Chapter 7

Efficiency and Exchange

Efficiency

Pareto Efficiency– 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.

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.

Consumer Surplus

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

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

Producer Surplus

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

Pc

Pf

Total Surplus

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.

Producer surplus = $900/day

Consumer surplus = $900/day

D

S

Economic Surplus in an Unregulated Market for Home Heating Oil

2.00

Quantity (1,000s of gallons/day)

Pri

ce (

$/g

allo

n)

1 2 3 4 5

1.60

1.20

1.00

.80

1.80

1.40

8

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

Figure 7.4, P. 196

Producer surplus = $100/day

Lost economic surplus = $800/day

Consumer surplus = $900/day

The Waste Caused by Price Controls

2.00

Quantity (1,000s of gallons/day)

D

S

1 2 3 4 5

1.60

1.20

1.00

.80

1.80

1.40

8

Pri

ce (

$/g

allo

n)

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

Price Ceiling set at $1.00

Figure 7.5, P. 197

Consumer surplus = $9,000/month

Reduction in total economic surplus = $1,000,000/month

Domestic price with subsidy

The Reduction in EconomicSurplus from a Subsidy

Quantity (millions of loaves/month

Pri

ce o

f b

read

($/

loaf

)

2 4 6

3.00

1.00

5.00

4.00

8

2.00World price = $

D

S

•The cost of the tax = $6 million•The benefit of the subsidy = $5 million•Loss of economic surplus = $1 million

Figure 7.8, P.200

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

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

6

Quantity (millions of pounds/month)

Pri

ce (

$/p

ou

nd

)

1 2 3 4 5

5

4

2

1D

S

3

Without a tax P = $3/lband 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

The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of

Supply

Quantity (millions of cars/month)

Pri

ce (

$/ca

r)

D

S

2.0

$20,000

Assume a tax levy of $100 tax/car

1.9

S + $100$20,100

• Supply shifts to $20,100• The burden of the tax falls

entirely on the consumer

Taxes and Efficiency

Who Pays a Tax?– When supply is perfectly elastic, the tax

burden will fall entirely on the consumer.

Total economic surplus = $9 million/month

How a tax collected for a seller affects economic surplus

The Market for Avocados Without Taxes

6

1 2 3 4 5

5

4

2

1

3

Pri

ce (

$/p

ou

nd

)

Quantity (millions of pounds/month)

D

S

The Effect of a $1 perPound Tax on Avocados

6

Quantity (millions of pounds/month)

Pri

ce (

$/p

ou

nd

)

1 2 3 4 5

5

4

2

1

3

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

6

Quantity (millions of pounds/month)

Pri

ce (

$/p

ou

nd

)

D

S

1 2 3 4 5

5

4

2

1

3

2.50

3.50

S + tax

2.5

Deadweight loss caused by tax

Elasticity of Demand and the Deadweight Loss from a Tax

Quantity (units/day)

Pri

ce (

$/u

nit

)

21

2.60

1.60

S + T

19

2.40

1.40

S + T

Deadweight loss Deadweight loss

Quantity (units/day)

Pri

ce (

$/u

nit

)

D1

S

24

2.00

D2

S

24

2.00

The greater the elasticity of demand, the greater the deadweight loss from a tax

57

2.65

1.65

S1 + T

63

2.35

1.35

S2 + T

Deadweight Loss Deadweight Loss

Elasticity of Supply and the Deadweight Loss from a Tax

Pri

ce (

$/u

nit

)

Pri

ce (

$/u

nit

)

D

S1

72

2.00

D

S2

72

2.00

The greater the elasticity of supply, the greater the deadweight loss from a tax

Quantity (units/day) Quantity (units/day)

Taxes and Efficiency

What do you think?– Why would a tax on land be efficient?

– Would a tax on pollution increase economic surplus?