare your answer with a)
The Market for Butter in the
Absence of Government Controls
The Effects of a Price Floor
Price Floor
Price Floor
 Exercise 1 (cont’d)

Supply: 10 P = 50 + 5 QS
Demand : 10P = 200 -10 QD
Calculate:
a) Efficient Equilibrium: PE, QE, CS, PS, TS?
b) Price Ceiling: PMAX = 2; New PE, QE, CS, PS, TS, DWL?
c) Price Floor PMIN = 6; New PE, QE, CS, PS, TS, DWL?
Compare your answer with a)
 Exercise 2 (at home)

Demand function: QD = 28 – 2P
Supply function: QS = 4 + 4P
Calculate:
a) Efficient Equilibrium: PE, QE, CS, PS, TW?
b) Price Ceiling: PMAX = 2; New PE, QE, CS, PS, TW, DWL?
c) Price Floor PMIN = 6; New PE, QE, CS, PS, TW, DWL?
Taxation

We have studied two interventions –

1. Price Ceiling

2. Price Floor

Let us consider a new intervention:

Taxation
A Tax Reduces Consumer and
Producer Surplus
The Deadweight Loss of a Tax
 Exercise 1 (cont’d)

Supply: 10 P = 50 + 5 QS
Demand : 10P = 200 -10 QD
a) Suppose the government levies an excise tax of $6. What is the new
supply function? The new quantity sold? What price do consumers pay?
What price do producers receive? Illustrate on a graph.
b) Find the new producer and consumer surplus.
c) How much revenue does the government raise from the tax?
d) How is the burden of the tax split between producers and consumers?
e) How does the sum of consumer surplus, producer surplus, and revenue
after the tax compared to the sum of producer and consumer surplus
found before the tax? What does the difference between the two
represent?
An Excise Tax Paid Mainly by
Consumers
An Excise Tax Paid Mainly by
Producers
Deadweight Loss and Elasticities
Deadweight Loss and Elasticities
 Exercise 3 (at home)

Demand function: QD = 10 – P
Supply function: QS = 4 + P
Calculate:
a) Efficient Equilibrium: PE, QE, CS, PS, TS?
b) Tax (t = 1); New Supply, PE, QE, CS, PS, TGR, TS,
DWL?
Consumer and Producer Surplus in Autarky
The Domestic Market with Exports
The Effect of Exports on Surplus
The Domestic Market with Imports
The Effects of Imports on Surplus
The Effect of a Tariff
A Tariff Reduces Total Surplus
 Exercise 1 (cont’d)

Supply: 10 P = 50 + 5 QS
Demand : 10P = 200 -10 QD
Calculate the Efficient Equilibrium:
a) Closed Economy = Autarky: PE, QE, CS, PS, TS?
b) Open Economy with PW = 14; New PE, QE,
CS, PS, exports, TS, ΔTS?
c) Open Economy with Pw = 7; New PE, QE, CS, PS,
imports, TS, ΔTS?
d) Open Economy with Pw = 7 and with Tariff z = 2; New PE,
QE, CS, PS, TGR, TS, DWL?
 Exercise 4 (at home)

Demand function: QD = 40 – 2P
Supply function: QS = 2P/3
Calculate the Efficient Equilibrium:
a) Closed Economy = Autarky: PE, QE, CS, PS, TS?
b) Open Economy with PW = 18; New PE, QE, CS, PS,
exports, TS, ΔTS?
c) Open Economy with Pw = 9; New PE, QE, CS, PS,
imports, TS, ΔTS?
d) Open Economy with Pw = 9 and with Tariff z = 3; New PE,
QE, CS, PS, TGR, TS, DWL?
 Efficiency versus Equity

 An economy is efficient (Pareto Efficiency) if

it takes all opportunities to make some people
better off without making other people worse
off. (Vilfredo Pareto 1848-1923)
 No one can be made better off without making someone
else worse off (Pareto effiency).
 Equity means that everyone gets his or her
fair share. Since people can disagree about
what’s “fair,” equity isn’t as well-defined a
concept as efficiency.
Efficiency versus Equity

