©2012 the mcgraw-hill companies, all rights reserved 1 chapter 5: efficiency and exchange

©2012 The McGraw-Hill Companies, All Rights Reserved

1

Chapter 5: Efficiency and Exchange


2

Learning Objectives

1. Define and calculate consumer and producer surplus

2. Define efficiency

3. Analyze how surplus and efficiency are affected by policies

4. Explain the role of efficiency in deciding the "right" price for public services

5. Examine the ways taxes affect efficiency


3

Free Markets

It is common to describe the free enterprise system as “the greatest engine of progress mankind has ever witnessed” or as “a rising tide that will lift all boats.”

Raising traffic fines in Morocco ought to reduce reckless driving.

Instead, it made corruption more rampant and had no noticeable effect on reckless driving.

Conclusion: In many instances, free markets should be supplemented with political coordination.


4

Role of the Market

Market allocation of resources Often maximizes efficiency Not right for all objectives

Corruption Income distribution

Unintended consequences of government policies

Public utilities Taxes


5

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

An outcome is more efficient if at least one person is made better off and nobody is made worse off

Different from engineering efficiency Maximizes the amount of work done while

minimizing the resources used

Market equilibrium price and quantity are efficient

Prices above or below equilibrium are not


6

Trade-Offs


7

Consumer and Producer Surplus

In economics, we assume that all exchange is purely voluntary In other terms, a transaction cannot take

place unless the consumer’s reservation price exceeds the producer’s reservation price

Consumer surplus (CS) Difference between the buyer’s reservation

price and the price he or she actually pays Usually the area below the demand curve

and above the market price


8

Consumer and Producer Surplus

In economics, we assume that all exchange is purely voluntary

Producer surplus (PS) Difference between the price received by

the seller and his or her reservation price Usually the area above the suppler and

below the market price

Total economic surplus = CS + PS Difference between the buyer’s

reservation price and the seller’s reservation price


9

Consumer Surplus

Consumer's surplus is the difference between the buyer's reservation price and the market price

With multiple buyers Find the consumer surplus for each

buyer Add up the individual surpluses


10

Consumer Surplus on a Graph

When a product is sold in whole units, the demand curve is a stair-step function Many goods are

indivisible: movie tickets and TVs

If the market supplied only one unit, the maximum price would be $11 For the second unit,

the price is $10, and so on

The last buyer gets no consumer surplus

D

Units/day

Pric

e (

$/ u

nit)

12

34

5

6789

1011

12

2 4 6 8 10 12


11

Consumer Surplus on a Graph

Market price is $6 for all sales

Total consumer surplus The first sale generates $5

of consumer surplus • Reservation price of $11

minus the price of $6 Selling the second unit has

$4 of consumer surplus, and so on

Total consumer surplus is the area under the demand curve and above market price

D

Units/day

Pric

e (

$/ u

nit)

12

345

67

89

1011

12

2 4 6 8 10 12


12

Consumer Surplus for Milk

Consider the market demand and supply of milk

The equilibrium price is $2 per liter

The equilibrium quantity is 4,000 liters per day Last customer pays his reservation price and gets no consumer surplus

Quantity (000s of l/day)

Pric

e ($

/lite

r)1

1.00

2.00

3.00

2 3 4 5 6

S

D


13

Consumer Surplus for Milk

Price is $2 and quantity is 4,000 liters per day

Consumer surplus is the area of the triangle between Horizontal intercept of

demand Market price Market quantity

Remember: area of a right triangle is ½ width times height The area is

½ ($1)(4,000 l) = $2,000

Quantity (000s of l/day)

Pric

e ($

/lite

r)1

1.00

2.00

3.00

2 3 4 5 6

S

D

Consumer Surplus


14

Producer Surplus

Producer surplus is the difference between the market price and the seller's reservation price

Reservation price is on the supply curve

Producer surplus is the area above the supply curve and below the market price


15

Socially Optimal Quantity

When do we have a socially optimal quantity? When the total surplus is maximized Keep expanding until marginal benefit = marginal

cost Economic efficiency

Occurs when all goods and services are produced and consumed at their respective socially optimal levels

