c hapter 5 e fficiency & e quity dr ikhlaas gurrib does the market achieve an efficient and fair...

CHAPTER 5EFFICIENCY & EQUITY

Dr Ikh

laas G

urrib

Does the market achieve an efficient and fair use of

resources?

CONSUMER SURPLUS

P

Q

6

5

D

Amount paid

Consumer surplus is the area below the demand curve and above the market price.

TOTAL BENEFITS

Total benefits = Consumer surplus +

Amount paid

P

Q

6

5

D

HOW A CHANGE IN PRICE AFFECTS CONSUMER SURPLUS

Quantity

Price

0

Demand

P1

A

B

Initialconsumersurplus

C

Q1 Q2

Supply

HOW A CHANGE IN PRICE AFFECTS CONSUMER SURPLUS

Quantity

Price

0

Demand

P1

P2

A

B

D

C

E

Q1 Q2

Initialconsumersurplus Increase in consumer

surplus

Supply

S

SUPPLY & PRODUCER SURPLUS

producer surplus = $10

P

Q

6

5

S

Cost of production = $20

HOW A CHANGE IN PRICE AFFECTS PRODUCER SURPLUS

Quantity

Price

0

P1B

C

Supply

A

Initialproducersurplus

Q1 Q2

Demand

HOW A CHANGE IN PRICE AFFECTS PRODUCER SURPLUS

Quantity

Price

0

P2

P1B

C

Supply

A

Initialproducersurplus

Q1 Q2

Demand

D

HOW A CHANGE IN PRICE AFFECTS PRODUCER SURPLUS

Quantity

Price

0

P2

P1B

C

Supply

A

D

Initialproducersurplus

EF

Q1 Q2

Increase in producersurplus

Demand

D

ECONOMIC WELL-BEING AND TOTAL SURPLUS

or

Total Surplus = Total

Benefits_ Total

Costs

Total Surplus = Consume

r SurplusProducer Surplus

+

TOTAL SURPLUS

Price

Equilibriumprice

0 QuantityEquilibriumquantity

Supply

Demand

TOTAL SURPLUS

Price

Equilibriumprice

0 QuantityEquilibriumquantity

Supply

DemandProducer Surplus

Consumer Surplus

SOURCES OF INEFFICIENCY

Deadweight LossThe decrease in total surplus

that results from an inefficient allocation of resources

Price

0 QuantityQe

Supply

Demand

UNDER & OVERPRODUCTION

Deadweightloss

underproduction

overproduction

REVIEWGayle 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. $700B. $2300C. $3000D. $3700

REVIEWMichele 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.

REVIEWThe Health Ministry announces that eating chocolate improves your health. As a result, the equilibrium market price of chocolate __________, and producer surplus ___________.A. increases, increasesB. increases, decreasesC. decreases, decreasesD. decreases, increases

CHAPTER 6MARKETS IN ACTION

The effects of • price restrictions

• quantity restrictions• taxes

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.

PRICE CEILINGS & PRICE FLOORS

Price Ceiling

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.

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?

Quantity Quantity (thousands of units per month)(thousands of units per month)

Ren

t (do

llars

per

uni

t per

mon

th)

Ren

t (do

llars

per

uni

t per

mon

th)

00 2020 3030 4040 60 60

500500

700700

900900

DD

SSSS

A HOUSING MARKET AFTER A CYCLONE

SSSSAAAfter the cycloneAfter the cyclone

Should rents be capped at $500?

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.

Rent ceiling

A RENT CEILING

Quantity (thousands of units per month)

Ren

t (do

llar

s pe

r un

it p

er m

onth

)

0 20 300 20 30 4040

500500

700700

900900

DD

SSSSAA

Housingshortage

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

Rent ceiling

A RENT CEILING

Quantity (thousands of units per month)

Ren

t (do

llar

s pe

r un

it p

er m

onth

)

0 20 300 20 30 4040

500500

700700

900900

DD

SSSSAA

Housingshortage

Maximum black market rent

A RENT CEILING

Quantity (thousands of units per month)

Ren

t (do

llar

s pe

r un

it p

er m

onth

)

