ECONOMICS Paul Krugman | Robin Wells with Margaret Ray and David Anderson SECOND EDITION in MODULES

MODULE 14 (50) Efficiency and Deadweight Loss Krugman/Wells

The meaning and importance of total surplus and how it can be used to illustrate efficiency in markets How taxes affect total surplus and can create deadweight loss 3 of 32

Total Surplus The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus. The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity. 4 of 32

Producer surplus Consumer surplus Total Surplus S D Price of book Quantity of books 1,000 $30 0 Equilibrium quantity Equilibrium price 5 of 32 E

The Gains from Trade The previous graph shows that both consumers and producers are better off because there is a market in this good (i.e. there are gains from trade). These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient. 6 of 32

The Efficiency of Markets Claim: The maximum possible total surplus is achieved at market equilibrium. The market equilibrium allocates the consumption of the good among potential consumers and sales of the good among potential sellers in a way that achieves the highest possible gain to society. Any change from the market equilibrium reduces total surplus. 7 of 32

The Efficiency of Markets 1.Reallocate consumption among consumers—take the good away from buyers who would have purchased the good in the market equilibrium, and give it to potential consumers who wouldn’t have bought it in equilibrium. 2.Reallocate sales among sellers—take sales away from sellers who would have sold the good in the market equilibrium, and instead compel potential sellers who would not have sold the good in equilibrium to sell it. 3.Change the quantity traded—compel consumers and producers to transact either more or less than the equilibrium quantity. 8 of 32

Reallocating Consumption Lowers Consumer Surplus S D Loss in consumer surplus if the book is taken from Ana and given to Bob E A B 1, $ Price of book Quantity of books 9 of 32

Reallocating Sales Lowers Producer Surplus S D E Loss in producer surplus if Yvonne is made to sell the book instead of Xavier 1, $ Price of book Quantity of books Y X 10 of 32

Changing the Quantity Lowers Total Surplus S D E Y X A B Loss in total surplus if the transaction between Ana and Xavier is prevented Loss in total surplus if the transaction between Yvonne and Bob is forced 1, $ Price of book Quantity of books 11 of 32

The Efficiency of Markets 1. It allocates consumption of the good to the potential buyers who value it the most, as indicated by the fact that they have the highest willingness to pay. 2. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost. 3. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial. 4. It ensures that every potential buyer who doesn’t make a purchase values the good less than every potential seller who doesn’t make a sale, so that no mutually beneficial transactions are missed. 12 of 32

Equity and Efficiency There is often a trade-off between equity and efficiency: – policies that promote equity often come at the cost of decreased efficiency. – policies that promote efficiency often result in decreased equity. This is often the debate about taxation. – A tax that rises more than in proportion to income is a progressive tax. – A tax that rises less than in proportion to income is a regressive tax. – A tax that rises in proportion to income is a proportional tax. 13 of 32

The Effects of Taxes on Total Surplus An excise tax is a tax on sales of a good or service. Excise taxes: – raise the price paid by buyers. – reduce the price received by sellers. Excise taxes also drive a wedge between the two. – Examples: Excise tax levied on sales of taxi rides and excise tax levied on purchases of taxi rides. 14 of 32

The Supply and Demand for Hotel Rooms in Potterville S D 05,00010,00015,000 $ E B Price of hotel room Quantity of hotel rooms Equilibrium quantity Equilibrium price 15 of 32

An Excise Tax Imposed on Hotel Owners S 1 S 2 A B 05,00010,00015,000 $ Quantity of hotel rooms Price D E Excise tax = $40 per room Supply curve shifts upward by the amount of the tax 16 of 32

An Excise Tax Imposed on Hotel Guests A B 05,00010,00015,000 $ Quantity of hotel rooms E S D 2 D 1 Excise tax = $40 per room Demand curve shifts downward by the amount of the tax Price 17 of 32

Price Elasticities and Tax Incidence The incidence of a tax is a measure of who really pays it. Who really bears the tax burden does not depend on who officially pays the tax. The wedge between the demand price and supply price becomes the government’s “tax revenue.” 18 of 32

An Excise Tax Paid Mainly by Consumers D S $ Price of gasoline (per gallon) 0 Quantity of gasoline (gallons) Tax burden falls mainly on consumers Excise tax = $1 per gallon When the price elasticity of demand is low and the price elasticity of supply is high, the burden of an excise tax falls mainly on consumers. 19 of 32

