Chapter 7 Efficiency and Exchange Market Equilibrium and

Chapter 7: Efficiency and Exchange 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 – Equilibrium price and quantity are efficient • Prices above or below equilibrium are not 1

Price Below Equilibrium • Suppose milk is $1 per gallon Price ($/gallon) 2. 50 S 2. 00 1. 50 1. 00 0. 50 D 1 2 3 4 5 Quantity (1, 000 s of gallons/day) 2

Price Below Equilibrium • A buyer offers $1. 25 per gallon Price ($/gallon) 2. 50 S 2. 00 1. 50 1. 25 1. 00 0. 50 D 1 2 3 4 5 Quantity (1, 000 s of gallons/day) 3

Price above Equilibrium Price ($/gallon) 2. 50 2. 00 1. 75 1. 50 1. 00 S Only equilibrium price is efficient 0. 50 D 1 2 3 4 5 Quantity (1, 000 s of gallons/day) 4

Efficiency Conditions 5

Heating Oil Market Price ($/gallon) 2. 00 1. 80 S 1. 60 Consumer surplus = $900/day 1. 40 1. 20 Producer surplus = $900/day 1. 00. 80 D 1 2 3 4 5 8 Quantity (1, 000 s of gallons/day) 6

Price Ceiling on Heating Oil 2. 00 1. 80 Price ($/gallon) 1. 60 1. 40 Consumer surplus = $900/ day S Lost surplus = $800/ day 1. 20 1. 00 0. 80 Producer surplus = $100/ day D 1 2 3 4 5 8 Quantity (1, 000 s of gallons/day) 7

Price Subsidies for Bread Price ($/loaf) $4. 00 Consumer Surplus = $4 M/month $3. 00 S $2. 00 Consumer Surplus = $9 M/month $1. 00 D S with subsidy 2 4 6 8 Quantity (millions of loaves/month) BUT… 8

The Cost of the Subsidy § 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 § Consumer surplus – government losses § Net benefit = $3 million 9

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 10

Tax on Avocado Sellers S + tax S Price ($/pound) 6 5 3. 50 2. 50 4 3 2 1 D 1 2 3 4 5 2. 5 Quantity (millions of pounds/month) 11

Taxes and Perfectly Elastic Supply Price ($/car) If supply is perfectly elastic, buyers pay all of the tax S + $100 S $20, 100 $20, 000 D 1. 9 2. 0 Quantity (millions of cars/month) 12

Tax on Avocado Sellers P 6 Before Tax §Consumer surplus = $4. 5 M §Producer surplus = $4. 5 M S 3 P 6 D 3 S + tax Q After Tax §Consumer surplus = $3. 125 M §Producer surplus = $3. 125 M §Total surplus = $6. 25 M §Loss = $2. 75 M 3. 50 1 D 2. 5 Q 13

Taxes and Price Elasticity of Demand More Elastic Demand Less Elastic Demand P P S+T 2. 40 2. 00 1. 40 2. 60 2. 00 1. 60 S S D 1 D 2 19 24 Q 21 24 Q Consumers pay a smaller share of the tax when demand is more elastic 14

Taxes and Deadweight Loss More Elastic Demand P Less Elastic Demand P Deadweight loss S+T 2. 40 2. 00 1. 40 2. 60 2. 00 1. 60 S S D 1 D 2 19 24 Q 21 24 Q Deadweight loss is larger when demand is relatively elastic 15