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Chapter 5: Efficiency
and Exchange
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1
Learning Objectives
1. Define and calculate consumer and producer
surplus
2. Define efficiency
3. Analyze how surplus and efficiency are affected by
policies
4. Explain the role of efficiency in deciding the "right"
price for public services
5. Examine the ways taxes affect efficiency
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Free Markets
 It is common to describe the free enterprise
system as “the greatest engine of progress
mankind has ever witnessed” or as “a rising
tide that will lift all boats.”
 Raising traffic fines in Morocco ought to
reduce reckless driving.
 Instead, it made corruption more rampant and
had no noticeable effect on reckless driving.
 Conclusion: In many instances, free markets
should be supplemented with political
coordination.
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Role of the Market
Market allocation of resources
 Often
maximizes efficiency
 Not right for all objectives


Corruption
Income distribution
 Unintended
consequences of government
policies
 Public utilities
 Taxes
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4
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


An outcome is more efficient if at least one person is made
better off and nobody is made worse off
Different from engineering efficiency

Maximizes the amount of work done while minimizing the
resources used
 Market equilibrium price and quantity are efficient
 Prices above or below equilibrium are not
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5
Trade-Offs
Efficiency
Equity
Maximum
Total
Surplus
Fairness
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Consumer and Producer Surplus
 In economics, we assume that all
exchange is purely voluntary
 In
other terms, a transaction cannot take place
unless the consumer’s reservation price exceeds
the producer’s reservation price
 Consumer surplus (CS)
 Difference
between the buyer’s reservation price
and the price he or she actually pays
 Usually the area below the demand curve and
above the market price
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Consumer and Producer Surplus
 In economics, we assume that all
exchange is purely voluntary
 Producer surplus (PS)
 Difference
between the price received by the
seller and his or her reservation price
 Usually the area above the suppler and below the
market price
 Total economic surplus = CS + PS
 Difference
between the buyer’s reservation price
and the seller’s reservation price
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Consumer Surplus
Consumer's surplus is the difference
between the buyer's reservation price and
the market price
With multiple buyers
 Find
the consumer surplus for each buyer
 Add up the individual surpluses
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 When a product is sold in
whole units, the demand
curve is a stair-step function
 Many goods are indivisible:
movie tickets and TVs
 If the market supplied only
one unit, the maximum price
would be $11
 For the second unit, the
price is $10, and so on
 The last buyer gets no
consumer surplus
Price ($/ unit)
Consumer Surplus on a Graph
12
11
10
9
8
7
6
5
4
3
2
1
D
2
4
6
8
10
12
Units/day
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 Market price is $6 for all sales
 Total consumer surplus
 The first sale generates $5 of
consumer surplus
• Reservation price of $11
minus the price of $6
 Selling the second unit has $4
of consumer surplus, and so on
 Total consumer surplus is the
area under the demand curve
and above market price
Price ($/ unit)
Consumer Surplus on a Graph
12
11
10
9
8
7
6
5
4
3
2
1
D
2
4
6
8
10
12
Units/day
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Consumer Surplus for Milk
S
3.00
Price ($/liter)
 Consider the market
demand and supply of
milk
 The equilibrium price is
$2 per liter
 The equilibrium quantity
is 4,000 liters per day
 Last customer pays his
reservation price and
gets no consumer
surplus
2.00
D
1.00
1
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3
4
5
6
Quantity (000s of l/day)
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Consumer Surplus for Milk
Consumer
Surplus
3.00
Price ($/liter)
 Price is $2 and quantity is
4,000 liters per day
 Consumer surplus is the
area of the triangle between
 Horizontal intercept of
demand
 Market price
 Market quantity
 Remember: area of a right
triangle is ½ width times
height
 The area is
½ ($1)(4,000 l) = $2,000
S
2.00
D
1.00
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1
2
3
4
5
6
Quantity (000s of l/day)
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Producer Surplus
 Producer surplus is the difference between the
market price and the seller's reservation price

Reservation price is on the supply curve
 Producer surplus is the area above the supply curve
and below the market price
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Socially Optimal Quantity
 When do we have a socially optimal quantity?


