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2. KRUGMAN’S
Economics
for AP®
S E C O N D E D I T I O N

3. Section 9
Module 50

4. What You Will Learn in this Module
Define total surplus and discuss its relevance to market efficiency
Explain how taxes affect total surplus and can create deadweight loss
What You Will Learn in this Module
Section 9 | Module 50

5. Total Surplus
The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus.
The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity.
Section 9 | Module 50

6. Total Surplus
Section 9 | Module 50

7. The Gains from Trade
The previous graph shows that both consumers and producers are better off because there is a market in this good (i.e. there are gains from trade).
These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient.
Section 9 | Module 50

8. The Efficiency of Markets
Claim: The maximum possible total surplus is achieved at market equilibrium.
The market equilibrium allocates the consumption of the good among potential consumers and sales of the good among potential sellers in a way that achieves the highest possible gain to society.
Any change from the market equilibrium reduces total surplus.
Section 9 | Module 50

9. The Efficiency of Markets
Reallocate consumption among consumers—take the good away from buyers who would have purchased the good in the market equilibrium, and give it to potential consumers who wouldn’t have bought it in equilibrium.
Reallocate sales among sellers—take sales away from sellers who would have sold the good in the market equilibrium, and instead compel potential sellers who would not have sold the good in equilibrium to sell it.
Change the quantity traded—compel consumers and producers to transact either more or less than the equilibrium quantity.
Section 9 | Module 50

10. Reallocating Consumption Lowers Consumer Surplus
Figure Caption Figure 14.2 (50.2): Reallocating Consumption Lowers Consumer Surplus
Ana (point A) has: a willingness to pay of $35. Bob (point B) has a willingness to pay of only $25. At the market equilibrium price of $30, Ana purchases a book but Bob does not. If we rearrange consumption by taking a book from Ana and giving it to Bob, consumer surplus declines by $10 and, as a result, total surplus declines by $10. The market equilibrium generates the highest possible consumer surplus by ensuring that those who consume the good are those who most value it.
Section 9 | Module 50

11. Reallocating Sales Lowers Producer Surplus
Figure Caption: Figure 14.3 (50.3): Reallocating Sales Lowers Producer Surplus
Yvonne (point Y) has a cost of $35, $10 more than Xavier (point X), who has a cost of $25. At the market equilibrium price of $30, Xavier sells a book but Yvonne does not. If we rearrange sales by preventing Xavier from selling his book and compelling Yvonne to sell hers, producer surplus declines by $10 and, as a result, total surplus declines by $10. The market equilibrium generates the highest possible producer surplus by assuring that those who sell the good are those who most value the right to sell it.
Section 9 | Module 50

12. Changing the Quantity Lowers Total Surplus
Figure Caption: Figure 14.4 (50.4): Changing the Quantity Lowers Total Surplus
If Xavier (point X) were prevented from selling his book to someone like Ana (point A), total surplus would fall by $10, the difference between Ana’s willingness to pay ($35) and Xavier’s cost ($25). This means that total surplus falls whenever fewer than 1,000 books—the equilibrium quantity—are transacted. Likewise, if Yvonne (point Y) were compelled to sell her book to someone like Bob (point B), total surplus would also fall by $10, the difference between Yvonne’s cost ($35) and Bob’s willingness to pay ($25). This means that total surplus falls whenever more than 1,000 books are transacted. These two examples show that at market equilibrium, all mutually beneficial transactions—and only mutually beneficial transactions—occur.
Section 9 | Module 50

13. The Efficiency of Markets
1. It allocates consumption of the good to the potential buyers who value it the most, 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.
Section 9 | Module 50

14. Equity and Efficiency
There is often a trade-off between equity and efficiency:
policies that promote equity often come at the cost of decreased efficiency.
policies that promote efficiency often result in decreased equity.
This is often the debate about taxation.
A tax that rises more than in proportion to income is a progressive tax.
A tax that rises less than in proportion to income is a regressive tax.
A tax that rises in proportion to income is a proportional tax.
Section 9 | Module 50

15. The Effects of Taxes on Total Surplus
An excise tax is a tax on sales of a good or service.
Excise taxes:
raise the price paid by buyers.
reduce the price received by sellers.
Excise taxes also drive a wedge between the two.
Examples: Excise tax levied on sales of taxi rides and excise tax levied on purchases of taxi rides.
Section 9 | Module 50

16. The Supply and Demand for Hotel Rooms in Potterville
Figure Caption: Figure 14.5 (50.5): The Supply and Demand for Hotel Rooms in Potterville
In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax.
Section 9 | Module 50

17. An Excise Tax Imposed on Hotel Owners
Figure Caption: Figure 14.5 (50.5): The Supply and Demand for Hotel Rooms in Potterville
In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax.
Section 9 | Module 50

