1. Efficiency of Markets1 EFFICIENCY OF MARKETS ECO 2023 Principles of Microeconomics Dr. McCaleb

2. Efficiency of Markets2 I.Consumer and Producer Surplus II.Efficiency of Competitive Markets III.Markets, Prices, and Efficiency IV.Prices and Markets V.Tax Incidence TOPIC OUTLINE

3. Efficiency of Markets3 Consumer and Producer Surplus

4. Efficiency of Markets4  Consumer Surplus Definition Consumer surplus is the difference between consumers’ marginal benefit, measured by their willingness to pay for a good, and the price they actually pay. Consumer Surplus=MB-P Consumer surplus is the difference between what consumers gain from having the good and what they must give up to get it, a measure of how much better off they are from having the good. CONSUMER AND PRODUCER SURPLUS

5. Efficiency of Markets5 The vertical distance to the demand curve shows the marginal benefit, measured by the maximum price the buyer would be willing to pay for each unit of the good. Consumer surplus is the difference between this MB and the P. In the diagram, consumer surplus is the green triangle, the area below the demand curve and above the price. It equals $10. Consumer Surplus: Illustration CONSUMER AND PRODUCER SURPLUS

6. Efficiency of Markets6 CONSUMER AND PRODUCER SURPLUS  Producer Surplus Definition Producer surplus is the difference between the price actually received by sellers for a unit of the good and the minimum price they at which they would be willing to sell it. The minimum price at which they would be willing to sell equals the marginal cost. Producer Surplus=P-MC Producer surplus is the difference between what the sellers’ gain from selling the good and their opportunity cost. Their opportunity cost is what they would gain if they used their resources to produce or sell the next best alternative good.

7. Efficiency of Markets7 CONSUMER AND PRODUCER SURPLUS The vertical distance to the supply curve shows the marginal cost, equal to the minimum price sellers are willing to accept for the good. Producer surplus is the difference between the P and this MC. Producer Surplus: Illustration In the diagram, producer surplus is the blue triangle, the area below the price and above the supply curve. It equals $400.

8. Efficiency of Markets8 Consumer surplus is measured by the area 1.between the demand curve and the supply curve. 2.between the MB curve and the MC curve. 3.between the MB curve and the price line. 4.under the supply curve 5.between the price line and the MC curve. 6.above the demand curve.

9. Efficiency of Markets9 True (T) or false (F): Producer surplus is the difference between what the sellers’ gain from selling the good and their opportunity cost.

10. Efficiency of Markets10 Efficiency of Competitive Markets

11. Efficiency of Markets11  Economic Efficiency Definition A situation in which the quantities of goods and services produced are those that people value most highly. Resource use is efficient when we cannot have more of one good without giving up some of another good that has greater value. Economic efficiency occurs where marginal benefit equals marginal cost. Efficient quantity: Where MB=MC EFFICIENCY OF COMPETITIVE MARKETS

12. Efficiency of Markets12 The Efficient Quantity If the marginal benefit of the current quantity exceeds the marginal cost (as at 5), the efficient quantity is greater than the current quantity. If the marginal cost of the current quantity exceeds the marginal benefit (as at 15), the efficient quantity is smaller than the current quantity. When marginal benefit equals marginal cost (as at 10), the quantity is efficient. EFFICIENCY OF COMPETITIVE MARKETS

13. Efficiency of Markets13  Market Equilibrium Definition A situation in which neither buyers nor sellers have any incentive to change their behavior. Market prices adjust up or down to bring about an equilibrium. At equilibrium, there are no forces causing either quantity or price to change. Market equilibrium occurs when quantity demanded=quantity supplied: Equilibrium Q: Where Q D =Q S EFFICIENCY OF COMPETITIVE MARKETS

14. Efficiency of Markets14  Efficiency of Competitive Equilibrium Fundamental Principle: Equilibrium in a competitive market is efficient The equilibrium quantity in any market is the quantity at which quantity demanded=quantity supplied. The efficient quantity is the quantity where marginal benefit equals marginal cost. But demand shows consumers’ marginal benefit and supply shows sellers’ marginal cost. Therefore, in a competitive market, the equilibrium quantity is the same as the efficient quantity. EFFICIENCY OF COMPETITIVE MARKETS

