Mod 50-Efficiency & Deadweight Loss Duffka School of Economics

Student learning objectives: • The meaning and importance of total surplus and how it can be used to illustrate efficiency in markets. • How taxes affect total surplus and can create deadweight loss. • How the division of the tax, or incidence, depends upon the relative price elasticities of demand and supply. 11/13/2018 Duffka School of Economics

Key Economic Concepts For This Module: • Total surplus is the sum of consumer and producer surplus. • When the competitive market reaches equilibrium, total surplus is maximized. This is the most efficient outcome, because there is no way to make some people better off without making other people worse off. Any alternative to the equilibrium outcome reduces total surplus and thus reduces efficiency. • An excise tax can be shown as either a tax on sellers or buyers. If it is a tax on sellers, the supply curve shifts upward by the amount of the tax. If it is a tax on buyers, the demand curve shifts downward by the amount of the tax. • The burden of the tax is paid by both the buyers and the sellers, but not always in equal shares. • If the supply curve is relatively more elastic than the demand curve, the buyers will pay a higher share of the tax. • If the demand curve is relatively more elastic than the supply curve, the sellers will pay a higher share of the tax. • Excise taxes have the benefit of generating tax revenue for the government. • These taxes however create inefficiencies because they typically reduce the number of transactions made between buyers and sellers. This is known as deadweight loss. 11/13/2018 Duffka School of Economics

Duffka School of Economics Notes Organization I. Consumer Surplus, Producer Surplus, and Efficiency A. The Gains From Trade B. The Efficiency of Markets 1. The Reallocation of Consumption Among Consumers 2. The Reallocation of Sales Among Sellers 3. Changes in the Quantity Traded C. Equity and Efficiency II. The Effects of Taxes and Total Surplus A. The Effect of an Excise Tax on Quantities and Prices B. Price Elasticities and Tax Incidence 1. When an Excise Tax is Paid Mainly by Consumers 2. When an Excise Tax is Paid Mainly by Producers III. The Benefits and Costs of Taxation A. The Revenue from an Excise Tax B. The Costs of Taxation 11/13/2018 Duffka School of Economics

I. Consumer Surplus, Producer Surplus, and Efficiency Economists measure efficiency by the ability of markets to provide outcomes that are the most efficient to all other ways of organizing the exchange of goods—also called socially optimal. 11/13/2018 Duffka School of Economics

Duffka School of Economics A. The Gains From Trade Economists talk about gains from trade in the abstract, but any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. These gains are the concepts of consumer and producer surplus. 11/13/2018 Duffka School of Economics

Duffka School of Economics A. The Gains From Trade Economists talk about gains from trade in the abstract, but any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. These gains are the concepts of consumer and producer surplus. 11/13/2018 Duffka School of Economics

B. The Efficiency of Markets Once this market is in equilibrium, there is no way to increase the gains from trade. Any other outcome reduces total surplus. 11/13/2018 Duffka School of Economics

B. The Efficiency of Markets 1. The Reallocation of Consumption Among Consumers This is not efficient because it lowers the total CS. 11/13/2018 Duffka School of Economics

B. The Efficiency of Markets 2. The reallocation of Sales Among Sellers This is not efficient because it lowers the total PS. 11/13/2018 Duffka School of Economics

B. The Efficiency of Markets 3. Changes in the Quantity Traded Reduces total surplus 11/13/2018 Duffka School of Economics

B. The Efficiency of Markets Summary: An efficient market performs four important functions: 1. It 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. 2. It 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. 3. It 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. 4. It ensures 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. 11/13/2018 Duffka School of Economics

C. Equity and Efficiency Are there goods and services that are priced “unfairly” high? What should you do about it? Often equity and efficiency are at the root of the debate surrounding taxes. Most nations have a system of taxation that serves to redistribute some income from the wealthy to the poor. This may not be efficient, but these nations have decided that it is fair. Economists classify three types of taxes according to how they vary with the income of individuals. 11/13/2018 Duffka School of Economics

C. Equity and Efficiency Economists classify three types of taxes according to how they vary with the income of individuals: A tax that rises more than in proportion to income, so that high-income taxpayers pay a larger percentage of their income than low-income taxpayers, is a progressive tax. A tax that rises less than in proportion to income, so that high-income taxpayers pay a smaller percentage of their income than low-income taxpayers, is a regressive tax. A taxes that rises in proportion to income, so that all taxpayers pay the same percentage of their income, is a proportional tax. 11/13/2018 Duffka School of Economics

