c h a p t e r f o u r © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. Prepared by: Fernando & Yvonn Quijano Economic Efficiency, Government Price Setting, and Taxes

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 2 of 27 After studying this chapter, you should be able to: Understand the concepts of consumer surplus and producer surplus. Understand the concept of economic efficiency, and use a graph to illustrate how economic efficiency is reduced when a market is not in competitive equilibrium. Use demand and supply graphs to analyze the economic impact of price ceilings and price floors. Use demand and supply graphs to analyze the economic impact of taxes. Should the Government Control Apartment Rents? LEARNING OBJECTIVES New York City … About one million of New York Citys two million apartments are subject to rent control. The other one million apartments have their rents determined in the market by the demand and supply for apartments.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 3 of 27 Economic Efficiency, Government Price Setting, and Taxes Price ceiling A legally determined maximum price that sellers may charge. Price floor A legally determined minimum price that sellers may receive.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 4 of 27 Consumer Surplus And Producer Surplus Consumer Surplus LEARNING OBJECTIVE 1 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 The Demand Curve is Also the Marginal Benefit Curve

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 5 of 27 Consumer Surplus and Producer Surplus Consumer Surplus Total Consumer Surplus in the Market for Chai Tea

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 6 of 27 The Consumer Surplus from Satellite Television How much consumer surplus will the owner of this satellite dish receive? 4 - 1

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 7 of 27 Consumer Surplus and Producer Surplus Producer Surplus Producer surplus The difference between the lowest price a firm would have been willing to accept and the price it actually receives. Marginal cost The additional cost to a firm of producing one more unit of a good or service Producer Surplus

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 8 of 27 Consumer Surplus and Producer Surplus What Consumer Surplus and Producer Surplus Measure Consumer surplus measures the benefit to consumers from participating in a market, and producer surplus measures the benefit to producers from participating in a market.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 9 of 27 The Efficiency of Competitive Markets LEARNING OBJECTIVE 2 Marginal Benefit Equals Marginal Cost in Competitive Equilibrium Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 10 of 27 The Efficiency of Competitive Markets Economic Surplus Economic Surplus Equals the Sum of Consumer Surplus and Producer Surplus

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 11 of 27 The Efficiency of Competitive Markets Deadweight Loss When a Market Is Not in Equilibrium There is a Deadweight Loss Deadweight loss The reduction in economic surplus resulting from a market not being in competitive equilibrium.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 12 of 27 The Efficiency of Competitive Markets Economic Surplus and Economic Efficiency Economic efficiency A market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production, and where the sum of consumer surplus and producer surplus is at a maximum.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 13 of 27 LEARNING OBJECTIVE The Economic Effect of a Price Floor in the Wheat Market Government Intervention in the Market: Price Floors And Price Ceilings Price Floors: The Example of Agricultural Markets

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 14 of 27 Price Floors in Labor Markets: The Minimum Wage Many economists believe there are better policies than the minimum wage for raising the incomes of low- skilled workers.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 15 of 27 Government Intervention In The Market: Price Floors And Price Ceilings Price Ceilings: The Example of Rent Controls The Economic Effect of a Rent Ceiling Dont Confuse Scarcity with a Shortage.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 16 of 27 Government Intervention In The Market: Price Floors And Price Ceilings Black Markets Black markets Buying and selling at prices that violate government price regulations.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 17 of 27 Whats the Economic Effect of a Black Market for Apartments? LEARNING OBJECTIVE 3

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 18 of 27 Does Holiday Gift Giving Have a Deadweight Loss? Caution: Gift giving may lead to deadweight loss.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 19 of 27 Government Intervention In The Market: Price Floors And Price Ceilings The Results of Government Intervention: Winners, Losers, and Inefficiency When the government imposes price floors or price ceilings, three important results occur: Some people win. Some people lose. There is a loss of economic efficiency. 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 make up for the losses to the losers and for the decline in economic efficiency is a matter of judgment and not strictly an economic question.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 20 of 27 The Economic Impact of Taxes LEARNING OBJECTIVE 4 The Effect of Taxes on Economic Efficiency The Effect of a Tax on the Market for Cigarettes

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 21 of 27 The Economic Impact of Taxes 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.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 22 of 27 The Economic Impact of Taxes Tax Incidence: Who Actually Pays a Tax? The Incidence of a Tax on Gasoline DETERMINING TAX INCIDENCE ON A DEMAND AND SUPPLY GRAPH

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 23 of 27 When Do Consumers Pay All of a Sales Tax Increase? LEARNING OBJECTIVE 4

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 24 of 27 The Economic Impact Of Taxes Tax Incidence: Who Actually Pays a Tax? The Incidence of a Tax on Gasoline Paid by Buyers DOES IT MATTER WHETHER THE TAX IS ON BUYERS OR SELLERS?

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 25 of 27 Is the Burden of the Social Security Tax Really Shared Equally between Workers and Firms? How much FICA do you think this employee pays?

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 26 of 27 The Romance of Rent Control Figure 1: In (a), the elimination of rent control causes an increase from Q 1 to Q 2 in the quantity of apartments being rented. In (b) this causes the demand for currently non-rent-controlled apartments to shift to the left from D 1 to D 2. The equilibrium rent declines from $2,000 to $1,500.

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 27 of 27 Black market Consumer surplus Deadweight loss Economic efficiency Economic surplus Marginal benefit Marginal cost Price ceiling Price floor Producer surplus Tax incidence

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 28 of 27 Appendix 4A: Quantitative Demand and Supply Analysis 4A-1 Graphing Supply and Demand Equations After statistically estimating supply and demand equations, we can use the equations to draw supply and demand curves. Q D = 3,000,000 – 1,000P Q S = – 450, ,300P Q D = Q S Demand and Supply Equations

© 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick OBrien1 st ed. CHAPTER 4: Economic Efficiency, Government Price Setting, and Taxes 29 of 27 4A-2 Calculating the Economic Effect of Rent Controls CONSUMER SURPLUS PRODUCER SURPLUS DEADWEIGHT LOSS COMPETITIVE EQUILIBRIUM $1,125$865.50$0 RENT CONTROL $1,338.75$278$ Appendix 4A: Quantitative Demand and Supply Analysis Calculating Consumer Surplus and Producer Surplus