Download Lecture 7 10_20

Econ 200: Lecture 7
October 20, 2016
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Learning Catalytics Session:
Economic Efficiency
Price Ceilings and Floors and Efficiency
Taxes and Efficiency
How Much Output is Efficient?
Two ways of defining Economic Efficiency:
1.
A market is efficient if all trades take place where the marginal benefit exceeds
the marginal cost, and no other trades take place.
2.
A market is efficient if it maximizes the sum of consumer and producer surplus
(i.e. the total net benefit to consumers and firms), known as the economic
surplus.
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The Efficiency of Competitive Equilibrium
Demand: Marginal Benefit of
each cup
Supply: Marginal Cost of each
cup
If Q too low MB>MC
If Q too high  MB<MC
Only at the competitive equilibrium is the last unit valued by consumers and
producers equally—economic efficiency.
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The Efficiency of Competitive Equilibrium—Surplus
At the competitive
equilibrium quantity, the
economic surplus (CS +
PS) is also maximized!
Our two concepts of
economic efficiency
result in the same level
of output.
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Economic Surplus if the Market is Not in Equilibrium
Total economic surplus decreases by the sum of areas C and E.
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Economic Surplus if the Market is Not in Equilibrium
Deadweight Loss (DWL): The amount of inefficiency in a market.
In competitive equilibrium, deadweight loss is zero.
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Price Ceilings and Price Floors
Price ceiling: A legally determined maximum price that
sellers can charge.
Price floor:
A legally determined minimum price that
sellers may receive.
Price ceilings and floors include:
Minimum wages
Rent controls
Agricultural price controls
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Price Floors: Agricultural Price Supports
Pe=$3.00
Qe=2 billion bushels per year
If wheat farmers convince the
government to impose a price
floor of $3.50 per bushel,
quantity traded falls to 1.8
billion.
Area A is the surplus transferred
from consumers to producers.
Economic surplus is reduced by
area B + C, the deadweight loss.
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Price Floors: It Gets Worse…
If farmers do not realize they will
not be able to sell all of their
wheat, they will produce 2.2
billion bushels.
This results in a surplus, or excess
supply, of 400 million bushels of
wheat.
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Price Ceilings: Rent Controls
Pe=$1,500 per month.
Qe = 2,000,000 apartments per month
If the government imposes a rent
ceiling of $1,000, what happens?
Qs=1,900,000,
but Qd=2,100,000,
A shortage of 200,000 apartments.
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Price Ceilings: the Effect of Rent Controls
Producer surplus equal to
the area of the blue
rectangle A is transferred
from landlords to renters.
There is a deadweight
loss equal to the areas of
yellow triangles B and C.
This deadweight loss
corresponds to the
surplus that would have
been derived from
apartments that are no
longer rented.
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The Results of Government Price Controls
When a government imposes price controls,
• Some people win,
• Some people lose, and
• Deadweight loss (loss of total surplus) will generally occur.
Economists seldom recommend price controls, with the possible
exception of minimum wage laws. Why minimum wage laws?
• Equity effects more important than efficiency loss.
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Rent Controls in the Market for Apartments
Suppose the city imposes a rent ceiling of
$1,500:
QS
= – 1,000,000 + 1,300P
= – 1,000,000 + 1,300(1,500)
= 950,000
The price at which Qd=950k:
Qd
950,000
P
= 4,750,000 – 1,000P
= 4,750,000 – 1,000P
= –3,800,000 / –1,000
= $3,800
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Computing Deadweight Loss
Triangles B + C represent the deadweight
loss. Area B is:
½ × (2,250,000 – 950,000) ×
(3,800 – 2,500)
= $845 million
Area C is:
½ × (2,250,000 – 950,000) ×
(2,500 – 1,500)
= $650 million
So the deadweight loss is
845 + 650 = $1,495 million.
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Computing the Change in Surplus for Consumers
Consumers lose area B ($845
million) but gain the area of
rectangle A:
(2,500 – 1,500) × (950,000)
= $950 million
So consumer surplus changes
from $2531.25 million to:
(2531.25 + 950) – 845
= $2636.25 million
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Computing the Change in Surplus for Producers
Producers lose area A ($950 million) and
area C ($650 million).
They originally had a surplus of $1947.375
million, so now producer surplus is:
1947.375 – (950 + 650)
= $347.375 million
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Taxes
Taxes are the most important method by which
governments fund their activities.
We will concentrate on per-unit taxes: taxes assessed as a
particular dollar amount on the sale of a good or service,
as opposed to a percentage tax.
The Effect of a Tax on Cigarettes
Without the tax:
Pe=$5.0 /pack
Qe=4 billion packs
A $1.00/pack tax on
cigarettes shift the
supply from S1 to S2
(vertical distance is $1).
After the tax:
Pe=$5.90/pack
Qe-3.7 billion packs
The Effect of a Tax on Cigarettes
• Consumers pay
$5.90 per pack.
• Producers receive a
price of $5.90 per
pack
• After paying the
$1.00 tax, they are
left with $4.90
 Tax revenue = the
green shadowed box
Tax Incidence on a Demand and Supply Graph
The effect of a $0.10 gas
tax:
• The price consumers pay
rises from $3.50 to
$3.58.
• The price sellers receive
falls from $3.50 to $3.48.
Therefore, consumers pay
8 cents of the 10-cents-pergallon tax on gasoline, and
sellers pay 2 cents.
Tax Incidence: Who Actually Pays for a Tax?
In the market for gasoline, the buyers effectively
paid 80% of the 10-cents-per-gallon tax, and sellers
paid 20%.
This is referred to as the tax incidence: the actual
division of the burden of a tax between buyers and
sellers in a market.
What determines this tax incidence?
What If the Tax is Collected From Buyers?
If a 10-cents-per-gallon tax
imposed on consumers, the
demand curve shifts down from
D1 to D2.
In the new equilibrium:
• Consumers pay $3.58 per
gallon
• Producers receive $3.48 per
gallon.
This is the same result we saw
when producers were responsible
for paying the tax!
What Does Determine the Tax Incidence?
The incidence of the tax is determined by the relative
slopes (or relative elasticity) of the demand and supply
curves.
A steep (relatively inelastic) demand curve means that
buyers pay more of the tax.
A shallow (relatively elastic) demand curve means that
buyers pay less of the tax.