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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 1 Price Below Equilibrium • Suppose milk is $1 per gallon Price ($/gallon) 2.50 S 2.00 1.50 1.00 0.50 D 1 2 3 4 5 Quantity (1,000s of gallons/day) 2 Price Below Equilibrium • A buyer offers $1.25 per gallon Price ($/gallon) 2.50 S 2.00 1.50 1.25 1.00 0.50 D 1 2 3 4 5 Quantity (1,000s of gallons/day) 3 Price above Equilibrium S Price ($/gallon) 2.50 2.00 1.75 1.50 Only equilibrium price is efficient 1.00 0.50 D 1 2 3 4 5 Quantity (1,000s of gallons/day) 4 Efficiency Conditions 5 Heating Oil Market Price ($/gallon) 2.00 1.80 S 1.60 Consumer surplus = $900/day 1.40 1.20 Producer surplus = $900/day 1.00 .80 D 1 2 3 4 5 8 Quantity (1,000s of gallons/day) 6 Price Ceiling on Heating Oil 2.00 1.80 Consumer surplus = $900/ day S Price ($/gallon) 1.60 1.40 Lost surplus = $800/ day 1.20 1.00 0.80 Producer surplus = $100/ day D 1 2 3 4 5 8 Quantity (1,000s of gallons/day) 7 Price Subsidies for Bread Price ($/loaf) $4.00 Consumer Surplus = $4 M/month $3.00 S $2.00 Consumer Surplus = $9 M/month $1.00 D S with subsidy 2 4 6 8 Quantity (millions of loaves/month) BUT… 8 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 = $3 million 9 Taxes on Sellers • Tax program – Seller reports sales in units to government – Seller pays a fixed dollar amount per unit sold • A tax on the seller shifts the supply curve up by the amount of the tax – Vertical interpretation of the supply curve • For each level of output, seller charges his marginal cost PLUS the tax 10 Tax on Avocado Sellers S + tax S Price ($/pound) 6 5 4 3.50 3 2.50 2 1 D 1 2 3 4 5 2.5 Quantity (millions of pounds/month) 11 Taxes and Perfectly Elastic Supply Price ($/car) If supply is perfectly elastic, buyers pay all of the tax S + $100 S $20,100 $20,000 D 1.9 2.0 Quantity (millions of cars/month) 12 Tax on Avocado Sellers P 6 Before Tax Consumer surplus = $4.5 M Producer surplus = $4.5 M S 3 P 6 D 3 S + tax Q After Tax Consumer surplus = $3.125 M Producer surplus = $3.125 M Total surplus = $6.25 M Loss = $2.75 M 3.50 1 D 2.5 Q 13 Taxes and Price Elasticity of Demand More Elastic Demand Less Elastic Demand P P S+T S+T 2.40 2.00 1.40 2.60 2.00 1.60 S S D1 D2 19 24 Q 21 24 Q Consumers pay a smaller share of the tax when demand is more elastic 14 Taxes and Deadweight Loss More Elastic Demand P Less Elastic Demand P Deadweight loss Deadweight loss S+T S+T 2.40 2.00 1.40 2.60 2.00 1.60 S S D1 D2 19 24 Q 21 24 Q Deadweight loss is larger when demand is relatively elastic 15