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Efficiency and Exchange
1
Market Equilibrium and Efficiency

A market equilibrium is efficient…

…if price and quantity take any other than
their equilibrium values, a transaction that
will make at least some people better off
without harming others can always be
found.
Slide 2
A Market in Which Price Is
Below the Equilibrium Level
S
Price ($/gallon)
2.50
2.00
1.50
1.00
.50
D
1
2
3
4
5
Quantity (1,000s of gallons/day)
Slide 3
How Excess Demand Creates an Opportunity
for a Surplus-Enhancing Transaction
S
Price ($/gallon)
2.50
• If P = $1 then QS = 2,000
gallons/day
• At 2,000 gallons the consumer is
willing to pay $2 and the MC = $1
• If the buyer pays $1.25 for an
extra gallon, producer is $.25
better off, and the consumer is
$.75 better off, or economic
surplus increases by $1.00
• At $1, the market is not efficient
2.00
1.50
1.25
1.00
.50
D
1
2
3
4
5
Quantity (1,000s of gallons/day)
Slide 4
How Excess Supply Creates an Opportunity
for a Surplus-Enhancing Transaction
S
Price ($/gallon)
2.50
•If P = $2 then QD = 2,000
gallons/day
•Additional output costs only $1
•This is $1 less than a buyer would
pay
•If the buyer pays the seller $1.75,
the buyer gains an economic
surplus of $0.25 then the seller
gains an economic surplus of
$0.75
2.00
1.75
1.50
1.00
.50
D
1
2
3
4
5
Quantity (1,000s of gallons/day)
Slide 5
Market Equilibrium and Efficiency



When price is above or below the
equilibrium, the quantity exchanged will
be below the equilibrium.
The vertical value on the demand curve
(marginal benefit) is greater than the
vertical value on the supply curve (MC).
Only the equilibrium will maximize
economic surplus.
Slide 6
Cash on the Table



When any “frictions” (typically government
regulation) prevents the market price from
reaching its equilibrium level, the total
economic surplus (economic benefits less
opportunity costs) available for buyers and
sellers is diminished.
Mutually beneficial exchanges are always
possible when a market is out of equilibrium.
When people have failed to take advantage
of all mutually beneficial exchanges, there is
"cash on the table.”
7
Social optimality



The socially optimal quantity of any good is
the quantity that maximizes the total
economic surplus that results from producing
and consuming the good.
Cost-benefit principle
 keep expanding production of the good as
long as its marginal benefit is at least as
great as its marginal cost.
Socially optimal quantity is that level for which
the marginal cost and marginal benefit of the
good are the same.
8
The Cost of Preventing
Price Adjustments

Price Ceilings: Do They Help the Poor?
A Price Ceiling for Housing Space
 Also known as rent control

Slide 9
Economic Surplus in an Unregulated
Market for Housing Space
2.00
Consumer surplus
= $900/day
1.80
S
1.60
1.40
Producer surplus
= $900/day
Price ($)
1.20
1.00
Without price controls:
•Equilibrium Price = $1.40
•Consumer surplus =
(1/2)(3,000)(.60) = $900/day
•Producer surplus =
(1/2)(3,000)(.6) = 900/day
•Economic surplus = $1,800/day
D
.80
1
2
3
4
5
8
Quantity of Housing /day
Slide 10
The Waste Caused by Price Controls
S
2.00
Price Ceiling set at $1.00
Consumer surplus =
$900/day
1.80
1.60
Lost economic
surplus = $800/day
1.40
Price ($)
1.20
1.00
Producer surplus =
$100/day
D
.80
With price controls:
•Producer surplus =
(1/2)(1,000)(.20) = $100/day or a
loss of $800/day
•Economic surplus = $1,000 or a
loss of $800/day
1
2
3
4
5
8
Quantity of Housing /day
Slide 11
The Cost of Preventing
Price Adjustments

The reduction in economic surplus from
a price ceiling will be underestimated
when
The consumers who receive the product
are not the consumers who value it the
most.
 Consumers take costly actions to enhance
their chances of being served.
Non-price competition

Slide 12
Non-price Competition



If sub-lease is allowed, existing tenants
may sub-lease part of their spaces to
those tenants that are willing to pay
more than the price ceiling.
If sub-lease is not allowed, shortage
and non-price competition will develop.
Discrimination based on non-money
considerations such as race, gender,
marital status, pet ownership, and
personalities

Dissipation of rent
Rent Control in the Long Run

If costs of maintaining and producing
housing has increased, esp. during high
inflation situation

Quality of housing deteriorates
Reduce

excess demand or “shortage”
Amount supplied would decrease in time as
residential space (under rent control) will be
converted to other uses, e.g., office space
E.g.
Housing in New York City and Los
Angeles
The Cost of Preventing
Price Adjustments

Question

What program could be used to help the
poor get housing spaces that would be
more efficient than a price ceiling?
Slide 15
When the Pie Is Larger,
Everyone Can Have a Bigger Slice
Surplus with price controls
R
Surplus with income transfers
and no price controls
R
P
P
With price controls set at $1.00 the
economic surplus is $1,000/day
*R = economic surplus received by
rich people
*P = economic surplus received by
poor people
Without price controls & with income
transfers economic surplus is $1,800/day
*R & P have the same share and a
much larger economic surplus
Slide 16
The Cost of Preventing
Price Adjustments

