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Chapter 7: Efficiency and Exchange

Chapter 7: Efficiency and Exchange. Market Equilibrium and Efficiency Economic efficiency exists when no change could be made to benefit one party without harming the other Sometimes called Pareto efficiency Equilibrium price and quantity are efficient

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Chapter 7: Efficiency and Exchange

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  1. Chapter 7: Efficiency and Exchange Market Equilibrium and Efficiency • Economic efficiency exists when no change could be made to benefit one party without harming the other • Sometimes called Pareto efficiency • Equilibrium price and quantity are efficient • Prices above or below equilibrium are not

  2. Price Below Equilibrium • Suppose milk is $1 per gallon S 2.50 2.00 1.50 Price ($/gallon) 1.00 0.50 D 1 2 3 4 5 Quantity (1,000s of gallons/day)

  3. Price Below Equilibrium • A buyer offers $1.25 per gallon S 2.50 2.00 1.50 Price ($/gallon) 1.25 1.00 0.50 D 1 2 3 4 5 Quantity (1,000s of gallons/day)

  4. Price above Equilibrium S 2.50 2.00 1.75 Only equilibrium price is efficient 1.50 Price ($/gallon) 1.00 0.50 D 1 2 3 4 5 Quantity (1,000s of gallons/day)

  5. Efficiency Conditions

  6. Heating Oil Market 2.00 S 1.80 1.60 Consumer surplus = $900/day 1.40 Producer surplus = $900/day 1.20 Price ($/gallon) 1.00 .80 D 1 2 3 4 5 8 Quantity (1,000s of gallons/day)

  7. Price Ceiling on Heating Oil Consumer surplus = $900/ day 2.00 1.80 S 1.60 Lost surplus = $800/ day 1.40 1.20 Price ($/gallon) 1.00 Producer surplus = $100/ day 0.80 D 1 2 3 4 5 8 Quantity (1,000s of gallons/day)

  8. Price Subsidies for Bread Price ($/loaf) $4.00 Consumer Surplus = $4 M/month $3.00 S $2.00 Consumer Surplus = $9 M/month $1.00 S with subsidy D 2 4 6 8 Quantity (millions of loaves/month) BUT…

  9. The Cost of the Subsidy • BUT … • The government loses $1 on every loaf • Imports 6 million loaves for $2 per loaf • Government losses are $6 million • The net benefit of the subsidy program • Consumer surplus – government losses • Net benefit = $3 million

  10. Taxes on Sellers • Tax program • Seller reports sales in units to government • Seller pays a fixed dollar amount per unit sold • A tax on the seller shifts the supply curve up by the amount of the tax • Vertical interpretation of the supply curve • For each level of output, seller charges his marginal cost PLUS the tax

  11. Tax on Avocado Sellers S + tax S 6 5 4 3.50 Price ($/pound) 3 2.50 2 1 D 1 2 3 4 5 2.5 Quantity (millions of pounds/month)

  12. Taxes and Perfectly Elastic Supply Price ($/car) If supply is perfectly elastic, buyers pay all of the tax S + $100 $20,100 S $20,000 D 1.9 2.0 Quantity (millions of cars/month)

  13. Tax on Avocado Sellers • Before Tax • Consumer surplus = $4.5 M • Producer surplus = $4.5 M P S 6 3 P S + tax D 6 3 Q 3.50 • After Tax • Consumer surplus = $3.125 M • Producer surplus = $3.125 M • Total surplus = $6.25 M • Loss = $2.75 M 1 D Q 2.5

  14. Taxes and Price Elasticity of Demand More Elastic Demand Less Elastic Demand P P S + T S + T 2.60 2.40 S S 2.00 2.00 1.60 1.40 D1 D2 19 24 21 24 Q Q Consumers pay a smaller share of the tax when demand is more elastic

  15. Taxes and Deadweight Loss More Elastic Demand Less Elastic Demand P P Deadweight loss Deadweight loss S + T S + T 2.60 2.40 S S 2.00 2.00 1.60 1.40 D1 D2 19 24 21 24 Q Q Deadweight loss is larger when demand is relatively elastic

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