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Chapter 16

Chapter 16. Competition and efficiency. To begin with … 16.1 Efficiency in economics 16.2 Perfect competition and efficiency 16.3 Inefficiency and deadweight loss 16.4 Deviations from efficiency. To begin with ….

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Chapter 16

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  1. Chapter 16 Competition and efficiency To begin with … 16.1 Efficiency in economics 16.2 Perfect competition and efficiency 16.3 Inefficiency and deadweight loss 16.4 Deviations from efficiency

  2. To begin with … We haveused the concept of total social surplus (TSS) to measure the total gains from market exchange. $ S TSS D Q 0 Q0

  3. To begin with … In this chapter, we will 1. discuss the conditions for efficiency with the concept of TSS; 2. explain how a perfectly competitive market can allocate resources efficiently; and 3. discuss the effects of government intervention on efficiency.

  4. Task 16.1 • We hear the word ‘efficiency’ all the time. Cost efficiency Dictionary: Efficiency means ‘the quality of doing something well and effectively, without wasting time, money, or energy’. Energy efficiency Government efficiency Do you know the meaning of ‘efficiency’ in economics? Answer: In economics, efficiency in resource allocation is attained when the total social surplus is maximised.

  5. 16.1 Efficiency in economics

  6. A. Definition of efficiency Efficiency in resource allocation is attained when. the total social surplus (TSS) is maximised

  7. B. The conditions for efficiency in resource allocation 1. MB = MC 2. Maximisation of the sum of CS and PS(when there are only consumers and producers in the market.) 3. MSB = MSC (when there is externality) [discussed in Chapter 17]

  8. 16.2 Perfect competition and efficiency

  9. 16.2 Perfect competition and efficiency • In a perfectly competitive market,  all consumers consume up to a point where MB = P in order to maximise CS; all producers produce up to a point where MC = P in order to maximise PS. As a result, $ S = MC • MB = MC; • the total gain from market exchange is maximised; CS Pe PS • the market has achieved efficiency. D = MB Q 0 Qe

  10. 16.3 Inefficiency and deadweight loss

  11. 16.3 Inefficiency and deadweight loss •  Inefficiency in resource allocation implies that the TSS is not maximised.  This occurs when MB MC. As the market fails to allocate resource efficiently, there must be a deadweight loss. Deadweight loss can be :  potential gains not being captured when MB > MC(i.e., underproduction)  the loss in total social surplus when MB < MC(i.e., overproduction)

  12. 1. Underproduction • When the output level is below the efficient level, there is underproduction. Suppose the output level is Q1, which is below the efficient level Qe. Deadweight loss $ S = MC MB1 a For units from Q1 to Qe(except for Qe), MB > MC. A deadweight loss (Area abc) exists as some potential gains are not fully captured. Pe b MC1 D = MB c Q 0 Q1 Qe

  13. 1. Underproduction • When the output level is below the efficient level, there is underproduction. It is possible to increase TSS by expanding production. Deadweight loss $ S = MC MB1 a The output level Q1 is not efficient. Pe b MC1 D = MB c Q 0 Q1 Qe

  14. 2. Overproduction • When the output level is above the efficient level, there is overproduction. Suppose the output level is Q2, which is above the efficient level Qe. Deadweight loss $ S = MC y MC2 x For units from Qeto Q2 (except for Qe), MB < MC. A deadweight loss (Area xyz) exists as there is a loss in TSS. Pe MB2 z D = MB Q 0 Qe Q2

  15. 2. Overproduction • When the output level is above the efficient level, there is overproduction. It is possible to increase TSS by cutting production. Deadweight loss $ S = MC y MB2 The output level Q2 is not efficient. x Pe MC2 z D = MB Q 0 Qe Q2

  16. Test yourself 16.1 • Refer to the table on the right. Calculate the value of the deadweight loss for each of the following output levels. Based on your result, determine which of them is inefficient. a. 2 units b. 4 units c. 5 units Answer: MC MB a. Deadweight loss = ( of 3rd unit – of 3rd unit) + ( of 4th unit – of 4th unit) = $ + $ = $ Efficient / Inefficient 0 5 5 MB MC

