1 Chapter 7: Efficiency and Exchange 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 –Equilibrium price and quantity are efficient Prices above or below equilibrium are not

2 Price Below Equilibrium Suppose milk is $1 per gallon 2.50 Quantity (1,000s of gallons/day) Price ($/gallon) D S

3 Price Below Equilibrium A buyer offers $1.25 per gallon 2.50 Quantity (1,000s of gallons/day) Price ($/gallon) D S 1.25

4 Price above Equilibrium 2.50 Quantity (1,000s of gallons/day) D S 1.75 Only equilibrium price is efficient Price ($/gallon)

5 Efficiency Conditions

6 Heating Oil Market D S 2.00 Quantity (1,000s of gallons/day) Price ($/gallon) Producer surplus = $900/day Consumer surplus = $900/day

7 Price Ceiling on Heating Oil D S 2.00 Quantity (1,000s of gallons/day) Consumer surplus = $900/ day Producer surplus = $100/ day Lost surplus = $800/ day Price ($/gallon)

8 Price Subsidies for Bread Quantity (millions of loaves/month) 246 $3.00 $1.00 $ $2.00 D S Price ($/loaf) Consumer Surplus = $4 M/month BUT… S with subsidy Consumer Surplus = $9 M/month

9 The Cost of the Subsidy  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  Consumer surplus – government losses  Net benefit = $3 million

10 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

11 Tax on Avocado Sellers S + tax Quantity (millions of pounds/month) Price ($/pound) D S 3

12 Taxes and Perfectly Elastic Supply Quantity (millions of cars/month) Price ($/car) D S 2.0 $20,000 If supply is perfectly elastic, buyers pay all of the tax 1.9 S + $100 $20,100

13 Tax on Avocado Sellers 6 Q P 3 D S 3 S + tax D Q P After Tax  Consumer surplus = $3.125 M  Producer surplus = $3.125 M  Total surplus = $6.25 M  Loss = $2.75 M Before Tax  Consumer surplus = $4.5 M  Producer surplus = $4.5 M

14 Taxes and Price Elasticity of Demand Q P S + T D1 S S + T Q D2 S 24 P More Elastic DemandLess Elastic Demand Consumers pay a smaller share of the tax when demand is more elastic

15 Taxes and Deadweight Loss Q P S + T D1 S Deadweight loss S + T Q D2 S 24 P Deadweight loss More Elastic DemandLess Elastic Demand Deadweight loss is larger when demand is relatively elastic