Lecture 2.

2 Chapter 5

Economic
Efficiency,
Government Price
Setting and Taxes

Learning Objectives
1. Understand the concepts of consumer surplus
and producer surplus.
2. Understand the concept of economic efficiency.
3. Explain the economic effect of governmentimposed price ceilings and price floors.
4. Analyse the economic impact of taxes.

2

Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

 Consumer surplus: The difference between the highest price a consumer is willing to pay and the price the consumer actually pays.Consumer surplus and producer surplus  Marginal benefit: The additional benefit to a consumer from consuming one more unit of a good or service. 3 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .

00.00 Demand 0 4 4 5 Quantity (cups per week) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .The demand curve is also the marginal benefit curve: Figure 5.00. $3.00 Jeff’s marginal benefit from consuming the fourth cup is $3. Jeff’s marginal benefit from consuming the fifth cup is $2.00 $2.1 Price (dollars per cup) $7.

Total consumer surplus in the market for chai tea: Figure 5.2 Price (dollars per cup) Total consumer surplus in the market for chai tea $2.00 Demand 0 5 15 000 Quantity (cups per week) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .

LEARNING OBJECTIVE 1 Consumer surplus and producer surplus  Marginal cost: The additional cost to a firm from producing one more unit of a good or service. 6 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .  Producer surplus: The difference between the lowest price a firm would have been willing to accept and the price it actually receives.

00 The marginal cost of producing the 50th cup is $2.80 The marginal cost of producing the 40th cup is $1.3a Price (dollars per cup) Supply Producer surplus on the 40th cup sold.00. 0 7 40 50 Quantity (cups per week) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .The supply curve shows marginal cost: Figure 5.80. $2. $1.

00 0 8 15 000 Quantity (cups per week) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .Total producer surplus in the market for chai tea: Figure 5.3b Price (dollars per cup) Total producer surplus from selling chai tea Supply $2.

Consumer surplus and producer surplus What consumer surplus and producer surplus measure Consumer surplus measures the net benefit (total benefit minus total price paid) to consumers from participating in a market. Producer surplus measures the net benefit (total benefit minus total cost of production) to producers from participating in a market. 9 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .

 Economic surplus: The sum of consumer surplus and producer surplus.  Deadweight loss: The reduction in economic surplus resulting from a market not being in competitive equilibrium. 10 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .The efficiency of competitive markets  Equilibrium in a competitive market results in the economically efficient level of output where marginal benefit equals marginal cost.

80.20. $1.80. marginal cost = $2. marginal cost = $1.20 $2. therefore output is inefficiently high. $2.00 Supply Marginal benefit = $1.00.4 Price (dollars per cup) Marginal benefit = $2. Both marginal benefit and marginal cost = $2.80 Demand 0 11 14 000 15 000 16 000 Quantity (cups per week) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .20. therefore output is inefficiently low.Marginal benefit equals marginal cost only at competitive equilibrium: Figure 5. which means an economically efficient output level.

Economic surplus equals the sum of consumer surplus and producer surplus: Figure 5.00 Producer surplus 0 12 Demand 15 000 Quantity (cups per week) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .5 Price (dollars per cup) Consumer surplus Supply $2.

When a market is not in equilibrium there is a deadweight loss: Figure 5.6 At competitive equilibrium At a price of $2.20 Supply A B $2.00 C E D Demand 0 13 14 000 15 000 Quantity (cups per week) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .20 Consumer surplus A+B+C A Producer surplus D+E B+D Deadweight loss None C+E Price (dollars per cup) $2.

14 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e . from the production of a good or service.  Equilibrium in a competitive market results in the greatest amount of economic surplus. or total net benefit to society.The efficiency of competitive markets Economic surplus and economic efficiency  Economic efficiency: A market outcome in which the marginal benefit to consumers of the last unit consumed is equal to its marginal cost of production. and where the sum of consumer surplus and producer surplus is at a maximum.

 Price ceiling: A legally determined maximum price that sellers may charge.Government intervention in the market Price floors and price ceilings  Price floor: A legally determined minimum price that sellers may receive. 15 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .

8 2.2 Quantity (billions of bushels per year) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .Price floor in the wheat market: Figure 5.50 A B $3.0 2.00 Deadweight loss = B+C C D 0 16 1.7 Price (dollars per bushel) Consumer surplus transferred to producers S Price floor Surplus wheat $3.

Price ceiling in the rental market: Figure 5.8 Price (dollars per month) Producer surplus transferred from landlords to renters Deadweight loss = B+C B $1500 A S Rent control price ceiling C $1000 Shortage of apartments 0 17 1 900 000 2 000 000 D 2 100 000 Quantity (apartments per month) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .

– Some people lose. three important effects occur: – Some people win.  When the government imposes price floors or price ceilings. – There is a loss of economic efficiency. 18 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .Price floors and price ceilings Price floors and price ceilings.  Black market: Buying and selling at prices that violate government price regulations. which is often very large. cont.

Price floors and price ceilings Positive and normative analysis of price ceilings and price floors Whether rent controls are desirable or undesirable is a normative question. 19 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e . Whether the gains to the winners more than compensate for the losses to the losers and the decline in economic efficiency is a matter of judgment and not strictly an economic question.

20 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e . and result in a deadweight loss. Taxes on goods and services affect market equilibrium and result in a decline in economic efficiency.The economic impact of taxes The effect of taxes on economic efficiency Taxes finance government activities. Taxes reduce the production of goods and services. Taxes reduce consumer surplus and reduce producer surplus.

9 Price (dollars per pack) Price the consumers pay after the $1.The effect of a tax on the market for cigarettes: Figure 5.00.00 tax is imposed S2 S1 B $2.90 Price received by producers after paying the tax 21 $1. Tax revenue C Demand 0 3.90 Deadweight loss or excess burden from tax 2.00 A 1.7 4 Quantity of cigarettes (billions of packets per year) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .00 per pack tax on cigarettes shifts the supply curve up by $1.

– Slope of the supply curve and the price elasticity of supply.  Who actually pays a tax? The answer depends on: – Slope of the demand curve and the price elasticity of demand.The economic impact of taxes Tax incidence: Who actually pays a tax?  Tax incidence: The actual division of the burden of a tax between buyers and sellers in a market. 22 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .

the incidence of the tax does not depend on whether a tax is collected from the buyers of the good or from the sellers.The economic impact of taxes Tax incidence: Who actually pays a tax?. cont.  Does it matter who has a legal responsibility to pay the tax?  No. 23 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .

10 1.05 Price the sellers of petrol receive after the 40 cents per litre tax 24 Demand 0 140 150 Quantity (millions of litres per year) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .10 Price (dollars per litre) Price the consumers of petrol pay after the 40 cents per litre tax S2 40 cents per litre excise tax on petrol shifts up the supply curve.The incidence of a tax on petrol: Figure 5.45 1. S1 $1.

45 of petrol pay after the 40 cents per litre tax 1.The incidence of a tax on petrol paid by buyers: Figure 5.11 Price (dollars per litre) S Price the consumers $1.05 Price the sellers of petrol receive after the 40 cents per litre tax 25 D2 0 140 150 D1 Quantity (millions of litres per year) Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .10 40 cents per litre excise tax on petrol shifts the demand curve down. 1.

26 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .What happens when the government increases ‘sin taxes’? Figure 2: Consumers pay all the tax only if demand is perfectly inelastic.

Key Terms Black market Marginal cost Consumer surplus Price ceiling Deadweight loss Price floor Economic efficiency Producer surplus Economic surplus Marginal benefit 27 Tax incidence Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e .