1. ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 5: Efficiency and Exchange

2. ©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Define and calculate consumer and producer surplus 2.Define efficiency 3.Analyze how surplus and efficiency are affected by policies 4.Explain the role of efficiency in deciding the "right" price for public services 5.Examine the ways taxes affect efficiency

3. ©2012 The McGraw-Hill Companies, All Rights Reserved 3 Free Markets It is common to describe the free enterprise system as “the greatest engine of progress mankind has ever witnessed” or as “a rising tide that will lift all boats.” Raising traffic fines in Morocco ought to reduce reckless driving. Instead, it made corruption more rampant and had no noticeable effect on reckless driving. Conclusion: In many instances, free markets should be supplemented with political coordination.

4. ©2012 The McGraw-Hill Companies, All Rights Reserved 4 Role of the Market Market allocation of resources  Often maximizes efficiency  Not right for all objectives  Corruption  Income distribution  Unintended consequences of government policies  Public utilities  Taxes

5. ©2012 The McGraw-Hill Companies, All Rights Reserved 5 Market Equilibrium and Efficiency Economic efficiency exists when no change could be made to benefit one party without harming the other  Sometimes called Pareto efficiency  An outcome is more efficient if at least one person is made better off and nobody is made worse off  Different from engineering efficiency  Maximizes the amount of work done while minimizing the resources used Market equilibrium price and quantity are efficient Prices above or below equilibrium are not

6. ©2012 The McGraw-Hill Companies, All Rights Reserved 6 Trade-Offs EfficiencyEquity Maximum Total Surplus Fairness

7. ©2012 The McGraw-Hill Companies, All Rights Reserved 7 Consumer and Producer Surplus In economics, we assume that all exchange is purely voluntary  In other terms, a transaction cannot take place unless the consumer’s reservation price exceeds the producer’s reservation price Consumer surplus (CS)  Difference between the buyer’s reservation price and the price he or she actually pays  Usually the area below the demand curve and above the market price

8. ©2012 The McGraw-Hill Companies, All Rights Reserved 8 Consumer and Producer Surplus In economics, we assume that all exchange is purely voluntary Producer surplus (PS)  Difference between the price received by the seller and his or her reservation price  Usually the area above the suppler and below the market price Total economic surplus = CS + PS  Difference between the buyer’s reservation price and the seller’s reservation price

9. ©2012 The McGraw-Hill Companies, All Rights Reserved 9 Consumer Surplus Consumer's surplus is the difference between the buyer's reservation price and the market price With multiple buyers  Find the consumer surplus for each buyer  Add up the individual surpluses

10. ©2012 The McGraw-Hill Companies, All Rights Reserved 10 Consumer Surplus on a Graph  When a product is sold in whole units, the demand curve is a stair-step function  Many goods are indivisible: movie tickets and TVs  If the market supplied only one unit, the maximum price would be $11  For the second unit, the price is $10, and so on  The last buyer gets no consumer surplus D Units/day Price ($/ unit) 1 2 3 4 5 6 7 8 9 10 11 12 24681012

11. ©2012 The McGraw-Hill Companies, All Rights Reserved 11 Consumer Surplus on a Graph  Market price is $6 for all sales  Total consumer surplus  The first sale generates $5 of consumer surplus Reservation price of $11 minus the price of $6  Selling the second unit has $4 of consumer surplus, and so on  Total consumer surplus is the area under the demand curve and above market price D Units/day Price ($/ unit) 1 2 3 4 5 6 7 8 9 10 11 12 24681012

12. ©2012 The McGraw-Hill Companies, All Rights Reserved 12 Consumer Surplus for Milk  Consider the market demand and supply of milk  The equilibrium price is $2 per liter  The equilibrium quantity is 4,000 liters per day  Last customer pays his reservation price and gets no consumer surplus Quantity (000s of l/day) Price ($/liter)1 1.00 2.00 3.00 23456 S D

13. ©2012 The McGraw-Hill Companies, All Rights Reserved 13 Consumer Surplus for Milk  Price is $2 and quantity is 4,000 liters per day  Consumer surplus is the area of the triangle between  Horizontal intercept of demand  Market price  Market quantity  Remember: area of a right triangle is ½ width times height  The area is ½ ($1)(4,000 l) = $2,000 Quantity (000s of l/day) Price ($/liter)1 1.00 2.00 3.00 23456 S D Consumer Surplus

14. ©2012 The McGraw-Hill Companies, All Rights Reserved 14 Producer Surplus Producer surplus is the difference between the market price and the seller's reservation price  Reservation price is on the supply curve Producer surplus is the area above the supply curve and below the market price

15. ©2012 The McGraw-Hill Companies, All Rights Reserved 15 Socially Optimal Quantity When do we have a socially optimal quantity?  When the total surplus is maximized  Keep expanding until marginal benefit = marginal cost Economic efficiency  Occurs when all goods and services are produced and consumed at their respective socially optimal levels Equilibrium principle A market in equilibrium is Pareto efficient since no reallocation is possible that will benefit some people without harming others

