c hapter 5 e fficiency & e quity dr ikhlaas gurrib does the market achieve an efficient and fair...
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CHAPTER 5EFFICIENCY & EQUITY
Dr Ikh
laas G
urrib
Does the market achieve an efficient and fair use of
resources?
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CONSUMER SURPLUS
P
Q
6
5
D
Amount paid
Consumer surplus is the area below the demand curve and above the market price.
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TOTAL BENEFITS
Total benefits = Consumer surplus +
Amount paid
P
Q
6
5
D
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HOW A CHANGE IN PRICE AFFECTS CONSUMER SURPLUS
Quantity
Price
0
Demand
P1
A
B
Initialconsumersurplus
C
Q1 Q2
Supply
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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
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SUPPLY & PRODUCER SURPLUS
producer surplus = $10
P
Q
6
5
S
Cost of production = $20
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HOW A CHANGE IN PRICE AFFECTS PRODUCER SURPLUS
Quantity
Price
0
P1B
C
Supply
A
Initialproducersurplus
Q1 Q2
Demand
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HOW A CHANGE IN PRICE AFFECTS PRODUCER SURPLUS
Quantity
Price
0
P2
P1B
C
Supply
A
Initialproducersurplus
Q1 Q2
Demand
D
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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
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ECONOMIC WELL-BEING AND TOTAL SURPLUS
or
Total Surplus = Total
Benefits_ Total
Costs
Total Surplus = Consume
r SurplusProducer Surplus
+
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TOTAL SURPLUS
Price
Equilibriumprice
0 QuantityEquilibriumquantity
Supply
Demand
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TOTAL SURPLUS
Price
Equilibriumprice
0 QuantityEquilibriumquantity
Supply
DemandProducer Surplus
Consumer Surplus
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SOURCES OF INEFFICIENCY
Deadweight LossThe decrease in total surplus
that results from an inefficient allocation of resources
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Price
0 QuantityQe
Supply
Demand
UNDER & OVERPRODUCTION
Deadweightloss
underproduction
overproduction
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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
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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.
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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
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CHAPTER 6MARKETS IN ACTION
The effects of • price restrictions
• quantity restrictions• taxes
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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.
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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.
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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?
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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?
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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.
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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
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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
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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
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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
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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
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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
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A PRICE FLOOR – WOOL
Quantity0
Price
Demand
Supply
Price floor
Qd Qs
Equilibriumprice
Minimumprice surplus
If government buys surplus
Cost to taxpayers
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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
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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.
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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?
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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
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$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
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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
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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
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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
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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
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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
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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
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TAXES AND EFFICIENCY
After a tax, consumers will pay more and consume less
Consumer surplus will decrease
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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
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TAXES AND EFFICIENCY
After a tax, producers will receive less and sell less
Producer surplus will decrease
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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
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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
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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.
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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.
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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.
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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?
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TAXES
What goods should we tax?Objective should be to
MAXIMISE TAX REVENUE andMINIMISE the DEADWEIGHT LOSS
Therefore tax goods that are relatively INELASTIC
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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
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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.
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REVIEW
A price floor set below the equilibrium price causesa. shortages.b. surpluses.c. excess supply.d. none of the above.
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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.
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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.