  17. Test yourself 16.1 • Refer to the table on the right. Calculate the value of the deadweight loss for each of the following output levels. Based on your result, determine which of them is inefficient. b. Deadweight loss = $  Efficient / Inefficient a. 2 units b. 4 units c. 5 units Answer: 0

  18. Test yourself 16.1 • Refer to the table on the right. Calculate the value of the deadweight loss for each of the following output levels. Based on your result, determine which of them is inefficient. a. 2 units b. 4 units c. 5 units Answer: c. Deadweight loss = of 5th unit – of 5th unit = $ Efficient / Inefficient) MC 5 MB

  19. Go further 16.1 Efficiency and the invisible hand Government intervention in the market is commonly known as the ‘ visible hand’. The ‘invisible hand’ also exists. What is an invisible hand?  Under the market mechanism, no individual plays a role in coordinating all production and consumption. Fig. 16.4 The idea of the invisible hand was put forward by Adam Smith (1723–1790), the father of modern economics. • However, all individuals pursuing their own interest help achieve market equilibrium and bring the most advantages to society.

  20. Go further 16.1 Efficiency and the invisible hand • Consumers consume up to the quantity where MB = P and producers produce up to the quantity where MC = P. Efficiency is attained when MB = P = MC. • The market price is said to act as an invisible hand, guiding individual decisions to bring the maximum gain to the economy as a whole. Fig. 16.4 The idea of the invisible hand was put forward by Adam Smith (1723–1790), the father of modern economics.

  21. Go further 16.1 Efficiency and the invisible hand • Hong Kong is the closest example that can be used to illustrate how the invisible hand allocates resources. ... Hong Kong followed a laissez-faire capitalist policy ... The results of (t)his policy were remarkable. At the end of World War II, Hong Kong was a dirt-poor island with a per capita income about one-quarter that of Britain’s. By 1997, ... its per capita income was roughly equal to that of the departing colonial power, even though Britain had experienced sizable growth over the same period. That was a striking demonstration of the productivity of freedom, of what people can do when they are left free to pursue their own interests ... Milton Friedman 6 October 2006

  22. 16.4 Deviations from efficiency

  23. 16.4 Deviations from efficiency • The government may sometimes intervene in a market. This may lead to inefficiency. Common types of government intervention Price control Quantity control Unit tax Unit subsidy Quota Price ceiling Price floor

  24. Task 16.2 • Who is right? Why? Carrie / Peter is right. Even though the market price decreases, consumers as a whole may not gain because the quantity transacted increases / decreases after the imposition of an effective price ceiling. After the imposition of aneffective priceceiling, the market price will decrease.Consumers must gain. No.Consumers may not gain because... Carrie Peter Answer:

  25. Task 16.2 • Who is right? Why? Consumer surplus (CS) may decrease. The change in consumer surplus depends on the size of the gain / loss in CS (due to price decrease) relative to the gain / loss in CS (due to quantity decrease). After the imposition of aneffective priceceiling, the market price will decrease.Consumers must gain. No.Consumers may not gain because... Carrie Peter Answer:

  26. A. Price ceiling After the imposition of an effective price ceiling:  Quantity transacted will decrease from Qe to QC. $ A S = MC PX  At QC, MB > MC. C G Pe  Some potential gains are not fully captured. E F PC Priceceiling  A deadweight loss is incurred from underproduction. D = MB B Q 0 Qe QC  The market is not efficient.

  27. A. Price ceiling After the imposition of an effective price ceiling:  The producer surplus (PS) decreases from Area PeGB to Area PcFB. $ A S = MC PX C G  The consumer surplus (CS) changes from Area PeGA to Area ACFPc. It may increase, decrease, or remain unchanged, depending on the size of the gain in CS relative to the loss in CS. Pe E F PC Priceceiling D = MB B Q 0 Qe QC

  28. A. Price ceiling $ $ S = MC C S = MC C Y G G E E Y Pe Pe X X PC PC Priceceiling Priceceiling F F D = MB D = MB Q Q 0 0 QC QC Qe Qe a. CS increases asGain in CS (X) > Loss in CS (Y). b. CS decreases asGain in CS (X) < Loss in CS (Y). Fig. 16.6 Change in CS depends on the relative size of the gain in CS and loss in CS.