18. An Excise Tax Imposed on Hotel Guests
Figure Caption: Figure 14.5 (50.5): The Supply and Demand for Hotel Rooms in Potterville
In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax.
Section 9 | Module 50

19. Price Elasticities and Tax Incidence
The incidence of a tax is a measure of who really pays it.
Who really bears the tax burden does not depend on who officially pays the tax.
The wedge between the demand price and supply price becomes the government’s “tax revenue.”
Section 9 | Module 50

20. An Excise Tax Paid Mainly by CONSUMERS
Figure Caption: Figure 14.5 (50.5): The Supply and Demand for Hotel Rooms in Potterville
In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax.
Section 9 | Module 50

21. An Excise Tax Paid Mainly by PRODUCERS
Figure Caption: Figure 14.5 (50.5): The Supply and Demand for Hotel Rooms in Potterville
In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax.
Section 9 | Module 50

22. Price Elasticities and Tax Incidence
When the price elasticity of demand is higher than the price elasticity of supply, an excise tax falls mainly on producers.
When the price elasticity of supply is higher than the price elasticity of demand, an excise tax falls mainly on consumers.
So elasticity—not who officially pays the tax—determines the incidence of an excise tax.
Section 9 | Module 50

23. The Revenue from an Excise Tax
Figure Caption: Figure 14.5 (50.5): The Supply and Demand for Hotel Rooms in Potterville
In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax.
Section 9 | Module 50

24. The Revenue from an Excise Tax
The general principle: The revenue collected by an excise tax is equal to the area of the rectangle whose height is the tax wedge between the supply and demand curves and whose width is the quantity transacted under the tax.
Section 9 | Module 50

25. The Costs of Taxation
A fall in the price of a good generates a gain in consumer surplus.
Similarly, a price increase causes a loss to consumers.
So it’s not surprising that, in the case of an excise tax, the rise in the price paid by consumers causes a loss.
Meanwhile, the fall in the price received by producers leads to a fall in producer surplus.
A tax reduces both, the CS and the PS.
Section 9 | Module 50

26. A Tax Reduces Consumer and Producer Surplus
Figure Caption: Figure 14.5 (50.5): The Supply and Demand for Hotel Rooms in Potterville
In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax.
Section 9 | Module 50

27. The Costs of Taxation
Although consumers and producers are hurt by the tax, the government gains revenue.
The revenue the government collects is equal to the tax per unit sold, T, multiplied by the quantity sold, QT.
But a portion of the loss to producers and consumers from the tax is not offset by a gain to the government.
The deadweight loss caused by the tax represents the total surplus lost to society because of the tax.
The deadweight loss is the amount of surplus that would have been generated by transactions that now do not take place because of the tax.
Section 9 | Module 50

28. The Deadweight Loss of a Tax
Figure Caption: Figure 14.5 (50.5): The Supply and Demand for Hotel Rooms in Potterville
In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax.
Section 9 | Module 50

29. The Deadweight Loss of a Tax
Using a triangle to measure deadweight loss is a technique used in many economic applications.
They are also used to measure the deadweight loss produced by monopoly, another kind of market distortion.
Deadweight-loss triangles are often used to evaluate the benefits and costs of public policies besides taxation—such as whether to impose stricter safety standards on a product.
Section 9 | Module 50

30. Cost of Collecting Taxes
The administrative costs of a tax are the resources used by government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it.
The total inefficiency caused by a tax is the sum of its deadweight loss and its administrative costs.
The general rule for economic policy is that, other things equal, a tax system should be designed to minimize the total inefficiency it imposes on society.
Section 9 | Module 50

31. Summary
Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price.
Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus.
Usually, markets are efficient and achieve the maximum total surplus.
Excise taxes — taxes on the purchase or sale of a good—raise the price paid by consumers and reduce the price received by producers, driving a wedge between the two.
Section 9 | Module 50

32. Summary
The incidence of the tax—how the burden of the tax is divided between consumers and producers—does not depend on who officially pays the tax.
The incidence of an excise tax depends on the price elasticities of supply and demand. If the price elasticity of demand is higher than the price elasticity of supply, the tax falls mainly on producers; if the price elasticity of supply is higher than the price elasticity of demand, the tax falls mainly on consumers.
Excise taxes cause inefficiency in the form of deadweight loss because they discourage some mutually beneficial transactions. Taxes also impose administrative costs —resources used to collect the tax.
Section 9 | Module 50

33. Summary
An excise tax generates revenue for the government, but lowers total surplus. The loss in total surplus exceeds the tax revenue, resulting in a deadweight loss to society.
An efficient tax minimizes both the sum of the deadweight loss due to distorted incentives and the administrative costs of the tax. However, tax fairness, or tax equity, is also a goal of tax policy.
Section 9 | Module 50