An Excise Tax Paid Mainly by Producers D S $ Price of parking space 0 Quantity of parking spaces Tax burden falls mainly on producers Excise tax = $5 per parking space When the price elasticity of demand is high and the price elasticity of supply is low, the burden of an excise tax falls mainly on producers. 20 of 32

Price Elasticities and Tax Incidence When the price elasticity of demand is higher than the price elasticity of supply, an excise tax falls mainly on producers. When the price elasticity of supply is higher than the price elasticity of demand, an excise tax falls mainly on consumers. So elasticity—not who officially pays the tax—determines the incidence of an excise tax. 21 of 32

The Revenue from an Excise Tax S B 605,00010,00015,000 $ Quantity of hotel rooms D E Area = tax revenue Excise tax = $40 per room A Price of hotel room The tax revenue collected is: Tax revenue = $40 per room × 5,000 rooms = $200,000 The tax revenue collected is: Tax revenue = $40 per room × 5,000 rooms = $200,000 The area of the shaded rectangle is: Area = Height × Width = $40 per room × 5,000 rooms = $200,000 The area of the shaded rectangle is: Area = Height × Width = $40 per room × 5,000 rooms = $200, of 32

The Revenue from an Excise Tax The general principle: The revenue collected by an excise tax is equal to the area of the rectangle whose height is the tax wedge between the supply and demand curves and whose width is the quantity transacted under the tax. 23 of 32

The Costs of Taxation A fall in the price of a good generates a gain in consumer surplus. Similarly, a price increase causes a loss to consumers. So it’s not surprising that, in the case of an excise tax, the rise in the price paid by consumers causes a loss. Meanwhile, the fall in the price received by producers leads to a fall in producer surplus. A tax reduces both, the CS and the PS. 24 of 32

A Tax Reduces Consumer and Producer Surplus Q E Quantity S E D Q T P E P C P P C A B F Excise tax = T Fall in consumer surplus due to tax Fall in producer surplus due to tax Price 25 of 32

The Costs of Taxation Although consumers and producers are hurt by the tax, the government gains revenue. The revenue the government collects is equal to the tax per unit sold, T, multiplied by the quantity sold, QT. But a portion of the loss to producers and consumers from the tax is not offset by a gain to the government. The deadweight loss caused by the tax represents the total surplus lost to society because of the tax. The deadweight loss is the amount of surplus that would have been generated by transactions that now do not take place because of the tax. 26 of 32

The Deadweight Loss of a Tax Q E Quantity S E D Price Q T P E P C P P Deadweight loss Excise tax = T 27 of 32

The Deadweight Loss of a Tax Using a triangle to measure deadweight loss is a technique used in many economic applications. They are also used to measure the deadweight loss produced by monopoly, another kind of market distortion. Deadweight-loss triangles are often used to evaluate the benefits and costs of public policies besides taxation— such as whether to impose stricter safety standards on a product. 28 of 32

Cost of Collecting Taxes The administrative costs of a tax are the resources used by government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it. The total inefficiency caused by a tax is the sum of its deadweight loss and its administrative costs. The general rule for economic policy is that, other things equal, a tax system should be designed to minimize the total inefficiency it imposes on society. 29 of 32

1.Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. 2.Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. 3.Usually, markets are efficient and achieve the maximum total surplus. 4.Excise taxes — taxes on the purchase or sale of a good— raise the price paid by consumers and reduce the price received by producers, driving a wedge between the two. 30 of 32

5.The incidence of the tax—how the burden of the tax is divided between consumers and producers—does not depend on who officially pays the tax. 6.The incidence of an excise tax depends on the price elasticities of supply and demand. If the price elasticity of demand is higher than the price elasticity of supply, the tax falls mainly on producers; if the price elasticity of supply is higher than the price elasticity of demand, the tax falls mainly on consumers. 7.Excise taxes cause inefficiency in the form of deadweight loss because they discourage some mutually beneficial transactions. Taxes also impose administrative costs — resources used to collect the tax. 31 of 32

8.An excise tax generates revenue for the government, but lowers total surplus. The loss in total surplus exceeds the tax revenue, resulting in a deadweight loss to society. 9.An efficient tax minimizes both the sum of the deadweight loss due to distorted incentives and the administrative costs of the tax. However, tax fairness, or tax equity, is also a goal of tax policy. 32 of 32