© 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R Consumers, Producers, and the Efficiency of Markets E conomics P R I N C I P L E S O F N. Gregory Mankiw

In this chapter, look for the answers to these questions:  What is consumer/producer surplus? How are they related to the demand/supply curves?  How do they relate to identifying the best market outcomes?  What is deadweight loss?  How do these concepts relate to mechanisms, like taxes, that are artificially imposed upon the marketplace? 1

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 2 Welfare Economics  Recall, the allocation of resources refers to:  how much of each good is produced  which producers produce it  which consumers consume it  Welfare economics studies how the allocation of resources affects economic well-being.  First, we look at the well-being of consumers.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 3 Willingness to Pay (WTP) A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good. nameWTP Anthony$250 Chad175 Flea300 John125 Example: 4 buyers’ WTP for an iPod

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 4 WTP and the Demand Curve PQdQd $301 & up0 251 – – – – 1254 P Q

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 5 Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays: CS = WTP – P nameWTP Anthony$250 Chad175 Flea300 John125 Suppose P = $260. Flea’s CS = $300 – 260 = $40. The others get no CS because they do not buy an iPod at this price. Total CS = $40.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 6 CS and the Demand Curve P Q Flea’s WTPAnthony’s WTP Instead, suppose P = $220 Flea’s CS = $300 – 220 = $80 Anthony’s CS = $250 – 220 = $30 Total CS = $110

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 7 CS and the Demand Curve P Q The lesson: Total CS equals the area under the demand curve above the price, from 0 to Q.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 8 P Q CS with Lots of Buyers & a Smooth D Curve The demand for shoes D CS is the area b/w P and the D curve, from 0 to Q. Recall: area of a triangle equals ½ x base x height Height = $60 – 30 = $30. So, CS = ½ x 15 x $30 = $225. h $

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 9 Cost and the Supply Curve namecost Jack$10 Janet20 Chrissy35 A seller will produce and sell the good/service only if the price exceeds his or her cost. Hence, cost is a measure of willingness to sell.  Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).  Includes cost of all resources used to produce good, including value of the seller’s time.  Example: Costs of 3 sellers in the lawn-cutting business.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 10 Producer Surplus P Q Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost PS = P – cost

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 11 Producer Surplus and the S Curve P Q PS = P – cost Suppose P = $25. Jack’s PS = $15 Janet’s PS = $5 Chrissy’s PS = $0 Total PS = $20 Janet’s cost Jack’s cost Total PS equals the area above the supply curve under the price, from 0 to Q. Chrissy’s cost

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 12 P Q How a Lower Price Reduces PS If P falls to $30, PS = ½ x 15 x $15 = $ Two reasons for the fall in PS. S 1. Fall in PS due to sellers leaving market 2. Fall in PS due to remaining sellers getting lower P

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 13 CS, PS, and Total Surplus CS = (value to buyers) – (amount paid by buyers) = buyers’ gains from participating in the market PS = (amount received by sellers) – (cost to sellers) = sellers’ gains from participating in the market Total surplus = CS + PS = total gains from trade in a market = (value to buyers) – (cost to sellers)

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 14 The Market’s Allocation of Resources  In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers.  Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off?  To answer this, we use total surplus as a measure of society’s well-being, and we consider whether the market’s allocation is efficient. (Policymakers also care about equality, though are focus here is on efficiency.)

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 15 Efficiency An allocation of resources is efficient if it maximizes total surplus. Efficiency means:  The goods are consumed by the buyers who value them most highly.  The goods are produced by the producers with the lowest costs.  Raising or lowering the quantity of a good would not increase total surplus. = (value to buyers) – (cost to sellers) Total surplus

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 16 Evaluating the Market Equilibrium Market eq’m: P = $30 Q = 15,000 Total surplus = CS + PS Is the market eq’m efficient? P Q S D CS PS

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 17 Does Eq’m Q Maximize Total Surplus? P Q S D The market eq’m quantity maximizes total surplus: At any other quantity, can increase total surplus by moving toward the market eq’m quantity.

CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS 18 The free market vs. central planning  Suppose resources were allocated not by the market, but by a central planner who cares about society’s well-being.  To allocate resources efficiently and maximize total surplus, the planner would need to know every seller’s cost and every buyer’s WTP for every good in the entire economy.  This is impossible, and why centrally-planned economies are never very efficient.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 19 Taxes  The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.  The govt can make buyers or sellers pay the tax.  The tax can be a % of the good’s price, or a specific amount for each unit sold.  For simplicity, we analyze per-unit taxes only.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 20 S1S1 EXAMPLE 3: The Market for Pizza Eq’m w/o tax P Q D1D1 $

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 21 S1S1 D1D1 $ A Tax on Buyers The price buyers pay is now $1.50 higher than the market price P. P would have to fall by $1.50 to make buyers willing to buy same Q as before. E.g., if P falls from $10.00 to $8.50, buyers still willing to purchase 500 pizzas. P Q D2D2 Effects of a $1.50 per unit tax on buyers $8.50 Hence, a tax on buyers shifts the D curve down by the amount of the tax. Tax

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 22 S1S1 D1D1 $ A Tax on Buyers P Q D2D2 $11.00 P B = $9.50 P S = Tax Effects of a $1.50 per unit tax on buyers New eq’m: Q = 450 Sellers receive P S = $9.50 Buyers pay P B = $11.00 Difference between them = $1.50 = tax 450

