Errol D’Souza

Economic Efficiency Government Price

The effects of government intervention in markets, such as
Setting and Taxes price ceilings and price floors, is analyzed using the
concepts of consumer surplus, producer surplus,
Errol D’Souza and economic surplus.

Consumer Surplus

Demand curves show the willingness of consumers to pay

a product at different prices. – In the next figure an
individual’s demand curve for chai is shown

If the price is Re 3 per cup, Ishan will buy 4 cups of chai

per week. If the price is Rs 2 per cup he will buy 5
cups per week. The fact that Ishan is willing to pay
Rs 3 for the 4th cup means that the marginal benefit
to him from the fourth cup is Rs 3. Similarly since
Email: errol@iima.ac.in he is willing to pay Rs 2 for the 5th cup means the
1 2
marginal benefit to him from that cup is Rs 2.

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Errol D’Souza Errol D’Souza

Price per cup Price per cup
7 7

3 3
2 2

Quantity (cups per week) Quantity (cups per week)

4 5 4 5

The marginal benefit is the additional benefit to a consumer If the market price is Rs 2 per cup. Then for the 5th cup that
from consuming one more unit of a good or service. Ishan buys in the week his marginal benefit equals the
price. – For the other 4 cups purchased, however, the
Another way to think of the demand curve is as a marginal benefit is greater than the price he pays. He
representation of Ishan’s marginal benefit curve for is thus paying less than the maximum price he would
chai. have been willing to pay for the first 4 cups of tea
3 4
bought in the week.

3 4

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 Errol D’Souza Errol D’Souza
Price per cup Price per cup
7
Market Demand for Chai

3
2 2

Quantity (cups per week) Quantity (cups per week)

4 5 15,000

The difference between the highest price a consumer is will- In the market the quantity demanded at a price of Rs 2 is
ing to pay and the price the consumer actually pays 15,000 cups per week. – The only consumers who
is called the consumer surplus. would receive no consumer surplus are those who
would not have purchased any chai if the price had
been higher than Rs. 2.
5 6

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Errol D’Souza Errol D’Souza

Price per cup
Producer Surplus

Market Demand for Chai Supply curves show the willingness of firms to supply a
product at different prices. The willingness to supply
a product depends on the cost of producing it. Firms
will supply an additional unit of a product only if
they receive a price equal to the additional cost of
2 producing it.

Quantity (cups per week)
15,000
We calculate the total consumer surplus in the market by
adding up the consumer surplus received on each
unit purchased. As the demand curve measures the
marginal benefit received by consumers, the total
consumer surplus is equal to the area below the
market demand curve and above the market price. Con- 7
sumer surplus is the shaded yellow area.
Marginal cost is the additional cost to a firm of prod-
ucing one more unit of a good or service.
In the next figure Chaiwala is willing to supply 50 cups of
tea at a price of Rs 2 per cup – the 50th cup must
have a marginal cost of Rs 2. The supply curve also
shows that Chaiwala is willing to supply 40 cups at
a price of Rs 1.80 per cup. The marginal cost of the
40th cup is Rs 1.80. The supply curve, then, is also 8
a marginal cost curve.

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 Errol D’Souza Errol D’Souza
Price (Rs per cup) Price (Rs per cup)
Supply Supply

2 2
1.80

Quantity (cups per week) Quantity (cups per week)

40 50
If the market price of chai is Rs 2 Chaiwala is able to sell the
40th cup for Rs 0.20 more than the lowest price – which
is Rs 1.80 – he would have been willing to accept. This
Rs 0.20 is the producer surplus on that particular cup
of tea.
Producer surplus is the difference between the lowest price a
firm would have been willing to accept and the price it 9
actually receives.
40 50
The total amount of producer surplus tea sellers receive from
selling chai can be calculated by adding up the produ-
cer surplus received on each cup sold. – Hence the total
producer surplus in a market is the area above the
market supply curve and below the market price. – This
is shown as the orange shaded area in the figure.
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Errol D’Souza Errol D’Souza

The Meaning of Consumer and Producer Surplus

We have introduced the terms marginal benefit and marginal
Consumer surplus measures the benefit to consumers from cost.
participating in a market, and producer surplus the
benefit to producers from participating in a market. We have also introduced the terms consumer surplus and
producer surplus.
Consumer surplus measures the net benefit to consumers
from participating in a market, rather than the total We shall now see that the two sets of concepts lead to the
benefit. When the price of a product is zero, the con- same outcome and that using both we can increase
sumer surplus would be all of the area under the our understanding of economic efficiency.
demand curve. When the price is non-zero, consumer
surplus is the total benefit received by consumers
minus the total amount they would have to pay to
buy the good.

