MARGINAL ANALYSIS AND MARKET EFFICIENCY

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MARGINAL ANALYSIS AND MARKET EFFICIENCY

• REFRESHER OF BASIC MICROECONOMICS CONCEPTS (3)

Dr. Fidel Gonzalez Department of Economics and
Intl. Business Sam Houston State University
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The first thing we have to do is to define
efficiency
Economic or Pareto Efficiency the economy is at
en efficient point if in order to make someone
better off we have to make someone else worse off.
Imagine that you have two buckets of Ice Cream,
but you can only eat one of them. The other
bucket will go bad so you have to options
1) Throw it away.
2) Give it to your best friend.
For you to have two buckets of Ice Cream when you
can only eat one, it is inefficient. It is
inefficient, because you can make you best friend
better off by giving him one bucket of Ice Cream
without making you or anyone else worse off.
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Imagine that you have 18 hours during the day.
You have to divide your time between time
studying and time playing PlayStation with your
friends.
Your production possibilities frontier will look
like the following
Point A is inefficient because you can increase
both the time studying and the time playing
PlayStation.
studying
Point B is efficient because in order to increase
the time studying you have to reduce the time
playing PlayStation.
C
B
Also, at point B in order to increase the time
playing PlayStation you have to reduce the time
studying.
A
playing PlayStation
Point C is unattainable, it is not efficient nor
inefficient.
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Now, lets use our marginal analysis for the
demand and supply.
Lets observe the demand curve for beer
Remember that for a given quantity the demand
curve tells us the Marginal Willingness to Pay
for that unit.

For instance, at point A, the consumer is willing
to pay 7 for the tenth beer
We can interpret this as the consumer values the
tenth beer in 7.
A
7
Then, a point on the demand curve is the value
that a consumer places on an extra beer.
B
Beer
10
If we care about consumer we will want to give
them an extra beer as long as they put some
positive value on that beer.
At point B the value that the consumer puts on an
extra beer is zero, so we will not want to give
him anymore.
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Now, lets observe the supply of beer
Remember that for a given quantity the supply
curve tells us the Marginal Cost, that is, the
cost of producing an extra unit.

For instance, at point C, the cost of producing
the tenth unit is 5.
SMC
Then, a point on the supply curve represents how
much it cost to produce an extra beer.
C
5
If we care about the producer we will want him to
sell an extra beer as long as what he gets from
selling an extra beer is equal or higher than the
cost of producing it.
Beer
10
Remember that the cost of producing beer includes
not only payments to workers, rent, electricity,
water, cans, bottles, and so on, but it also
includes the opportunity cost of the owner.
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Demand measures the benefit from consuming an
additional beer (benefit measured as the
willingness to pay for the extra beer).
Demand measures the marginal benefit.
Supply measures the cost of producing an
additional beer.
Supply measures the marginal cost.
We want an activity to continue to take place as
long as the marginal benefit is higher than the
marginal cost.
When three beers are consumed

The marginal benefit 10
SMC
The marginal cost 2
10
Hence, the activity should continue, I should
drink another beer.
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D

Marginal Willingness to Pay

Marginal Benefit
Beer
3
7

• From the pareto efficiency perspective when the
  MBMC is possible to make both the consumer and
  the producer better off, so it is not an
  efficient point.
• For instance at Q3,
• We can increase the consumer surplus at the
  market price by increasing the quantity purchased
  by the consumer.
• We can increase the producer surplus at the
  market price by increasing the quantity sold by
  the producer.