  29. Task 16.3 • Peter is right. Can you explain why? As discussed in Chapter 6 of book 1, some workers will become unemployed. In terms of producer surplus (PS), workers as a whole may be worse off if the gain / loss in PS (due to wage increase) is greater / smaller than the gain / loss in PS (due to quantity decrease). I think the minimum wage law can benefit workers as their income increases. Not all workers can benefit from the minimum wage. Workers as a whole may be worse off than before. Carrie Peter Answer:

  30. B. Price floor After the imposition of an effective price floor:  Quantity transacted will decrease from Qe to Qf. $ A S = MC C PX  At Qf, MB > MC. G Pe  Some potential gains are not fully captured. E F Pf Pricefloor  A deadweight loss is incurred from underproduction. D = MB B Q 0 Qf Qe  The market is not efficient.

  31. B. Price floor After the imposition of an effective price floor:  The CS decreases from Area AGPe to Area ACPf. $ A S = MC C PX  The PS changes from Area BGPe to Area BFCPf. It may increase, decrease or remain unchanged, depending on the size of the gain in PS relative to the loss in PS. G Pe E F Pf Pricefloor D = MB B Q 0 Qf Qe

  32. B. Price floor $ $ S = MC S = MC C C Pf Pf Pricefloor Pricefloor G G X X Pe Pe E E Y Y D = MB F F D = MB Q Q 0 0 Qf Qf Qe Qe a. PS increases as Gain in PS (X) > Loss in PS (Y). b.PS decreases as Gain in PS (X) < Loss in PS (Y). Fig. 16.8 Change in PS depends on the relative size of the gain in PS and loss in PS.

  33. Learning tips 16.1 Excess demand, excess supply and underproduction c • In both cases of excess demand and excess supply, there are underproduction. The quantities transacted are lower than the efficient output level. As a result, MB > MC. Therefore, to determine whether there is underproduction or overproduction, we should: compare MB with MC at the quantity transacted, OR compare the quantity transacted with the efficient output level.

  34. Test yourself 16.2 • Summarise the effects of an effective price ceiling and an effective price floor in a perfectly competitive market by choosing the correct answers in the table below.

  35. Test yourself 16.3 • Suppose the government has imposed an effective price ceiling on rental housing. Without using a diagram, what can you tell about the change in TSS and the state of market efficiency under each of the following situations? a. The price ceiling becomes ineffective due to a decrease in demand for rental housing. Answer: TSS will increase / decrease but market efficiency is / is not achieved.

  36. Test yourself 16.3 • Suppose the government has imposed an effective price ceiling on rental housing. Without using a diagram, what can you tell about the change in TSS and the state of market efficiency under each of the following situations? b. The government removes the price ceiling. Answer: TSS will increase / decrease and market efficiency is / is not achieved.

  37. Test yourself 16.4 • Applying what you have learned in this chapter, explain why an effective minimum wage may NOT benefit the workers. Answer: In terms of producer surplus (PS), workers as a whole may be worse off under an effective minimum wage if the gain / loss in PS (due to wage increase) is greater / smaller than the gain / loss in PS (due to quantity decrease). [see Fig. 16.8 (b)]

  38. Past exam Q 1. The following diagram shows the demand and supply curves of good X in a perfectly competitive market. • Suppose a price floor is set at P1. As a result, • the deadweight loss is equal to area BEF. • the producer surplus is equal to area P1BC0. • the consumer surplus is equal to area AEPe. • the total social surplus is equal to area P1BCG. A Price ($) B S P1 Pe F E G C D Quantity 0 (HKDSE Practice Paper, Q15)

  39. C. Quota After the imposition of an effective quota:  Quantity transacted will decrease from Qe to Qq. $ S’’ A S = MC E PX  At Qq, MB > MC. Pq G Pe  Some potential gains are not fully captured. F S’  A deadweight lossis incurred from underproduction. D = MB C Q 0 Qq Qe  The market is not efficient.

