Market Efficiency and Total Surplus Analysis

1. Chapter 7 Efficiency and Exchange

2. Efficiency • Pareto Efficiency • No change is possible that will help some people without harming others • It is not possible to make some people better-off without harming others • Inefficiency: • It is possible to help some people without harming others

3. A market equilibrium is efficient • if price and quantity take any other than values different from the values in equilibrium, some people can be better- off by having more or less transactions without harming others • If away from equilibrium, some people can be better-off without harming others by moving toward equilibrium

4. Recall: Consumer Surplus • the net gain to an individual buyer from the purchase of a good. • the difference between the buyer’s willingness to pay and the price paid.

5. Consumer Surplus The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price.

6. Producer Surplus • the net gain to a seller from selling a good • the difference between the price received and the minimum price the producer is willing to accept

7. Producer Surplus The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price.

8. Total Surplus • the total net gain to consumers and producers from trading in the market • the sum of the producer surplus and the consumer surplus

9. Total Surplus Pf Pc

10. Observations on Efficiency • When price is above or below the equilibrium, the quantity exchanged will be below the equilibrium. • The vertical value on the demand curve (marginal benefit) is greater than the vertical value on the supply curve (MC). • Only the equilibrium will maximize economic surplus.

11. Consumer surplus = $900/day S Producer surplus = $900/day D Economic Surplus in an Unregulated Market for Home Heating Oil Figure 7.4, P. 196 2.00 1.80 1.60 1.40 1.20 1.00 • Without price controls: • Equilibrium Price = $1.40 • Consumer surplus = (1/2)(3,000)(.60) = $900/day • Producer surplus = (1/2)(3,000)(.6) = 900/day • Economic surplus = $1,800/day Price ($/gallon) .80 1 2 3 4 5 8 Quantity (1,000s of gallons/day)

12. Consumer surplus = $900/day Lost economic surplus = $800/day Producer surplus = $100/day The Waste Caused by Price Controls Price Ceiling set at $1.00 S 2.00 1.80 1.60 1.40 1.20 1.00 D Price ($/gallon) .80 • With price controls: • Producer surplus = (1/2)(1,000)(.20) = $100/day or a loss of $800/day • Economic surplus = $1,000 or a loss of $800/day Figure 7.5, P. 197 1 2 3 4 5 8 Quantity (1,000s of gallons/day)

13. Consumer surplus = $9,000/month Reduction in total economic surplus = $1,000,000/month S Domestic price with subsidy D The Reduction in EconomicSurplus from a Subsidy • The cost of the tax = $6 million • The benefit of the subsidy = $5 million • Loss of economic surplus = $1 million 5.00 4.00 Price of bread ($/loaf) 3.00 2.00 World price = $ 1.00 Figure 7.8, P.200 2 4 6 8 Quantity (millions of loaves/month

14. Market Equilibrium and Efficiency • Markets will be efficient when: • Buyers and sellers are well informed. • Markets are perfectly competitive. • Supply measures all relevant costs. • Demand measures all relevant benefits. • Government intervention needed when market failure

15. Market Equilibrium and Efficiency • What do you think? • Is efficiency the only goal? • Why should efficiency be the first goal?

16. Without a tax P = $3/lb and Q = 3 million lbs/month S + tax S • With a tax of $1/lb • MC increases by $1/lb • Supply shifts up by $1 • P = $3.50; Q = 2.5 million • Consumers and producers share the burden of the tax equally • Producers receive $2.50/lb • Consumers pay $3.50/lb 3.50 3 2.50 D 2.5 The Effect of a Tax on the Equilibrium Quantity and Price of Avocados 6 5 4 Price ($/pound) 2 1 1 2 3 4 5 Quantity (millions of pounds/month)

17. S + $100 $20,100 S $20,000 • Supply shifts to $20,100 • The burden of the tax falls entirely on the consumer D 1.9 2.0 The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply Assume a tax levy of $100 tax/car Price ($/car) Quantity (millions of cars/month)

18. Taxes and Efficiency • Who Pays a Tax? • When supply is perfectly elastic, the tax burden will fall entirely on the consumer.

19. S Total economic surplus = $9 million/month How a tax collected for a seller affects economic surplus D The Market for Avocados Without Taxes 6 5 4 Price ($/pound) 3 2 1 1 2 3 4 5 Quantity (millions of pounds/month)

20. S + tax S 6 5 How a tax collected from a seller affects economic surplus 4 3.50 Price ($/pound) 3 2.50 2 1 D 1 2 3 4 5 2.5 Quantity (millions of pounds/month) The Effect of a $1 perPound Tax on Avocados

21. Taxes and Efficiency • Deadweight Loss • The reduction in total economic surplus that results from the adoption of a policy

22. S + tax Deadweight loss caused by tax 3.50 2.50 2.5 The Deadweight Loss Caused by a Tax S 6 5 4 Price ($/pound) 3 2 1 D 1 2 3 4 5 Quantity (millions of pounds/month)

23. Deadweight loss Deadweight loss S + T S + T 2.60 S S 2.40 2.00 2.00 1.60 1.40 D1 D2 19 24 21 24 Elasticity of Demand and the Deadweight Loss from a Tax Price ($/unit) Price ($/unit) Quantity (units/day) Quantity (units/day) The greater the elasticity of demand, the greater the deadweight loss from a tax

24. Deadweight Loss Deadweight Loss S2 + T S1 + T S2 2.65 S1 2.35 2.00 2.00 1.65 1.35 D D 57 72 63 72 Elasticity of Supply and the Deadweight Loss from a Tax Price ($/unit) Price ($/unit) Quantity (units/day) Quantity (units/day) The greater the elasticity of supply, the greater the deadweight loss from a tax

25. Taxes and Efficiency • What do you think? • Why would a tax on land be efficient? • Would a tax on pollution increase economic surplus?