Anologously producer surplus is the total amount firms re-

ceive from consumers minus the cost of producing
the good. 11 12

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 Errol D’Souza Errol D’Souza
Price (Rs per cup) Price (Rs per cup)
Supply Supply

2.20 2.20
A
2 2

1.80 1.80

Demand Demand
Quantity (cups per week) Quantity (cups per week)
14,000 16,000 14,000 16,000
15,000 15,000

The demand curve shows the marginal benefit received by
consumers and the supply curve the marginal cost
of production. – Economic efficiency is when the mar-
ginal benefit from the last unit sold equals the marg-
inal cost of production. This occurs at 15,000 cups
per week of production. 13
Why is the outcome at point A economically efficient?
Because every cup of chai has been produced where the
marginal benefit to buyers is greater than or equal
to the marginal cost of production.
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Errol D’Souza Errol D’Souza

Suppose that output of chai were 14,000 cups per week. At

this output the marginal benefit from the last cup of
chai sold is Rs 2.20 whereas the marginal cost is only
Rs 1.80. – This level of output is not efficient because
1,000 cups more could be produced for which the
additional benefit to consumers is greater than the
additional cost of production.
Consumers would willingly purchase those cups, and
chai sellers would willingly supply them, making
both consumers and sellers better off. 15
Similarly if the output of chai were 16,000 cups per week
the marginal cost of the 16,000th cup is Rs 2.20
and the marginal benefit is only Rs 1.80. Consumers
would not be willing to pay the price tea sellers would
need to receive for any cup beyond the 15,000th.
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 Errol D’Souza Errol D’Souza
Price (Rs per cup)
Supply
To summarize: Equilibrium in a competitive market results
in the economically efficient level of output, where
marginal benefit equals marginal cost. A
2

Economic surplus in a market is the sum of consumer

surplus and producer surplus. – In a competitive
market with many buyers and sellers and no Demand
government restrictions, economic surplus is at Quantity (cups per week)
a maximum when the market is in equilibrium.
15,000
To see this look at the market for chai

The consumer surplus is the yellow area under the

demand curve and above the line indicating the
equilibrium price of Rs 2.00. The producer surplus
is the orange area above the supply curve and 17 18
below the price line.

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Errol D’Souza Errol D’Souza

Price (Rs per cup)
Deadweight loss Supply

To show that economic surplus is maximized at equilibrium, 2.20

A
consider the situation where the price of chai is above B C
the equilibrium price as shown in the following figure 2

At a price of Rs 2.20 per cup, the number of cups consumers

will be willing to buy per week drops from 15,000 to Demand
14,000. At competitive equilibrium, consumer surplus Quantity (cups per week)
is equal to the sum of areas A, B, and C. – Fewer cups 14,000
15,000
are sold at the higher price and the consumer surplus
has declined to just the area of A when the price is
At competitive equilibrium, consumer surplus is equal to
Rs 2.20.
the sum of areas A, B, and C.

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 Errol D’Souza Errol D’Souza
Price (Rs per cup) Price (Rs per cup)
Supply Supply

2.20
A 2.20
B C
2 2
E
D
1.80

Demand Demand
Quantity (cups per week) Quantity (cups per week)
14,000 14,000
15,000 15,000

At competitive equilibrium, consumer surplus is equal to At competitive equilibrium producer surplus is the sum of
the sum of areas A, B, and C. areas D and E.

Fewer cups are sold at the higher price and the consumer
surplus has declined to just the area of A when
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the price is Rs 2.20.

