The Idealized Competitive Model

1
The Idealized Competitive Model

• Weimer and Vining Ch.4 5

2
Objectives

• 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
• Indifference Maps
• Pareto Optimality
• Potential Pareto Optimality
• Competitive Markets and Efficiency

3
Some Basic Concepts

• Collective Action
• 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?
• WV approach begins with the concept of the
  perfectly competitive economy.

4
The Rationale
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.

• 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

5
The Rationale

• 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?

6
Modeling Social Value

• Policy analysts have a conception of the good
  that is to be pursued in policy
• Derived from utility theory and individualism
• Individuals assumed to define their own lives
• Value is a function of an individuals values,
  preferences, choices and outcomes -- a life.
• Avoidance of paternalism
• Social value is the aggregation of individual
  values
• Differences from alternative definitions?

7
Modeling Social Value

• The nature of models
• Simplification, abstraction, essentials
• The model of the competitive economy
• Why use it?
• Ideal-type of voluntary exchange
• Results in efficient outcomes
• 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

8
The Competitive Market Model

• Model components
• Consumers, consumption and utility
• Producers, production and pricing
• Budgets and choices
• The central idea is simple
• Given values (preferences), resources, and
  technologies, how can society arrange things to
  produce the maximum value at least cost?

9
Modeling Consumer Behavior

• Some key assumptions
• 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
• Consumption of hamburgers
• Information and search costs
• Preservation of wilderness

All else being equal
10
Consumer Behavior, Continued

• Consumers enter into market exchange with budgets
  made up of
• Income -- selling labor (including ideas)
• Endowments -- initial capital, savings,
  inheritance
• These are not assumed to be equal!
• Consumers trade money for the things they value
• Idealized competitive market assumes no
  significant market failure (externalities, market
  power, etc.)

11
Some Thought Experiments

• What would you be willing to pay for
• A loaf of really fresh bread
• A front-row seat at the Beatles last concert
• Prices people are willing to pay express
  trade-off they make
• What are you willing to forego to get the good?
• 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
  wed have been willing to pay (why?!)

12
Price, Quantity and ValueThe Essentials
Value to individual i
(Price)
Marginal valuation schedule
Q0 Quantity purchased at price P0
P0
Q1 Quantity purchased at price P1
P1
Q0
Q1
Q (Quantity)
Assuming no price discrimination, all consumers
pay the marginal price -- P0
13
Recalling the Basics of Consumer Demand

• 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

14
So, what is consumer surplus and how is it
related to demand?
15
Consumer Values and Surpluses

• 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.

16

• 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.

17
Consumer Surplus

• 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.

18
Consumer Surplus An Example

• 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?

19
Example, (cont.)

• By measuring the change in consumer surplus, we
  can begin to quantify the change in consumer
  welfare from the increase in gasoline prices
• CS before 15.00CS after     6.00?CS      
  -9.00
• The 2.00 increase in the price of gasoline has
  led to a 9.00 reduction in consumer welfare.

20
Analyzing Effects of a Tax
P1 P0 Tax
21
Status check

• 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.

22
The Edgeworth Box Indifference Mapping
23

• 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.

24

• 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.

25
Concepts of Efficiency

• Pareto Optimality
• 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
• 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.

26
Competitive Markets and Efficiency

• 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
• Tastes and preferences
• Technologies
• The idea is that the ICM is always moving toward
  an efficient allocation of goods

27
Next Time

• Producer Behavior
• Producer Surplus
• Market Failures
• Tutorial on consumer surplus http//www.digitalec
  onomist.com/cs_tutorial.html
• Discussion paper will be assigned this week, for
  next week.