Question

What would be a potential cost of income
transfers?
Slide 17
The Cost of Preventing
Price Adjustments

Price Subsidies: Do They Help the Poor?
By how much do subsidies reduce total
economic surplus in the market for bread?
 Assume a small nation imports all its bread
at the world price of $2.00

Slide 18
Price of bread ($/loaf)
Economic Surplus in a
Bread Market Without Subsidy
Economic surplus
maximized where
MC($2) = MB($2) at
4 million loaves
5.00
4.00
Consumer surplus
= $4,000,000/month
3.00
S
World price = $2.00
1.00
D
2
4
6
8
Quantity (millions of loaves/month)
Slide 19
The Reduction in Economic
Surplus from a Subsidy

Assume a $1/loaf subsidy
Consumers buy 6 million loaves
 Consumer surplus will increase to $9
million
 Economic surplus will fall by $1 million

Slide 20
Price of bread ($/loaf)
The Reduction in Economic
Surplus from a Subsidy
5.00
•The cost of the subsidy = $6 million/month
•The benefit of the subsidy = $5 million/month
•Loss of economic surplus = $1 million /month
Consumer surplus =
$4,000,000/month
Reduction in total
economic surplus =
$1,000,000/month
4.00
3.00
S
World price = $2.00
Domestic price
with subsidy
1.00
D
2
4
6
8
Quantity (millions of loaves/month)
Slide 21
The Cost of Preventing
Price Adjustments

Price Subsidies

How could we provide assistance to low
income consumers more efficiently?
Slide 22
The Cost of Preventing
Price Adjustments

Economic Naturalist

First-Come, First-Served Policies
 Why
does no one complain any longer about
being bumped from an overbooked flight?
Slide 23
Equilibrium in the Market
for Seats on Oversold Flights
Demand for remaining
on the flight
Supply of seats
Price ($/seat)
60
24
33
37
Seats
Slide 24
Equilibrium in the Market
for Seats on Oversold Flights
Price ($/seat)
60
First-come, First-served
•Average reservation prices =
(60+59+…+24)/37 = $42/passenger
•4 bumped @ $42 each or $168
loss in economic surplus
Supply of seats
27
24
33
37
Seats
Slide 25
Equilibrium in the Market
for Seats on Oversold Flights
Price ($/seat)
60
Compensation Policy
•$27 = reservation price (compensation) to get
4 passengers to volunteer to stay
•The cost of the compensation = 4 x $27 = $108
minus the economic surplus to the passengers
of $6 = $102
Supply of seats
27
24
33
37
Seats
Slide 26
The Cost of Preventing
Price Adjustments

Example

How should a tennis pro handle an
overbooking problem?
Slide 27
The Cost of Preventing
Price Adjustments
Player
Arrival time
Reservation price
Ann
9:50 A.M.
$4
Bill
9:52 A.M.
3
Carrie
9:55 A.M.
6
Dana
9:56 A.M.
10
Earl
9:59 A.M.
2
•5 bookings for 3 slots
•All 5 show up for the lesson
•How can the tennis pro minimize the cost of
rescheduling two students?
•HINT: First-come, First-served or compensation
Slide 28
The Cost of Preventing
Price Adjustments

What do you think?

Why offer compensation when the cost of
first-come, first-served to the seller is zero?
Slide 29
The Marginal Cost Pricing of
Public Services

Example

How much should a city charge for water,
electricity, or some other service?
Slide 30
The Marginal Cost Curve for Water
Ocean
Cost (cents/gallon)
4.0
Three sources of water
•Spring: 1 million gallons/day
@ 0.2 cents/gallon
•Lake: 2 million gallons/day
@ 0.8 cents/gallon
•Ocean: 4 cents/gallon
Lake
Spring
0.8
0.2
1
3
Water supplied (millions of gallons/day)
Slide 31
The Marginal Cost Curve for Water

Example

How much should a city charge for water?
Slide 32
The Marginal Cost Curve for Water
Ocean
Cost (cents/gallon)
4.0
Assume
•If P = 4 cents/gallon, Q = 4
million gallons
Lake
Spring
Question
•Why should all residents
pay 4 cents per gallon
0.8
0.2
1
3
Water supplied (millions of gallons/day)
Slide 33
Taxes and Subsidies

Effect of a sales tax on price and
quantity


Imposition of a sales tax on goods lower
their sales but increase their prices (in
most cases).
Does it matter whether the tax is
imposed on consumer or producers?