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Errol D’Souza Errol D’Souza

Price (Rs per cup) Price (Rs per cup)
Supply Supply

2.20 2.20
A
B B C
2 2
E E
D D
1.80 1.80

Demand Demand
Quantity (cups per week) Quantity (cups per week)
14,000 14,000
15,000 15,000

At competitive equilibrium producer surplus is the sum of
areas D and E. At the higher price of Rs 2.20, producer
surplus changes to be equal to the sum of areas B and
D.
23
At competitive equilibrium producer surplus is the sum of
areas D and E. At the higher price of Rs 2.20, producer
surplus changes to be equal to the sum of areas B and
D.
The sum of consumer & producer surplus – economic surplus
- has been reduced to the sum of areas A, B, and D. 24

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 Errol D’Souza Errol D’Souza
Price (Rs per cup)
The reduction in economic surplus from a market not being
Supply in competitive equilibrium is called the deadweight
loss.
2.20
A
B C This is equal to the sum of areas C and E in the
2 figure.
E
D
1.80 Price (Rs per cup)
Demand Supply
Quantity (cups per week) A
14,000 2.20
15,000 B C
2
Economic surplus has declined because at a price of Rs 2.20 E
D
all the cups between the 14,000th and the 15,000th 1.80
which would have been produced in competitive equ-
ilibrium, are not being produced. These “missing cups” Demand
are not providing any consumer or producer surplus, Quantity (cups per week)
25 26
so economic surplus has declined. 14,000
15,000

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Errol D’Souza Errol D’Souza

Economic surplus and economic efficiency

Anything that causes a market for a good or service not to
Consumer surplus measures the benefit to consumers from be in competitive equilibrium reduces the total
buying a product. Producer surplus measures the ben- benefit to society from the production of that good
efit to firms from selling a product. or service.

Therefore, economic surplus – the sum of the benefit Therefore, economic efficiency is a market outcome in which
to firms plus the benefit to consumers – is the the marginal benefit to consumers of the last unit
best measure of the benefit to society from the produced is equal to its marginal cost of production,
production of a particular good or service. and in which the sum of consumer surplus and
producer surplus is at a maximum.
This gives us a second way of characterizing efficiency of a
competitive market: Equilibrium in a competitive mar-
ket results in the greatest amount of economic surplus
or total net benefit to society, from the production of
a good or service.
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 Errol D’Souza Errol D’Souza

Note that we have not concluded that every individual is
better off if a market is at competitive equilibrium.
We have only concluded that economic surplus, or
the total net benefit to society, is greatest at
competitive equilibrium.
Any individual producer would rather charge a
higher price, and any individual consumer
would rather pay a lower price, but usually
producers can sell and consumers can buy
only at the competitive equilibrium price.
Producers or consumers who are dissatisfied with the
competitive equilibrium price can lobby the gov-
ernment to legally require that a different price
be charged.
When the government does intervene, it can either
attempt to aid sellers by requiring that a
price be above equilibrium – a price floor –
or to aid buyers by requiring that a price
be below equilibrium – a price ceiling.
We now use the concepts of producer and consumer
surplus and deadweight loss to see the eco-
nomic inefficiency of binding price floors and
price ceilings.

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Errol D’Souza Errol D’Souza

Price supports to Agriculture Price (Rs per kg)
Supply
Price (Rs per kg)
Supply
35
A
35 30
A C
30

Demand

Demand Quantity (million kg per year)

1.8 2.0 2.2
Quantity (million kg per year)
1.8 2.0 Suppose initially the production of wheat also falls to 1.8 mn.
kg. per year. – The producer surplus received by farm-
Suppose equilibrium price is Rs 30 per kg. in the wheat ers increases by an amount equal to the area of rect-
market. – On the lobbying of farmers government angle A and falls by an amount equal to area of tri-
decides to set a price floor of Rs 35 per kg. angle C.
The quantity of wheat sold then falls from 2 to 1.8 31 32
million kg per year.

