Efficiency and Deadweight Loss Micro: Econ: 14 50 Module Efficiency and Deadweight Loss KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: The meaning and importance of total surplus and how it can be used to illustrate efficiency in markets How taxes affect total surplus and can create deadweight loss The purpose of this module is to show that, when competitive markets reach equilibrium, total surplus (the sum of consumer and producer surplus) is maximized. Whenever something distorts the competitive market outcome, like excise taxes, total surplus is not maximized and deadweight loss emerges.

Consumer Surplus, Producer Surplus, And Efficiency Gains from trade The efficiency of markets Equity and Efficiency  When you hear economists hailing the power of markets, they are typically alluding to the ability of markets to provide outcomes that are the most efficient to all other ways of organizing the exchange of goods.

Gains from Trade Any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. Gains from trade are represented by consumer and producer surplus. At the market equilibrium price and quantity, total surplus is the sum of the CS and PS triangles. Economists talk about gains from trade in the abstract, but any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. These gains are the concepts of consumer and producer surplus.

The 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 A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency.   Summary: An efficient market performs four important functions: 1. It 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. 2. It 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. 3. It 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. 4. It ensures 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.

The Efficiency of Markets Summary: An efficient market performs four important functions: 1. It 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. 2. It 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. A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency.   Summary: An efficient market performs four important functions: 1. It 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. 2. It 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. 3. It 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. 4. It ensures 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.

The Efficiency of Markets Summary: An efficient market performs four important functions: 3. It 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. 4. It ensures 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. A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency.   Summary: An efficient market performs four important functions: 1. It 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. 2. It 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. 3. It 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. 4. It ensures 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.

Equity and Efficiency Efficiency is not society’s only concern. We are also concerned with equity. What is considered “fair” or “equitable” depends on many factors. Often equity and efficiency are at the root of the debate surrounding taxes. Progressive, regressive, and proportional taxes What is considered “fair” or “equitable” depends on many factors. A market price of $6 for a gadget may seem completely fair to a person who can afford $6, but extremely unfair to a person who cannot.   Most societies have found it desirable to sacrifice some efficiency to gain a little equity. The book example is designating parking spaces for disabled persons. Most nations have a system of taxation that serves to redistribute some income from the wealthy to the poor. This may not be efficient, but these nations have decided that it is fair. Economists classify three types of taxes according to how they vary with the income of individuals. A tax that rises more than in proportion to income, so that high-income taxpayers pay a larger percentage of their income than low-income taxpayers, is a progressive tax. A tax that rises less than in proportion to income, so that high-income taxpayers pay a smaller percentage of their income than low-income taxpayers, is a regressive tax. A taxes that rises in proportion to income, so that all taxpayers pay the same percentage of their income, is a proportional tax.

Equity and Efficiency A tax that rises more than in proportion to income, so that high-income taxpayers pay a larger percentage of their income than low-income taxpayers, is a progressive tax. A tax that rises less than in proportion to income, so that high-income taxpayers pay a smaller percentage of their income than low-income taxpayers, is a regressive tax. A taxes that rises in proportion to income, so that all taxpayers pay the same percentage of their income, is a proportional tax. What is considered “fair” or “equitable” depends on many factors. A market price of $6 for a gadget may seem completely fair to a person who can afford $6, but extremely unfair to a person who cannot.   Most societies have found it desirable to sacrifice some efficiency to gain a little equity. The book example is designating parking spaces for disabled persons. Most nations have a system of taxation that serves to redistribute some income from the wealthy to the poor. This may not be efficient, but these nations have decided that it is fair. Economists classify three types of taxes according to how they vary with the income of individuals. A tax that rises more than in proportion to income, so that high-income taxpayers pay a larger percentage of their income than low-income taxpayers, is a progressive tax. A tax that rises less than in proportion to income, so that high-income taxpayers pay a smaller percentage of their income than low-income taxpayers, is a regressive tax. A taxes that rises in proportion to income, so that all taxpayers pay the same percentage of their income, is a proportional tax.

The Effect of Taxes The effect on total surplus Price Qt Q D DWL Price Q CS PS The effect on total surplus Price elasticity and tax incidence  Who ultimately pays the tax (the tax incidence) depends on the price elasticity of demand and supply in the market. S One tax that is used in many countries is the excise tax. This is a tax levied on each unit of a good that is sold. In the U.S. excise taxes are imposed upon the sale of goods such as gasoline, tobacco, alcohol and, in many cities, hotel rooms. Excise taxes will affect total surplus in a market. Who untimately pays the tax (the tax incidence) depends on the price elasticity of demand and supply in the market.

Taxes and Total Surplus A tax on sellers will shift the supply curve to the left. A tax on buyers will shift the demand curve to the left, which leads to In either case, the tax leads to; a decrease in quantity an increase in the price paid by consumers. a decrease in the price received by sellers a “wedge” between the price consumers pay and the price producers receive (equal to the amount of the tax) A tax on sellers: Politicians decide to impose on gasoline tax on sellers, equal to $1on every gallon of gasoline sold. For sellers, this means that to continue to sell 1 million gallons per day, they must receive $3 per gallon because $1 must be sent to the government. In other words, the supply curve shifts upward by $1, the amount of the tax. A tax on buyers: Politicians decide to impose the $1 tax on gasoline buyers. Buyers must pay $1 to the government for every gallon of gasoline that they purchase. This would lower consumer willingness to pay by $1 for each gallon purchased, which serves to shift the demand curve downward by the amount of the tax.

Elasticity and Tax Incidence The tax incidence really depends upon the shape of the demand and supply curves. This shape, steep vs. flat, depends upon the price elasticity of demand and supply. Tax incidence: the measure of who really pays a tax If the demand curve is relatively inelastic and the supply curve is relatively elastic, the buyers will pay the larger share of the excise tax. If the demand curve is relatively elastic and the supply curve is relatively inelastic, the sellers will pay the larger share of the excise tax.

The Benefits and Costs of Taxation Benefits (Revenue) Costs Taxes, like all things, come with benefits and costs. The revenue from a tax is equal to the amount of the tax times the number of units sold. The 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.

Figure 50.5 The Supply and Demand for Hotel Rooms in Potterville Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 50.6 An Excise Tax Imposed on Hotel Owners Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 50.7 An Excise Tax Imposed on Hotel Guests Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 50.8 An Excise Tax Paid Mainly by Consumers Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 50.9 An Excise Tax Paid Mainly by Producers Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 50.10 The Revenue from an Excise Tax Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Figure 50.11 A Tax Reduces Consumer and Producer Surplus Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers

Deadweight Loss: losses associated with quantities of output that are great than or less than the efficient level. Figure 50.12 The Deadweight Loss of a Tax Ray and Anderson: Krugman’s Economics for AP, First Edition Copyright © 2011 by Worth Publishers