1 Introductory Microeconomics Efficiency and Exchange.

1

Introductory Microeconomics

Efficiency and Exchange

2

Is it unfair

Markets allocate scarce goods and services on the basis of willingness to pay.

Similarly, cost-benefit analysis resolves public decisions on the basis of willingness to pay.

Is that a good thing to do? Doesn’t willingness-to-pay unfairly disadvantage those who don’t have much money?

3

Example 7.1.

A public radio station currently offers all-music programming. A proposal has been introduced to switch the station’s format to all talk.

4

Example 7.1.

All community residents are neutral with respect to this proposal except for the following three:

A rich resident (R), who favors the proposal…

P1 P2

..and two poor residents (P1 and P2), who oppose it.

5

Example 7.1.

Each of these three feels equally strongly about the issue.

But because R is wealthy, he is willing to pay $1000 to see the switch enacted, while P1 and P2 are willing to pay only $100 each to prevent it.

Should the switch be made?

6

Example 7.1.

Cost-benefit analysis says to make the switch, because the benefit ($1000) exceeds the cost ($200).

Is willingness to pay (WTP) the right basis for making such decisions?

Many social critics say no, that WTP gives unfair decision weight to the preferences of the wealthy.

7

Example 7.1.

In the US, recent Presidential executive orders, for example, have directed agencies to temper cost-benefit calculations with “distributional concerns.”

These orders militate against making the format switch. Yet both rich and poor would benefit if we resolved all such

cases on the basis of pure, unweighted willingness to pay, using the tax and transfer system to compensate those who would be hurt in the process.

For instance, raise R’s taxes by $500, reduce those of P1 and P2 by $250 each.

Compared to the status quo, R has net gain of $500,while P1 and P2 each reap a net gain of $150.

8

Decision based on unweighted WTP

Persons Favor switch WTP Weight

R 1 1000 1

P1 -1 100 1

P2 -1 100 1

Aggregate unweighted WTP = 1000 – 100 – 100 = 800 >0. Thus, based on pure unweighted WTP, the station should switch to all talk.

Persons Favor switch WTP Weight

R 1 1000 0.01

P1 -1 100 0.9

P2 -1 100 0.09

Aggregate weighted WTP = 0.01*1000 – 0.9*100 – 0.09*100 = - 89 <0. Thus, based on weighted WTP (with this particular weight), the station should not switch to all talk.

9

Example 7.2.

City Lights Antiques has a 1905 Stickley grandfather clock on display in its showroom…

10

Example 7.2.

Susan, a fourth grade teacher and an aficionado of early 20th century grandfather clocks, would LOVE to own it.

11

Example 7.2.

Malcolm, a personal injury lawyer, has no particular interest in clocks—from that period or any other. But he happened to see the Stickley as he walked by and thought it might look nice in his office waiting room.

12

Example 7.2.

Susan, a single mother of two who earns $28,000/yr, is willing to pay up to $5000 for the clock.

Malcolm earns $950,000/yr and is willing to pay $10,000 for it.

Who “should” get the clock?

13

Example 7.2.

10096

50

2575

Susan

100

3650

2575

Malcolm

Utility from Owning the Clock

14

Example 7.2.

The attraction of willingness to pay

Yes, Susan would enjoy the clock more than Malcolm would.

But because of her relatively low income, she also values other things that money can buy more highly than Malcolm does.

If she were given the clock, her best option would be to sell it to Malcolm.

15

Example 7.2.

Suppose Malcolm buys it from her for $8000. Since the clock was worth “only” $5000 to her,

Susan can now buy goods and services that are worth $3000 more to her than the clock.

Taking the initial distribution of income as given, the best attainable outcome entails Malcolm getting the clock.

If you think the distribution of income is problematic, try to change it. Meanwhile, allocating the clock to the highest bidder is the best we can do.

16

A bigger pie

Using unweighted willingness to pay results in the largest possible economic pie.When the pie is bigger, everyone can have a larger slice.