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 Errol D’Souza Errol D’Souza
Price (Rs per kg) Price (Rs per kg)
Supply Supply

35 35
A B A B
30 30
C C

Demand Demand
Quantity (million kg per year) Quantity (million kg per year)
1.8 2.0 2.2 1.8 2.0 2.2

Suppose initially the production of wheat also falls to 1.8 mn. Total fall in consumer surplus = Area of rectangle A + Area
kg. per year. – The producer surplus received by farm- of triangle B.
ers increases by an amount equal to the area of rect- Total gain in producer surplus = Area of rectangle A ― Area
angle A and falls by an amount equal to area of tri- of triangle C.
angle C. – The triangle B represents a loss of cons- Deadweight loss = Area of triangle B + Area of triangle C.
umer surplus as does triangle A. 33 34

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Errol D’Souza Errol D’Souza

There is a deadweight loss because the price floor has reduced There is a deadweight loss because the price floor has reduced
the amount of economic surplus in the market. the amount of economic surplus in the market.

The price floor has caused the marginal benefit of the The price floor has caused the marginal benefit of the
last kg of wheat to be greater than the marginal last kg of wheat to be greater than the marginal
cost of producing it. Thus the price floor reduces cost of producing it. Thus the price floor reduces
economic efficiency. economic efficiency.

So far we have assumed that farmers reduce their output of

wheat to the amount consumers are willing to buy.

However at the price floor established farmers want

to supply 2.2 mn. kg. The result is a surplus
of 0.4 mn. kg of wheat.

The government then purchases the surplus or pays

35 farmers a subsidy to take some land out of
36
cultivation.

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 Errol D’Souza Errol D’Souza
The Minimum Wage – Another Price floor

Wage (Rs per hour) Whatever the extent of employment losses from the minimum
Supply wage, it will cause a deadweight loss just as a price
Surplus workers floor in the wheat market does.
Min Wage
A B
Market Wage Price Ceilings
C
Support for price floors typically comes from sellers but
support for governments setting price ceilings typ-
Demand
ically comes from consumers. – For e.g. when there
Quantity (no. workers per is a sharp increase in oil prices, there will often be
L3 L1 L2 year) proposals for the government to impose a price
The minimum wage is above the equilibrium market wage. ceiling on the market for petrol and diesel.
The quantity of workers demanded by employers falls
to L3 and the quantity supplied increases to L2. There
is a surplus of workers equal to L2 – L3 who are not
able to find jobs. 37 38

37

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Errol D’Souza Errol D’Souza

Price Ceiling – Rent Control

Rent (Rs per month) Rent (Rs per month)

Supply Supply

B
6,000 6,000
A C
5,000 5,000
Shortage of
Demand Demand apartments
Quantity (apartments per Quantity (apartments per
1.9 2 2.1 month in million) 1.9 2 2.1 month in million)
With a rent ceiling the quantity of apartments demanded rises
Without rent control the equilibrium rent would be Rs 6,000 to 2.1 mn. There is a shortage of 200,000 apartments.
per month and 2 million apartments would be rented. Consumer surplus increases by rectangle A and falls by
With rent control landlords reduce the quantity of apartments triangle B.
supplied to 1.9 million. Producer surplus to landlords falls by rectangle A plus tri-
39 40
angle C.
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 Errol D’Souza Errol D’Souza

Total gain in consumer surplus = Area of rectangle A ― Area

Suppose renters and landlords do not abide by the price
of triangle B.
ceiling. As there is a shortage of apartments, renters
Total fall in producer surplus = Area of rectangle A + Area
who would otherwise not be able to find apartments
of triangle C.
have an incentive to offer landlords rents above the
Deadweight loss = Area of triangle B + Area of triangle C.
legal maximum.
There is a deadweight loss because rent control has reduced
The result is a black market where buying and selling
the amount of economic surplus in the market.
takes place at prices that violate price regulations.
Rent control has caused the marginal benefit of the
Tenants will write a check for the legally allowed rent
last apartment rented to be greater than the
and pay an additional amount in cash.
marginal cost of supplying it.
Black market rent would rise to Rs 7,000 per month
Though renters as a group benefit, the number of
as there would be competition among tenants.
renters is reduced so some renters are made
worse off by rent controls because they are
unable to find an apartment at the legal rent.
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Rent (Rs per month) Errol D’Souza

