lecture 2.2 market efficiency govt regulation

Lecture 2.2 Chapter 5

Economic Efficiency, Government Price Setting and Taxes

Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

1. Understand the concepts of consumer surplus and producer surplus.

2. Understand the concept of economic efficiency.

3. Explain the economic effect of government-imposed price ceilings and price floors.

4. Analyse the economic impact of taxes.

Learning Objectives

2


Marginal benefit: The additional benefit to a consumer from consuming one more unit of a good or service.

Consumer surplus: The difference between the highest price a consumer is willing to pay and the price the consumer actually pays.

Consumer surplus and producer surplus

3


Price (dollars per cup)

Quantity (cups per week)0 4

Demand

$7.00

$3.00

5

Jeff’s marginal benefit from consuming the fourth cup is $3.00.

$2.00

Jeff’s marginal benefit from consuming the fifth

cup is $2.00.

Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e 4

The demand curve is also the marginal benefit curve: Figure 5.1



Quantity (cups per week)

0

Demand

15 000

$2.00

Total consumer surplus in the market

for chai tea


Total consumer surplus in the market for chai tea: Figure 5.2


Marginal cost: The additional cost to a firm from producing one more unit of a good or service.

Producer surplus: The difference between the lowest price a firm would have been willing to accept and the price it actually receives.

6


LEARNING OBJECTIVE 1



Quantity (cups per week)0 40

Supply

$1.80

50

The marginal cost of producing the 40th

cup is $1.80.

$2.00

The marginal cost of producing the 50th

cup is $2.00.

Producer surplus on the 40th cup sold.


The supply curve shows marginal cost: Figure 5.3a




015 000

$2.00

Total producer surplus from selling chai tea Supply


Total producer surplus in the market for chai tea: Figure 5.3b


What consumer surplus and producer surplus measure

Consumer surplus measures the net benefit (total benefit minus total price paid) to consumers from participating in a market.

Producer surplus measures the net benefit (total benefit minus total cost of production) to producers from participating in a market.

9



Equilibrium in a competitive market results in the economically efficient level of output where marginal benefit equals marginal cost.

Economic surplus: The sum of consumer surplus and producer surplus.

Deadweight loss: The reduction in economic surplus resulting from a market not being in competitive equilibrium.

The efficiency of competitive markets

10




014 000

Supply

$1.80

16 000

Both marginal benefit and marginal cost =

$2.00, which means an economically efficient

output level.

$2.20

Marginal benefit = $2.20, marginal cost = $1.80,

therefore output is inefficiently low.

15 000

$2.00

Demand

Marginal benefit = $1.80, marginal cost = $2.20,

therefore output is inefficiently high.


Marginal benefit equals marginal cost only at competitive equilibrium: Figure 5.4



Quantity (cups per week)0

Demand

15 000

$2.00

Consumer surplus

Supply

Producer surplus

12 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Economic surplus equals the sum of consumer surplus and producer surplus: Figure 5.5


A


Quantity (cups per week)0

Demand

15 000

$2.00

Supply

13 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

When a market is not in equilibrium there is a deadweight loss: Figure 5.6

$2.20

14 000

C

E

B

D

At competitive equilibrium

At a price of $2.20

Consumer surplus A + B + C A

Producer surplus D + E B + D

Deadweight loss None C + E


Economic surplus and economic efficiency

Economic efficiency: A market outcome in which the marginal benefit to consumers of the last unit consumed is equal to its marginal cost of production, and where the sum of consumer surplus and producer surplus is at a maximum.

Equilibrium in a competitive market results in the greatest amount of economic surplus, or total net benefit to society, from the production of a good or service.

14

The efficiency of competitive markets


Price floors and price ceilings

Price floor: A legally determined minimum price that sellers may receive.

Price ceiling: A legally determined maximum price that sellers may charge.

Government intervention in the market

15


BA

C

0

$3.00

$3.50

S

D

Surplus wheat

Price (dollars per bushel)

Quantity (billions of bushels per year)

2.01.8 2.2

Consumer surplus transferred to producers

Deadweight loss = B + C

Price floor

16

Price floor in the wheat market: Figure 5.7



B

CA

0

S

D

$1000

Price (dollars per month)

Quantity (apartments per month)

$1500

1 900 000 2 000 000 2 100 000

Deadweight loss = B + C

Producer surplus transferred from landlords

to renters

Shortage of apartments

Rent control price ceiling

17

Price ceiling in the rental market: Figure 5.8


Price floors and price ceilings, cont.

Black market: Buying and selling at prices that violate government price regulations.

When the government imposes price floors or price ceilings, three important effects occur:

– Some people win.

– Some people lose.

– There is a loss of economic efficiency, which is often very large.


18


Positive and normative analysis of price ceilings and price floors

Whether rent controls are desirable or undesirable is a normative question.

Whether the gains to the winners more than compensate for the losses to the losers and the decline in economic efficiency is a matter of judgment and not strictly an economic question.

19



The effect of taxes on economic efficiency

Taxes finance government activities.

Taxes on goods and services affect market equilibrium and result in a decline in economic efficiency.

Taxes reduce consumer surplus and reduce producer surplus, and result in a deadweight loss.

Taxes reduce the production of goods and services.

The economic impact of taxes

20


Price (dollars per pack)

Quantity of cigarettes (billions of packets per year)

0 4

2.00

S1

Demand

$1.00 per pack tax on cigarettes shifts the supply

curve up by $1.00.

$2.90

3.7

S2

Deadweight loss or excess burden from tax

Price received by producers after paying

the tax

1.90

Price the consumers

pay after the $1.00 tax is

imposed

Tax revenue

A

C

B

21

The effect of a tax on the market for cigarettes: Figure 5.9



Tax incidence: Who actually pays a tax?

Tax incidence: The actual division of the burden of a tax between buyers and sellers in a market.

Who actually pays a tax? The answer depends on:

– Slope of the demand curve and the price elasticity of demand.

– Slope of the supply curve and the price elasticity of supply.

22



Tax incidence: Who actually pays a tax?, cont.

Does it matter who has a legal responsibility to pay the tax?

No, the incidence of the tax does not depend on whether a tax is collected from the buyers of the good or from the sellers.

23



Price (dollars per litre)

Quantity (millions of litres per year)

0 150

1.10

S1

Demand

40 cents per litre excise tax on petrol shifts up the supply

curve.

$1.45

140

S2

Price the sellers of

petrol receive after the 40

cents per litre tax

1.05

Price the consumers of

petrol pay after the 40

cents per litre tax

24

The incidence of a tax on petrol: Figure 5.10



Price (dollars per litre)

Quantity (millions of litres per year)

0 150

1.10

S

D1

40 cents per litre excise tax on petrol shifts the demand

curve down.

$1.45

140

Price the sellers of

petrol receive after the 40

cents per litre tax

1.05

Price the consumers

of petrol pay after the 40

cents per litre tax

25

The incidence of a tax on petrol paid by buyers: Figure 5.11


D2


Figure 2: Consumers pay all the tax only if demand is perfectly inelastic.

26

What happens when the government increases ‘sin taxes’?


Black market

Consumer surplus

Deadweight loss

Economic efficiency

Economic surplus

Marginal benefit

Marginal cost

Price ceiling

Price floor

Producer surplus

Tax incidence

27

Key Terms

lecture 2.2 market efficiency govt regulation

Documents

total consumer surplus

total producer surplus

concepts of consumer

price floors

highest price

lowest price

marginal benefit curve

jeffs marginal benefit