15. Efficiency of Markets15 At the efficient quantity, the sum of consumer surplus and producer surplus is greater than at any other quantity. The efficient quantity maximizes the sum of consumer and producer surplus. The equilibrium quantity is the efficient quantity because at this quantity marginal benefit equals marginal cost. An Efficient Pizza Market The equilibrium price is $10 and the equilibrium quantity is 10,000 pizzas per day. EFFICIENCY OF COMPETITIVE MARKETS

16. Efficiency of Markets16  When A Market Is Inefficient Deadweight loss from underproduction or overproduction If the quantity of a good is either less than the efficient quantity (underproduction) or greater than the efficient quantity (overproduction), consumer and producer surplus are not maximized. We say that there is a deadweight loss. The deadweight loss is the reduction in the sum of consumer and producer surplus that results when the quantity is inefficient. It is a net social loss. EFFICIENCY OF COMPETITIVE MARKETS

17. Efficiency of Markets17  When A Market Is Inefficient Sources of market inefficiency Taxes and subsidies Regulated prices and quantities (price ceilings, price floors, quotas) Positive and negative externalities Monopoly and other limits to competition EFFICIENCY OF COMPETITIVE MARKETS

18. Efficiency of Markets18 The competitive equilibrium quantity is defined as the quantity at which 1.Demand equals supply 2.Quantity demanded equals quantity supplied 3.Marginal benefit equals marginal cost 4.Price equals quantity

19. Efficiency of Markets19 The efficient quantity is defined as the quantity at which 1.Demand equals supply 2.Quantity demanded equals quantity supplied 3.Marginal benefit equals marginal cost 4.Price equals quantity

20. Efficiency of Markets20 True (T) or false (F): The demand curve shows the buyers’ marginal benefit.The supply curve shows the sellers’ marginal cost. Therefore, at the competitive equilibrium quantity demanded equals quantity supplied, marginal benefit also equals marginal cost, and the equilibrium quantity is also the efficient quantity.

21. Efficiency of Markets21 Inefficiency of Taxes and Subsidies

22. Efficiency of Markets22 Suppose a tax is imposed on DVD recorder/players. Because of the tax, the price is so high that no one buys DVD recorder/players. Instead, they buy only VCR’s. 1.How much revenue does the tax raise? 2.Is anyone worse off because of the tax?

23. Efficiency of Markets23 INEFFICIENCY OF TAXES AND SUBSIDIES  Taxes Taxes are economically inefficient A tax places a wedge between buyers’ marginal benefit and sellers’ marginal cost. Because of the tax, at the equilibrium quantity MB>MC. The equilibrium quantity of a taxed good is less than the efficient quantity. The good is underproduced. There is a loss in consumer and producer surplus. This is the deadweight loss or excess burden of a tax.

24. Efficiency of Markets24 A $10 tax shifts the supply curve to S + tax. The equilibrium quantity is now 2000 instead of 5000. At the new equilibrium, MB>MC. Consumer surplus and producer surplus are less than without the tax. The loss in the sum of consumer and producer surplus is the deadweight loss or excess burden of the tax. Inefficiency of a Tax INEFFICIENCY OF TAXES AND SUBSIDIES

25. Efficiency of Markets25  Subsidies Subsidies are economically inefficient Subsidies are essentially negative taxes. Like a tax, a subsidy places a wedge between buyers’ marginal benefit and sellers’ marginal cost, but with a subsidy, at the equilibrium quantity MB<MC. The equilibrium quantity of a subsidized good is greater than the efficient quantity. The good is overproduced. Because of the overproduction, there is a loss in consumer and producer surplus. This is the deadweight loss of the subsidy. INEFFICIENCY OF TAXES AND SUBSIDIES