II. The Effects of Taxes on Total Surplus One tax that is used in many countries is the excise tax. This is a tax levied on each unit of a good that is sold. In the U.S. excise taxes are imposed upon the sale of goods such as gasoline, tobacco, alcohol and, in many cities, hotel rooms. 11/13/2018 Duffka School of Economics

II. The Effects of Taxes on Total Surplus One tax that is used in many countries is the excise tax. This is a tax levied on each unit of a good that is sold. In the U.S. excise taxes are imposed upon the sale of goods such as gasoline, tobacco, alcohol and, in many cities, hotel rooms. 11/13/2018 Duffka School of Economics

II. The Effects of Taxes on Total Surplus Suppose the market for gasoline in Smog City is free of any taxes. The equilibrium price is $2 per gallon, and 1 million gallons are sold every day. Compute the total surplus as the combined area of two triangles seen in the graph Consumer surplus = ½*($3)(1million) = $1.5 million Producer surplus = ½*($2)(1 million) = $1 million Total surplus = $2.5 million CS PS 11/13/2018 Duffka School of Economics

II. The Effects of Taxes on Total Surplus Example Politicians in Smog City decide to impose on gasoline sellers a $1 tax on every gallon of gasoline sold. Sellers want to continue to sell 1 million gallons per day, they must receive $3 per gallon because $1 must be sent to the government. In other words, the supply curve shifts upward by $1, the amount of the tax. After the tax, only .8 million (or 800,000) gallons of gasoline are exchanged and the price paid by consumers at the pump has risen to $2.60. The price sellers actually receive is equal to $2.60 - $1.00 = $1.60 because they have to send $1 to the government for every gallon that they sell. Thus the tax creates a wedge between the price the buyers pay ($2.60) and the price the sellers actually receive ($1.60). CS PS 11/13/2018 Duffka School of Economics

II. The Effects of Taxes on Total Surplus Who is really paying the tax? Consumers see a price that is $.60 higher than before. Sellers receive, after tax, a price that is $.40 lower than before. Consumers are paying $.60 of a $1 tax (60%) and sellers are paying $.40 (40%) of the $1 tax CS PS 11/13/2018 Duffka School of Economics

II. The Effects of Taxes on Total Surplus Example Politicians in Smog City decide to impose the $1 tax on gasoline buyers, rather than sellers. Buyers must pay $1 to the government for every gallon of gasoline that they purchase. This would lower consumer willingness to pay by $1 for each gallon purchased, which serves to shift the demand curve downward by the amount of the tax. After the tax, 800,000 gallons are exchanged. Sellers receive $1.60 for each gallon of gasoline sold, and buyers pay a total of $1.60 + $1 = $2.60 for each gallon purchased. So again, the tax has created a wedge between the price received by sellers and the price paid by buyers. Now who is paying the tax? Buyers are still paying 60% and sellers are still paying 40% of a $1 tax. In other words, not much has changed. This is referred to as the “incidence of the tax”. In this case, the consumers have a slightly larger share of the tax than do the sellers. CS PS 11/13/2018 Duffka School of Economics

1. When an Excise Tax is Paid Mainly by Consumers If the demand curve is relatively inelastic and the supply curve is relatively elastic, the buyers will pay the larger share of the excise tax. 11/13/2018 Duffka School of Economics

2. When an Excise Tax is Paid Mainly by Producers If the demand curve is relatively elastic and the supply curve is relatively inelastic, the sellers will pay the larger share of the excise tax. 11/13/2018 Duffka School of Economics

III. The Benefits and Costs of Taxation A. The Revenue from an Excise Tax After the gasoline tax in Smog City, the buyers are paying higher prices and sellers are receiving lower prices, for the gasoline they exchange. However the government is collecting tax revenue that can be used to help the city pay for roads, parks, and other services. How much are they collecting? We can see the revenue in the graph as the area of a rectangle. Tax revenue = (# of gallons sold)*(per gallon tax) = 800,000 gallons*$1 per gallon = $800,000 CS $1 PS 11/13/2018 Duffka School of Economics