0 20 300 20 30 4040

500500

700700

900900

DD

SSSSAA

Rent Ceiling

ProducerSurplus

ConsumerSurplus

Deadweight loss

Unemployment

MINIMUM WAGE AND UNEMPLOYMENT

Quantity (millions of hours per year)

Wag

e R

ate

(dol

lars

per

hou

r)

20 21 22 23

3

4

5

6 SS

DA

Minimumwage

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

A PRICE FLOOR – WOOL

Quantity0

Price

Demand

Supply

Price floor

Qd Qs

Equilibriumprice

Minimumprice surplus

If government buys surplus

Cost to taxpayers

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

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.

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?

A TAX ON SELLERS

Quantity (millions of packets per year)

Pri

ce (

dolla

rs p

er p

acke

t)

SS

DD

5.00

4.00

3.00

2.50 2.00

1.00 0 50 75 100 125 150 175 200 225

S + tax on sellers

Price withno tax

Price receivedby sellers

$1.50 tax

Price paidby buyers

A tax on sellers shifts the S curve upward by the amount of the tax

$1.50 tax

A TAX ON BUYERS

Quantity (millions of packets per year)

Pri

ce (

dolla

rs p

er p

acke

t)

SS

DD

5.00

4.00

3.00

2.50

2.00

1.50

1.00 0

50 75 100 125 150 175 200 225

D - tax on buyers

Price withno tax

Price receivedby sellers

Price paidby buyers

A tax on buyersshifts the Dcurve downwardby the size ofthe tax

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

A TAX ON SELLERS – INELASTIC D

Quantity (millions of packets per year)

Pri

ce (

dolla

rs p

er p

acke

t)

SS

DD

5.00

4.00

3.00

2.00

1.00 0 50 75 100 125 150 175 200 225

S + tax on sellers

The tax burden on the buyer is ___The tax burden on the seller is ___D is more ______ compared to S

2.50

B

S

A TAX ON SELLERS – ELASTIC D

Quantity (millions of packets per year)

Pri

ce (

dolla

rs p

er p

acke

t)

SS

DD

5.00

4.00

3.00

2.00

1.00 0 50 75 100 125 150 175 200 225

S + tax on sellers

The tax burden on the buyer is ___The tax burden on the seller is ___D is more ______ compared to S

3.50B

S

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

TAX REVENUE & ELASTICITY

Quantity (millions of packets per year)

Pri

ce (

dolla

rs p

er p

acke

t)

SS

DiDi

5.00

4.00

3.00

2.00

1.00 0 50 75 100 125 150 175 200 225

S + tax on sellers

Tax Revenue $ = size of T x Q

2.50

DeDe

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

TAXES AND EFFICIENCY

After a tax, consumers will pay more and consume less

Consumer surplus will decrease

A TAX ON SELLERS – INELASTIC D

Quantity (millions of packets per year)

Pri

ce (

dolla

rs p

er p

acke

t)

SS

DD

5.00

4.00

3.00

2.00

1.00 0 50 75 100 125 150 175 200 225

S + tax on sellers

2.50Consumer

surplus decreases

TAXES AND EFFICIENCY

After a tax, producers will receive less and sell less

Producer surplus will decrease

A TAX ON SELLERS – INELASTIC D

Quantity (millions of packets per year)

Pri

ce (

dolla

rs p

er p

acke

t)

SS

DD

5.00

4.00

3.00

2.00

1.00 0 50 75 100 125 150 175 200 225

S + tax on sellers

2.50Producer surplus

decreases

A TAX ON SELLERS – INELASTIC D

Quantity (millions of packets per year)

Pri

ce (

dolla

rs p

er p

acke

t)

SS

DD

5.00

4.00

3.00

2.00

1.00 0 50 75 100 125 150 175 200 225

S + tax on sellers

2.50

Tax revenue

Deadweight loss

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.

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?

TAXES

What goods should we tax?Objective should be to

MAXIMISE TAX REVENUE andMINIMISE the DEADWEIGHT LOSS

Therefore tax goods that are relatively INELASTIC

REVIEWWould 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.

REVIEW

A price floor set below the equilibrium price causesa. 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.