Total surplus with unweighted willingness to pay

Total surplus with weighted willingness to pay

17

Example 7.3.

260 people show up for a flight from New York to LA that has only 250 seats.

18

Example 7.3.

John was the second passenger to arrive. An office custodian on his way to visit his seriously ill

mother, he would have to wait 10 hours for the next available seat to LA.

He would be willing to pay $200 to avoid missing the flight.

Eric was the 255th passenger to arrive (because of a delayed connection to NY). A Microsoft vice-president, he can reach his vacation

destination in Hawaii via Seattle with only one hour’s delay.

He is willing to pay $1000 to avoid missing the flight.

Who “should” miss the flight?

19

Example 7.3.

Total wealth is maximized if scarce seats on overbooked flights are allocated on the basis of unweighted willingness to pay.

Pre-1979, seats on overbooked flights were allocated by airlines on a first-come, first-served basis.

Some of those forced to wait suffered large losses (as measured by WTP), while many others had no pressing reasons to arrive on time (again as measured by WTP)..

20

Example 7.3.

1979: Civil Aeronautics Board proposed a new rule that would require carriers to offer cash payments or free tickets to induce volunteers to wait for the next available flight.

Ralph Nader’s Aviation Consumer Action Project (ACAP) promptly filed a vociferous objection. If the new rule were adopted, the burden of waiting would fall disproportionately on the poor.

21

Example 7.3.

“Run that by me again, Ralph:

How, exactly, are you protecting my interests by denying me the option of volunteering to earn $400 by waiting?”

22

Example 7.4.

Illinois needs a new maximum security prison...

23

Example 7.4.

Two locations under consideration: Dixon, average income $100,000/yr. Moline, average income $22,000/yr.

Neither community wants the prison.

24

Example 7.4.

Two locations under consideration: Dixon, average income $100,000/yr. Moline, average income $22,000/yr. Neither community wants the prison.

Dixon residents are collectively willing to pay $1 million to avoid it.

Moline residents collectively willing to pay only $100,000 to avoid it.

Where should the prison be built?

25

Example 7.4.

Build the prison in Moline.

Levy $200,000 in supplemental taxes on Dixon residents.

Reduce taxes by $200,000 in Moline.

26

Should redistribution of wealth be allowed?

Former Bush Treasury Secretary Paul O’Neill: The business of government is to make rules that foster the creation of wealth. Government has absolutely no business redistributing wealth from rich to poor.

“I don't believe this society should still be operating with a robber baron premise as the basis for how we discuss public policy. I think it is really corrosive to have this argument about the rich and the poor. It’s not worthy of where we are in our development as a country.”

27


O’Neill and other supply-siders invoke the writings of Richard Posner, one of the founders of the law and economics movement:

“Legislators should be concerned principally with protecting people’s ability to bargain freely, and not with redistributing wealth. Indeed, redistribution actually decreases total social wealth, since it takes something from those who value it and puts it in the service of those who, not having transacted for it, will not feel the market pressures to wring the most efficient use out of it.”

28


Posner and O’Neill miss important parts of the picture.

In a democracy, single-minded insistence on the illegitimacy of redistribution actually prevents actions that would increase total wealth.

29


Recall Example 7.1. R is willing to pay $1000 for the switch from all music to all talk.

P1 and P2 are willing to pay only $100 each to prevent the switch.

If redistribution is ruled out and we settle the issue democratically, the switch loses, two votes to one.

30


But a better outcome is to redistribute and make the switch.

For example, raise R’s taxes by $500, reduce those of P1 and P2 by $250 each.

Compared to the status quo, R has net gain of $500,while P1 and P2 each reap a net gain of $150.

Refusal to redistribute makes the economic pie smaller.

31

Example 7.5.

The energy crisis of 1979 led President Carter to propose a 50-cent per gallon tax on gasoline to cut dependence on foreign oil.

Critics: Unacceptable hardship on the poor!

Carter response: Cut payroll taxes by the same amount as the amount raised in additional gasoline taxes.

