Microeconomics in Modules and Economics in Modules Third

Microeconomics in Modules and Economics in Modules Third Edition Krugman/Wells Module 12 Efficiency and Markets

What You Will Learn 1 2 The meaning and importance of total surplus and how it can be used to illustrate efficiency in markets How taxes affect total surplus and can create deadweight loss 2 of 32

Total Surplus • The total surplus generated in a market is the total net gain to consumers and producers from trading. It is the sum of the producer surplus and the consumer surplus. • The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity. 3 of 32

Total Surplus Price of book S Consumer surplus Equilibrium price $30 E Producer surplus D 0 1, 000 Quantity of books Equilibrium quantity 4 of 32

The Gains from Trade • The previous graph shows that both consumers and producers are better off because there is a market in this good (i. e. , there are gains from trade). • These gains from trade are the reason everyone is better off participating in a market economy than if each individual tried to be self-sufficient. 5 of 32

The Efficiency of Markets • Claim: The maximum possible total surplus is achieved at market equilibrium. • Market equilibrium allocates consumption of the good among potential consumers and sales of the good among potential sellers in a way that achieves the highest possible gain to society. • Any change from the market equilibrium reduces total surplus. 6 of 32

How to Make Markets Inefficient 1. Reallocate consumption among consumers. Take the good away from buyers who would have purchased it at market equilibrium and give it to consumers who wouldn’t have bought it at equilibrium. 2. Reallocate sales among sellers. Take sales away from those who would have sold the good at market equilibrium and instead compel sales by producers who would not have sold the good at equilibrium. 3. Change the quantity traded. Compel consumers and producers to transact either more or less than the equilibrium quantity. 7 of 32

Reallocating Consumption Lowers Consumer Surplus Price of book Loss in consumer surplus if the book is taken from Ana and given to Bob S A $35 30 E B 25 D 0 1, 000 Quantity of books 8 of 32

Reallocating Sales Lowers Producer Surplus Price of book S Y $35 E 30 25 X Loss in producer surplus if Yvonne is made to sell the book instead of Xavier D 0 1, 000 Quantity of books 9 of 32

Changing the Quantity Lowers Total Surplus Price of book $35 Loss in total surplus if the transaction between Ana and Xavier is prevented A E 30 25 Y X S Loss in total surplus if the transaction between Yvonne and Bob is forced B D 0 1, 000 Quantity of books 10 of 32

The Efficient Market 1. It allocates consumption of the good to the potential buyers who value it the most, as indicated by the fact that they have the highest willingness to pay. 2. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost. 3. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial. 4. It ensures that every potential buyer who doesn’t make a purchase values the good less than every potential seller who doesn’t make a sale, so that no mutually beneficial transactions are missed. 11 of 32

Cost of Collecting Taxes • The administrative costs of a tax are the resources used—over and above the value of the tax itself—(1) to collect it, (2) to pay it, and (3) to avoid it. • The total inefficiency caused by a tax is the sum of its deadweight loss and its administrative costs. • The general rule for economic policy is that other things equal, a tax system should be designed to minimize the total inefficiency it imposes on society. 12 of 32

Why Markets Work So Well • The economy is made up of many interrelated markets. • Well-functioning markets owe their effectiveness to two features: – Property rights: a system in which valuable items in the economy have specific owners who can dispose of them as they choose. – Economic signals: any piece of information that helps people make better economic decisions. 13

Why Markets Sometimes Go Wrong • When markets are inefficient, production or consumption could be rearranged to make some people better off without making other people worse off. 14

Why Markets Sometimes Go Wrong • When a market is inefficient, there is a market failure. • Markets can fail when: – one party prevents mutually beneficial trades. – actions of individuals have side effects on the welfare of others that markets don’t take into account. – goods are unsuited for efficient management by markets. 15

Summary 1. In a market, total producer surplus—the sum of the individual producer surpluses—is equal to the area above the market supply curve but below the price. 2. Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. 3. Usually, markets are efficient and achieve the maximum total surplus. 4. Markets can fail to organize effectively because of market failures. 16 of 32