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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.
