Lecture 2.2 Chapter 5
Economic Efficiency, Government Price Setting and Taxes
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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
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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
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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.
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The demand curve is also the marginal benefit curve: Figure 5.1
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Price (dollars per cup)
Quantity (cups per week)
0
Demand
15 000
$2.00
Total consumer surplus in the market
for chai tea
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Total consumer surplus in the market for chai tea: Figure 5.2
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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
Consumer surplus and producer surplus
LEARNING OBJECTIVE 1
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Price (dollars per cup)
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.
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The supply curve shows marginal cost: Figure 5.3a
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Price (dollars per cup)
Quantity (cups per week)
015 000
$2.00
Total producer surplus from selling chai tea Supply
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Total producer surplus in the market for chai tea: Figure 5.3b
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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
Consumer surplus and producer surplus
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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
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Price (dollars per cup)
Quantity (cups per week)
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.
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Marginal benefit equals marginal cost only at competitive equilibrium: Figure 5.4
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Price (dollars per cup)
Quantity (cups per week)0
Demand
15 000
$2.00
Consumer surplus
Supply
Producer surplus
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Economic surplus equals the sum of consumer surplus and producer surplus: Figure 5.5
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A
Price (dollars per cup)
Quantity (cups per week)0
Demand
15 000
$2.00
Supply
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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
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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
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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
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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
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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
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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.
Price floors and price ceilings
18
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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
Price floors and price ceilings
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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
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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
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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
The economic impact of taxes
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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
The economic impact of taxes
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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
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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
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D2
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Figure 2: Consumers pay all the tax only if demand is perfectly inelastic.
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What happens when the government increases ‘sin taxes’?
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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