Topic4 : Efficiency
Consumer SurplusI. Definition of welfare economics: the study of how the allocation of resources affects economic well-being.
II. Consumer Surplus
A. Willingness to Pay
1. Definition of willingness to pay: the maximum amount that a buyer will pay for a good.
2. Example: You are auctioning a mint-condition recording of Elvis Presley’s first album. Four buyers show up.
3. Definition of consumer surplus: the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.
4. Note that if you had more than one copy of the album, the price in the auction would end up being lower (a little over $70 in the case of two albums) and both John and Paul would gain consumer surplus.
C. How a Lower Price Raises Consumer Surplus
1. As price falls, consumer surplus increases for two reasons.
a. Those already buying the product will receive additional consumer surplus because they are paying less for the product than before (area A on the graph).
b. Because the price is now lower, some new buyers will enter the market and receive consumer surplus on these additional units of output purchased (area B on the graph).
D. What Does Consumer Surplus Measure?
1. Remember that consumer surplus is the difference between the amount that buyers are willing to pay for a good and the price that they actually pay.
2. Thus, it measures the benefit that consumers receive from the good as the buyers themselves perceive it.
III. Producer Surplus
A. Cost and the Willingness to Sell
1. Definition of cost: the value of everything a seller must give up to produce a good.
2. Example: You want to hire someone to paint your house. You accept bids for the work from four sellers. Each painter is willing to work if the price you will pay exceeds her opportunity cost. (Note that this opportunity cost thus represents willingness to sell.) The costs are:
3. Bidding will stop when the price gets to be slightly below $600. All sellers will drop out except for Grandma. Because Grandma receives more than she would require to paint the house, she derives some benefit from producing in the market.
4. Definition of producer surplus: the amount a seller is paid for a good minus the seller’s cost of providing it.
5. Note that if you had more than one house to paint, the price in the auction would end up being higher (a little under $800 in the case of two houses) and both Grandma and Georgia would gain producer surplus.
a. Those already selling the product will receive additional producer surplus because they are receiving more for the product than before (area C on the graph).
b. Because the price is now higher, some new sellers will enter the market and receive producer surplus on these additional units of output sold (area D on the graph).
1. The economic well-being of everyone in society can be measured by total surplus, which is the sum of consumer surplus and producer surplus: Total Surplus = Consumer Surplus + Producer Surplus Total Surplus = (Value to Buyers – Amount Paid by Buyers) + (Amount Received by Sellers – Cost to Sellers) Because the Amount Paid by Buyers = Amount Received by Sellers: Total Surplus = Value to BuyersCost to Sellers
2. Definition of efficiency: the property of a resource allocation of maximizing the total surplus received by all members of society.
Definition of equity: the fairness of the distribution of well-being among the members of society.
Evaluating the market equilibrium
Evaluating Market Equilibrium
1. At the market equilibrium price:
a. Buyers who value the product more than the equilibrium price will purchase the product; those who do not, will not purchase the product. In other words, the free market allocates the supply of a good to the buyers who value it most highly, as measured by their willingness to pay.
b. Sellers whose costs are lower than the equilibrium price will produce the product; those whose costs are higher, will not produce the product. In other words, the free market allocates the demand for goods to the sellers who can produce it at the lowest cost.
2. Total surplus is maximized at the market equilibrium.
a. At any quantity of output smaller than the equilibrium quantity, the value of the product to the marginal buyer is greater than the cost to the marginal seller so total surplus would rise if output increases.
b. At any quantity of output greater than the equilibrium quantity, the value of the product to the marginal buyer is less than the cost to the marginal seller so total surplus would rise if output decreases.
V. Market Efficiency and Market Failure
A. To conclude that markets are efficient, we made several assumptions about how markets worked.
1. Perfectly competitive markets.
2. No externalities.
3. Perfect information
4. Rational behavior
B. When these assumptions do not hold, the market equilibrium may not be efficient.
C. When markets fail, public policy can potentially remedy the situation.
I. The Deadweight Loss of Taxation
A. Remember that it does not matter who a tax is levied on; buyers and sellers will likely share in the burden of the tax.
B. If there is a tax on a product, the price that a buyer pays will be greater than the price the seller receives. Thus, there is a tax wedge between the two prices and the quantity sold will be smaller if there was no tax.
Tax Revenue and Deadweight Loss
1. We can measure the effects of a tax on consumers by examining the change in consumer surplus. Similarly, we can measure the effects of the tax on producers by looking at the change in producer surplus.
2. However, there is a third party that is affected by the tax—the government, which gets total tax revenue of T × Q. If the tax revenue is used to provide goods and services to the public, then the benefit from the tax revenue must not be ignored.
The Determinants of the Deadweight Loss
A. The price elasticities of supply and demand will determine the size of the deadweight loss that occurs from a tax.
1. Given a stable demand curve, the deadweight loss is larger when supply is relatively elastic.
2. Given a stable supply curve, the deadweight loss is larger when demand is relatively elastic.
3. There would also be no tax wedge in this case because the supply curve is vertical and this implies that there is no deadweight loss (because the government’s tax revenue is exactly equal to the landowners’ losses).
4. However, the tax would occur without a deadweight loss only if it was a tax on raw land rather than improvements on the land.
A. As taxes increase, the deadweight loss from the tax increases.
B. In fact, as taxes increase, the deadweight loss rises more quickly than the size of the tax.
1. The deadweight loss is the area of a triangle and the area of a triangle depends on the square of its size.
2. If we double the size of a tax, the base and height of the triangle both double so the area of the triangle (the deadweight loss) rises by a factor of four.
C. As the tax increases, the level of tax revenue will eventually fall.
KEY POINTS:
1.Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it, and it measures the benefit buyers get from participating in a market. Consumer surplus can be computed by finding the area below the demand curve and above the price.
2.Producer surplus equals the amount sellers receive for their goods minus their costs of production, and it measures the benefit sellers get from participating in a market. Producer surplus can be computed by finding the area below the price and above the supply curve.
3.An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes.
4.The equilibrium of supply and demand maximizes the sum of consumer and producer surplus. That is, the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently.
5.Markets do not allocate resources efficiently in the presence of market failures such as market power or externalities
6.A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenue raised by the government.
The fall in total surplus—the sum of consumer surplus, producer surplus, and tax revenue—is called the deadweight loss of the tax.
7.Taxes have deadweight losses because they cause buyers to consume less and sellers to produce less, and these changes in behavior shrink the size of the market below the level that maximizes total surplus.
Because the elasticities of supply and demand measure how much market participants respond to market conditions, larger elasticities imply larger deadweight losses.
