AP Economics

Mr. Bernstein

Module 50: Efficiency and Deadweight Loss

October 23, 2014

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AP EconomicsMr. Bernstein

Total Surplus• When markets reach equilibrium, Total Surplus is

maximized• Distortions to competitive market outcomes(ie

excise taxes) create Total Surplus that is not maximized and Deadweight Loss emerges

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AP EconomicsMr. Bernstein

Efficiency and Gains From Trade• When economists speak of efficiency, they are

typically eluding to the ability of markets to produce outcomes that are most efficient to all other ways of organizing the exchange of goods

• When a consumer makes a purchase from a producer, a trade has occurred and both sides gain

• Gains are represented by Consumer and Producer Surplus, or Total Surplus

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AP EconomicsMr. Bernstein

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• Once the market has reached equilibrium, there is no other way to increase the gains from trade. Any of these 3 possible reallocations would reduce total surplus and thus reduces efficiency.

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AP EconomicsMr. Bernstein

An Efficient Market• 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

• 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.

• 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.

• Insures 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.

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AP EconomicsMr. Bernstein

Equity and Efficiency - Review• Societies may be concerned with Equity as well as Efficiency• Example: Handicapped Parking• Another example: Progressive tax rates

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AP EconomicsMr. Bernstein

The Effect of Taxes

• Excise tax imposed on producers Qt Q

D

Dead Weight LossP

Q

SCS

PS

S1

T

T

D

D

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AP EconomicsMr. Bernstein

The Effect of Taxes on Total Surplus• Who pays the tax (tax incidence) depends on the price

elasticities of demand and supply• Tax on sellers shifts the supply curve to the left• Tax on buyers shifts the demand curve to the left• Example: Gas tax can be imposed on producers or consumers• In either case, the tax leads to:

• Decrease in quantity• Increase in price paid by consumers, but…• Decrease in price received by producers• A “wedge” between consumer and producer prices equal to the tax

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AP EconomicsMr. Bernstein

Elasticity and Tax Incidence• Relatively inelastic (steep) demand curve - consumers pay• Relatively elastic (flat) demand curve - producers pay• Relatively inelastic (steep ) supply curve – producers pay• Relatively elastic (flat) supply curve – consumers pay• On costs and benefits of taxes:

• 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