Welfare and Efficiency

Understanding the efficiency of markets

1 Consumer Surplus vs. Producer Surplus

The two pieces of the pie

Consumer surplus: The difference between how much a buyer is willing to pay for a
good and how much the buyer actually pays for it.

Producer surplus: The difference between how much a seller is willing to accept for a
good and how much the buyer actually gets for it.

Consumer surplus  net gain for buyers

Producer surplus  net gain for sellers

2 The Market Price

Determines the respective sizes of the two surpluses

3 Social Welfare
Total surplus is known as social welfare.

CONSUMER SURPLUS + PRODUCER SURPLUS = TOTAL SURPLUS = SOCIAL WELFARE

3.1 Graphical Representation

 Below price, above supply  producer

surplus
 Above price, below demand 
consumer surplus

In this graph, consumers and producers get the same net gain from the interaction. As later can be
seen, it’s not always equal.
3.2 Maximization

DEAD WEIGHT LOSS (DWL)  price too high/low to clear the market; is the area not captured by anyone

 Markets strive to get rid of DWL, they keep adjusting the price till the DWL is minimal.
 Social welfare is always maximized at equilibrium price and quantity, thus
 Price controls are inefficient!

4 Efficiency
An outcome is efficient when an allocation of resources maximizes total surplus. Equilibrium is the
market that achieves efficiency. When it’s not at equilibrium, there’s an inefficiency in the market.

“Honesty is highly efficient, because it gets you to equilibrium.”

4.1 Does efficiency achieve equality?

The outcome/social welfare is maximized in both graphs (efficient), but they’re not equal.

“The drive for fairness and equality is innate.”

4.2 The efficiency of cash gifts
People would prefer cash gifts>gift cards>surprise. From an efficiency point of view, cash can never
go wrong.

5 The Cost of Taxation

5.1 Welfare Before Tax

CS before tax = ½ (60) (10) = 300

PS before tax = ½ (60) (20) = 600

Social welfare = 300 + 600 = 900

5.2 A $5 tax is levied on sellers

5.3 Welfare After Tax

CS before tax = ½ (60) (10) = 300

PS before tax = ½ (60) (20) = 600

CS after tax = ½ (50) (8) = 200

PS after tax = ½ (50) (17) = 425

Both sides are now worse off

The total surplus shrunk after the tax.

Tax Revenue = (50) (5) = 250 || DWL = ½ (5) (10) = 25

On every particular market, tax creates dead weight loss (DWL)

6 The Laffer Curve

Relationship between tax revenue and rate.

If you increase the tax beyond the optimum, people would just not work (choose leisure) to not pay
salary taxes, etc. You just end up making the same at some point. The government would make the
same amount of revenue regardless of amount of tax because people would just not work.