26. Efficiency of Markets26 S - subsidy A $5 subsidy shifts the supply curve to S - subsidy. The equilibrium quantity is now 15,000 instead of 10,000. At the new equilibrium, MB<MC. Inefficiency of a Subsidy Consumer surplus and producer surplus are less than without the subsidy. The loss in the sum of consumer and producer surplus is the deadweight loss from the subsidy. INEFFICIENCY OF TAXES AND SUBSIDIES

27. Efficiency of Markets27 A tax is inefficient because it results in _____ and a subsidy is inefficient because it results in _____. 1.Overproduction; overproduction 2.Overproduction; underproduction 3.Underproduction; overproduction 4.Underproduction; underproduction

28. Efficiency of Markets28 Markets and Prices

29. Efficiency of Markets29 MARKETS, PRICES, AND EFFICIENCY  The Invisible Hand Principle Free markets and prices allocate resources efficiently When prices are determined by the market forces of consumer demand and producer supply, consumers get the quantity of each good or service that they value most highly and are willing to pay for. Prices provide incentives for producers to supply the efficient quantity of each good. Market determined prices ensure that the sum of consumer and producer surplus is maximized. MARKETS AND PRICES

30. Efficiency of Markets30  The Invisible Hand Principle Underproduction Prices provide incentives for producers to allocate more resources to those goods that are underproduced because they are in excess demand. The price consumers are willing to pay for additional (marginal) units is greater than the cost to produce those units. Overproduction Prices provide incentives for producers to allocate fewer resources to those goods that are overproduced because they are in excess supply. The price consumers are willing to pay for additional (marginal) units is less than the cost to produce those units. MARKETS AND PRICES

31. Efficiency of Markets31  Three Great Myths about Prices Prices ration goods to high income people. Lower prices always benefit consumers, especially low income consumers. Lower prices mean lower costs for consumers. MARKETS AND PRICES

32. Efficiency of Markets32  Three Truths about Prices Prices do not necessarily ration goods and services to high income people Having more of one good means giving up some of other goods. Prices ration goods to those who are willing to give up the most other goods. Therefore, using prices to ration a good favors those individuals who place the highest value on the good relative to other goods. High income or wealthy individuals do not always place the highest value on a good. MARKETS AND PRICES

33. Efficiency of Markets33  Three Truths about Prices Low prices do not necessarily benefit consumers People, including low income people, are not necessarily better off with lower prices. If prices are held below the market equilibrium price, the good will be underproduced creating an excess demand. A low price is of no benefit if you can’t get as much of the good as you would like or if you incur significant time and money costs searching for the good or if you have to make “side payments” such as bribes to get the good. MARKETS AND PRICES

34. Efficiency of Markets34  Three Truths about Prices Lower prices do not necessarily mean lower costs Lower prices do not necessarily mean lower opportunity costs. With prices below equilibrium, opportunity costs often increase, and may increase more for low income people than for higher income people. It is even possible that opportunity costs rise for everyone so that everyone is worse off with prices below equilibrium. MARKETS AND PRICES

35. Efficiency of Markets35 Tax Incidence

36. Efficiency of Markets36 When Oregon increased the excise tax on cigarettes, who was legally responsible for paying the tax to the government? On whom did the real economic burden of Oregon’s cigarette tax rest? Is the real economic burden of a tax always on the same economic agents?

37. Efficiency of Markets37 Who Pays the U.S. Income Tax? Share of 2001 Individual Income Tax Liabilities Income QuintileShare of TaxesShare of Income Lowest-2.3%4.2% Second3.0%9.2% Middle5.2%14.2% Fourth14.3%20.7% Highest82.5%52.4% Top 10%67.7%37.6% Top 5%55.2%27.5% Top 1%34.4%14.8% Source: U.S. Congressional Budget Office

38. Efficiency of Markets38 Who Bears How Much of the Tax Burden? 2001 Tax Shares Income Quintile All Federal Taxes Individual Income Tax Payroll Tax Corporate Income Tax Excise Taxes Lowest1.1%-2.3%4.2%0.8%11.1% Second5.0%3.0%10.3%2.1%14.6% Middle10.0%5.2%16.0%5.4%18.0% Fourth18.5%14.3%25.6%7.7%22.0% Highest65.3%82.5%43.9%82.6%33.9% Source: U.S. Congressional Budget Office

39. Efficiency of Markets39 TAX INCIDENCE  Tax Incidence Definition The division of the burden of a tax between the buyer and the seller. If the price rises by the full amount of the tax, then the burden of the tax falls entirely on the buyer. If the price doesn’t change, then the burden of the tax falls entirely on the seller. If the price rises by a lesser amount than the tax, then the burden of the tax falls partly on the buyer and partly on the seller.