Plan was never enacted, partly because critics failed to grasp why it would reduce gas consumption.

Instead, gasoline price controls were adopted to ease the burden on the poor.

32

Example 7.5.

Carter’s proposal would have been better for both rich and poor.

Line at a gas station, June 15, 1979.

33

Example 7.6. Free directory assistance

Prior to 1976, calls to directory assistance operators were provide free of charge in New York State, as they continue to be today in many other states.

This policy was inefficient, because it resulted in many calls whose costs exceeded their benefits.

In 1976 the New York Public Service Commission proposed that a charge of ten cents per directory-assistance call be added to each subscriber’s monthly bill.

This proposal was bitterly opposed by public interest groups, who insisted that it would weaken relationships in the community by disrupting essential patterns of communications.

Directory Assistance Service allows the customer to request the telephone number or area code of a party located in another state or a United States territory. The Directory Assistance operator provides assistance in locating business, residence, and government listings.

34

Example 7.6. Free directory assistance

B = -$0.30 + $0.10 D

Alfred Kahn’s solution:

Additional reading for hard-working students:Daly, George and Thomas Mayor (1980): “Estimating the Value of a Missing Market: The Economics of Directory Assistance,” Journal of Law and Economics, 23 (1): 147-166.

35

If willingness to pay is so great, why do people object to its use?

Objection 1. There are thousands of public decisions made every day. It is impractical to assess the distributional consequences of each one and arrange for the necessary transfers.

Compensation can sometimes be geared to specific cases: Negative-intercept term in directory assistance billing

equation. Denied boarding compensation Auctions to determine the siting of prisons and other

unattractive facilities

36


Objection 1 continued. Still, case-by-case compensation has practical limits.

But the distributional issue arises in the same form in virtually every potential application of cost-benefit analysis.

The problem is that using unweighted willingness to pay biases outcomes in favor of high-income taxpayers generally.

37


This problem has a simple solution: Compensate not case-by-case but once for all, but

making the tax and transfer system more progressive. Give the poor whatever transfers society deems fit in

the name of distributive justice, plus an additional amount to compensate for the use of unweighted willingness to pay in cost benefit analysis.

Relative to abandoning willingness-to-pay for public decisions, this move would create net benefits for rich and poor alike.

38


Objection 2. “Cost benefit analysis with compensation is fine in principle, but realists know that in practice the poor never get compensated, because of their lack of political power.”

True, political influence grows with wealth. But the claim that we should abandon willingness to pay

to protect the interests of the non-wealthy is interesting only if the non-wealthy or their defenders have the political power to force that outcome.

In a democracy that is a fair assumption.

39


In the radio format case, the two poor citizens can vote down the proposal of the wealthy citizen.

So if the poor have the political power to block the use of willingness to pay, why don’t they use that power to bargain for sufficient transfers to compensate for agreeing to the use of willingness to pay?

40




41




42

Calculating Total Economic Surplus

Consumer surplus: the difference between the most a buyer would have been willing to pay for a product and the amount it actually costs her.

Producer surplus: the difference between what a company gets paid for the goods it sells, and the smallest amount it would have been willing to accept for them.

Total economic surplus: the sum of consumer surplus and producer surplus for all buyers and sellers in a market. It is a measure of the total amount by which they benefit from their participation in that market.

43

Example 7.7.

Price ($/gal)

Quantity(1000s of gals/day)

D

S

1.50

3

63

For the equilibrium price and quantity implied by the demand and supply curves shown for the gasoline market, compute consumer and producer surplus. Consumer surplus=$2250/day

Producer surplus = 2250/day

44

“Efficient” does not mean the same thing as “good.”

Still, efficiency should be our primary objective, because it enables us to pursue all other goals more effectively.

When the economic pie is larger, everyone can have a larger slice.

45

The Efficiency Criterion

If resources are to be used efficiently, price must be equal to marginal cost.

If price is not equal to marginal cost, resources will be used inefficiently.

To say that resources are being used inefficiently is the same thing as saying that resources can be rearranged in a way that helps some people with out hurting others.

