Econ 2610: Principles of Microeconomics Yogesh Uppal

Chapter 7 Efficiency and Exchange

Role of the Market Market allocation of resources Often maximizes efficiency Unintended consequences of government policies, such as public utilities, taxes, subsidies etc. Some Caveats, which we shall talk about later

First-Come, First-Served A non-market way of allocating scarce goods Airline seats Prime student seats at a basketball game The price mechanism used is time spent waiting People who wait generally have lower opportunity cost of time People with high opportunity cost would pay to move up in the line

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

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

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

Efficiency Conditions Market Efficiency Perfectly Competitive Markets No Costs or Benefits Shifted

Price Subsidy for Bread Imported bread costs $2 Perfectly elastic supply Government program to subsidize bread Government imports bread for $2 Government sells bread for $1 Results More bread Less efficiency

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 Consumer Surplus = $9 M/month BUT… S with subsidy

The Cost of the Subsidy The bread subsidy appears to increase consumer surplus from $4 million to $9 million 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

Price Subsidies for Bread Quantity (millions of loaves/month) 246 $3.00 $1.00 $ $2.00 D S Price ($/loaf) Consumer Surplus S with subsidy Government Losses Total Surplus Lost = $1 M/month

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

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

Taxes and Total Surplus Taxes lead to Lower equilibrium quantity Higher equilibrium price What happens to total economic surplus?

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

Total Surplus Lost Tax revenue is $2.5 million If other taxes go down by $2.5 million, this is not a loss Net loss is $0.25 million Deadweight loss is the reduction in total economic surplus that results form the adoption of a policy

Taxes and Price Elasticity of Demand Avocado tax was shared equally Buyers paid $0.50 more Sellers received $0.50 less The amount of the tax paid by buyers and sellers depends on the price elasticity of demand Implications for deadweight loss of the tax

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

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

Caveats to the role of the Market Not right for all objectives Income distribution Public goods such as clean air and public safety

Trade-Offs EfficiencyEquity Fairness Basic Needs Maximum Total Surplus