◼ In addition to efficiency, it is desirable

that the allocation of scarce resources
is equitable and economically just.
◼ The measurement of equity has to do
with income distribution.
Income Distribution

◼ We can get an indication of relative

income inequality through the use of
Lorenz curves and Gini coefficients.
 A Lorenz curve is a graphical
representation of income inequality.
 A Gini coefficient is a summary measure
of income inequality.
Lorenz curve
LORENZ
CURVE
Gini coefficient

Area between the line of equality and the Lorenz curve

G=
Total area below the line of equality

A
G= A+B

G = 0 (complete equality) G = 1 (complete inequality)

 Utilitarianism Jeremy Bentham (1748-1832)

The goal is
maximizing total
welfare.

Utilitarianism is not in
favor of
egalitarianism.
 The Rawls’ criterion John Rawls (1921-2002)
The criterion of
MAXIMIN (short for
"Maximum
minimorum") i.e.
maximizing
minimum wage.
The emphasis is on
the most
disadvantaged.
Income Redistributive Policies

◼ Fiscal Policy Instruments:

 Via revenue (taxes)
◼ Principle of ability to pay
◼ Principle of profit
 Via expenditure
◼ The Welfare State (e.g., social housing, food
stamps, transfers)
 Justification of the Public
Sector's role on economics
◼ The failures of the market mechanism:
 Equitable income distribution
 Public goods and services
◼ Non-excludable
◼ Non-rival in consumption
 Externalities in production and consumption
◼ Property rights (Ronald Coase, Nobel 1960)
 Efficiency of markets and free competition
◼ Imperfectly competitive market structures
 Typology of goods / services
◼ Goods can be classified according to two attributes:
 whether they are excludable or non-excludable
 whether they are rival or non-rival in consumption

◼ A good is excludable if the supplier of that good can

prevent people who do not pay from consuming it.
◼ When a good is non-excludable, the supplier cannot
prevent consumption by people who do not pay for it.
◼ A good is rival in consumption if the same unit of the
good cannot be consumed by more than one person at the
same time.
◼ A good is non-rival in consumption if more than one
person can consume the same unit of the good at the same
time.
 Typology of goods / services

PRIVATE GOODS COLLECTIVE GOODS (clubs,

Rival and Excludable artificially scarce goods)
• shoes Non-rival and Excludable
• cars • subscr. streaming services
• restaurant meals • softwares
• pools and gyms
COMMON GOODS PUBLIC GOODS
(common resources) Non-rival and Non-Excludable
Rival and Non-Excludable • national defence
• marine fauna • public health
• clean water • clean environment
 Typology of goods / services
◼ PRIVATE GOODS (Goods that are both excludable and
rival in consumption) can be efficiently produced and
consumed in a competitive market.
◼ Goods that are nonexcludable (COMMON RESOURCES
and PUBLIC GOODS) suffer from the free-rider problem:
individuals have no incentive to pay for their own
consumption and instead will take a “free ride” on anyone
who does pay.
◼ When goods are nonrival in consumption, the efficient
price for consumption is zero. If a positive price is charged
to compensate producers for the cost of production, the
result is inefficiently low consumption.
◼ A PUBLIC GOOD is the exact opposite of a private good:
it is a good that is both non-excludable and non-rival in
consumption
Marginal (a) Ted’s Individual Marginal Benefit Curve
benefit
25
$25

18
18
12
12
7 MB
7
3 T
3 1
1
0 1 2 3 4 5 6
Quantity of street cleansings (per month)
Marginal (b) Alice’s Individual Marginal Benefit Curve
benefit
21
$21
17
17
13
13
9
9
5 MBA
5
1
1
0 1 2 3 4 5 6
Quantity of street cleansings (per month)
 (c) The Marginal Social Benefit Curve
Marginal
benefit, 46
$46
marginal cost
The marginal social benefit curve of a
public good equals the vertical sum of
35
35 21 individual marginal benefit curves

