Chapter 5 Efficiency & Equity Does the market achieve an efficient and fair use of resources? Dr Ikhlaas Gurrib 1

P Q 6 D 5 Amount paid Consumer Surplus Consumer surplus is the area below the demand curve and above the market price. P Amount paid 6 D 5 Q

Total Benefits P Total benefits = Consumer surplus + Amount paid 6 D 5 Q

How a change in Price affects consumer surplus Supply Initial consumer surplus C P1 B Demand Q1 Q2 Quantity

How a change in Price affects consumer surplus Supply S Initial consumer surplus Increase in consumer surplus C P1 B P2 E D Demand Q1 Q2 Quantity

Supply & Producer Surplus 6 Cost of production = $20 5 Q

How a change in price affects producer surplus Supply B P1 C Initial producer surplus Demand A Q1 Q2 Quantity

How a change in price affects producer surplus Supply P2 B P1 C Initial producer surplus D Demand A Q1 Q2 Quantity

How a change in price affects producer surplus Increase in producer surplus Supply D E P2 F B P1 C Initial producer surplus D Demand A Q1 Q2 Quantity

Economic well-being and total surplus = Consumer Surplus Producer Surplus + or Total Surplus = Total Benefits _ Total Costs

Total Surplus Price Supply Equilibrium price Demand Quantity Equilibrium quantity Quantity

Total Surplus Consumer Surplus Producer Surplus Price Supply Equilibrium price Producer Surplus Demand Equilibrium quantity Quantity

Sources of Inefficiency Deadweight Loss The decrease in total surplus that results from an inefficient allocation of resources 51

Under & Overproduction Price Deadweight loss Supply underproduction overproduction Demand Qe Quantity 8

Review Gayle decides that she would pay as much as $3000 for a new laptop computer. She buys the computer and realises a consumer surplus of $700. How much did Gayle pay for her computer? A. $700 B. $2300 C. $3000 D. $3700

Review Michele is willing to pay $20 to see Legally Blonde for the fourth time. She finds a theatre showing Legally Blonde for $5. Michele’s consumer surplus is: A. $5. B. $15. C. $20. D. $25.

Review The Health Ministry announces that eating chocolate improves your health. As a result, the equilibrium market price of chocolate __________, and producer surplus ___________. A. increases, increases B. increases, decreases C. decreases, decreases D. decreases, increases

Chapter 6 Markets in Action The effects of price restrictions quantity restrictions taxes 1

Price Controls These are price restrictions imposed on a market Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and price floors. 3 3

Price Ceilings & Price Floors A legally established maximum price at which a good can be sold. Price Floor A legally established minimum price at which a good can be sold. 4 4

Housing Markets and Rent Ceilings Imagine that a tropical cyclone destroys much of the city’s homes How would the housing market cope with such a devastating reduction in the supply of housing?

A Housing Market After a Cyclone After the cyclone SSA 900 SS 700 Should rents be capped at $500? Rent (dollars per unit per month) 500 D 0 20 30 40 60 Quantity (thousands of units per month)

Housing Markets and Rent Ceilings When a price ceiling is applied to a housing market, it is called a rent ceiling. If the rent ceiling is set above the equilibrium rent, it has no effect. But if the rent ceiling is set below the equilibrium rent, it has powerful effects.

A Rent Ceiling SSA Rent ceiling D Rent (dollars per unit per month) 900 700 Rent (dollars per unit per month) 500 Housing shortage D 0 20 30 40 Quantity (thousands of units per month)

Housing Markets and Rent Ceilings The time spent looking for someone with whom to do business is called search activity. When a price is regulated and there is a shortage, search activity increases. Search activity is costly. It uses time and other resources

A Rent Ceiling Maximum black market rent SSA Rent ceiling D 900 700 Rent (dollars per unit per month) 500 Housing shortage D 0 20 30 40 Quantity (thousands of units per month)

A Rent Ceiling Deadweight loss SSA D Rent (dollars per unit per month) 900 Consumer Surplus 700 Rent (dollars per unit per month) Producer Surplus Rent Ceiling 500 D 0 20 30 40 Quantity (thousands of units per month)

Minimum Wage and Unemployment 6 SS Unemployment Wage Rate (dollars per hour) 5 Minimum wage 4 3 DA 20 21 22 23 Quantity (millions of hours per year) 38

Other Price Floors Price floors are common in agricultural markets e.g. minimum wool price Price floors create surpluses because QS > QD. Taxpayers fund the purchase of the surplus output Price floors are also inefficient (they create a deadweight loss) and unfair Dr Ikhlaas Gurrib 15 25

A Price Floor – Wool If government buys surplus Cost to taxpayers Supply Minimum price surplus Price floor Cost to taxpayers Equilibrium price Demand Qd Qs Quantity 8 23

Taxes Governments levy taxes on goods and services to raise revenue for public purposes. Taxes discourage market activity. When a good is taxed, the quantity sold is smaller; the price is higher A tax creates a wedge between buyer and seller 20 29

Taxes Tax incidence is the study of who bears the burden of a tax. Taxes result in a change in the market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on. 21 31

Taxes Taxes can be levied on buyers or sellers A tax on sellers will decrease supply A tax on buyers will decrease demand Example: The govt wants to impose a new tax on chewing gum (Tax = $1.50) Should the tax be imposed on buyers or sellers? 21 31

