Private Markets: Benefits and Costs

course, getting to the heart of market efficiency requires a careful explanation of what the “efficient” amount of a good or service means.

The main step in our examination of market efficiency is the valuation (in dollar terms) of benefits and costs. We begin the analysis with a single transaction and move on to the thousands of transactions that take place within markets. Consider the following example.

THE DEMAND AND SUPPLY OF DAY CARE A couple is seeking to obtain up to 10 hours of day care per week for their 2-year-old. Through informal inquiries in their neighborhood, they have found a grandmother who has done baby-sitting and some day care in the past and comes highly recommended. The grandmother is not sure whether she is willing to commit to 10 hours. Before any discussion of price takes place, the couple has thought hard about their value for day care. They have decided that the maximum amount they are willing to pay is $8 per hour (that is, they would be indifferent to the options of getting day care at this price and not getting it at all). For her part, the grandmother has decided that her minimum acceptable price is $4. (Thus, $4 is the best estimate of her “cost” based on the value of her time and the strain of taking care of a 2-year-old. All things considered, she just breaks even at this price.) Can the couple and the grandmother conclude a mutually beneficial agreement? How can we measure the parties’ gains from an agreement?

The answer to the first question clearly is yes. Any negotiated price between $4 and $8 would be mutually beneficial. What about the second question? If the parties are equally matched bargainers, we might expect the final price to be $6. The grandmother makes a profit of $2 per hour, or $20 per week. Similarly, the couple makes a $2-per-hour “profit”; that is, they pay only $6 for a day-care hour that is worth $8 to them. Their “profit” per week is $20. The couple’s gain (or any consumer’s gain in general) is customarily labeled consumer surplus. Although it goes under a different name, the couple’s gain is identical in kind (and here in amount) to the grandmother’s profit.

Figure 7.5 makes the same point in graphical terms. The couple’s $8 value is drawn as a horizontal demand curve (up to a maximum of 10 hours per week). The grandmother’s $4 cost line and a $6 price line are also shown. The grandmother’s profit is depicted as the area of the rectangle between the price and cost lines. In turn, the couple’s consumer surplus is shown as the area of the rectangle between the value and price lines. The areas of the profit and consumer surplus rectangles are both $20. The total gain from trade—the sum of consumer surplus and profit—is given by the area of the rectangle between the value and cost lines and comes to $40.

Couple’s maximum value

Price Dollars per Hour

$8

6

Grandmother’s cost 4

2 Consumer surplus $20 per week

Producer profit $20 per week

0 Q

2 4 6 8 10 12

Hours of Day Care per Week

An agreement calling for 10 hours of day care per week delivers the maximum total gain to the parties together. For this reason, we call such a transaction efficient. In contrast, an agreement that called for only five hours of day care per week would furnish only $20 of total gain ($10 to each side). Although this agreement is better than nothing, it would rightly be labeled inefficient because it generates less than the maximum total gain. (More than 10 hours is infeasible because the grandmother is willing to supply 10 hours at most.)

We note two simple, but important, points about the efficiency concept. First, the actual price negotiated is not a matter of efficiency. An agreement calling for 10 hours of day care at a price of $7 (or at any other price between $4 and $8) would generate the same total profit, $40 per week. Of course, at $7 the total gain is redistributed. The grandmother’s profit is $30 per week, and the couple’s is $10. But the total gain has not changed. In algebraic terms, the total gain is

FIGURE 7.5

A Day-Care Transaction

This transaction provides the couple with a consumer surplus of $20 per week and the grandmother with a profit of $20 per week.

CS (8 P)Q (P 4)Q 4Q.

In computing this total gain, the price paid by the buyer to the supplier just cancels out; that is, the terms involving the price P disappear. Note that for 10 hours of care (Q 10), the total gain is $40.

Second, starting from any inefficient agreement, there is a different, efficient agreement that is better for both parties. In short, the best split of the proverbial pie for both parties is attained when the pie is made as big as possible in the first place. For instance, suppose the parties agreed on seven hours of day care per week at a price of $7. This inefficient agreement generates gains to the grandmother and couple of $21 and $7, respectively. Clearly, both parties would benefit from a 10-hour deal at an appropriate price. For instance, a price concession by the grandmother to $6.50 with a 10-hour deal would bring her $25 in profit and the couple $15 in consumer surplus. Both parties are better off than with the seven-hour agreement.