Duffka School of Economics B. The Costs of Taxation The 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. Remember the total surplus that was calculated at the beginning of this module? Before the Tax Consumer surplus = ½*($3)(1million) = $1.5 million Producer surplus = ½*($2)(1 million) = $1 million Total surplus = $2.5 million After the Tax Consumers are now paying $2.60 for only 800,000 gallons of gasoline. New CS = ½*($2.40)(800,000) = $960,000 Sellers are now receiving $1.60 for those 800,000 gallons. New PS = ½*($1.60)(800,000) = $640,000 Add the area of government tax revenue = $800,000 CS + PS + Revenue = $2.4 million. 11/13/2018 Duffka School of Economics

Duffka School of Economics Main Idea Check 11/13/2018 Duffka School of Economics

Duffka School of Economics 2009 Free Response #2 2. The graph above illustrates the market for calculators. S denotes the current supply curve, and D denotes the demand curve. (a) Calculate the producer surplus before the tax. (b) Now assume a per-unit tax of $2 is imposed whose impact is shown in the graph above. (i) Calculate the amount of tax revenue. (ii) What is the after-tax price that the sellers now keep? (iii) Calculate the producer surplus after the tax. (c) Is the demand price elastic, inelastic, or unit elastic between the prices of $5 and $6 ? Explain. (d) Assuming no externalities, how does the tax affect allocative efficiency? Explain 11/13/2018 Duffka School of Economics

2009 Free Response #2--ANSWER 2. The graph above illustrates the market for calculators. S denotes the current supply curve, and D denotes the demand curve. (a) Calculate the producer surplus before the tax. (a) 1 point: One point is earned for the correct calculation of the producer surplus: (1/2) × $3 × 90 = $135. Consumer Surplus $3 X 90=$270/2=$135 Producer Surplus 11/13/2018 Duffka School of Economics

2009 Free Response #2--ANSWER 2. The graph above illustrates the market for calculators. S denotes the current supply curve, and D denotes the demand curve. (b) Now assume a per-unit tax of $2 is imposed whose impact is shown in the graph above. (i) Calculate the amount of tax revenue. •One point is earned for the correct calculation of the amount of tax revenue: $2 × 60 = $120. (ii) What is the after-tax price that the sellers now keep? • One point is earned for the correct calculation of the after-tax price received by sellers: $4. (iii) Calculate the producer surplus after the tax. • One point is earned for the correct calculation of the producer surplus: (1/2) × $2 × 60 = $60. 11/13/2018 Duffka School of Economics

Duffka School of Economics 2009 Free Response #2 2. The graph above illustrates the market for calculators. S denotes the current supply curve, and D denotes the demand curve. (c) Is the demand price elastic, inelastic, or unit elastic between the prices of $5 and $6 ? Explain. 1 point: • One point is earned for concluding that the demand price is elastic AND showing the correct calculation of the elasticity coefficient using endpoint or midpoint method, or the correct calculation using the total revenue formula. TOTAL REVENUE: $5 X 90=$450 $6 X 60=$360 P increase-TR decrease ELASTIC 11/13/2018 Duffka School of Economics

Duffka School of Economics 2009 Free Response #2 2. The graph above illustrates the market for calculators. S denotes the current supply curve, and D denotes the demand curve. (d) Assuming no externalities, how does the tax affect allocative efficiency? Explain 1 point: • One point is earned for concluding that, owing to the tax, the market is no longer allocatively efficient AND that total surplus decreases or the tax creates a dead-weight loss. A market is ONLY efficient when there is no difference in the price the seller receives and the consumer pays. 11/13/2018 Duffka School of Economics

Duffka School of Economics Practice Question 1. At market equilibrium in a competitive market, which of the following is necessarily true? I. Consumer surplus is maximized. II. Producer surplus is maximized. III. Total surplus is maximized. a. I only b. II only c. III only d. I and II only e. I, II, and III 11/13/2018 Duffka School of Economics

Duffka School of Economics Practice Question 2. When a competitive market is in equilibrium, total surplus can be increased by I. reallocating consumption among consumers. II. reallocating sales among sellers. III. changing the quantity traded. a. I only b. II only c. III only d. I, II, and III e. None of the above 11/13/2018 Duffka School of Economics

Duffka School of Economics Practice Question 3. Which of the following is true regarding equity and efficiency in competitive markets? a. Competitive markets ensure equity and efficiency. b. There is often a trade-off between equity and efficiency. c. Competitive markets lead to neither equity nor efficiency. d. There is generally agreement about the level of equity and efficiency in a market. e. None of the above. 11/13/2018 Duffka School of Economics