Equilibrium principle A market in equilibrium is Pareto efficient since

no reallocation is possible that will benefit some people without harming others


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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 Different from engineering efficiency Equilibrium price and quantity are

efficient Prices above or below equilibrium are not


17

Price Below Equilibrium

Suppose milk is $1 per liter

2.50

Quantity (1,000s of liters/day)

Pric

e ($

/lite

r)

1 2 3 4 5

2.00

1.50

1.00

0.50

D

S


18

Price Below Equilibrium

A buyer offers $1.25

2.50


Pric

e ($

/lite

r)

1 2 3 4 5

2.00

1.50

1.00

0.50

D

S

1.25


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Price above Equilibrium

2.50


Pric

e ($

/lite

r)

1 2 3 4 5

2.00

1.50

1.00

0.50

D

S

1.75 Only equilibrium

price is efficient


20

Efficiency

Efficiency is not the only goal Was Dubai’s decision to impose a

ceiling on (annual) rental price increases to 7 percent motivated by economic efficiency goals or social justice?

Efficiency should be the first goal Efficiency enables us to achieve all our

other goals to the fullest possible extent


21

Trade-Offs


22

Cement Market

D

S2.00

Quantity (1,000s of kg/day)

Pric

e ($

/kg)

1 2 3 4 5

1.60

1.20

1.00

.80

1.80

1.40

8

Producer surplus = $900/day

Consumer surplus = $900/day


23

Price Ceiling on Cement

D

S

2.00

Quantity (1,000s of kg/day)

Pric

e ($

/kg)

1 2 3 4 5

1.60

1.20

1.00

0.80

1.80

1.40

8

Lost surplus = $800/ day

Consumer surplus = $900/ day

Producer surplus = $100/ day


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Cement Story

Price ceilings reduce total economic surplus Their defenders argue that they help small

builders to buy cement at affordable prices The same goal could have been achieved

through a cheaper method, say: give the smaller builders more income to buy cement income transfers

Would cement builders be willing to pay taxes to generate the extra income to be transferred?

Yes since with a price ceiling they are losing $800

What potential consequence might arise from using income transfers?


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Alternative Cement Policy

L

S

L

S

Surplus with Price Controls

Surplus with Income

Transfers Only

L = Large buildersS = Small builders


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Price Subsidy for Bread: The Case of Egypt

Imported bread costs $2 Perfectly elastic supply

Because it is a small country so it takes the world’s price for bread as given and fixed

Government program to subsidize bread Government imports bread for $2 Government sells bread for $1

Results• More bread• Less efficiency


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Price Subsidies for Bread

Quantity (millions of loaves/month)2 4 6

$3.00

$1.00

$4.00

8

$2.00

D

S

Price ($/loaf)

Consumer Surplus = $4 m/month

Consumer Surplus = $9 m/month

BUT…

S with subsidy


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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 Even though consumer surplus is larger than

before The net effect of the subsidy program is $5 -

$6 which is a reduction in the total economic surplus by $1


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Price Subsidies for Bread

Quantity (millions of loaves/month)2 4 6

$3.00

$1.00

$4.00

8

$2.00

D

S

Price ($/loaf) Consumer Surplus

S with subsidy

Government Losses

Government Losses

Total Surplus Lost

= $1 m/month

Total Surplus Lost

= $1 m/month


30

First-Come, First-Served

A non-market way of allocating scarce goods Low income students seats for sporting

events They can buy tickets at lower prices following first

come first served

Airline seats Historically, airlines overbook their flights because

many passengers do not make the flights• However, in many cases everyone shows up at the gate.

How do airlines solve this issue?