THE DAY-CARE MARKET Let’s now extend the previous analysis to the large day-care market that emerged in the last 25 years. Figure 7.6 shows the weekly demand curve for day care in a given geographical region. There is nothing remarkable about this bare-bones demand curve. Depending on the going hourly price for day care, more or less millions of day-care hours will be demanded. The lower the price, the greater the number of hours purchased. However, one aspect of this demand curve (or any demand curve) is important: Besides showing the quantity consumed at any price, the demand curve shows the monetary value that consumers are willing to pay for each unit. For instance, the “first” few units consumed are valued at roughly $12, the demand curve’s price intercept. Even at a rate this high, some parents (with high incomes, rotten kids, or both) are willing to pay the high price for day care. But what about the 8 millionth hour of day care consumed? For this hour to be purchased, the hourly price must drop to $4. Put simply, the value of any unit of day care is given by the price the consumer is willing to pay for it.9 (Thus, it is hard to claim that the 8 millionth hour is worth $4.50 because the would-be consumer of this hour is unwilling to pay that high a price.) In short, the value of a particular unit is given by the height of the demand curve at that quantity.10 For this reason, the demand curve can be thought of as a marginal benefit curve.

Now suppose the going price for day care is in fact $4 per hour, with the result that 8 million hours are purchased per week. What is the total consumer

9This valuation method is based on the notion of consumer sovereignty: Each individual is the best judge of the value he or she derives from a purchase. When all the individual purchases are added together, we obtain a market demand curve—the best measure of aggregate value from day-care services. Thus, under the doctrine of consumer sovereignty, it would be improper for a government authority to place either an arbitrarily high value (say, $30 per hour) or low value (e.g., $.50 per hour) on day-care services. 10Caution: We are not saying that each of the 8 million day-care hours consumed at a price of $4 is worth $4. We mean only that the last, 8-millionth, unit is worth $4. The other hours are worth much more, as shown by the rising height of the demand curve as we move to smaller and smaller quantities.

Hourly Price $14

12

10

8

6

P = 4 Regional demand curve

Consumer surplus

$32 million

2

0 2 4 6 8 10 12 Q

14

Hours of Day Care (Millions)

surplus enjoyed by purchasers? The answer is straightforward: Consumer surplus is measured by the triangle inscribed under the demand curve and above the price line. After all, the demand curve indicates what consumers are willing to pay, and the price line indicates what they actually pay, so the difference (added up over all units consumed) is their total surplus. Recall that the area of a triangle is given by one-half of its height times its base. Thus, the consumer surplus from 8 million hours demanded at a $4 price comes to (.5)(12 4)(8) $32 million.11

FIGURE 7.6

Regional Demand for Day Care

At a price of $4, the total demand for day care is 8 million hours per week. Parents receive a total consumer surplus of $32 million.

11An equivalent way to find consumer surplus is to reason as follows. The first unit consumed earns a surplus of 12 4 8. The last (i.e., 8-millionth) unit consumed earns a surplus of 4 4 0. Since demand is linear, the average surplus per unit is (8 0)/2 $4. We multiply this by 8 million units to arrive at a total surplus of $32 million.

FIGURE 7.7

A Competitive DayCare Market

The competitive price ($2.50) and output (9.5 million hours) are determined by the intersection of the supply and demand curves.

To complete the description of the market, let’s consider the supply of day care. A day-care supply curve is shown in Figure 7.7. Notice that the main part of the supply curve is provided by low-cost suppliers at $2.50 per hour. Let’s say these suppliers enjoy significant economies of scale while maintaining quality day care. In fact, as we shall see, “grandmotherly” day care at $4 per hour will become a thing of the past. Less efficient, high-cost grandmothers will be priced out of the day-care market.

Now we are ready to take a closer look at market efficiency. To begin, we know that, in a competitive day-care market, the intersection of supply and demand determines price and quantity. In Figure 7.7, the competitive price is $2.50 and quantity is 9.5 million hours per week. Now we can make our key point: This competitive outcome is efficient; that is, it delivers the maximum total dollar benefit to consumers and producers together. This is particularly easy to see in

Hourly Price $14

12

10

8

6

4

PC = 2.50 2 Regional daycare demand

“Store-bought” day care Equilibrium: PC = $2.50 QC = 9.5 million hours

Grandmothers’ day-care supply $4

0 2 4 6 8 10 12 Q

14

9.5 Hours of Day Care (Millions)

Figure 7.7, because day-care suppliers earn zero profits: Price equals average cost. All gain takes the form of consumer surplus. It is easy to check that the total surplus measures out to (.5)(12 2.5)(9.5) $45.125 million.

