Markets, equilibrium, and welfare theorem Flashcards
Consider the market for a single good, A. Given standard demand and supply curves, there exists an equilibrium price and quantity in the market p* and q* where the curves intersect.
Imagine the going rate for A is actually p’, above p, describe this scenario. Describe the same scenario for p’’, below p.
p’ above p: The amount of good A suppliers would offer for sale would be greater than the amount customers would be willing to buy (as the new q’ exceeds q). There would be an excess supply of good A. Suppliers, expecting to be able to sell for p’ and being unable to do so, would likely offer discounts that would force market prices more towards p*.
p’’ below p: A similar situation occurs. With p’’ below p, there will be excess demand for good A. Consumers would effectively bid against each other until the price was raised to p*.
What happens when the demand and supply for a good are equal?
The market is in equilibrium, also known as “the market clears”. Price suppliers expect for the good and demand of consumers for said good are equal, and rest at p* and q*. There is no upwards or downwards pressure on price due to excess demand or supply.
Consider a market where equilibrium price and quantity for good B is £1.00 and 150 units. Suppose that, to sell exactly 100 units , the price must be £1.50.
In terms of the buyer of the 100th good B, what does £1.50 represent?
This £1.50 reflects the consumers’ willingness to pay, or the marginal benefit of consumption, of that 100th good B.
Recall that in a market, the aggregate demand is the sum of all consumers’ individual marginal benefit curves. Lowering the price of good B below £1.50 would raise sales above the 100 mark, as marginal benefit of consumption could still rise.
Recall the example where, to sell 100 units of B, the price of the good must be £1.50. Equilibrium price is £1.00, which results in 150 units being sold.
What can we say about the consumer of the 100th good B.
The consumer would have been willing to pay £1.50 for good B, but only spent £1.00. They received a surplus of £0.50 via this transaction.
Summing all individual surpluses in the market gives the total consumer surplus gained by consumers participating in the market.
This is visualised by a shaded triangle area between the demand curve and the horizontal line extending from the intersection of supply and demand curves.
Recall the example where, to sell 100 units of B, the price of the good must be £1.50. Equilibrium price is £1.00, which results in 150 units being sold.
What can we say about the producers in this situation, if the vertical line from p’ equalling £1.50 intersects the marginal cost curve at £0.50?
This states the marginal cost of producing the 100th good B was £0.50, but as equilibrium price p* is £1.00, the producer received a $0.50 surplus from the sale.
The summation of all 150 individual surpluses (the 150th being zero, as marginal benefit equals marginal cost at equilibrium) is the total producer surplus.
The producer surplus holds different interpretations in the short and long-run - what are they?
Short: The difference between industry revenues and variable costs, since firms bear fixed costs whether they participate in the market or not.
Long: Producer surplus equals total industry profit.
One way of judging the performance of a market is to tally up the total surplus (consumer and producer) it produces in equilibrium (ignoring distributional questions/impacts on where that surplus goes for now).
Does a market in equilibrium produce the maximum-possible total surplus? Why?
Yes. This is because pushing quantity produced in a market past q* results in marginal costs outweighing the marginal benefits.
As we assume consumers are rational agents acting in self-interest, no one would buy a good where the marginal costs exceed marginal private benefit.
Consider a single-good market in equilibrium; the government imposes fixed tax “t” on the good.
Describe how this impacts the market and also what effects this has on surplus?
As the tax is fixed, the marginal cost curve of the firm shifts upwards by t to MC’. This forces price up to p’ and quantity sold down to q’.
Total surplus is now distorted by taxation. It forms a rectangle with the height determined by the distance between the MC’ and MB curve’s intersection and MB below this point.
“Dead weight loss” (DWL) is a byproduct of taxation. It takes the form of a small triangle between the tax revenue wedge imposed on total surplus and the equilibrium market point.
Describe how this tax is “distortionary” and what exactly DWL is.
As the government takes a slice of total surplus via tax revenue, the utility-maximising actions of rational agents is no longer enough to ensure all gains from trade are exploited. This is the distortionary aspect of tax.
The problem is the tax drives a t-pence wedge between the price buyers pay and sellers receive, so trade is impossible whenever the surplus it would create is smaller than t pence. The lost surplus results in the triangle-shaped DWL area of the tax.
Fundamental theorems of welfare economics apply to markets in competitive equilibrium. Define the three conditions that underpin a competitive equilibrium.
There are free markets for all goods.
Everyone - consumers and producers - act as price takers, that is, they behave competitively.
Everyone has the same information available on the goods being traded (no asymmetric information).
Considering the first welfare theorem (concerning social performance of markets), what is a Pareto improvement and what is Pareto efficiency?
Pareto improvement: A situation where a reorganisation of production and consumption in the economy could be made such that at least one person is made better off without another being made worse off. A mutually-beneficial trade between a group of consumers and producers.
Pareto efficiency: Where no reorganisations of production and consumption result in Pareto improvements.
Adam Smith posed the “invisible hand” guides rational agents towards the social goal of Pareto efficiency. This process can be traced out in three steps.
Describe the first step, relating to efficiency of consumption.
Efficiency of consumption determines that, if consumers act like utility maximisers, it’s impossible for them to make mutually-beneficial trades with each other.
Consumers spend income choosing bundles where utility is maximised, where personal rate of exchanges equal the market rate of exchange. In doing so, they exploit all possible gains from trade on the market.
As everyone faces the same prices, all consumers have the same personal rate of exchange, so as a result trade with one another yields no additional benefit.
Adam Smith posed the “invisible hand” guides rational agents towards the social goal of Pareto efficiency. This process can be traced out in three steps.
Describe the second step, relating to efficiency of production.
If firms maximise profits, it’s impossible for them to exchange inputs with each other to reduce costs - there is efficiency in production.
Profit-maximising firms organise production so that the ratio of their inputs’ marginal products is equal to the market rate of exchange between these inputs. This ensures they cash in on all available cost reductions from trading inputs in the market.
Assuming all firms are price-takers, this implies all firms have the same ratio of marginal products, so firms must exhaust all possible cost savings from trading inputs from each other.
Adam Smith posed the “invisible hand” guides rational agents towards the social goal of Pareto efficiency. This process can be traced out in three steps.
Describe the third step, relating to efficiency of the market’s product mix.
In competitive equilibrium, it’s impossible for firms and consumers to change what is produced and consumed in a mutually-beneficial way - there is efficiency in the product mix.
This is because the ratio of the marginal costs of two goods is the same rate at which firms are willing to shift production from one good to another.
If, for instance, the marginal cost of good A was 20x that of good B, then in order to induce a firm that made both A and B to produce one fewer B and one more A, you’d need to increase the compensation it received for that unit of output by 20x.
The second theorem of welfare concerns fairness, or equity. Related to this is a person’s “endowment”, a broad conception of wealth covering possessions, cash saved, etc. a person has.
What does the second theorem of welfare economics say about redistributing endowments? How is this process non-discretionary?
Any Pareto efficient pattern of production and consumption can arise in a competitive equilibrium, given a suitable reallocation of endowments.
Redistributing endowments is akin to redistributing resources, through a poll or some form of wealth tax, and redistributing the proceeds to others. This is non-discretionary as it has no direct impact on the price mechanism.