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Overbooked Airplane

In general, airlines board passengers on a first come first serve basis However, those who show up late end

up missing their flights and typically complain about getting a later flight

Solution? 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


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Overbooked Airplane: Example

33 seats, 37 reservations Highest willingness to pay to get on the

flight is $60 and then $59 and so on… until $24

Actual amounts range from $60 to $24 Average willingness to pay to get on the

plane is $42 ($60 + $59 + $58 + … + $24)/37 = $42

The last 4 people arriving are bumped Total consumer surplus lost: ($42) (4) =

$168


33

Over-Booked Airplane: Example

With compensation many people volunteer However, it is safe to assume that people

with the lowest willingness to pay would volunteer so that means those from $24 to $27

Value they place on taking that flight ($24 to $27)

Total consumer surplus lost: $102The change to compensation approach

rather than first come first served creates a surplus of $66


34

Public Services

So far, we looked at private markets where the most efficient point is at equilibrium gives the highest total economic surplus

What if the government is producing a service or a good? Local governments typically supply water

Its goal is to maximize total surplus

What price should be charged? Value of the last unit to the last buyer should be

equal to the marginal cost of supplying the water

• Charge is 4 cents


35

Water in Egypt with 3 potential sources

Water supplied (millions of liters/day)

Cos

t (c

ents

/lite

r)

4.0

0.8

0.21 3

SpringSpring

Nile Nile

SeaSea

4

If P = 4.0¢,

QD = 4


36

Taxes on Sellers

Tax program Seller reports sales in units to

government Seller pays a fixed dollar amount per unit

soldA 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


37

Tax on Potato Sellers

S + tax

2.50

3.50

2.5

6

Quantity (millions of kg/month)

Pric

e ($

/kg)

1 2 3 4 5

5

4

2

1D

S

3


38

Taxes and Perfectly Elastic Supply

Quantity (millions of cars/month)

Price ($/car)

D

S

2.0

$20,000

1.9

S + $100$20,100

If supply is perfectly elastic, buyers pay all of the tax


39

Taxes and Total Surplus

We know that taxes lead to Lower equilibrium quantity Higher equilibrium price

What happens to total economic surplus? How do taxes affect total surplus?


40


Before TaxConsumer surplus = $4.5 MProducer surplus = $4.5 M

Total surplus =$9M

After TaxConsumer surplus = $3.125 MProducer surplus = $3.125 M

Total surplus = $6.25 MLoss = $2.75 M


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Total Surplus Lost

Tax revenue is $2.5 million = $1 * 2.5 million If the government has a specific revenue

target, then by adding an extra $2.5 million from taxes on potatoes it can decrease other taxes

If other taxes go down by $2.5 million, this is not a large loss then since the

Net loss becomes $0.25 million

Deadweight loss is the reduction in total economic surplus that results form the adoption of a policy The net loss equaling $0.25 million


42


S + tax

2.50

3.50

2.5

6

Quantity (millions of kg/month)

Pric

e ($

/kg)

1 2 3 4 5

5

4

2

1D

S

3

Tax revenu

e

Deadweight Loss

Total surplus

after tax

Total surplus

before tax


43

Taxes and Price Elasticity of Demand

Potato 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


44

Taxes and Price Elasticity of Demand

Q

P

19

2.40

1.40

S + T

D1

S

24

2.00

More Elastic Demand Less Elastic Demand

2.60

1.602.00

21

S + T

Q

D2

S

24

P

Consumers pay a smaller share of the tax when demand is more elastic


45

Taxes and Deadweight Loss

More Elastic Demand Less Elastic Demand

Deadweight loss is larger when demand is relatively elastic

Q

P

19

2.40

1.40

S + T

D1

S

24

2.00

Deadweight loss

2.60

1.602.00

21

S + T

Q

D2

S

24

P Deadweight loss


46

Efficiency and Exchange

Economic Efficiency

Market Equilibrium

Equity

Price Ceilings

Subsidies

First Come,First

Served

Deadweight Loss

Shifting the Tax

Elasticity

Public Services

Taxes on Sellers

©2012 the mcgraw-hill companies, all rights reserved 1 chapter 5: efficiency and exchange

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