An equivalent way to confirm that the competitive level of output is efficient is to appeal to the logic of marginal benefits and costs. We have argued that the height of the demand curve at a given output level, Q, measures the marginal benefit (in dollar terms) of consuming the last (Qth) unit. Similarly, the height of the supply curve indicates the marginal cost of producing the Qth unit. At a competitive equilibrium, demand equals supply. A direct consequence is that marginal benefit equals marginal cost. Equating marginal benefits and marginal costs ensures that the industry supplies the “right” quantity of the good—the precise output that maximizes the total net benefits (consumer benefits minus supplier costs) from production.

In contrast, at a noncompetitive price—say $4—only 8 million day-care hours would be demanded. At this reduced output, the marginal benefit (what consumers are willing to pay for additional day-care hours) is $4, and this is greater than the marginal cost of supplying extra hours, $2.50. Thus, there is a net welfare gain of 4.00 2.50 $1.50 for each additional day-care hour supplied. More generally, as long as the demand curve lies above the supply curve (MB MC), there is a net gain (MB MC 0) from increasing the output of day care. Conversely, at any output level beyond the competitive quantity (say, 11 million hours), the marginal benefit of extra hours falls short of the marginal cost of supply (MB MC). Producing these units is a “losing” proposition. Thus, there is a net gain from cutting output back to the competitive level.12

Figure 7.7 provides a visual depiction of our original proposition:

Competitive markets provide efficient levels of goods and services at minimum cost to the consumers who are most willing (and able) to pay for them.

Think of this statement in three parts, focusing on production, consumption, and total output in turn. First, in a competitive market, the active firms are

12In mathematical terms, consider the objective of maximizing the sum of consumer surplus and producer profit:

where B denotes the total consumer benefits associated with a given level of output, R is total revenue paid by consumers to producers, and C is the total cost of production. The revenue term is simply a transfer between consumers and producers and does not affect the objective. Thus, maximizing this sum is equivalent to maximizing net benefits, B C. At the optimal level of output, it must be the case that MB MC.

Furthermore, the competitive equilibrium achieves this optimal level of output. To see this, consider the demand and supply curves, denoted by the functions D(Q) and S(Q), respectively. The competitive price and output are determined by the intersection of supply and demand, D(QC) S(QC) PC. By our earlier argument, D(Q) ≡ MB(Q) and S(Q) ≡ MC(Q) for all Q, where MB and MC denote the marginal benefit and cost functions, respectively. It follows that MB(QC) MC(QC) Pc. Thus, the competitive level of output is efficient.

Surplus Profit (B R) (R C) B C,

CHECK STATION 5

necessarily least-cost suppliers; all other higher-cost would-be suppliers are priced out of the market. (In our example, grandmothers cannot compete; “store-bought” day care is more efficiently supplied than “home-made.”) The supply curve in Figure 7.7 is not drawn arbitrarily; rather, it describes the lowest possible costs of production. In this sense, production is efficient.

Second, competitive markets obey the “law of one price”; that is, all buyers and suppliers face the same price. In particular, this means that only consumers who are most willing (and able) to pay this price (i.e., those who reside on the highest portion of the demand curve) will actually end up with the goods. In this sense, consumption is efficient.

Third, given the market selection of minimum-cost producers and maximum-value consumers, the optimal output is achieved at the competitive intersection of supply and demand. Since PC MB MC, it is impossible to alter output—above or below the competitive level—and increase net benefits. In this sense, the level of output is efficient.

What are the efficiency implications of a government program to provide universal, free day care?

EFFICIENCY AND EQUITY It is important to emphasize that efficient markets are not necessarily equitable or fair. The outcomes of competitive markets directly reflect the distribution of incomes of those who buy and sell in these markets. An inability to pay excludes many people from the economic equation. In trying to solve the problems of poverty, malnutrition, inadequate health care, and the like, the government has the responsibility of addressing equity issues (as well as efficiency issues).