Economic incidence of a tax is
independent of its legal incidence
Taxes and Subsidies

Who bears the burden of the tax?
Consumers or producers


Effect of Subsidies (negative taxes)


Depends on the relative elasticity of
demand and supply
Opposite effect to sales tax
Taxes and Efficiency
The Effect of a Tax on the
Equilibrium Quantity and Price of Avocados
Without a tax P = $3/lb
and Q = 3 million lbs/month
S + tax
S
6
Price ($/pound)
5
With a tax of $1/lb
• MC increases by $1/lb
• Supply shifts up by $1
• P = $3.50; Q = 2.5 million
• Consumers and producers share
the burden of the tax equally
• Producers receive $2.50/lb
• Consumers pay $3.50/lb
4
3.50
3
2.50
2
1
D
1
2
3
4
5
2.5
Quantity (millions of pounds/month)
Slide 36
Government levies taxes on
consumers: upward slopping supply
$t / unit
P1 – Net Price received by seller
P
P2 – Gross Price received by the
buyers (P0 +a)
t=a+b
P2
P0
P1
S
a – borne by consumer
a
b – borne by producer
b
t
D
D’
Q1
Q0
Q
Government levies taxes on sellers:
upward slopping supply
$t / unit
P2 – Gross price received by
seller
P
P1 – Net price received by the
seller
S’
P2
P0
P1
a – borne by consumer
S
b – borne by producer
a
b
D
Q1
Q0
Q
Government levies taxes on
sellers: vertical supply
$t / unit
P0 – Price before/after the new
tax
P
S
P1 – Net price received by the
seller after the new tax
P0
Consumers bear no burden
t
P1
Producers bear full burden
D
Q0
Q
Government levies taxes on
consumers: vertical supply
$t / unit
P0 – Price received by the seller
prior to the new tax
P
S
P1 – Price received by the seller
after the new tax
P0-P1 = t
P0
Consumers bear no burden
t
P1
D
t
Producers bear full burden
D’
Q0
Q
The Effect of a Tax on Sellers of a
Good with Infinite Price Elasticity of Supply
Price ($/car)
Assume a tax levy of $100 tax/car
$20,100
S + $100
$20,000
S
• Supply shifts to $20,100
• The burden of the tax falls
entirely on the consumer
D
1.9
2.0
Quantity (millions of cars/month)
Slide 41
Taxes and Efficiency

Who Pays a Tax?

When supply is perfectly elastic, the tax
burden will fall entirely on the consumer.
Slide 42
In a Nutshell

Economic incidence of a tax is
independent of its legal incidence

It does not matter whether the government
imposes the tax on the sellers or the buyers, the
ultimate burden of the tax depends on the relative
elasticity of demand and supply.

In the case of an infinite inelastic supply curve
(e.g., lands and human capital) , sellers bear the
full burden of the tax, while consumers bear none.
In contrast, consumers bear the full burden of the
tax if the demand curve is perfectly inelastic.
Sales Tax on Food

If Hong Kong government proposes to
levy a sale tax on rice? Who bears
most of the tax burden?

Demand for food (relatively inelastic) and
supply for food (relatively elastic). why?
Sales Tax on Food

The Japanese government protects her
local farmers and imposes import
restrictions on many agricultural
produces, e.g., apple. If a sale tax on
apple is imposed in Japan, who bears
most of the tax burden? Why?
Mandatory Provident Fund (MPF)



Currently, employers contribute a half of
the MPF (5%) and employees contribute
another half of it (5%).
Who bears the burden of the MPF?
Employers or employees?
If government shifts the MPF share from
50-50 sharing to 80-20 sharing (with
employers contribute 80% of the MPF),
does employees benefit from this new
law?
Taxes and Quality of Goods


If government levies a tax (flat rate) by
the bottle of wine, what is its effect on
the sales of high-quality to low-quality
wine?
Suppose Hong Kong government
passes a law and subsidizes college
students to buy computers. Each
student gets $200 cash when the buy a
computer, what is this law on the sales
of high-end to low-end computers?
Taxes and Efficiency

Question

How will a tax on cars affect their prices in
the long run?
Slide 48
Taxes and Efficiency

Deadweight Loss

The reduction in total economic surplus
that results from the adoption of a policy
Slide 49
The Deadweight Loss Caused by a Tax
S + tax
S
6
Price ($/pound)
5
4
Deadweight loss
caused by tax
3.50
3
2.50
2
1
D
1
2
3
4
5
2.5
Quantity (millions of pounds/month)
Slide 50
Taxes and Efficiency

Question

How would you determine the economic
feasibility of a tax?
Slide 51
Elasticity of Demand and
the Deadweight Loss from a Tax
Deadweight loss
Deadweight loss
2.40
2.00
S+T
2.60
S
1.40
D1
Price ($/unit)
Price ($/unit)
S+T
S
2.00
1.60
D2
19 24
Quantity (units/day)
21 24
Quantity (units/day)
The greater the elasticity of demand, the
greater the deadweight loss from a tax
Slide 52
Elasticity of Supply and the
Deadweight Loss from a Tax
Deadweight Loss
Deadweight Loss
S2 + T
S1 + T
S2
S1
2.00
1.65
D
57 72
Quantity (units/day)
Price ($/unit)
Price ($/unit)
2.65
2.35
2.00
1.35
D
63 72
Quantity (units/day)
The greater the elasticity of supply, the
greater the deadweight loss from a tax
Slide 53
Taxes and Efficiency

What do you think?
Why would a tax on land be efficient?
 Would a tax on pollution increase
economic surplus?

Slide 54
End
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