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Does the market achieve an efficient and fair use of resources? Dr Ikhlaas Gurrib CHAPTER 5 EFFICIENCY & EQUITY CONSUMER SURPLUS Consumer surplus is the area below the demand curve and above the market price. P 6 Amount paid D 5 Q TOTAL BENEFITS P Total benefits = Consumer surplus Amount paid 6 D 5 Q + HOW A CHANGE IN PRICE AFFECTS CONSUMER SURPLUS Price A Supply Initial consumer surplus P1 C B Demand 0 Q1 Q2 Quantity HOW A CHANGE IN PRICE AFFECTS CONSUMER SURPLUS Price A Supply S Initial consumer surplus Increase in consumer surplus C P1 B P2 D E Demand 0 Q1 Q2 Quantity SUPPLY & PRODUCER SURPLUS P S producer surplus = $10 6 Cost of production = $20 5 Q HOW A CHANGE IN PRICE AFFECTS PRODUCER SURPLUS Price Supply P1 B Initial producer surplus C Demand A 0 Q1 Q2 Quantity HOW A CHANGE IN PRICE AFFECTS PRODUCER SURPLUS Price Supply P2 P1 B Initial producer surplus C D Demand A 0 Q1 Q2 Quantity HOW A CHANGE IN PRICE AFFECTS PRODUCER SURPLUS Price Increase in producer surplus P2 P1 D Supply E F B Initial producer surplus C D Demand A 0 Q1 Q2 Quantity ECONOMIC WELL-BEING AND TOTAL SURPLUS Total Surplus = Consumer Surplus + Producer Surplus or Total Surplus = Total Benefits _ Total Costs TOTAL SURPLUS Price Supply Equilibrium price Demand 0 Equilibrium quantity Quantity TOTAL SURPLUS Price Consumer Surplus Supply Equilibrium price Producer Surplus Demand 0 Equilibrium quantity Quantity SOURCES OF INEFFICIENCY Deadweight Loss The decrease in total surplus that results from an inefficient allocation of resources UNDER & OVERPRODUCTION Price Deadweight loss overproduction Demand underproduction 0 Supply Qe Quantity REVIEW Gayle decides that she would pay as much as $3000 for a new laptop computer. She buys the computer and realises a consumer surplus of $700. How much did Gayle pay for her computer? A. $700 B. $2300 C. $3000 D. $3700 REVIEW Michele is willing to pay $20 to see Legally Blonde for the fourth time. She finds a theatre showing Legally Blonde for $5. Michele’s consumer surplus is: A. $5. B. $15. C. $20. D. $25. REVIEW The Health Ministry announces that eating chocolate improves your health. As a result, the equilibrium market price of chocolate __________, and producer surplus ___________. A. increases, increases B. increases, decreases C. decreases, decreases D. decreases, increases CHAPTER 6 MARKETS IN ACTION The effects of • price restrictions • quantity restrictions • taxes PRICE CONTROLS These are price restrictions imposed on a market Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and price floors. PRICE CEILINGS & PRICE FLOORS Price Ceiling A legally established maximum price at which a good can be sold. Price Floor A legally established minimum price at which a good can be sold. HOUSING MARKETS AND RENT CEILINGS Imagine that a tropical cyclone destroys much of the city’s homes How would the housing market cope with such a devastating reduction in the supply of housing? A HOUSING MARKET AFTER A CYCLONE After the cyclone Rent (dollars per unit per month) SSA 900 SS 700 Should rents be capped at $500? 500 D 0 20 30 40 60 Quantity (thousands of units per month) HOUSING MARKETS AND RENT CEILINGS When a price ceiling is applied to a housing market, it is called a rent ceiling. If the rent ceiling is set above the equilibrium rent, it has no effect. But if the rent ceiling is set below the equilibrium rent, it has powerful effects. Rent (dollars per unit per month) A RENT CEILING SSA 900 700 Rent ceiling 500 Housing shortage 0 20 30 D 40 Quantity (thousands of units per month) HOUSING MARKETS AND RENT CEILINGS The time spent looking for someone with whom to do business is called search activity. When a price is regulated and there is a shortage, search activity increases. Search activity is costly. It uses time and other resources A RENT CEILING Rent (dollars per unit per month) Maximum black market rent SSA 900 700 Rent ceiling 500 Housing shortage 0 20 30 D 40 Quantity (thousands of units per month) Rent (dollars per unit per month) A RENT CEILING 900 Consumer Surplus Deadweight SSA loss 700 Producer Surplus Rent Ceiling 500 D 0 20 30 40 Quantity (thousands of units per month) Wage Rate (dollars per hour) MINIMUM WAGE AND UNEMPLOYMENT 6 SS Unemployment 5 Minimum wage 4 3 DA 20 21 22 23 Quantity (millions of hours per year) OTHER PRICE FLOORS Price floors are common in agricultural markets e.g. minimum wool price Price floors create surpluses because QS > QD. Taxpayers fund the purchase of the surplus output Price floors are also inefficient (they create a deadweight loss) and unfair Dr Ikhlaas Gurrib A PRICE FLOOR – WOOL Price If government buys surplus Supply Minimum price surplus Price floor Cost to taxpayers Equilibrium price Demand 0 Qd Qs Quantity TAXES Governments levy taxes on goods and services to raise revenue for public purposes. Taxes discourage market activity. When a good is taxed, the quantity sold is smaller; the price is higher A tax creates a wedge between buyer and seller TAXES Tax incidence is the study of who bears the burden of a tax. Taxes result in a change in the market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on. TAXES Taxes can be levied on buyers or sellers A tax on sellers will decrease supply A tax on buyers will decrease demand Example: The govt wants to impose a new tax on chewing gum (Tax = $1.50) Should the tax be imposed on buyers or sellers? A TAX ON SELLERS Price (dollars per packet) 5.00 S + tax on sellers Price paid by buyers $1.50 tax S 4.00 A tax on sellers shifts the S curve upward by the amount of the tax Price with no tax 3.00 2.50 2.00 1.00 0 Price received by sellers 50 75 D 100 125 150 175 200 225 Quantity (millions of packets per year) A TAX ON BUYERS 5.00 Price paid by buyers Price (dollars per packet) S 4.00 Price with no tax A tax on buyers shifts the D $1.50 tax curve downward by the size of the tax 3.00 2.50 2.00 1.50 Price received by sellers D 1.00 D - tax on buyers 50 0 75 100 125 150 175 200 225 Quantity (millions of packets per year) THE INCIDENCE OF TAX In what proportions is the burden of the tax divided? Who pays more of the tax – the buyer or the seller? It depends . . . on the elasticity of demand and supply Dr Ikhlaas Gurrib A TAX ON SELLERS – INELASTIC D S + tax on sellers Price (dollars per packet) 5.00 S 4.00 The tax burden on the buyer is ___ The tax burden on the seller is ___ D D is more ______ compared to S B 3.00 2.50 S 2.00 1.00 0 50 75 100 125 150 175 200 225 Quantity (millions of packets per year) A TAX ON SELLERS – ELASTIC D S + tax on sellers Price (dollars per packet) 5.00 S 4.00 3.50 3.00 The tax burden on the buyer is ___ The tax burden on D the seller is ___ D is more ______ compared to S B S 2.00 1.00 0 50 75 100 125 150 175 200 225 Quantity (millions of packets per year) THE INCIDENCE OF TAX Who pays more of the tax – the buyer or the seller? The incidence of a tax will fall more on the buyer when demand is more ____Inelastic____ compared to supply The incidence of a tax will fall more on the seller when demand is more ____Elastic____ compared to supply TAX REVENUE & ELASTICITY S + tax on sellers Price (dollars per packet) 5.00 S 4.00 Tax Revenue $ = size of T x Q 3.00 2.50 De 2.00 Di 1.00 0 50 75 100 125 150 175 200 225 Quantity (millions of packets per year) TAXES AND EFFICIENCY What about the efficiency of a tax? How does a tax affect consumer & producer surplus? Will total surplus increase or decrease? Taxes increase the price paid by consumers, decrease the price received by sellers & decrease quantity sold TAXES AND EFFICIENCY After a tax, consumers will pay more and consume less Consumer surplus will decrease A TAX ON SELLERS – INELASTIC D S + tax on sellers Price (dollars per packet) 5.00 S 4.00 3.00 Consumer surplus decreases 2.50 2.00 D 1.00 0 50 75 100 125 150 175 200 225 Quantity (millions of packets per year) TAXES AND EFFICIENCY After a tax, producers will receive less and sell less Producer surplus will decrease A TAX ON SELLERS – INELASTIC D S + tax on sellers Price (dollars per packet) 5.00 S 4.00 3.00 2.50 2.00 D Producer surplus decreases 1.00 0 50 75 100 125 150 175 200 225 Quantity (millions of packets per year) A TAX ON SELLERS – INELASTIC D S + tax on sellers Price (dollars per packet) 5.00 Deadweight loss S 4.00 3.00 2.50 2.00 D 1.00 0 50 75 100 125 150 Tax revenue 175 200 225 Quantity (millions of packets per year) DETERMINANTS OF DEADWEIGHT LOSS The magnitude of the deadweight loss depends on the decline in market size as a result of the tax. That, in turn, depends on the price elasticities of supply and demand. DETERMINANTS OF DEADWEIGHT LOSS The more elastic are demand and supply, the larger will be the decline in equilibrium quantity and the larger the deadweight loss. In panel (a), the deadweight-loss triangle is large because demand is relatively elastic. In panel (b), the deadweight-loss triangle is much smaller because demand is now relatively inelastic. SHOULD WE HAVE TAXES? Assume tax revenue = $1 mill. while welfare loss = $ 0.1 mill The tax is beneficial if tax $ are spent to generate more than $1.1 million in benefits to the community Does this always happen? TAXES What goods should we tax? Objective should be to MAXIMISE TAX REVENUE and MINIMISE the DEADWEIGHT LOSS Therefore tax goods that are relatively INELASTIC REVIEW Would a consumer prefer a tax to be placed on goods with elastic demand or inelastic demand? Elastic D Why? Consumer surplus would decrease most when a tax is placed on a good with INELASTIC demand REVIEW A price ceiling set below equilibrium will cause greater shortages if a. both supply and demand are inelastic. b. both supply and demand are elastic. c. supply is elastic, but demand is inelastic. d. supply is inelastic, but demand is elastic. REVIEW A price floor set below the equilibrium price causes a. shortages. b. surpluses. c. excess supply. d. none of the above. REVIEW If the tax on cigarettes is increased by $1.00 per packet we should expect a. the consumer to pay more of the tax the more elastic the demand for cigarettes. b. the equilibrium price to be $1.00 higher if demand is perfectly elastic. c.government revenue from the tax to increase if cigarette demand is relatively inelastic. d. the suppliers to pay all of the tax if demand is completely inelastic. REVIEW Assume that a tax is levied on a good and the government uses the funds to build statues of Kevin Rudd. In this case there would be: A. a decrease in consumer surplus to consumers of the taxed good. B. a decrease in producer surplus to producers of the taxed good. C. a probable decrease in the welfare of society that exceeded the deadweight economic loss from the tax. D. All of the above would occur.