Efficiency and Deadweight Loss AP Economics Mr. Bernstein Module 50: Efficiency and Deadweight Loss October 23, 2014

AP Economics Mr. Bernstein Total Surplus When markets reach equilibrium, Total Surplus is maximized Distortions to competitive market outcomes(ie excise taxes) create Total Surplus that is not maximized and Deadweight Loss emerges

AP Economics Mr. Bernstein Efficiency and Gains From Trade When economists speak of efficiency, they are typically eluding to the ability of markets to produce outcomes that are most efficient to all other ways of organizing the exchange of goods When a consumer makes a purchase from a producer, a trade has occurred and both sides gain Gains are represented by Consumer and Producer Surplus, or Total Surplus

AP Economics Mr. Bernstein Efficiency of Markets No reallocation of consumption among consumers could increase consumer surplus No reallocation of sales among producers could increase producer surplus No change in the quantity traded could increase total surplus Once the market has reached equilibrium, there is no other way to increase the gains from trade. Any of these 3 possible reallocations would reduce total surplus and thus reduces efficiency.

AP Economics Mr. Bernstein An Efficient Market Allocates consumption of the good to the potential buyers who most value it, as indicated by the fact that they have the highest willingness to pay 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. 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. Insures 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.

AP Economics Mr. Bernstein Equity and Efficiency - Review Societies may be concerned with Equity as well as Efficiency Example: Handicapped Parking Another example: Progressive tax rates

AP Economics Mr. Bernstein The Effect of Taxes Excise tax imposed on producers Qt Q D Dead Weight Loss P Q S1 S CS T D D T PS

AP Economics Mr. Bernstein The Effect of Taxes on Total Surplus Who pays the tax (tax incidence) depends on the price elasticities of demand and supply Tax on sellers shifts the supply curve to the left Tax on buyers shifts the demand curve to the left Example: Gas tax can be imposed on producers or consumers In either case, the tax leads to: Decrease in quantity Increase in price paid by consumers, but… Decrease in price received by producers A “wedge” between consumer and producer prices equal to the tax

AP Economics Mr. Bernstein Elasticity and Tax Incidence Relatively inelastic (steep) demand curve - consumers pay Relatively elastic (flat) demand curve - producers pay Relatively inelastic (steep ) supply curve – producers pay Relatively elastic (flat) supply curve – consumers pay On costs and benefits of taxes: Tax revenue collected by the government is not a cost of the tax It is a redistribution of surplus from consumers and producers to the government The true cost of the tax is the inefficiency that it creates in the form of deadweight loss