40. Efficiency of Markets40  Two Types of Tax Incidence Legal incidence and economic incidence Legal incidence: Who is legally liable for payment of the tax. The legal incidence is determined by the tax law. Economic incidence: Who ultimately bears the real economic burden of the tax. The economic incidence is determined by the market forces of demand and supply. It is unrelated to the legal incidence. TAX INCIDENCE

41. Efficiency of Markets41 TAX INCIDENCE A $10 tax per CD player legally imposed on sellers of CD players shifts the supply curve to S + tax. Economic Incidence of a Tax on CD Players (1) With no tax, the price of a CD player is $100 and 5,000 CD players a week are bought.

42. Efficiency of Markets42 TAX INCIDENCE Sellers receive $95 after payment of the tax—a decrease of $5 per CD player. Economic Incidence of a Tax on CD Players (2) The equilibrium price rises to $105—an increase of $5 a CD player. The equilibrium quantity decreases to 2,000 CD players a week.

43. Efficiency of Markets43 TAX INCIDENCE The burden of the tax is split equally between the buyer and the seller—each pays $5 per CD player. Economic Incidence of a Tax on CD Players (3) The government collects tax revenue of $20,000 a week—the purple rectangle.

44. Efficiency of Markets44 Because the law specifies that sellers of cigarettes in Oregon are responsible for paying the tax to the government, the _____ incidence of the cigarette tax is on the _____. 1.Legal; buyers 2.Legal; sellers 3.Economic; buyers 4.Economic; sellers

45. Efficiency of Markets45 Because the price of cigarettes in Oregon increased by the full amount of the cigarette tax, the _____ incidence of the tax is on the _____. 1.Legal; buyers 2.Legal; sellers 3.Economic; buyers 4.Economic; sellers

46. Efficiency of Markets46  Tax Incidence and Elasticity Economic incidence depends on elasticities of demand and supply The division of the real tax burden between buyers and sellers--the economic incidence of the tax--depends on the relative price elasticities of demand and supply. If demand is more elastic (less inelastic), the price increase is smaller and the buyers bear the smaller share of the tax. If supply is more elastic (less inelastic), the price increase is larger and the buyers bear the larger share of the tax. TAX INCIDENCE

47. Efficiency of Markets47 TAX INCIDENCE Tax Incidence in a Market with Perfectly Elastic Supply—The Market for Sand A tax of 1¢ a pound increases the price by 1¢ a pound, and the buyer pays all the tax.

48. Efficiency of Markets48 TAX INCIDENCE Tax Incidence in a Market with Perfectly Inelastic Demand—The Market for Insulin A tax of 20¢ a dose raises the price by 20¢, and the buyer pays all the tax.

49. Efficiency of Markets49 TAX INCIDENCE Tax Incidence in a Market with Perfectly Elastic Demand—The Market for Pink Marker Pens A tax of 10¢ a pen lowers the price received by the seller by 10¢, and the seller pays all the tax.

50. Efficiency of Markets50 TAX INCIDENCE Tax Incidence in a Market with Perfectly Inelastic Supply—The Market for Spring Water A tax of 5¢ a bottle lowers the price received by the seller by 5¢, and the seller pays all the tax.