  40. C. Quota After the imposition of an effective quota:  The CS decreases from Area AGPe to AEPq. $ S’’ A S = MC E PX  The PS changes from Area PeGC to Area PqES’C. It may increase, decrease, or remain unchanged, depending on the size of the gain in PS relative to the loss in PS. Pq G Pe F S’ D = MB C Q 0 Qq Qe

  41. Test yourself 16.5 • Summarise the effects of an effective quota in a perfectly competitive market by choosing the correct answers in the table below.

  42. Past exam Q • 2. Refer to the following demand-supply diagram of a good with the government setting a quota at Q1. • Which of the following will be the result of a reduction in quota on the good? • The total expenditure on the good may increase or decrease. • The consumer surplus will decrease. • The total social surplus may increase or decrease. Price S1 S0 D0 Quantity A. (1) only B. (1) and (2) only C. (2) and (3) only D. (1), (2) and (3) 0 (HKDSE 2013, Q19)

  43. D. Unit taxes After the imposition of a unit tax:  Quantity transacted will decrease from Qe to Qt. $ S2 = MC + Unit tax A S1 = MC Tax  At Qt, MB > MC.(MC is measured by S1, the original supply curve without subsidy.) C P1 G Pe E P2 F B  Some potential gains are not fully captured. D = MB Q 0 Qt Qe  A deadweight lossis incurred fromunderproduction.  The market is not efficient.

  44. D. Unit taxes After the imposition of a unit tax:  The CS decreases by Area P1CGPe, and becomes Area ACP1. $ S2 = MC + Unit tax A S1 = MC Tax C P1  The PS decreases by Area PeGFP2, and becomes Area P2FB. G Pe E P2 F B D = MB  The government’s tax revenue is equal to Area P1CFP2. Q 0 Qt Qe Consumer surplus Total social surplus under unit tax Producer surplus Tax revenue + + =

  45. D. Unit taxes P1 C P1 C CS < Tax collected Pe Deadweight loss G PS P2 F P2 F $ S2 = MC + Unit tax A S1 = MC Tax C P1 G Pe E P2 F B D = MB Q 0 Qt Qe

  46. Test yourself 16.6 • Suppose the government increases a unit tax on a good. Explain how this would affect the following: a. Consumer surplus Answer: Increase / Decrease. This is because the market price increases / decreases and the quantity consumed increases / decreases.

  47. Test yourself 16.6 • Suppose the government increases a unit tax on a good. Explain how this would affect the following: b. Producer surplus Increase / Decrease. This is because both the price received and the quantity sold increase / decrease. Uncertain. The change in tax revenue depends on the of demand and supply. Answer: c. Government’s tax revenue Answer: elasticities

  48. Test yourself 16.6 • Suppose the government increases a unit tax on a good. Explain how this would affect the following: d. Total social surplus Increase / Decrease. Even if the tax revenue increases, the extra tax revenue collected is still greater / smaller than the increase / decrease in the sum of the consumer surplus and the producer surplus. Answer:

  49. Task 16.4 I think a subsidy is different from other government measures such as unit tax, price ceiling and price floor. Why? Both consumers and producers enjoy the benefit of a subsidy. Thus, no one suffers from it. The total surplus must increase. Oh! I guess you have missed something. Carrie Peter Do you agree with Carrie? Has Carrie missed anything? Answer: No, Carrie is wrong.

  50. Task 16.4 I think a subsidy is different from other government measures such as unit tax, price ceiling and price floor. Why? Both consumers and producers enjoy the benefit of a subsidy. Thus, no one suffers from it. The total surplus must increase. Oh! I guess you have missed something. Carrie Peter Do you agree with Carrie? Has Carrie missed anything? Answer: Carrie has missed the point that the subsidy is paid by the government. The total subsidy paid by the government is greater / smaller than the increase / decrease in the sum of CS and PS. The economy as a whole suffers as TSS increases / decreases.

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