SUPPLY, DEMAND, AND GOVERNMENT POLICIES S1S1 The Incidence of a Tax: how the burden of a tax is shared among market participants P Q D1D1 $ D2D2 $11.00 P B = $9.50 P S = Tax In our example, buyers pay $1.00 more, sellers get $0.50 less.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 24 S1S1 A Tax on Sellers P Q D1D1 $ S2S2 Effects of a $1.50 per unit tax on sellers The tax effectively raises sellers’ costs by $1.50 per pizza. Sellers will supply 500 pizzas only if P rises to $11.50, to compensate for this cost increase. $11.50 Hence, a tax on sellers shifts the S curve up by the amount of the tax. Tax

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 25 S1S1 A Tax on Sellers P Q D1D1 $ S2S2 450 $11.00 P B = $9.50 P S = Tax Effects of a $1.50 per unit tax on sellers New eq’m: Q = 450 Buyers pay P B = $11.00 Sellers receive P S = $9.50 Difference between them = $1.50 = tax

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 26 S1S1 The Outcome Is the Same in Both Cases ! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. P Q D1D1 $ $9.50 $11.00 P B = P S = Tax The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers!

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 27 Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax PBPB PSPS It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax. It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 28 Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax PBPB PSPS It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax. It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax.

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 29 CASE STUDY: Who Pays the Luxury Tax?  1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc.  Goal of the tax: raise revenue from those who could most easily afford to pay – wealthy consumers.  But who really pays this tax?

SUPPLY, DEMAND, AND GOVERNMENT POLICIES 30 CASE STUDY: Who Pays the Luxury Tax? The market for yachts P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden PBPB PSPS Demand is price-elastic. In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax.

APPLICATION: THE COSTS OF TAXATION 31 QTQT The Effects of a Tax P Q D S Eq’m with no tax: Price = P E Quantity = Q E PSPS PBPB PEPE QEQE Eq’m with tax = $T per unit: Sellers receive P S Quantity = Q T Buyers pay P B Size of tax = $T

APPLICATION: THE COSTS OF TAXATION 32 The Effects of a Tax P Q D S Revenue from tax: $ T x Q T PSPS PBPB PEPE QEQE QTQT Size of tax = $T

APPLICATION: THE COSTS OF TAXATION 33 The Effects of a Tax  Next, we apply welfare economics to measure the gains and losses from a tax.  We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax.  Tax revenue can fund beneficial services (e.g., education, roads, police) so we include it in total surplus.

APPLICATION: THE COSTS OF TAXATION 34 The Effects of a Tax P Q D S Without a tax, PEPE QEQE QTQT A B C D E F CS = A + B + C PS = D + E + F Tax revenue = 0 Total surplus = CS + PS = A + B + C + D + E + F

APPLICATION: THE COSTS OF TAXATION 35 The Effects of a Tax P Q D S PSPS PBPB QEQE QTQT A B C D E F CS = A PS = F Tax revenue = B + D Total surplus = A + B + D + F With the tax, The tax reduces total surplus by C + E

APPLICATION: THE COSTS OF TAXATION 36 The Effects of a Tax P Q D S PSPS PBPB QEQE QTQT A B C D E F C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax.

APPLICATION: THE COSTS OF TAXATION 37 About the Deadweight Loss P Q D S PSPS PBPB QEQE QTQT Because of the tax, the units between Q T and Q E are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax prevents some mutually beneficial trades.

APPLICATION: THE COSTS OF TAXATION 38 What Determines the Size of the DWL?  Which goods or services should govt tax to raise the revenue it needs?  One answer: those with the smallest DWL.  When is the DWL small vs. large? Turns out it depends on the price elasticities of supply and demand.  Recall: The price elasticity of demand (or supply) measures how much Q D (or Q S ) changes when P changes.

APPLICATION: THE COSTS OF TAXATION 39 When supply is inelastic, it’s harder for firms to leave the market when the tax reduces P S. So, the tax only reduces Q a little, and DWL is small. When supply is inelastic, it’s harder for firms to leave the market when the tax reduces P S. So, the tax only reduces Q a little, and DWL is small. DWL and the Elasticity of Supply P Q D S Size of tax

APPLICATION: THE COSTS OF TAXATION 40 DWL and the Elasticity of Supply P Q D S Size of tax The more elastic is supply, the easier for firms to leave the market when the tax reduces P S, the greater Q falls below the surplus- maximizing quantity, the greater the DWL. The more elastic is supply, the easier for firms to leave the market when the tax reduces P S, the greater Q falls below the surplus- maximizing quantity, the greater the DWL.

 The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants.  Which should it tax? A C T I V E L E A R N I N G 3 Discussion question 41

APPLICATION: THE COSTS OF TAXATION 42 The Effects of Changing the Size of the Tax  Policymakers often change taxes, raising some and lowering others.  What happens to DWL and tax revenue when taxes change? We explore this next….

APPLICATION: THE COSTS OF TAXATION 43 Q3Q3 DWL and the Size of the Tax P Q D S Q1Q1 3T3T T causes the DWL to more than triple. Tripling the tax Initially, the tax is T per unit. initial DWL new DWL

APPLICATION: THE COSTS OF TAXATION 44 Q3Q3 Revenue and the Size of the Tax P Q D S Q2Q2 PBPB PSPS PBPB PSPS 3T3T 2T2T When the tax is larger, increasing it causes tax revenue to fall.

APPLICATION: THE COSTS OF TAXATION 45 The Laffer curve shows the relationship between the size of the tax and tax revenue. Revenue and the Size of the Tax Tax size Tax revenue The Laffer curve