Efficiency and Exchange Chapter 7 Efficiency and Exchange

Efficiency Pareto Efficiency Inefficiency: 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.

Consumer Surplus 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.

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

Producer Surplus The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price.

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

Total Surplus Pf Pc

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.

Economic Surplus in an Unregulated Market for Home Heating Oil Producer surplus = $900/day Consumer surplus = $900/day Figure 7.4, P. 196 2.00 D S 1.80 1.60 1.40 1.20 1.00 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 = $1,800/day Price ($/gallon) .80 1 2 3 4 5 8 Quantity (1,000s of gallons/day)

The Waste Caused by Price Controls Price Ceiling set at $1.00 S 2.00 Consumer surplus = $900/day 1.80 Lost economic surplus = $800/day 1.60 1.40 1.20 1.00 Producer surplus = $100/day D Price ($/gallon) .80 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 Figure 7.5, P. 197 1 2 3 4 5 8 Quantity (1,000s of gallons/day)

The Reduction in Economic Surplus from a Subsidy The cost of the tax = $6 million The benefit of the subsidy = $5 million Loss of economic surplus = $1 million 5.00 Consumer surplus = $9,000/month Reduction in total economic surplus = $1,000,000/month Domestic price with subsidy 4.00 Price of bread ($/loaf) D S 3.00 World price = $ 2.00 1.00 Figure 7.8, P.200 2 4 6 8 Quantity (millions of loaves/month

Market Equilibrium and Efficiency 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 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 3 Without a tax P = $3/lb and 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 $3.50/lb 6 5 4 Price ($/pound) 2 1 1 2 3 4 5 Quantity (millions of pounds/month)

Quantity (millions of cars/month) The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply Assume a tax levy of $100 tax/car D S 2.0 $20,000 1.9 S + $100 $20,100 Supply shifts to $20,100 The burden of the tax falls entirely on the consumer Price ($/car) Quantity (millions of cars/month)

Taxes and Efficiency Who Pays a Tax? When supply is perfectly elastic, the tax burden will fall entirely on the consumer.

The Market for Avocados Without Taxes Total economic surplus = $9 million/month How a tax collected for a seller affects economic surplus 6 5 4 Price ($/pound) 3 2 1 1 2 3 4 5 Quantity (millions of pounds/month)

The Effect of a $1 per Pound Tax on Avocados 6 Quantity (millions of pounds/month) Price ($/pound) 1 2 3 4 5 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 2.50 3.50 S + tax 2.5 Deadweight loss caused by tax S 6 5 4 Price ($/pound) 3 2 1 D 1 2 3 4 5 Quantity (millions of pounds/month)

Elasticity of Demand and the Deadweight Loss from a Tax 21 2.60 1.60 S + T 19 2.40 1.40 Deadweight loss D1 S 24 2.00 D2 Price ($/unit) Price ($/unit) Quantity (units/day) Quantity (units/day) The greater the elasticity of demand, the greater the deadweight loss from a tax

Elasticity of Supply and the Deadweight Loss from a Tax 57 2.65 1.65 S1 + T 63 2.35 1.35 S2 + T Deadweight Loss D S1 72 2.00 S2 Price ($/unit) Price ($/unit) Quantity (units/day) Quantity (units/day) The greater the elasticity of supply, the greater the deadweight loss from a tax

Taxes and Efficiency What do you think? Why would a tax on land be efficient? Would a tax on pollution increase economic surplus?