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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
(\$/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
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
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
More Elastic Demand
P
Less Elastic Demand
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
Deadweight loss is larger when demand is relatively elastic
15
```
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