16. ©2012 The McGraw-Hill Companies, All Rights Reserved 16 Market Equilibrium and Efficiency  Economic efficiency exists when no change could be made to benefit one party without harming the other  Sometimes called Pareto efficiency  Different from engineering efficiency  Equilibrium price and quantity are efficient  Prices above or below equilibrium are not

17. ©2012 The McGraw-Hill Companies, All Rights Reserved 17 Price Below Equilibrium Suppose milk is $1 per liter 2.50 Quantity (1,000s of liters/day) Price ($/liter) 12345 2.00 1.50 1.00 0.50 D S

18. ©2012 The McGraw-Hill Companies, All Rights Reserved 18 Price Below Equilibrium A buyer offers $1.25 2.50 Quantity (1,000s of liters/day) Price ($/liter) 12345 2.00 1.50 1.00 0.50 D S 1.25

19. ©2012 The McGraw-Hill Companies, All Rights Reserved 19 Price above Equilibrium 2.50 Quantity (1,000s of liters/day) Price ($/liter) 12345 2.00 1.50 1.00 0.50 D S 1.75 Only equilibrium price is efficient

20. ©2012 The McGraw-Hill Companies, All Rights Reserved 20 Efficiency Efficiency is not the only goal  Was Dubai’s decision to impose a ceiling on (annual) rental price increases to 7 percent motivated by economic efficiency goals or social justice? Efficiency should be the first goal  Efficiency enables us to achieve all our other goals to the fullest possible extent

21. ©2012 The McGraw-Hill Companies, All Rights Reserved 21 Trade-Offs EfficiencyEquity Fairness Basic Needs Maximum Total Surplus

22. ©2012 The McGraw-Hill Companies, All Rights Reserved 22 Cement Market D S 2.00 Quantity (1,000s of kg/day) Price ($/kg)12345 1.60 1.20 1.00.80 1.80 1.40 8 Producer surplus = $900/day Consumer surplus = $900/day

23. ©2012 The McGraw-Hill Companies, All Rights Reserved 23 Price Ceiling on Cement D S 2.00 Quantity (1,000s of kg/day) Price ($/kg) 12345 1.60 1.20 1.00 0.80 1.80 1.40 8 Lost surplus = $800/ day Consumer surplus = $900/ day Producer surplus = $100/ day

24. ©2012 The McGraw-Hill Companies, All Rights Reserved 24 Cement Story Price ceilings reduce total economic surplus  Their defenders argue that they help small builders to buy cement at affordable prices The same goal could have been achieved through a cheaper method, say: give the smaller builders more income to buy cement  income transfers Would cement builders be willing to pay taxes to generate the extra income to be transferred?  Yes since with a price ceiling they are losing $800 What potential consequence might arise from using income transfers?

25. ©2012 The McGraw-Hill Companies, All Rights Reserved 25 Alternative Cement Policy L S L S Surplus with Price Controls Surplus with Income Transfers Only L = Large builders S = Small builders L = Large builders S = Small builders

26. ©2012 The McGraw-Hill Companies, All Rights Reserved 26 Price Subsidy for Bread: The Case of Egypt Imported bread costs $2  Perfectly elastic supply  Because it is a small country so it takes the world’s price for bread as given and fixed Government program to subsidize bread  Government imports bread for $2  Government sells bread for $1  Results More bread Less efficiency

27. ©2012 The McGraw-Hill Companies, All Rights Reserved 27 Price Subsidies for Bread Quantity (millions of loaves/month) 246 $3.00 $1.00 $4.00 8 $2.00 D S Price ($/loaf) Consumer Surplus = $4 m/month Consumer Surplus = $9 m/month BUT… S with subsidy

28. ©2012 The McGraw-Hill Companies, All Rights Reserved 28 The Cost of the Subsidy The bread subsidy appears to increase consumer surplus from $4 million to $9 million BUT …  The government loses $1 on every loaf  Imports 6 million loaves for $2 per loaf  Government losses are $6 million The net benefit of the subsidy program  Even though consumer surplus is larger than before  The net effect of the subsidy program is $5 - $6 which is a reduction in the total economic surplus by $1

29. ©2012 The McGraw-Hill Companies, All Rights Reserved 29 Price Subsidies for Bread Quantity (millions of loaves/month) 246 $3.00 $1.00 $4.00 8 $2.00 D S Price ($/loaf) Consumer Surplus S with subsidy Government Losses Total Surplus Lost = $1 m/month

30. ©2012 The McGraw-Hill Companies, All Rights Reserved 30 First-Come, First-Served A non-market way of allocating scarce goods  Low income students seats for sporting events  They can buy tickets at lower prices following first come first served  Airline seats  Historically, airlines overbook their flights because many passengers do not make the flights However, in many cases everyone shows up at the gate. How do airlines solve this issue?