DYNAMIC, MARKETWIDE EFFICIENCY In our examination of competitive efficiency, we have focused on a single market and found that the efficient level of output occurs at the intersection of demand and supply, where PC MB MC. Can this “invisible hand” result be extended to encompass at once all the innumerable markets in a modern economy? The generalization to multiple markets is more complicated than it might seem at first. When dealing with many markets, it is not quite correct to focus on them separately, one at a time. After all, demands for different goods and services in the economy are interdependent. Changing the price of one good affects not only its consumption but also the consumption of substitute and complementary goods. Similarly, any change in price and output in one market generates marginal benefits and costs not only for that good but also for other affected markets. Given these interdependencies, can we draw any conclusions about the workings of private markets and economic efficiency?

Modern economic theory provides an elegant and important answer to this question: If all markets in the economy are perfectly competitive, the economy as a whole is efficient; that is, it delivers an efficient quantity of each good and service to consumers

at least cost. In short, a system of competitive markets in which all goods and services and all inputs (including labor) can be freely bought and sold provides a solution to the economic problem of resource allocation.13 Indeed, no matter how well intentioned, government measures that interfere with competitive markets can cause welfare losses.

A final virtue of competitive markets is that they are dynamically efficient; that is, they respond optimally to changes in economic conditions. If a new product or service can be supplied at a cost below the price consumers are willing to pay, profit-seeking firms will create and supply a market where none formerly existed. If demand for an existing product rises, so will price, thus attracting new entrants and further supply. At the new equilibrium, the efficiency condition, P MB MC, will be restored. Alternatively, if costs decline, the efficient response is achieved via a fall in price, causing consumption to increase to a new, optimal level. Finally, markets encourage the pursuit of technological innovations. Firms have a continuous incentive to search for and adopt more profitable methods of production.

The “invisible hand” theorem—that perfectly competitive markets ensure maximum social benefits—is best thought of as a benchmark. Although many markets in the United States meet the requirements of perfect competition, notable cases of market failures also exist. Market failures usually can be traced to one of three causes: (1) the presence of monopoly power, (2) the existence of externalities, or (3) the absence of perfect information. In Chapter 11, we analyze each of these sources of market failure.

Is competition on the Internet one further step toward the textbook case of perfect competition?14 The affirmative view holds that Internet competition, where consumers can easily find and identify the cheapest prices, should squeeze prices and profit margins to the bone. The early evidence suggests that the Internet can promote competition and efficiency in several respects. First, transacting online provides buyers and sellers much better information about available prices for competing goods. Clearly, the ability of customers to find better prices for standardized goods increases competition and induces more

13The proof of the “efficiency theorem” is beyond the scope of this book. It can be shown that a perfectly competitive economy is Pareto efficient; that is, it is impossible to reorganize the economy to make some economic agent (an individual or a firm) better off without making some other agent worse off. 14For interesting discussions of market competition and the Internet, see J. D. Levin, “The Economics of Internet Markets.” National Bureau of Economic Research, Working Paper 16852, March 2011; G. Ellison and S. F. Ellison, “Lessons about Markets from the Internet,” Journal of Economic Perspectives (Spring 2005): 139–158; “A Perfect Market: Survey of E-commerce,” The Economist (May 15, 2004), special supplement; E. Brynjolfsson, Y. Hu, and M. D. Smith, “Consumer Surplus in the Digital Economy: Estimating the Value of Increased Product Variety at Online Booksellers,” Management Science (November 2003): 1580–1596; M. E. Porter, “Strategy and the Internet,” Harvard Business Review (March 2001): 63–78; S. Borenstein and G. Saloner, “Economics and Electronic Commerce,” Journal of Economic Perspectives (Winter 2001): 3–12; and R. E. Litan and A. M. Rivlin, “Projecting the Economic Impact of the Internet,” American Economic Review, Papers and Proceedings (May 2001): 313–317.

Market Competition and the Internet

favorable prices. For instance, Internet prices for books and CDs tend to be 9 to 16 percent lower than traditional retail prices. New automobile prices are about 2 percent lower on average to buyers who enlist online comparison and referral services. Online insurance fees and brokerage charges are lower than charges for similar storefront products and services (and over time tend to exert downward pressure on storefront prices). Internet prices also display less dispersion than do retail prices. (However, online price dispersion persists. Competition is not so intense that all sellers are forced to charge the same market price.)