Rent (Rs per month) Errol D’Souza

Supply Supply

E E
7,000 7,000
D B D B
6,000 6,000
A C A C
5,000 5,000
Shortage of Shortage of
Demand apartments Demand apartments
Quantity (apartments per Quantity (apartments per
1.9 2 2.1 month in million) 1.9 2 2.1 month in million)
Comparison with Equilibrium Situation (before rent controls)
The black market rent being Rs 7,000 – higher than the com-
petitive rent of Rs 6,000 – consumer surplus declines Total fall in consumer surplus = Area of rectangle D + Area of
by an amount equal to rectangle D. triangle B
Total increase in producer surplus = Area of rectangle D ― Area
Producer surplus has increased by an amount equal to of triangle C
rectangles A and D and consumer surplus has dec-
43
43
44
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lined by the same amount. Deadweight loss = Area of triangle B + Area of triangle C.

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 Rent (Rs per month) Errol D’Souza Errol D’Souza

Supply
When governments impose price ceilings or price floors
E three important results occur:
7,000
D B
6,000 ● Some people win
A C ● Some people lose
5,000
Shortage of ● There is a loss of economic efficiency
Demand apartments
The winners with rent control are the people who are paying
Quantity (apartments per less for rent. Landlords may also gain if they break the
1.9 2 2.1 month in million) law by charging rents above the legal maximum and
also higher than the competitive equilibrium rents
With an active black market rent control leaves renters as would have been.
a group worse off – with less consumer surplus – Losers are landlords who abide by the law and renters who
than if there were no rent control. are unable to find apartments to rent at the controlled
price.
Rent control reduces efficiency because fewer apartments are
45
45 rented than would be in a competitive market. – The 46
deadweight loss measures the loss in efficiency.

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Errol D’Souza
Price per pack Supply after Rs 10 tax Errol D’Souza

The Economic Impact of Taxes Supply

B
27
Whenever a government taxes a good or service, less of that
good or service is produced. For e.g., a tax on cigar- 20
ettes will raise the cost of smoking and reduce the 17
quantity of smoking that takes place.
Demand
Without the tax, let the equilibrium price of cigarettes be
Rs 20 per pack and 2 mn. packs of cigarettes would Quantity(millions of cig-
be sold per year. 1.8 2 arette packets per year)
The shift in supply will result in a new price of Rs 27 and a
If the government requires sellers to pay Rs 10 per pack as new equilibrium quantity of 1.8 mn. packs – point B.
tax, their cost of selling cigarettes would increase by
Rs 10 per pack. This causes the supply curve to shift The government will collect tax revenue equal to the tax per
up by Rs 10. pack multiplied by the no. of packs sold or Rs 1.8 mn.

47 The area that is shaded represents the government’s tax

48
revenue.

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 Price per pack Supply after Rs 10 tax Errol D’Souza
Price per pack Supply after Rs 10 tax Errol D’Souza

Supply Supply
B B
27 27

20 20 A
17 17
C
Demand Demand
Quantity(millions of cig- Quantity(millions of cig-
1.8
2 arette packets per year) 1.8 2 arette packets per year)
Consumers pay a higher price of Rs 27 per pack. Some of the loss in consumer and producer surplus becomes
tax revenue for the government. The rest of the loss
Since sellers pay the tax the price they receive falls from Rs 20 from consumer and producer surplus is equal to the
per pack to Rs 17 per pack. deadweight loss from the tax, shown as the shaded
orange triangle in the figure – triangle ABC.
There is a loss of consumer surplus because they are pay-
ing a higher price. The price producers receive falls 49
and 50
there is also a loss of producer surplus.

49 50

Price per pack Supply after Rs 10 tax Errol D’Souza Errol D’Souza

Supply Tax Incidence: Who Actually pays a tax?

B
27
There is an important difference between who is legally
20 required to pay a tax and who actually bears the
A
burden of the tax. The actual division of the burden
17
C is referred to as tax incidence.