A Tax on Sellers S + tax on sellers 5.00 4.00 3.00 2.50 2.00 1.00 Price paid by buyers $1.50 tax S Price with no tax A tax on sellers shifts the S curve upward by the amount of the tax Price (dollars per packet) Price received by sellers D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

A Tax on Buyers A tax on buyers shifts the D curve downward 5.00 4.00 3.00 2.50 2.00 1.50 1.00 Price paid by buyers S D - tax on buyers Price with no tax A tax on buyers shifts the D curve downward by the size of the tax $1.50 tax Price (dollars per packet) Price received by sellers D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

The Incidence of Tax In what proportions is the burden of the tax divided? Who pays more of the tax – the buyer or the seller? It depends . . . on the elasticity of demand and supply Dr Ikhlaas Gurrib 29 39

A Tax on Sellers – Inelastic D S + tax on sellers 5.00 4.00 3.00 2.00 1.00 S B The tax burden on the buyer is ___ The tax burden on the seller is ___ D is more ______ compared to S S 2.50 Price (dollars per packet) D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

A Tax on Sellers – Elastic D 5.00 4.00 3.00 2.00 1.00 S + tax on sellers S 3.50 The tax burden on the buyer is ___ The tax burden on the seller is ___ D is more ______ compared to S B S Price (dollars per packet) D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

The Incidence of Tax Who pays more of the tax – the buyer or the seller? The incidence of a tax will fall more on the buyer when demand is more ____Inelastic____ compared to supply The incidence of a tax will fall more on the seller when demand is more ____Elastic____ compared to supply 29 39

Tax Revenue & Elasticity S + tax on sellers 5.00 4.00 3.00 2.00 1.00 S Tax Revenue $ = size of T x Q 2.50 Price (dollars per packet) De Di 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

Taxes and Efficiency What about the efficiency of a tax? How does a tax affect consumer & producer surplus? Will total surplus increase or decrease? Taxes increase the price paid by consumers, decrease the price received by sellers & decrease quantity sold

After a tax, consumers will pay more and consume less Taxes and Efficiency After a tax, consumers will pay more and consume less Consumer surplus will decrease

A Tax on Sellers – Inelastic D S + tax on sellers 5.00 4.00 3.00 2.00 1.00 S Consumer surplus decreases 2.50 Price (dollars per packet) D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

After a tax, producers will receive less and sell less Taxes and Efficiency After a tax, producers will receive less and sell less Producer surplus will decrease

A Tax on Sellers – Inelastic D S + tax on sellers 5.00 4.00 3.00 2.00 1.00 S 2.50 Price (dollars per packet) Producer surplus decreases D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

A Tax on Sellers – Inelastic D S + tax on sellers 5.00 4.00 3.00 2.00 1.00 S Deadweight loss 2.50 Price (dollars per packet) Tax revenue D 50 75 100 125 150 175 200 225 Quantity (millions of packets per year)

Determinants of Deadweight Loss The magnitude of the deadweight loss depends on the decline in market size as a result of the tax. That, in turn, depends on the price elasticities of supply and demand.

Determinants of Deadweight Loss The more elastic are demand and supply, the larger will be the decline in equilibrium quantity and the larger the deadweight loss.

In panel (a), the deadweight-loss triangle is large because demand is relatively elastic. In panel (b), the deadweight-loss triangle is much smaller because demand is now relatively inelastic.

Assume tax revenue = $1 mill. while welfare loss = $ 0.1 mill Should we have taxes? Assume tax revenue = $1 mill. while welfare loss = $ 0.1 mill The tax is beneficial if tax $ are spent to generate more than $1.1 million in benefits to the community Does this always happen?

What goods should we tax? Objective should be to Taxes What goods should we tax? Objective should be to MAXIMISE TAX REVENUE and MINIMISE the DEADWEIGHT LOSS Therefore tax goods that are relatively INELASTIC

Review Would a consumer prefer a tax to be placed on goods with elastic demand or inelastic demand? Elastic D Why? Consumer surplus would decrease most when a tax is placed on a good with INELASTIC demand

Review A price ceiling set below equilibrium will cause greater shortages if a. both supply and demand are inelastic. b. both supply and demand are elastic. c. supply is elastic, but demand is inelastic. d. supply is inelastic, but demand is elastic.

A price floor set below the equilibrium price causes a. shortages. Review A price floor set below the equilibrium price causes a. shortages. b. surpluses. c. excess supply. d. none of the above.

Review If the tax on cigarettes is increased by $1.00 per packet we should expect a. the consumer to pay more of the tax the more elastic the demand for cigarettes. b. the equilibrium price to be $1.00 higher if demand is perfectly elastic. c. government revenue from the tax to increase if cigarette demand is relatively inelastic. d. the suppliers to pay all of the tax if demand is completely inelastic.

Review Assume that a tax is levied on a good and the government uses the funds to build statues of Kevin Rudd. In this case there would be: A. a decrease in consumer surplus to consumers of the taxed good. B. a decrease in producer surplus to producers of the taxed good. C. a probable decrease in the welfare of society that exceeded the deadweight economic loss from the tax. D. All of the above would occur.