Second, the Internet increases the geographic range of markets and the variety of items sold in those markets. Hundreds of fragmented transactions are readily enlisted in unified markets. For example, a consumer could expend the time and effort to find a used copy of a John Grisham legal mystery by going to several bookstores and paying about $4.50 (half the new price in paperback). Or the consumer could use the Internet’s unified used book market, where scores of the same title sell for about $3.50, shipping included. The important point is that unified markets directly increase overall economic efficiency. However, unified markets need not always imply lower prices. For instance, with numerous buyers seeking scarce copies of original Nancy Drew mysteries (dust jackets intact), the Internet price averages $20 to $30 per copy. By comparison, the rare buyer who is lucky enough to find the same book on a bookstore shelf might pay only $5 to $15. As always the price effect of moving to a unified market depends on the relative increases in supply versus demand. An additional key benefit of online markets is greater product variety. One research study discovered that some 45 percent of all books sold online at Amazon were “rare” titles (ranked below the top 100,000). Using fitted demand curves, the study estimated the associated consumer surplus for these purchases with dramatic results. Consumer surplus averaged about 70 percent of the purchase price of each rare title. In total, the ability to find a wide variety of rare books was worth about $1 billion in 2000. By comparison, Amazon’s low prices saved consumers about $100 million. Item variety proved to be worth 10 times more than price reductions.

Third, in many important instances, a firm’s use of the Internet lowers costs: from finding and serving customers to ordering and procuring inputs, to lowering inventories. Selling online also may reduce the need for “bricksand-mortar” investments, and online promotion and marketing may take the place of a direct sales force. Specific examples of cost savings abound: The cost of selling an airline ticket online is $20 cheaper than the cost of selling through a travel agent. Online automobile sales reduce the need for dealerships and vehicle inventories. Online stock trades are much less costly than brokered trades. Just as important, the Internet lowers the internal costs of the firm—by serving as a platform for sharing and disseminating information throughout the firm and for better managing all aspects of the supply chain. Of course, each firm is constantly in pursuit of lower costs—via online

initiatives or in any other areas—as a way to gain a competitive advantage over its rivals. However, if all (or most) firms in a given market successfully exploit e-business methods to lower unit costs, the upshot is that the entire industry supply curve shifts downward. In a perfectly competitive market, these cost reductions are passed on, dollar for dollar, in lower prices to consumers. In the long run, only the most efficient firms will serve the market and economic profits again converge to zero.

Fourth, by lowering barriers to entry, online commerce moves markets closer to the perfectly competitive ideal. The e-business environment frequently means a reduced need for capital expenditures on plant, equipment, and inventories as well as for spending on highly trained direct sales forces. Elimination or reduction of these fixed costs makes it easier for numerous (perhaps small) firms to enter the market and compete evenhandedly with current competitors.

What aspects of the online business environment are at odds with perfect competition? First, numerous e-business goods and services are highly differentiated. (They do not fit the standardized designation of perfect competition.) Differentiation allows the firm to raise price without immediately losing all sales. (Its demand curve is downward sloping, not horizontal.) For example, the firm can potentially command higher prices for ease of use, better customer service and support, faster shipping, and customized offers and services. Even in cyberspace, a firm’s ability to earn positive economic profits depends on how well it differentiates its product and how effectively it establishes a strong brand name. Thus, a loyal customer of Amazon.com will continue to shop there for the ease, convenience, and product selection, even if prices are somewhat higher than at other sites. (Moreover, information goods usually exhibit high switching costs: Consumers are reluctant to learn to use a new software system or to navigate through an unfamiliar Web site.) Second, network externalities and economies of scale confer market power. The firm with the largest user network (e.g., Google in search, Microsoft in PC operating systems, eBay in online auctions, America Online in instant messaging, Oracle in database software) will claim increasing market share and be able to command premium prices. In addition, the presence of economies of scale (due to high fixed costs and low marginal costs) means that market leaders (such as Google and Apple’s itunes) will command a significant average-cost advantage relative to smaller rivals. All of these factors create barriers to entry, preventing new rivals from penetrating the market. Thus, shielded from price competition, the market leaders are able to earn positive economic profits.

Although e-business offers obvious avenues for increased competition, it does not eliminate the potential for claiming and exploiting market power in a number of traditional ways. As management expert Michael Porter puts it, “Because the Internet tends to weaken industry profitability, it is more important than ever for companies to distinguish themselves through strategy.”