Efficiency and Deadweight Loss Micro: Econ: 14 50 Module Efficiency and Deadweight Loss KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will know: How can we show the total gains from economic exchange? Why do economists believe that taxes destroy efficiency? Given that taxes are economically bad, why does society choose taxes? The purpose of this module is to show that, when competitive markets reach equilibrium, total surplus (the sum of consumer and producer surplus) is maximized. Whenever something distorts the competitive market outcome, like excise taxes, total surplus is not maximized and deadweight loss emerges.

Gains from Trade Any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. Gains from trade are represented by consumer and producer surplus. At the market equilibrium price and quantity, total surplus is the sum of the CS and PS triangles. 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.

The Efficiency of Markets A market is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. No reallocation of consumption among consumers could increase consumer surplus No reallocation of sales among producers could increase producer surplus A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency.   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.

The Efficiency of Markets 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. A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency.   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.

The Efficiency of Markets Draw: any point to the left of a demand curve is an acceptable price and quantity combination for consumers [shade left to right], likewise with producers related to cost. [shade right to left] Draw: Q1 at equilibrium price. Note the general area of the total surplus. Draw: Q2 left of equilibrium. Note the general reduction in total surplus. A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency.   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.

Concept Check [easy] A market is efficient when: Sum of consumer and producer surpluses are maximized. Deadweight gains are maximized. Quantity produced is maximized. Marginal benefit exceeds marginal cost. Total surplus equals total cost. A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency.   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.

Concept Check [hard] Which of the following can result in a market producing an inefficient quantity of a good? Competition 2) An external cost or benefit 3)A tax 1 only b) 2 only c) 3 only d) 2 and 3 e) 1 and 3 A markets is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off. Once the market has reached equilibrium, there is no other way to increase the gains from trade. All of these 3 possible reallocations reduce total surplus and thus reduces efficiency.   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.

Equity and Efficiency Efficiency is not society’s only concern. We are also concerned with equity. Is it efficient for there to be handicapped parking? Often equity and efficiency are at the root of the debate surrounding taxes. Progressive, regressive, and proportional taxes What is considered “fair” or “equitable” depends on many factors. A market price of $6 for a gadget may seem completely fair to a person who can afford $6, but extremely unfair to a person who cannot.   Most societies have found it desirable to sacrifice some efficiency to gain a little equity. The book example is designating parking spaces for disabled persons. 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. 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.

Equity and Efficiency   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. What is considered “fair” or “equitable” depends on many factors. A market price of $6 for a gadget may seem completely fair to a person who can afford $6, but extremely unfair to a person who cannot.   Most societies have found it desirable to sacrifice some efficiency to gain a little equity. The book example is designating parking spaces for disabled persons. 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. 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.

Effects of Taxation Stax P S 5$ 4$ 3$ D 100 200 Q 2$ tax on gas Suppliers shift inwards to 5$ from 4$. How much do suppliers make per gallon? Government now makes 2$ per. Changes in surpluses. Deadweight loss S 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. Excise taxes will affect total surplus in a market. Who ultimately pays the tax (the tax incidence) depends on the price elasticity of demand and supply in the market. 5$ 4$ 3$ D 100 200 Q

Effects of Taxation Stax P S D 10 12 Q Tax per unit? Total tax revenue? Tax paid by consumers? Tax paid by producers? Total expenditures? Firm TR? P S $15 $14 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. Excise taxes will affect total surplus in a market. Who ultimately pays the tax (the tax incidence) depends on the price elasticity of demand and supply in the market. $13 $12 $11 $10 D 10 12 Q

Efficient or not? 1) Buyers want new shoes, and are willing to buy if the price is between 8 – 15$. Producers are willing to make them for between 2 and 8$. 2) The government decides to tax DUANG videos. 3) Somebody finds a way to turn economics homework into gold. Judge the market’s efficiency right after this discovery. 4) One producer privately makes a technological discovery and starts manufacturing tons and tons of high quality paintings. Judge the market’s efficiency right after this discovery. Taxes, like all things, come with benefits and costs. The revenue from a tax is equal to the amount of the tax times the number of units sold. 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.

Taxes and Total Surplus Tax leads to; a decrease in quantity an increase in the price paid by consumers. a decrease in the price received by sellers a “wedge” between the price consumers pay and the price producers receive (equal to the amount of the tax) A tax on sellers: Politicians decide to impose on gasoline tax on sellers, equal to $1 on every gallon of gasoline sold. For sellers, this means that 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. A tax on buyers: Politicians decide to impose the $1 tax on gasoline buyers. 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.

Elasticity and Tax Incidence The tax incidence really depends upon the shape of the demand and supply curves. This shape, steep vs. flat, depends upon the price elasticity of demand and supply. Tax incidence: the measure of who really pays a tax 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. 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.

Elasticity and Tax Incidence The tax incidence really depends upon the shape of the demand and supply curves. This shape, steep vs. flat, depends upon the price elasticity of demand and supply.

Elasticity and Tax Incidence If demand is more elastic than supply, then the suppliers pay. If supply is more elastic than demand, the consumers pay. Simplified – Inelastic  pay more tax The tax incidence really depends upon the shape of the demand and supply curves. This shape, steep vs. flat, depends upon the price elasticity of demand and supply.

The Benefits and Costs of Taxation Benefits (Revenue) Costs: Deadweight Loss Taxes, like all things, come with benefits and costs. The revenue from a tax is equal to the amount of the tax times the number of units sold. 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.

Concept Check [easy] A sales tax _____ consumer surplus and ______ producer surplus. [choose one or more: increases, decreases, does not change] Tax incidence refers to: a) How government taxes are spent b) the incidences of tax revolts by the payers c) the amount of a tax minus its burden d) the division of the burden of a tax between buyers and sellers e) tax revenue minus excess burden. The tax incidence really depends upon the shape of the demand and supply curves. This shape, steep vs. flat, depends upon the price elasticity of demand and supply.

Concept Check [hard] To determine who bears the greater share of a tax, we compare: a) the number of buyers to the number of sellers b) the elasticity of supply to the elasticity of demand c) the size of the tax to the price of the good d) government tax revenue to the revenue collected by the suppliers e) the pre-tax quantity to the post-tax quantity The tax incidence really depends upon the shape of the demand and supply curves. This shape, steep vs. flat, depends upon the price elasticity of demand and supply.

Can you do it? The tax incidence really depends upon the shape of the demand and supply curves. This shape, steep vs. flat, depends upon the price elasticity of demand and supply.