Download Quantity (units/day)

Chapter 7
Efficiency and Exchange
Efficiency

Pareto Efficiency
– No change is possible that will help some
people without harming others
– It is not possible to make some people
better-off without harming others

Inefficiency:
– It is possible to help some people without
harming others
A market equilibrium is efficient
if price and quantity take any other
than values different from the values in
equilibrium, some people can be
better- off by having more or less
transactions without harming others
 If away from equilibrium, some people
can be better-off without harming
others by moving toward equilibrium

Recall: Consumer Surplus
 the
net gain to an individual buyer
from the purchase of a good.
 the difference between the buyer’s
willingness to pay and the price paid.
Consumer Surplus
The total consumer surplus generated by purchases of a good at a
given price is equal to the area below the demand curve but
above that price.
Producer Surplus
the net gain to a seller from
selling a good
 the difference between the
price received and the minimum
price the producer is willing to
accept

Producer Surplus
The total producer surplus from sales of a good at a given price is
the area above the supply curve but below that price.
Total Surplus
the total net gain to consumers and
producers from trading in the market
 the sum of the producer surplus and
the consumer surplus

Total Surplus
Pf
Pc
Observations on 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.

Economic Surplus in an Unregulated
Market for Home Heating Oil
2.00
Consumer surplus
= $900/day
1.80
Figure 7.4, P. 196
S
1.60
Price ($/gallon)
1.40
Producer surplus
= $900/day
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 (1,000s of gallons/day)
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 = $800/day
Price ($/gallon)
1.40
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 $800/day
Figure 7.5, P. 197
1
2
3
4
5
8
Quantity (1,000s of gallons/day)
Price of bread ($/loaf)
The Reduction in Economic
Surplus from a Subsidy
5.00
•The cost of the tax = $6 million
•The benefit of the subsidy = $5 million
•Loss of economic surplus = $1 million
Consumer surplus
= $9,000/month
4.00
Reduction in total
economic surplus =
$1,000,000/month
3.00
S
World price = $2.00
Domestic price
with subsidy
1.00
D
Figure 7.8, P.200
2
4
6
8
Quantity (millions of loaves/month
Market Equilibrium and Efficiency

Markets will be efficient when:
– Buyers and sellers are well informed.
– Markets are perfectly competitive.
– Supply measures all relevant costs.
– Demand measures all relevant benefits.

Government intervention needed when
market failure
Market Equilibrium and
Efficiency

What do you think?
– Is efficiency the only goal?
– Why should efficiency be the first goal?
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 $3.50/lb
4
3.50
3
2.50
2
1
D
1
2
3
4
5
2.5
Quantity (millions of pounds/month)
The Effect of a Tax on Sellers of a
Good with Infinite Price Elasticity of
Supply
Price ($/car)
Assume a tax levy of $100 tax/car
$20,100
S + $100
$20,000
S
• Supply shifts to $20,100
• The burden of the tax falls
entirely on the consumer
D
1.9
2.0
Quantity (millions of cars/month)
Taxes and Efficiency

Who Pays a Tax?
– When supply is perfectly elastic, the tax
burden will fall entirely on the consumer.
The Market for Avocados Without Taxes
6
5
Price ($/pound)
S
Total economic
surplus = $9
million/month
How a tax collected for
a seller affects
economic surplus
4
3
2
1
D
1
2
3
4
5
Quantity (millions of pounds/month)
The Effect of a $1 per
Pound Tax on Avocados
S + tax
S
6
Price ($/pound)
5
How a tax collected
from a seller affects
economic surplus
4
3.50
3
2.50
2
1
D
1
2
3
4
5
2.5
Quantity (millions of pounds/month)
Taxes and Efficiency

Deadweight Loss
– The reduction in total economic surplus
that results from the adoption of a policy
The Deadweight Loss Caused by a Tax
S + tax
S
6
Price ($/pound)
5
4
Deadweight loss
caused by tax
3.50
3
2.50
2
1
D
1
2
3
4
5
2.5
Quantity (millions of pounds/month)
Elasticity of Demand and
the Deadweight Loss from a Tax
Deadweight loss
Deadweight loss
2.40
2.00
S+T
2.60
S
1.40
D1
Price ($/unit)
Price ($/unit)
S+T
S
2.00
1.60
D2
19 24
Quantity (units/day)
21 24
Quantity (units/day)
The greater the elasticity of demand, the
greater the deadweight loss from a tax
Elasticity of Supply and the
Deadweight Loss from a Tax
Deadweight Loss
Deadweight Loss
S2 + T
S1 + T
S2
S1
2.00
1.65
D
57 72
Quantity (units/day)
Price ($/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
Taxes and Efficiency

What do you think?
– Why would a tax on land be efficient?
– Would a tax on pollution increase
economic surplus?