Duffka School of Economics Practice Question 4. An excise tax imposed on sellers in a market will result in which of the following? I. an upward shift of the supply curve II. a downward shift of the demand curve III. deadweight loss a. I only b. II only c. III only d. I and III only e. I, II, and III 11/13/2018 Duffka School of Economics

Duffka School of Economics Practice Question 5. An excise tax will be paid mainly by producers when a. it is imposed on producers. b. it is imposed on consumers. c. the price elasticity of supply is low and the price elasticity of demand is high. d. the price elasticity of supply is high and the price elasticity of demand is low. e. the price elasticity of supply is perfectly elastic. 11/13/2018 Duffka School of Economics

Duffka School of Economics .25 .30 .35 .40 .45 .50 S+tax 11/13/2018 Duffka School of Economics

Duffka School of Economics S+tax Tax=$.15 200 $0.25 $50 (.25X200=$50) $50 (.25X200=$50) 150 Qe2 11/13/2018 Duffka School of Economics $0.35 Pb=Pe2

Duffka School of Economics $0.20 (Ps=Pb-TAX or $0.35-$0.15=$0.20) $52.5 (Pb X 150=$0.35 X 150) $30 (Ps X 150=$0.20 X150) $22.5 (TAX X 150=$0.15 X 150) $15 This is calculated by the equilibrium quantity times the difference in (Pb-E1). ($.35-$.25)X150=$.10X150 $7.5 (Pe1-Ps)X150=($.25-$.20) X 150=$0.05 X 150 $12.5 11/13/2018 Duffka School of Economics

Duffka School of Economics Tax=$.15 200 S+tax $0.25 $50 $50 100 $0.30 $0.15 $30 $15 $15 $5 $10 11/13/2018 Duffka School of Economics $25

Duffka School of Economics $30 $30 S+tax $0 $0 200 $0.25 $50 $50 200 $0.40 $0.25 $80 11/13/2018 $50 Duffka School of Economics

Duffka School of Economics S+tax 50 $0.25 $0.10 $12.5 PbX50=$0.25 X 50 200 $5 $0.25 (PsX50=$0.10 X 50=$5) $50 $7.5 $50 $0 $7.5 37.5 11/13/2018 Duffka School of Economics

Duffka School of Economics Relatively INELASTIC. No good substitutes for the addicted. Also considerable revenue is collected from these taxes. 11/13/2018 Duffka School of Economics

Duffka School of Economics The long run supply curve would NOT be perfectly inelastic. Additional parking spaces could added as prices increased. Existing facilities now used for other things could be converted to parking garages. Downtown shoppers have more substitutes than downtown office workers but even office workers would carpool or take public transportation. Price would be higher. Number of spaces used would be smaller. See Part C, except a percentage tax would result in St getting progressively farther from S compared with Part C, where a tax was a fixed cents-per-unity amount rather than a percentage. No, there would most likely be some “sharing” of the burden, since neither supply nor demand is perfectly inelastic. The burden would fall entirely upon the driver if demand were perfectly inelastic. 11/13/2018 Duffka School of Economics

Free Response Practice #1 a.  What quantity will be sold in the market? $1,000 b.  What price will consumers pay in the market? $90 c.  By how much will consumer surplus change as a result of the tax? CS will decrease by $45k, from $60k before to $15K after d.  By how much will producer surplus change as a result of the tax? PS will decrease by $45 from $60 to $15. e.  How much revenue will the government collect from this excise tax? $60 X 1,000 = $60,000 f.  Calculate the deadweight loss created by the tax. $30,000 11/13/2018 Duffka School of Economics

Free Response Practice #2 2. Draw a correctly labeled graph of a competitive market in equilibrium. Use your graph to illustrate the effect of an excise tax imposed on consumers. Indicate each of the following on your graph: a. the equilibrium price and quantity without the tax, labeled PE and QE b. the quantity sold in the market post-tax, labeled QT c. the price paid by consumers post-tax, labeled PC d. the price received by producers post-tax, labeled PP e. the tax revenue generated by the tax, labeled “Tax revenue” f. The deadweight loss resulting from the tax, labeled “DWL.” 11/13/2018 Duffka School of Economics