1. Efficiency and Exchange
Chapter 7
Efficiency and Exchange

2. Efficiency Pareto Efficiency Inefficiency:
No change is possible that will help some people without harming others
It is not possible to make some people better-off without harming others
Inefficiency:
It is possible to help some people without harming others

3. A market equilibrium is efficient
if price and quantity take any other than values different from the values in equilibrium, some people can be better- off by having more or less transactions without harming others
If away from equilibrium, some people can be better-off without harming others by moving toward equilibrium

4. Recall: Consumer Surplus
the net gain to an individual buyer from the purchase of a good.
the difference between the buyer’s willingness to pay and the price paid.

5. Consumer Surplus
The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price.

6. Producer Surplus the net gain to a seller from selling a good
the difference between the price received and the minimum price the producer is willing to accept

7. Producer Surplus
The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price.

8. Total Surplus
the total net gain to consumers and producers from trading in the market
the sum of the producer surplus and the consumer surplus

9. Total Surplus Pf Pc

10. Observations on Efficiency
When price is above or below the equilibrium, the quantity exchanged will be below the equilibrium.
The vertical value on the demand curve (marginal benefit) is greater than the vertical value on the supply curve (MC).
Only the equilibrium will maximize economic surplus.

11. Economic Surplus in an Unregulated Market for Home Heating Oil
Producer surplus = $900/day
Consumer surplus = $900/day
Figure 7.4, P. 196
2.00 D S
1.80
1.60
1.40
1.20
1.00
Without price controls:
Equilibrium Price = $1.40
Consumer surplus = (1/2)(3,000)(.60) = $900/day
Producer surplus = (1/2)(3,000)(.6) = 900/day
Economic surplus = $1,800/day
Price ($/gallon)
.80 1 2 3 4 5 8
Quantity (1,000s of gallons/day)

12. The Waste Caused by Price Controls
Price Ceiling set at $1.00 S
2.00
Consumer surplus = $900/day
1.80
Lost economic surplus = $800/day
1.60
1.40
1.20
1.00
Producer surplus = $100/day D
Price ($/gallon)
.80
With price controls:
Producer surplus = (1/2)(1,000)(.20) = $100/day or a loss of $800/day
Economic surplus = $1,000 or a loss of $800/day
Figure 7.5, P. 197 1 2 3 4 5 8
Quantity (1,000s of gallons/day)

13. The Reduction in Economic Surplus from a Subsidy
The cost of the tax = $6 million
The benefit of the subsidy = $5 million
Loss of economic surplus = $1 million
5.00
Consumer surplus = $9,000/month
Reduction in total economic surplus = $1,000,000/month
Domestic price with subsidy
4.00
Price of bread ($/loaf) D S
3.00
World price = $
2.00
1.00
Figure 7.8, P.200 2 4 6 8
Quantity (millions of loaves/month

14. Market Equilibrium and Efficiency
Markets will be efficient when:
Buyers and sellers are well informed.
Markets are perfectly competitive.
Supply measures all relevant costs.
Demand measures all relevant benefits.
Government intervention needed when market failure

15. Market Equilibrium and Efficiency
What do you think?
Is efficiency the only goal?
Why should efficiency be the first goal?

16. The Effect of a Tax on the Equilibrium Quantity and Price of Avocados3
Without a tax P = $3/lb
and Q = 3 million lbs/month
2.50
3.50
S + tax
2.5
With a tax of $1/lb
MC increases by $1/lb
Supply shifts up by $1
P = $3.50; Q = 2.5 million
Consumers and producers share the burden of the tax equally
Producers receive $2.50/lb
Consumers pay $3.50/lb 6 5 4
Price ($/pound) 2 1 1 2 3 4 5
Quantity (millions of pounds/month)

17. Quantity (millions of cars/month)
The Effect of a Tax on Sellers of a Good with Infinite Price Elasticity of Supply
Assume a tax levy of $100 tax/car D S
2.0
$20,000
1.9
S + $100
$20,100
Supply shifts to $20,100
The burden of the tax falls entirely on the consumer
Price ($/car)
Quantity (millions of cars/month)

18. Taxes and Efficiency Who Pays a Tax?
When supply is perfectly elastic, the tax burden will fall entirely on the consumer.

19. The Market for Avocados Without Taxes
Total economic surplus = $9 million/month
How a tax collected for a seller affects economic surplus 6 5 4
Price ($/pound) 3 2 1 1 2 3 4 5
Quantity (millions of pounds/month)

20. The Effect of a $1 per Pound Tax on Avocados6
Quantity (millions of pounds/month)
Price ($/pound) 1 2 3 4 5
2.50
3.50
S + tax
2.5 D S
How a tax collected from a seller affects economic surplus

21. Taxes and Efficiency Deadweight Loss
The reduction in total economic surplus that results from the adoption of a policy

22. The Deadweight Loss Caused by a Tax
2.50
3.50
S + tax
2.5
Deadweight loss caused by tax S 6 5 4
Price ($/pound) 3 2 1 D 1 2 3 4 5
Quantity (millions of pounds/month)

23. Elasticity of Demand and the Deadweight Loss from a Tax21
2.60
1.60
S + T 19
2.40
1.40
Deadweight loss D1 S 24
2.00 D2
Price ($/unit)
Price ($/unit)
Quantity (units/day)
Quantity (units/day)
The greater the elasticity of demand, the
greater the deadweight loss from a tax

24. Elasticity of Supply and the Deadweight Loss from a Tax57
2.65
1.65
S1 + T 63
2.35
1.35
S2 + T
Deadweight Loss D S1 72
2.00 S2
Price ($/unit)
Price ($/unit)
Quantity (units/day)
Quantity (units/day)
The greater the elasticity of supply, the
greater the deadweight loss from a tax

25. Taxes and Efficiency What do you think?
Why would a tax on land be efficient?
Would a tax on pollution increase economic surplus?