Government Policies &
Efficiency
Econ 1
Chapters 7,6
Periods of Analysis
• Long-Run: All inputs are variable
(prospective)
• Short-Run: Some inputs fixed, some
variable
• Market Period: All inputs Fixed  Output
Fixed ( vertical supply)
Market Analysis
•
•
•
•
The Market for Rental apartments
Analyze an increase in demand
Analyze price effects in the market period
Analyze supply and price effects in the
long-run
$ Rent
Supply
LR new Supply
D0
New LR Equilibrium
$ 1000
$ 880
$ 800
D1
1000
1500
Units/
Month
$ Rent
Supply
D0
Price Ceiling
$ 800
D1
Short
1000
1500
Units/
Month
Implications Price Ceiling below
Equilibrium
• Increased Transaction Costs to Buyers &
Sellers
• Increase in Non-Market rationing:
Discrimination
• Decrease in Quality
• Decrease in Supply
Price Floor above Equilibrium
• How does the labor Market work?
• What happens when you place the
Minimum Wage above Equilibrium wage ?
$ Wage
Supply of
Labor
Demand
Min. Wage
Wage E
Surplus
Qd
QE
Qs
Qty/T
The Minimum Wage: A Price
Floor
$Wage
D
S
Minimum Wage
Pe
D
Qd
Qe
Qs
QTY / T
Implications of Price Floor above Equilibrium
• Increase in transaction costs
• Increase in non-market rationing
(discrimination)
• Increase in quality (not demand driven)
• Increase in supply
• Wealth transfer: from unemployed to
employed
ECON 1
Market Efficiency
Chapter 7
$Px
$ 10
$ 9
$ 8
$ 7
Pe $ 6
$ 5
$ 4
$ 3
$ 2
$ 1
Market Interaction
Demand
Supply
Exchange Value
Dx
1 2 3 4 5 6 7 8 9 10 11 12
Qe
Qtyx /T
Allocation Efficiency:
Price allocates the goods to highest valued users
Market Demand determines Price. Each buyer responds to price by buying till
Marginal Value equals price. No reallocation can generate greater value.
A
B
Market
C
$P
$P
$P
D
D
Demand
Supply
$P
D
Pe
Pe
Qa
Q/T
Qb
Marginal Value A = Marginal Value B
Qc
= Marginal Value C
Qe
= Market Price
Production Efficiency:
Price coordinates the efficient use or resources
Market Supply is the sum of the industry output at alternative prices. Each firm
produces up to the quantity where Price = Marginal Cost. No reallocation of resources
will produce at a lower opportunity cost.
$P
Market
Demand
Firm 1
Firm 2
Supply $ P
$P
$P
S2
Pe
S1
Qe
Market Price
Q/T
Firm 3
Q1
Pe
Q2
S3
Q3
= Marginal Cost Firm 1 = Marginal Cost Firm 2 = Marginal Cost Firm 3
$Px
$ 10
$ 9
$ 8
$ 7
Pe $ 6
$ 5
$ 4
$ 3
$ 2
$ 1
Market is Efficient since at Qe the
Marginal Value = Marginal cost
Demand
Supply
Marginal
Value
Marginal
Cost
Dx
1 2 3 4 5 6 7 8 9 10 11 12
Qe
Qtyx /T
MVx
$ 10
$ 9
$ 8
$ 7
Pe $ 6
$ 5
$ 4
$ 3
$ 2
$ 1
Demand = Marginal Value
Consumer Surplus Value
(MV – Price)
Exchange
Value
MVx = Dx
1 2 3 4 5 6 7 8 9 10
Qe
Qtyx / T
$Px
$ 10
$ 9
$ 8
$ 7
Pe $ 6
$ 5
$ 4
$ 3
$ 2
$ 1
Supply Reflects Marginal Cost
The height reflects
the marginal cost of
producing an
additional unit.
Producer Surplus Value
Price – Marginal Cost
1 2 3 4 5 6 7 8 9 10 11 12
Qe
Qtyx /T
Market: Gains from
Trade
$Px
$ 10
$ 9
$ 8
$ 7
Pe $ 6
$ 5
$ 4
$ 3
$ 2
$ 1
Demand
Supply
C.S V.
P.S.V.
Sx
Dx
1 2 3 4 5 6 7 8 9 10 11 12
Qe
Qtyx /T
Market Efficiency:
Reduced Output
$Px
$ 10
$ 9
$ 8
$ 7
Pe $ 6
$ 5
$ 4
$ 3
$ 2
$ 1
Demand
Supply
Efficiency Loss
Sx
Dx
1 2 3 4 5 6 7 8 9 10 11 12
Qe
Qtyx /T
Market Efficiency:
Increased Output
$Px
$ 10
$ 9
$ 8
$ 7
Pe $ 6
$ 5
$ 4
$ 3
$ 2
$ 1
Demand
Supply
Efficiency Loss
Sx
Dx
1 2 3 4 5 6 7 8 9 10 11 12
Qe
Qtyx /T
Market Outcome is Efficient
• Marginal Value (MV) of last unit
produced = Marginal Cost of production
(MC)
• Producing less  Efficiency loss
• Producing more  Efficiency Loss