The Idealized Competitive Model
Weimer and Vining
Ch.4 & 5
Objectives:
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The model: The concept of a perfectly
competitive economy
The virtues and limits of the competitive market
model
Utility and “consumer behavior”
The concept(s) of efficiency
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Indifference Maps
Pareto Optimality
Potential Pareto Optimality
Competitive Markets and Efficiency
Some Basic Concepts
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Collective Action
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What is it? Define it for a policy analyst.
How is collective action related to “public
policy”?
What is the rationale for government
intervention in private choice?
W&V approach: begins with the concept of the
perfectly competitive economy.
*efficient: it would not be possible to change the
patterns in such a way, so as to make some
person better off without making some other
person worse off.
The Rationale…
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Consider the properties of idealized economies
involving large numbers of profit maximizing firms and
utility maximizing consumers.
Under certain assumptions, the self-motivated behaviors
of these economic actors lead to patterns of
consumption and production that are efficient*
Economists recognize several commonly occurring
circumstances of private choice that violate the
assumptions of the idealized model and interfere with
efficiency in consumption or production
The Rationale…
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These violations are called market failures.
Traditional market failures, provide widely
accepted rationales for such public policies
as the provision of goods and the regulation
of markets by government agencies.
Is efficiency the only important social value?
Modeling Social Value
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Policy analysts have a conception of the
“good” that is to be pursued in policy
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Derived from utility theory and individualism
Individuals assumed to define their own lives
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Value is a function of an individual’s values, preferences,
choices and outcomes -- a life.
Avoidance of paternalism
Social value is the aggregation of individual values
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Differences from alternative definitions?
Modeling Social Value
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The nature of models
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Simplification, abstraction, essentials
The model of the competitive economy
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Why use it?
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Ideal-type of voluntary exchange
Results in “efficient” outcomes
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No additional exchanges will lead to improvements for anyone
without hurting someone else
Hence, no additional voluntary trades will be made
Model indicates where efficiency is not achieved
The Competitive Market Model
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Model components
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Consumers, consumption and utility
Producers, production and pricing
Budgets and choices
The central idea is simple:
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Given values (preferences), resources, and
technologies, how can society arrange things to
produce the maximum value at least cost?
Modeling Consumer Behavior
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Some key assumptions
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People have identifiable (to them) bundles of
utilities, translatable into preferences
Ceteris paribus*, the greater the quantity of a good,
the greater the value to the consumer
But consumption in aggregate is subject to
diminishing marginal value
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Consumption of hamburgers
Information and search costs
Preservation of wilderness
* All else being equal
Consumer Behavior, Continued
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Consumers enter into market exchange with
budgets made up of
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Income -- selling labor (including ideas…)
Endowments -- initial capital, savings, inheritance
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These are not assumed to be equal!
Consumers trade money for the things they
value
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Idealized competitive market assumes no significant
market failure (externalities, market power, etc.)
Some Thought Experiments
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What would you be “willing to pay” for
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A loaf of really fresh bread
A front-row seat at the Beatles’ last concert
Prices people are willing to pay express tradeoff they make
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What are you willing to forego to get the good?
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You give up the other things the money could have
purchased.
Money is the “medium” of the trade-off.
Surprisingly, we usually get things for less than
we’d have been willing to pay (why?!)
Price, Quantity and Value:
The Essentials
Value to individual i
$
Marginal valuation schedule
Q0= Quantity purchased at price P0
(Price)
P0
Q1= Quantity purchased at price P1
P1
Q0
Q1
Q (Quantity)
Assuming no “price discrimination”, all consumers pay the marginal price -- P0
Recalling the Basics of Consumer
Demand…
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Consumer demand is a measure of willingness to pay.
consumers often value each additional unit consumed less that
previous units (i.e., the concept of diminishing marginal utility)
Give me an example…
So, what is consumer
surplus and how is it
related to demand?
Consumer Values and Surpluses
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When analyzing changes to a consumer optimum given
changes in the market price of a particular commodity, we
often speak of the consumer being better or worse off.
One method used to measure these welfare changes is
through the use of a concept known as Consumer
Surplus.