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When the quantity is below the equilibrium, the
consumer surplus (blue area A) and producer
surplus (red area B) can both increase at the
same time. The green triangles represent what the
consumer and producer gain by increasing the
quantity in the market
SMC
P
Any quantity below the equilibrium level is not
efficient because we can make both consumers and
producers better off by increasing quantity,
A
B
DMB
Beer
9
What happens to the right of equilibrium?
When twelve beers are consumed

The marginal cost 8
SMC
8
The marginal benefit 4
4
D

Marginal Willingness to Pay

Marginal Benefit
Beer
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Hence, the activity should not only stop but it
should decrease, the production of beer should go
down, we are producing too much beer.
When 12 beers are produced and consumed, if we
reduce the quantity in the market to 11 we will
be saving 8 in costs but he will be losing a
benefit of 4.
The amount saved is higher than the benefit, so
we should continue reducing the quantity in the
market.
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• From the pareto efficiency perspective when the
  MBthe producer better off, so it is not an
  efficient point.
• For instance at Q12,
• We can increase the consumer surplus at the
  market price by decreasing the quantity purchased
  by the consumer.
• We can increase the producer surplus at the
  market price by decreasing the quantity sold by
  the producer.

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When the quantity is above the equilibrium, the
consumer surplus is the blue area A and the blue
area with stripes A2. The blue area A2 is
actually a negative consumer surplus, the
consumer is forced to pay more than what he is
willing to pay for the good. That is, the price
paid by the consumer is above the demand curve.
Hence, the final consumer surplus is A A2.
Any quantity above the equilibrium level is not
efficient because we can make both consumers and
producers better off by decreasing quantity and
eliminating the parts where they consumer and
producer surplus are negative.
The producer surplus is the red area B and the
red area with stripes B2. The red area B2 is
actually a negative producer surplus, the
producer is selling units of beer that are more
costly to produce than what he receives for them.
For the units sold abode the equilibrium, the
price received by the producer is above the
supply curve. Hence, the final producer surplus
is B B2. Both producer and consumer surplus
increase by reducing the quantity and eliminating
the areas where they are negative (A2 and B2)
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What happens in Equilibrium?
When six beers are consumed

The marginal cost 5
SMC
The marginal benefit 5
6
5
4
D

Marginal Willingness to Pay

Marginal Benefit
Beer
6
7
5
The activity should stop at this point, the
marginal cost marginal benefit
When six beers are produced and consumed,
If we reduce the quantity in the market to five
we will be saving 4 in costs but he will be
losing a benefit of 6, we will be worse off.
If we increase the quantity in the market to five
we will be incurring in a cost of 6 and we will
be obtaining a benefit of 4, we will be worse
off.
Equilibrium is the efficient point because we can
not improve by producing more or producing less
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The fact that the competitive market equilibrium
is Pareto optimal is known as the First
Fundamental Theorem of Welfare Economics. Roughly
speaking the First Fundamental Theorem of
Welfare Economics states that in the presence of
competitive markets the market equilibrium is
efficient. However, this theorem holds if there
are no public goods, no externalities, no
monopolies, no increasing returns to scale, no
information problem, no transaction costs, no
taxes, no common property and no other
distorsions between the cost paid by the buyers
and the benefits received by the seller. As you
can probably guess these are very restrictive
conditions that apply to only a few set of
markets. Finally, the first welfare does not
say anything about the fairness of the market or
the distribution of the economic benefits.
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MATH APPLICATIONEQUILIBRIUM
Consider the following graph and the
corresponding demand and supply equation.
Inverse Demand Equation
P - 1/5 QD 8
Obtain Equilibrium P and Q
Demand Equation
QD - 5 P 40
QS QD
3P - 5 P 40
8 P 40
P 5
Inverse Supply Equation
P 1/3 QS
Q3(5) 15 Q15
QS 3 P
Supply Equation
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Consumer Surplus area above the price paid by
the consumer and below the demand curve. That
area is a triangle, remember the area of a
triangle is equal to the height times the width
divided by two. In this case (3 X 15)/2
22.5 Consumer surplus 22.5 Producer Surplus
area above the supply curve and below the price
received by the producer. Producer surplus (5 X
15)/2 37.5
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Total Surplus the total surplus is defined as
the sum of the producer plus the consumer
surplus. Because the consumer surplus represents
the benefit of consumers and the producer surplus
is the benefit to producers, the total surplus is
then the total benefit of the market. In other
words, the total surplus represents the total
welfare of the market. It is now clear that we
would want the total surplus to be the highest as
possible. In our previous example Total Surplus
22.5 37.5 60 or you can also calculate it
as (8 x 15)/260