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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.
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.
Consumer Surplus
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
The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price.
Producer Surplus
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
Pc
Pf
Total Surplus
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.
Producer surplus = $900/day
Consumer surplus = $900/day
D
S
Economic Surplus in an Unregulated Market for Home Heating Oil
2.00
Quantity (1,000s of gallons/day)
Pri
ce (
$/g
allo
n)
1 2 3 4 5
1.60
1.20
1.00
.80
1.80
1.40
8
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
Figure 7.4, P. 196
Producer surplus = $100/day
Lost economic surplus = $800/day
Consumer surplus = $900/day
The Waste Caused by Price Controls
2.00
Quantity (1,000s of gallons/day)
D
S
1 2 3 4 5
1.60
1.20
1.00
.80
1.80
1.40
8
Pri
ce (
$/g
allo
n)
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
Price Ceiling set at $1.00
Figure 7.5, P. 197
Consumer surplus = $9,000/month
Reduction in total economic surplus = $1,000,000/month
Domestic price with subsidy
The Reduction in EconomicSurplus from a Subsidy
Quantity (millions of loaves/month
Pri
ce o
f b
read
($/
loaf
)
2 4 6
3.00
1.00
5.00
4.00
8
2.00World price = $
D
S
•The cost of the tax = $6 million•The benefit of the subsidy = $5 million•Loss of economic surplus = $1 million
Figure 7.8, P.200
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
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
6
Quantity (millions of pounds/month)
Pri
ce (
$/p
ou
nd
)
1 2 3 4 5
5
4
2
1D
S
3
Without a tax P = $3/lband Q = 3 million lbs/month
2.50
3.50
S + tax
2.5
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
The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of
Supply
Quantity (millions of cars/month)
Pri
ce (
$/ca
r)
D
S
2.0
$20,000
Assume a tax levy of $100 tax/car
1.9
S + $100$20,100
• Supply shifts to $20,100• The burden of the tax falls
entirely on the consumer
Taxes and Efficiency
Who Pays a Tax?– When supply is perfectly elastic, the tax
burden will fall entirely on the consumer.
Total economic surplus = $9 million/month
How a tax collected for a seller affects economic surplus
The Market for Avocados Without Taxes
6
1 2 3 4 5
5
4
2
1
3
Pri
ce (
$/p
ou
nd
)
Quantity (millions of pounds/month)
D
S
The Effect of a $1 perPound Tax on Avocados
6
Quantity (millions of pounds/month)
Pri
ce (
$/p
ou
nd
)
1 2 3 4 5
5
4
2
1
3
2.50
3.50
S + tax
2.5
D
S
How a tax collected from a seller affects economic surplus
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
6
Quantity (millions of pounds/month)
Pri
ce (
$/p
ou
nd
)
D
S
1 2 3 4 5
5
4
2
1
3
2.50
3.50
S + tax
2.5
Deadweight loss caused by tax
Elasticity of Demand and the Deadweight Loss from a Tax
Quantity (units/day)
Pri
ce (
$/u
nit
)
21
2.60
1.60
S + T
19
2.40
1.40
S + T
Deadweight loss Deadweight loss
Quantity (units/day)
Pri
ce (
$/u
nit
)
D1
S
24
2.00
D2
S
24
2.00
The greater the elasticity of demand, the greater the deadweight loss from a tax
57
2.65
1.65
S1 + T
63
2.35
1.35
S2 + T
Deadweight Loss Deadweight Loss
Elasticity of Supply and the Deadweight Loss from a Tax
Pri
ce (
$/u
nit
)
Pri
ce (
$/u
nit
)
D
S1
72
2.00
D
S2
72
2.00
The greater the elasticity of supply, the greater the deadweight loss from a tax
Quantity (units/day) Quantity (units/day)
Taxes and Efficiency
What do you think?– Why would a tax on land be efficient?
– Would a tax on pollution increase economic surplus?