46

Example 7.8.

Citizens of a small country use coal for home heating.

The country imports all of its coal supplies from abroad.

To keep coal affordable for the poor, the government purchases coal at the world price of $100/ton and then sells it to citizens for only $50/ton.

Will coal use be efficient in this country?

47

Example 7.8.

DQ

100

50

Q'

Price($/ton)

Quantity(millions of tons/yr)

When P=$50/ton, people will continue to purchase coal until the benefit of the last ton of coal consumed is $50.

Each ton consumed, however, costs the country $100.

If people used a ton less coal, they would lose benefits worth $50.

But the country would save $100.

48

Example 7.8.

The efficiency properties of market equilibrium do not challenge the notion that it is difficult, often even painful, to be poor.

The efficiency properties merely say that, given the low incomes of the poor, free exchange enables them to do the best they can.

One can hold this view and yet still believe that it is desirable to provide public assistance to people who are unable to earn adequate incomes in the marketplace.

49

Example 7.8.

Concern for the well-being of the poor motivates most societies to try to alter market outcomes.

The difficulty is that many of our direct interventions in markets produce unintended and often very harmful consequences.

50

Example 7.9.

In the preceding example, if Q = 80 million tons/yr and Q’ = 100 million tons/yr, how much economic surplus is lost as a result of pegging the price of coal at $50/ton?

Welfare loss = $500 million /yr

Consumer surplus with subsidy

Cost of subsidy

Total welfare = CS -Subsidy

80 100Quantity(millions of tons/yr)

Price ($/ton)

Consumer surplus without subsidy

100

50

51

Example 7.9.

At world price of 100/ton, what is the producer surplus of the local supplier?


Price ($/ton)

100

50

Producer surplus: the difference between what a company gets paid for the goods it sells, and the smallest amount it would have been willing to accept for them.Price = 100, MC = 100. PS = 0.

S

52

Example 7.10.

In the preceding example, describe a change in policy that would make all citizens better off.

Welfare (surplus) loss = $500 million /yr


100

50

Price ($/ton)

53

Example 7.10.

First the cost of subsidy….

Cost of subsidy=(100-50)*100 = 5 billions


Price ($/ton)

100

50

54

Example 7.10.

“Five billions is five thousand million? Why wasn’t I informed of this?”

55

Example 7.10.

Suppose the government were to eliminate the subsidy and return the $5 billion to citizens in the form of lower taxes.

56

Example 7.10.

Confronted with the market price of $100/ton, citizens would respond by consuming 20 tons/yr less than before.

Loss in consumer surplus = (100-50)*80 + (100-50)*(100-80)/2=4.5 billions


100

50

Price ($/ton)

57

Example 7.10.

Thus families would be better off in the aggregate by $5 billion - $4.5 billion (tax refund) (lost CS from coal)= $500 million each year.

Welfare (surplus) loss = $500 million /yr


100

50

Price ($/ton)

58

Example 7.11.

What will be the effect on total economic surplus in this rental market of setting a rent control price of $200/month?Rent ($/apt)

Quantity(1000s of apts/month)0

S

D

1000

600

200

1 2 3 4 5

59

Example 7.11.

In an unregulated market,equilibrium rent = $600/apt equilibrium quantity = 3000 apts/mo.Rent ($/apt)


S

D

1200

600

200

1 2 3 4 5

Total economic surplus = 0.5($1200/apt)(3000 apts/mo) = $1,800,000/mo

60

Example 7.11.

With rents controlled at $200/apt, landlords will offer only 1000 apartments per month.

Rent ($/apt)


S

D

1200

600

200

1 2 3 4 5

Loss in economic surplus = 0.5($800/apt)(2000 apt/mo)= $800,000 /mo

61

Example 7.12.

Anticipating a high proportion of no-shows, a hair salon manager routinely books five people for each appointment time, even though only three slots are available during each appointment time.

One day, all five people show up for 6 p.m. appointments.

62

Example 7.12.