17 25
25

13 16
16 MSB
25
18 9 8
8 12 MC=$6
6 5
7 2 1
2 3 1
0 1 2 3 4 5 6
Quantity of street cleansings
(per month)
Efficient quantity of the
public good
 Providing Public Goods
◼ No individual has an incentive to pay for providing the
efficient quantity of a public good because each
individual’s marginal benefit is less than the marginal
social benefit.
MBi < MBsociety
◼ The marginal social benefit of an additional unit of a
public good is equal to the sum of each consumer’s
individual marginal benefit from that unit.
ΣMBi = MBsociety
◼ At the efficient quantity, the marginal social benefit
equals the marginal cost.
MBsociety = MC
◼ This is a primary justification for the existence of
PUBLIC SECTOR (Government)
 Private Goods versus Public Goods

I
 Externalities
◼ An external cost is an uncompensated or collateral
cost that an individual (consumption) or firm
(production) imposes on others.
↳ NEGATIVE EXTERNALITY

◼ An external benefit is an uncompensated benefit or

side effect that an individual (consumption) or firm
(production) provides to others.
↳ POSITIVE EXTERNALITY
 Examples of Externalities
NEGATIVE EXTERNALITIES
◼ Air pollution from a factory
◼ The neighbor’s barking dog
◼ Late-night stereo blasting from the dorm room next to yours
◼ Noise pollution from construction projects
◼ Health risk to others from smoking
◼ Talking on cell phone while driving makes the roads less safe for others

POSITIVE EXTERNALITIES
◼ Being vaccinated against contagious diseases protects not only you but
also others.
◼ R&D creates knowledge others can use.
◼ People going to college raise the population’s education level, which
reduces crime and improves government.
◼ People going to vote ensure democracy
 Costs and Benefits of Pollution
◼ The marginal social cost of pollution is the
additional cost imposed on society as a whole by an
additional unit of pollution.
◼ The marginal social benefit of pollution is the
additional gain to society as a whole from an additional
unit of pollution.
◼ The socially optimal quantity of pollution is the
quantity of pollution that society would choose if all the
costs and benefits of pollution were fully accounted for.
◼ Left to itself, a market economy will typically generate
too much pollution because polluters have no incentive
to take into account the costs they impose on others.
Costs and Benefits of Pollution
Is the market economy polluting?
 Public Policies Toward Externalities
Two approaches to remedy the problem:
"internalize the externality"
◼ Command-and-control policies regulate behavior
directly. Examples:
 limits on quantity of pollution emitted: Environmental
standards
 requirements that firms adopt a particular technology to
reduce emissions
◼ Market-based policies provide incentives so that private
decision-makers will choose to solve the problem on their
own. Examples:
 corrective taxes and subsidies (Pigouvian taxation)

 tradable pollution permits (e.g. EU ETS)

Policy Options
 Pigouvian Tax and Pigouvian Subsidy

◼ Arthur Cecil Pigou (1877-1959): An emissions tax is a

form of Pigouvian tax, a tax designed to reduce
external costs.

◼ The effect of a Pigouvian tax is to make that private

marginal cost plus this tax equals the marginal social
cost.

◼ The Pigouvian tax does not generate any efficiency

loss of markets, as internalize the externality costs for
producers and consumers, rather than changing them.

◼ A Pigouvian subsidy is a payment designed to

encourage activities that yield external benefits.
 A Pigouvian Tax

P
MSC = MPC + t

a MPC
OPT
POPT e t
b
c d
t PMK MK
f h
g
POPT ̵ t
i
D = MB
QOPT QMK Q
 A Pigouvian Tax : Welfare Effect

Without Tax With Pigouvian Tax

(MK eq.) (OPT eq.)
Consumer Surplus a+b+c+d a
Producer Surplus f+g+h+i i
Pollution Impact -(c+d+e+g+h+i) -(c+g+i)
Tax Revenue none b+c+f+g
TOTAL WELFARE a+b+f-e a+b+f
 Private Solutions to Externalities
◼ The economist Ronald Coase (1910-2013)
(Nobel Prize in Economics – 1991)
pointed out that, in an ideal world, the private sector
could indeed deal with all externalities. When
individuals or firms do take externalities into account,
they internalize the externality

◼ According to the Coase theorem (1960), even in the

presence of externalities, An economy can always
reach an efficient solution once property rights have
been defined and when the transaction costs are
sufficiently low.

◼ The costs of making a deal are known as transaction

costs.