When the total surplus is maximized
Keep expanding until marginal benefit = marginal cost
 Economic efficiency

Occurs when all goods and services are produced and
consumed at their respective socially optimal levels
 Equilibrium principle
 A market in equilibrium is Pareto efficient since no
reallocation is possible that will benefit some people
without harming others
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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
 Different from engineering efficiency
 Equilibrium price and quantity are efficient


Prices above or below equilibrium are not
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Price Below Equilibrium
Suppose milk is $1 per liter
S
Price ($/liter)
2.50
2.00
1.50
1.00
0.50
D
1
2
3
4
5
Quantity (1,000s of liters/day)
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Price Below Equilibrium
A buyer offers $1.25
S
Price ($/liter)
2.50
2.00
1.50
1.25
1.00
0.50
D
1
2
3
4
5
Quantity (1,000s of liters/day)
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Price above Equilibrium
S
Price ($/liter)
2.50
2.00
1.75
1.50
Only equilibrium
price is efficient
1.00
0.50
D
1
2
3
4
5
Quantity (1,000s of liters/day)
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Efficiency
Efficiency is not the only goal
 Was
Dubai’s decision to impose a ceiling on
(annual) rental price increases to 7 percent
motivated by economic efficiency goals or
social justice?
Efficiency should be the first goal
 Efficiency
enables us to achieve all our other
goals to the fullest possible extent
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Trade-Offs
Efficiency
Equity
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Cement Market
Price ($/kg)
2.00
1.80
S
1.60
Consumer surplus = $900/day
1.40
Producer surplus = $900/day
1.20
1.00
.80
D
1
2 3 4 5
8
Quantity (1,000s of kg/day)
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Price Ceiling on Cement
Consumer surplus = $900/ day
2.00
1.80
S
Price ($/kg)
1.60
Lost surplus = $800/ day
1.40
1.20
1.00
Producer surplus = $100/ day
0.80
D
1
2 3 4 5
8
Quantity (1,000s of kg/day)
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Cement Story
 Price ceilings reduce total economic surplus

Their defenders argue that they help small builders to
buy cement at affordable prices
 The same goal could have been achieved through a
cheaper method, say: give the smaller builders
more income to buy cement  income transfers
 Would cement builders be willing to pay taxes to
generate the extra income to be transferred?

Yes since with a price ceiling they are losing $800
 What potential consequence might arise from using
income transfers?
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Alternative Cement Policy
Surplus with
Price Controls
Surplus with Income
Transfers Only
L
L
S
S
L = Large builders
S = Small builders
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Price Subsidy for Bread: The Case of Egypt
Imported bread costs $2
 Perfectly

elastic supply
Because it is a small country so it takes the world’s
price for bread as given and fixed
Government program to subsidize bread
 Government
imports bread for $2
 Government sells bread for $1

Results
• More bread
• Less efficiency
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Price Subsidies for Bread
Price
($/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)
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BUT…
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The Cost of the Subsidy
 The bread subsidy appears to increase consumer
surplus from $4 million to $9 million
 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
Even though consumer surplus is larger than before
 The net effect of the subsidy program is $5 - $6 which
is a reduction in the total economic surplus by $1

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Price Subsidies for Bread
Price
($/loaf)
Consumer Surplus
$4.00
Total Surplus Lost
= $1 m/month
$3.00
S
$2.00
Government Losses
$1.00
D
S with subsidy
2
4
6
8
Quantity (millions of loaves/month)
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First-Come, First-Served
A non-market way of allocating scarce goods
 Low

income students seats for sporting events
They can buy tickets at lower prices following first
come first served
 Airline

seats
Historically, airlines overbook their flights because
many passengers do not make the flights
• However, in many cases everyone shows up at the gate.
How do airlines solve this issue?
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Overbooked Airplane
In general, airlines board passengers on a
first come first serve basis
 However,
those who show up late end up
missing their flights and typically complain
about getting a later flight
 Solution?