Demand For instance, the government currently levies a tax of say

Quantity(millions of cig-
1.8 2 arette packets per year)
The burden of a tax then is not just the amount paid to the
government by consumers and producers, but also
includes the deadweight loss.
The deadweight loss from a tax is referred to as the excess
burden of a tax. A tax is efficient if it imposes a small
excess burden relative to the tax revenue it raises. 51
60 per cent on petrol sold. This tax is collected by
petrol station owners and forwarded to the govern-
ment. But who actually bears the burden of the tax?
Suppose the retail price of petrol inclusive of the excise tax
levied is Rs 56 per litre, 150 billion litres of petrol are
sold per year, and the excise tax is Rs 24 per litre.
At the equilibrium inclusive of the tax where demand equals
supply S2, the price has risen from Rs 40 to Rs 56.52

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 Price per litre S2, Supply after Rs 24 tax Errol D’Souza
When do consumers pay all of the sales tax increase?
Errol D’Souza

B Supply
56

40
32

Demand
Quantity(billions of litres
145 150 of petrol per year)

The price has risen by Rs 16 per litre from Rs 40 to Rs 56.

Sellers are receiving a new price of Rs 56 but after
paying the Rs 24 per litre tax, they are left with Rs
32, or, Rs 8 less than they had been receiving.
rds
2
The consumers pay 16/24 = 3 of the tax and sellers pay
53
rd
8/24 = 13 of the tax.

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Errol D’Souza Errol D’Souza

When do consumers pay all of the sales tax increase?
S2, Supply after Rs 24 tax Does it matter whether the tax is on buyers or on sellers?
Price per litre
B
64 Supply The incidence of a tax does not depend on whether a tax is
collected from the buyers of a good or the sellers.

40 Suppose the tax on petrol is imposed on buyers rather than

on sellers. Buyers have to report their purchases of
petrol and send the tax to the government.
Demand
Since consumers now have to pay a Rs 24 tax on every litre
Quantity(billions of litres of petrol they buy they are willing to pay a price of
150 of petrol per year) Rs 24 less than they would have without the tax.

Consumers will pay all of an increase in a sales tax only The demand curve now shifts down by Rs 24 to D2.
if the demand curve is a vertical line.
After the demand curve shifts down with the impos-
ition of the tax the new equilibrium quantity of
56
petrol is 150 mn. litres, as before.

55 56

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 Errol D’Souza
Price per litre
56 B Supply

40
32

Demand

D2, Demand after Rs 24 tax

150 154 Quantity(billions of litres
of petrol per year)
The new equilibrium price appears to be different. But it is a
pre-tax price of Rs 32. If we include the tax, then buy-
ers will pay the same price of Rs 56 and sellers will
receive the same Rs 32 as before.

The incidence of the tax does not depend on whether the tax
57 58
is collected from the buyers or the sellers.

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Errol D’Souza
Price (Rs.) Supply after war Errol D’Souza

Supply
Problem: An advocate of the medical care system reform B
75
makes the following argument ―

The 15,000 kidneys that are transplanted each year 60

are received free from organ donors. Despite this,
because of hospital costs and doctor’s fees, the
average price of a kidney transplant is Rs 250,000. Demand
As a result only rich people can afford these trans-
plants. The government should put a ceiling of Quantity(millions of
Rs 100,000 on the price of kidney transplants. That 40 45 litres per month)
way, middle income people will be able to afford Initially the market for petrol is in equilibrium at a price of
them, the demand for kidney transplants will incr- Rs. 60 per litre and quantity of 45 mn. litres per month. A
ease, and more kidney transplants will take place. war in the Middle East disrupts imports shifting the supply
curve upwards. The price of gasoline begins to rise and
Do you agree with the advocate’s reasoning? Use consumers begin to protest. The government responds by
a demand and supply graph to illustrate setting a price ceiling of Rs. 60 per litre.
your answer. 59 60

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 Errol D’Souza Errol D’Souza
Price (Rs.) Supply after war Price (Rs.) Supply after war
90 90
Supply Supply

75 75
60 60

Demand Demand
Quantity(millions of Quantity(millions of
30 40 45 litres per month) 30 40 45 litres per month)
If there were no price ceiling what would be the price of Let the price ceiling of Rs 60 per litre be imposed. Show on
petrol? ― Now assume the price ceiling is imposed and the graph the areas representing consumer surplus, pro-
there is no black market in petrol. What are the price of ducer surplus, and deadweight loss.
petrol, the quantity demanded, and quantity supplied? How
large is the shortage of petrol?

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