31. ©2012 The McGraw-Hill Companies, All Rights Reserved 31 Overbooked Airplane In general, airlines board passengers on a first come first serve basis  However, those who show up late end up missing their flights and typically complain about getting a later flight  Solution?  The price mechanism used is time spent waiting People who wait generally have lower opportunity cost of time People with high opportunity cost would pay to move up in the line

32. ©2012 The McGraw-Hill Companies, All Rights Reserved 32 Overbooked Airplane: Example 33 seats, 37 reservations  Highest willingness to pay to get on the flight is $60 and then $59 and so on… until $24  Actual amounts range from $60 to $24  Average willingness to pay to get on the plane is $42  ($60 + $59 + $58 + … + $24)/37 = $42 The last 4 people arriving are bumped  Total consumer surplus lost: ($42) (4) = $168

33. ©2012 The McGraw-Hill Companies, All Rights Reserved 33 Over-Booked Airplane: Example With compensation many people volunteer  However, it is safe to assume that people with the lowest willingness to pay would volunteer so that means those from $24 to $27  Value they place on taking that flight ($24 to $27)  Total consumer surplus lost: $102 The change to compensation approach rather than first come first served creates a surplus of $66

34. ©2012 The McGraw-Hill Companies, All Rights Reserved 34 Public Services So far, we looked at private markets where the most efficient point is at equilibrium  gives the highest total economic surplus What if the government is producing a service or a good?  Local governments typically supply water  Its goal is to maximize total surplus What price should be charged?  Value of the last unit to the last buyer should be equal to the marginal cost of supplying the water Charge is 4 cents

35. ©2012 The McGraw-Hill Companies, All Rights Reserved 35 Water in Egypt with 3 potential sources Water supplied (millions of liters/day) Cost (cents/liter) 4.0 0.8 0.2 13 Spring Nile Sea Sea 4 If P = 4.0¢, Q D = 4

36. ©2012 The McGraw-Hill Companies, All Rights Reserved 36 Taxes on Sellers Tax program  Seller reports sales in units to government  Seller pays a fixed dollar amount per unit sold A tax on the seller shifts the supply curve up by the amount of the tax  Vertical interpretation of the supply curve  For each level of output, seller charges his marginal cost PLUS the tax

37. ©2012 The McGraw-Hill Companies, All Rights Reserved 37 Tax on Potato Sellers S + tax 2.50 3.50 2.5 6 Quantity (millions of kg/month) Price ($/kg) 12345 5 4 2 1 D S 3

38. ©2012 The McGraw-Hill Companies, All Rights Reserved 38 Taxes and Perfectly Elastic Supply Quantity (millions of cars/month) Price ($/car) D S 2.0 $20,000 1.9 S + $100 $20,100 If supply is perfectly elastic, buyers pay all of the tax

39. ©2012 The McGraw-Hill Companies, All Rights Reserved 39 Taxes and Total Surplus We know that taxes lead to  Lower equilibrium quantity  Higher equilibrium price What happens to total economic surplus?  How do taxes affect total surplus?

40. ©2012 The McGraw-Hill Companies, All Rights Reserved 40 Tax on Potato Sellers Before Tax  Consumer surplus = $4.5 M  Producer surplus = $4.5 M  Total surplus =$9M After Tax  Consumer surplus = $3.125 M  Producer surplus = $3.125 M  Total surplus = $6.25 M  Loss = $2.75 M

41. ©2012 The McGraw-Hill Companies, All Rights Reserved 41 Total Surplus Lost Tax revenue is $2.5 million = $1 * 2.5 million  If the government has a specific revenue target, then by adding an extra $2.5 million from taxes on potatoes it can decrease other taxes  If other taxes go down by $2.5 million, this is not a large loss then since the  Net loss becomes $0.25 million Deadweight loss is the reduction in total economic surplus that results form the adoption of a policy  The net loss equaling $0.25 million

42. ©2012 The McGraw-Hill Companies, All Rights Reserved 42 Tax on Potato Sellers S + tax 2.50 3.50 2.5 6 Quantity (millions of kg/month) Price ($/kg) 12345 5 4 2 1 D S 3 Tax revenue Deadweight Loss Total surplus after tax Total surplus before tax

43. ©2012 The McGraw-Hill Companies, All Rights Reserved 43 Taxes and Price Elasticity of Demand Potato tax was shared equally  Buyers paid $0.50 more  Sellers received $0.50 less The amount of the tax paid by buyers and sellers depends on the price elasticity of demand  Implications for deadweight loss of the tax

44. ©2012 The McGraw-Hill Companies, All Rights Reserved 44 Taxes and Price Elasticity of Demand Q P 19 2.40 1.40 S + T D1 S 24 2.00 More Elastic DemandLess Elastic Demand 2.60 1.60 2.00 21 S + T Q D2 S 24 P Consumers pay a smaller share of the tax when demand is more elastic

45. ©2012 The McGraw-Hill Companies, All Rights Reserved 45 Taxes and Deadweight Loss More Elastic DemandLess Elastic Demand Deadweight loss is larger when demand is relatively elastic Q P 19 2.40 1.40 S + T D1 S 24 2.00 Deadweight loss 2.60 1.60 2.00 21 S + T Q D2 S 24 P Deadweight loss

46. ©2012 The McGraw-Hill Companies, All Rights Reserved 46 Efficiency and Exchange Economic Efficiency Market Equilibrium Equity Price Ceilings Subsidies First Come, First Served First Come, First Served Deadweight Loss Shifting the Tax Elasticity Public Services Taxes on Sellers