The price mechanism used is time spent waiting
• People who wait generally have lower opportunity cost of
time
• People with high opportunity cost would pay to move up
in the line
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Overbooked Airplane: Example
33 seats, 37 reservations
 Highest
willingness to pay to get on the flight is
$60 and then $59 and so on… until $24

Actual amounts range from $60 to $24
 Average
is $42

willingness to pay to get on the plane
($60 + $59 + $58 + … + $24)/37 = $42
The last 4 people arriving are bumped
 Total
consumer surplus lost: ($42) (4) = $168
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Over-Booked Airplane: Example
With compensation many people volunteer
 However,
it is safe to assume that people with
the lowest willingness to pay would volunteer
so that means those from $24 to $27
 Value they place on taking that flight ($24 to
$27)
 Total consumer surplus lost: $102
The change to compensation approach
rather than first come first served creates a
surplus of $66
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Public Services
 So far, we looked at private markets where
the most efficient point is at equilibrium 
gives the highest total economic surplus
 What if the government is producing a service
or a good?
 Local

governments typically supply water
Its goal is to maximize total surplus
 What price should be charged?

Value of the last unit to the last buyer should be equal
to the marginal cost of supplying the water
• Charge is 4 cents
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Water in Egypt with 3 potential sources
Sea
Cost (cents/liter)
4.0
Nile
Spring
If P = 4.0¢,
QD = 4
0.8
0.2
1
3
Water supplied (millions of liters/day)
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Taxes on Sellers
Tax program
 Seller
reports sales in units to government
 Seller pays a fixed dollar amount per unit sold
A tax on the seller shifts the supply curve
up by the amount of the tax
 Vertical

interpretation of the supply curve
For each level of output, seller charges his marginal
cost PLUS the tax
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Tax on Potato Sellers
S + tax
S
6
Price ($/kg)
5
4
3.50
3
2.50
2
1
D
1
2
3
4
5
2.5
Quantity (millions of kg/month)
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Taxes and Perfectly Elastic Supply
Price
($/car)
If supply is perfectly elastic,
buyers pay all of the tax
$20,100
S + $100
$20,000
S
D
1.9 2.0
Quantity (millions of cars/month)
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Taxes and Total Surplus
We know that taxes lead to
 Lower
equilibrium quantity
 Higher equilibrium price
What happens to total economic surplus?
 How
do taxes affect total surplus?
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Tax on Potato Sellers
Before Tax
Consumer surplus = $4.5 M
Producer surplus = $4.5 M
Total surplus =$9M
After Tax
Consumer surplus = $3.125 M
Producer surplus = $3.125 M
Total surplus = $6.25 M
Loss = $2.75 M
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Total Surplus Lost
 Tax revenue is $2.5 million = $1 * 2.5 million
 If
the government has a specific revenue target,
then by adding an extra $2.5 million from taxes on
potatoes it can decrease other taxes
 If other taxes go down by $2.5 million, this is not a
large loss then since the

Net loss becomes $0.25 million
 Deadweight loss is the reduction in total
economic surplus that results form the
adoption of a policy
 The
net loss equaling $0.25 million
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Tax on Potato Sellers
6
S
revenue
5
Price ($/kg)
S + tax
Totalsurplus
surplus
Total
before
tax
after
tax
Tax
4
Deadweight
Loss
3.50
3
2.50
2
1
D
1
2
3
4
5
2.5
Quantity (millions of kg/month)
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42
Taxes and Price Elasticity of Demand
Potato tax was shared equally
 Buyers
paid $0.50 more
 Sellers received $0.50 less
The amount of the tax paid by buyers and
sellers depends on the price elasticity of
demand
 Implications
for deadweight loss of the tax
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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
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Taxes and Deadweight Loss
More Elastic Demand
P
Less Elastic Demand
Deadweight loss
P
Deadweight loss
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
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45
Efficiency and Exchange
Market
Equilibrium
First Come,
First Served
Price Ceilings
Economic
Efficiency
Subsidies
Equity
Public
Services
Deadweight
Loss
Shifting
the Tax
Elasticity
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Taxes on
Sellers
46