Their respective arrival times and the most each would be willing to pay to avoid postponing his or her appointment :

Customer Arrival time WTP

Ann 5:50 $6

Bill 5:52 $11

Carrie 5:55 $4

Dana 5:56 $12

Earl 5:59 $5

63

Example 7.12.

Suppose the salon manager accommodates the customers on a first-come-first-served basis.By how much will total economic surplus be smaller than if she had offered cash compensation to induce two volunteers to reschedule?


Ann 5:50 $6

Bill 5:52 $11

Carrie 5:55 $4

Dana 5:56 $12

Earl 5:59 $5

64

Example 7.12.

First-come-first-served means that Ann, Bill, and Carrie get to keep their appointments, which results in a surplus of $6+$11+$4=$21.


Ann 5:50 $6

Bill 5:52 $11

Carrie 5:55 $4

Dana 5:56 $12

Earl 5:59 $5

65

Example 7.12.

Suppose instead that the three willing to pay most (Dana, Bill, and Ann) had been permitted to keep their appointments. Total surplus would then have been $12+$11+$6=$29, or $8 more than before.Customer Arrival time WTP

Ann 5:50 $6

Bill 5:52 $11

Carrie 5:55 $4

Dana 5:56 $12

Earl 5:59 $5

The salon owner can achieve this result by offering a cash payment of at least $5 to those willing to volunteer to postpone their appointments, which will induce Earl and Carrie to volunteer.

66

Example 7.12.

The cash payments to the volunteers have no other net effect on total economic surplus (or welfare).

Thus, the owner loses $10 of economic surplus (the $5 payments she makes to Earl and Carrie), while Earl and Carrie each experience a gain in surplus of $5—a net change in surplus of 0 for these three as a group.

However, the distribution of the total economic surplus is different.

67

In-class exercise:

The market for massages is perfectly competitive with an equilibrium price of $20 per massage.

68

In-class exercise:

Terry’s personal demand for massages is P = 60 – Q, where P is the price per massage in dollars and Q is the number of massages per year.

40 60Massages / yr

20

Price ($/massage)

60

69

In-class exercise:

Before marrying Susan, a masseuse, Terry purchased his massages from her at the market price.

Now, however, he receives massages from her “free of charge.”

Price apart, Terry is indifferent between receiving massages from Susan or from some other masseuse; and Susan is indifferent between giving massages to Terry or to some other client.

By how much does the new arrangement alter total economic surplus?

70

In-class exercise:


a. The new arrangement results in an increase in total economic surplus of $800.

b. The new arrangement results in an increase in total economic surplus of $1000.

c. The new arrangement results in a decline in total economic surplus of $200.

d. The new arrangement results in a decline in total economic surplus of $1000.

e. None of the above.

71

In-class exercise:

The opportunity cost of each massage that Terry receives from Susan is $20, the amount that she could have earned by providing a massage for a paying client.

40 60Massages / yr

20

If Terry treats Susan’s massages as if they were free, he will consume 60 of them per year, instead of the 40 he would have consumed if he had to pay $20 per massage.

Price ($/massage)

60

72

In-class exercise:

The opportunity cost of each massage that Terry receives from Susan is $20, the amount that she could have earned by providing a massage for a paying client.

40 60Massages / yr

20

Price ($/massage)

60

Welfare loss = $200 / yr

Consumer surplus if Terry gets the massages for free from his wife.Susan’s opportunity cost of supplying the messages to Terry without charge.Total welfare = CS -OC

Consumer surplus if Terry buys the massage service at market price.

73

In-class exercise:


a. The new arrangement results in an increase in total economic surplus of $800.

b. The new arrangement results in an increase in total economic surplus of $1000.

c. The new arrangement results in a decline in total economic surplus of $200.

d. The new arrangement results in a decline in total economic surplus of $1000.

e. None of the above.

74

End

1 Introductory Microeconomics Efficiency and Exchange.

Documents

Transcript of 1 Introductory Microeconomics Efficiency and Exchange.