This method compares the value of each unit of a
commodity consumed against the price of that commodity.
Stated differently, consumer surplus measures the
difference between what is person is willing to pay for a
commodity and the amount he/she actually is required to
pay.
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Assume a market price =
$4.00/gal then, quantity
demanded = to 6 gallons
the total value of consumption is
$39.00 ($9 + 8 + 7 + 6 + 5 + 4).
Part of this value is given up in
the form of total expenditure
equal to $24.00 ($4 x 6gal) as
shown by the gray-shaded area
in the right diagram.
The difference of $15.00
($39.00-$24.00) represents
consumer surplus as shown by
the cross-hatched colored bars
in the right diagram.
Consumer Surplus
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These measures of total
expenditure and
consumer surplus can
be neatly defined as
geometric areas below a
given demand curve.
We can use this
measures to quantify
the welfare effects of a
change in market price
by examining the
corresponding changes
in consumer surplus.
Consumer Surplus:
An Example
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For example, suppose
that the market price
increases to $6.00 due to
an increase in excise
taxes.
At this higher price, the
consumer would be
willing to purchase only 4
units of this product.
In purchasing these 4
units, the consumer
receives $30.00 worth of
value ($9.00, $8.00,
$7.00, $6.00) and spends
$24.00 ($6.00 x 4 units).
What is the new level of
consumer surplus?
Example, (cont.)
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By measuring the change in consumer surplus,
we can begin to quantify the change in
consumer welfare from the increase in gasoline
prices:
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CS before = $15.00
CS after = $6.00
ΔCS
= -$9.00
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The $2.00 increase in the price of gasoline has
led to a $9.00 reduction in consumer welfare.
Analyzing Effects of a Tax
Remaining Consumer
Surplus
$
Deadweight
Loss in Consumer Surplus
(Price)
P1
Size of tax
P1 = P0 + Tax
Tax Revenue
P0
Lost Revenue
To producers
Q1
Q0
Reduction in
Consumption
= Q0 - Q1
Q (Quantity)
Status check…
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Now, using the tools of indifference curve
analysis, we can demonstrate that in
increase in market price indeed makes the
consumer worse off – Edgeworth Box
Recall that by measuring the changes in
consumer surplus, we can define how much
worse off the consumer has become - a
useful empirical tool for policy analysis.
The Edgeworth Box: Indifference
Mapping
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Any trade that puts
these two individuals
into, or on the border
of, the shaded area
will make one or both
individuals better off.
This is known as a
Pareto
Improvement.
As long as any
Pareto Improvements
remain, an incentive
for trade exists
between these two
agents.
For example, a trade such that these two individuals
move to point 'R' in the diagram below would make
person 'B' better-off with out harm to 'A'
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An optimal
allocation of
commodities is
determined by the
concept of Pareto
optimality.
A Pareto optimal
allocation of
commodities is
that allocation
where it is not
possible to make
one person better
off without making
any other person
worse off.
Concepts of Efficiency
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Pareto Optimality:
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The strict criterion of efficiency is met when a system
allocates resources in such a way that no further
reallocation of goods can increase any individual's
utility without diminishing the utility of others. A given
policy is efficient in this strict sense if it increases the
well-being of at least one individual without diminishing
that of others.
The Kaldor-Hicks Criterion:
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The Kaldor-Hicks criterion allows redistributions that
increase net welfare such that those who gain from the
distribution could compensate those who lose,
restoring the losers to their prior level of well-being,
while the winners retain enough of their gains to be
better-off than they would have been without the
redistribution.
Competitive Markets and
Efficiency
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It can be demonstrated that an idealized
competitive market (ICM) would maximize
consumer (and producer) surplus such that
any externally induced change will not be
Pareto efficient
But many elements of the model change
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Tastes and preferences
Technologies
The idea is that the ICM is always moving
toward an efficient allocation of goods
Next Time
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Producer Behavior
Producer Surplus
Market Failures
Tutorial on consumer surplus:
http://www.digitaleconomist.com/cs_tutorial.html
Discussion paper will be assigned this week, for
next week.