51. Efficiency of Markets51 The entire economic incidence of a tax is on the buyers if either demand is perfectly _____ or supply is perfectly _____. 1.Elastic; elastic 2.Elastic; inelastic 3.Inelastic; elastic 4.Inelastic; inelastic

52. Efficiency of Markets52 The entire economic incidence of a tax is on the sellers if either demand is perfectly _____ or supply is perfectly _____. 1.Elastic; elastic 2.Elastic; inelastic 3.Inelastic; elastic 4.Inelastic; inelastic

53. Efficiency of Markets53  Example 1: Incidence of the Payroll Tax Legal Incidence Social security and Medicare are financed by a payroll tax. The total tax is 15.3% of an employer’s payroll. The legal incidence of the payroll tax is divided equally between the employer and the employee. The employer pays 7.65% of each worker’s pay and the employee has 7.65% deducted from his or her pay. Who really pays the payroll tax? TAX INCIDENCE

54. Efficiency of Markets54  Example 1: Incidence of the Payroll Tax Economic Incidence Empirical evidence shows the supply of labor is very inelastic (0.1- 0.2). With a very inelastic supply, the economic incidence of a tax is mostly on the sellers. In the labor market, the workers or employees are the sellers. Therefore, no matter how the legal incidence is divided between employers and employees, the economic incidence of the payroll tax is primarily on workers. The net wage received by workers is approximately 15.3% lower than it would be if there were no payroll tax. TAX INCIDENCE

55. Efficiency of Markets55  Example 2: Incidence of Taxes on Business Legal Incidence Businesses do not pay taxes in any real economic sense. Only people pay taxes. All of a business’s revenues are derived from people (consumers) and ultimately become income to other people (employees, suppliers of other resources, owners and shareholders). Even though the legal incidence of a tax may be on business, the economic incidence must rest on people. TAX INCIDENCE

56. Efficiency of Markets56  Example 2: Incidence of Taxes on Business Economic Incidence: What Are the Possibilities? Just because the legal incidence of a tax is on business income or profits does not necessarily mean that profits are lower by the amount of the tax. The tax may instead raise prices or reduce wages or lower the prices paid to other resource suppliers. TAX INCIDENCE

57. Efficiency of Markets57  Example 2: Incidence of Taxes on Business Consumers If consumer demand for the goods produced by the business is relatively inelastic, then consumers pay higher prices than they would if there were no tax. A share of the real tax burden is shifted from business owners to consumers. Because of the higher prices, consumers bear part of the economic incidence of the tax. The tax business is actually a tax on consumers. TAX INCIDENCE

58. Efficiency of Markets58  Example 2: Incidence of Taxes on Business Workers If workers’ supply of labor is relatively inelastic, then workers are paid lower wages than they would receive if there were no tax. Part of the real tax burden is shifted to workers. Because of lower wages, workers bear part of the economic incidence of the tax. The tax on business is actually a tax on workers. TAX INCIDENCE

59. Efficiency of Markets59  Example 2: Incidence of Taxes on Business Suppliers of other resources If the supply of other productive resources used by the business (physical capital, land) is relatively inelastic, then the suppliers of those other resources receive lower prices than they would if there were no tax. Part of the real tax burden is shifted to other resource suppliers. Because of lower prices for other resources, suppliers of other resources bear part of the economic incidence of the tax. The tax on business is actually a tax on other resource suppliers. TAX INCIDENCE

60. Efficiency of Markets60  Example 2: Incidence of Taxes on Business Investors, entrepreneurs and suppliers of financial capital If the supply of financial capital and entrepreneurship to the business is relatively inelastic, then part of the economic incidence of a tax on business rests on the business’s owners and shareholders who supply these services. The income they earn from their investment in the business is lower than it would be if there were no tax. Only in this case is a tax on business really a tax on profits. TAX INCIDENCE

61. Efficiency of Markets61  Example 2: Incidence of Taxes on Business Who ultimately bears the economic incidence of a tax on business? Legislators have no influence over the economic incidence of taxes on business. Economics, not politics, determines where the ultimate burden of a tax on business rests. Because the supply of labor is very inelastic and consumer demand is often less elastic than the supply of capital or entrepreneurship, a large part of any tax on business is likely to rest on workers and consumers, not on owners and shareholders. TAX INCIDENCE