Week 4 Chap 5

Review
Suppose the price elasticity of demand for your

economics textbook is 1. If the publishers raise
the price by 5 percent,
a. total revenue will increase
b. quantity demanded will rise 5 percent
c. total revenue will not change
d. total revenue will decrease
Elasticity & Pricing
Firms base their pricing on price
elasticity of D to increase their revenue
& profit
Hairdressers – males versus females
◦ Who pays the higher price? Why?
Telephone calls – day-time versus
night-time calls
Cinema tickets – adults versus
children
Topic 4
Economic Efficiency
(Reference: Chapter 5)
Does the market achieve an

efficient allocation of resources?
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
government-imposed price ceilings
and price floors.
4. Analyse the economic impact of
taxes.
4
Demand, Marginal Benefit,
and Consumer Surplus
Your willingness to pay for something
equals the marginal benefit - the maximum
price that a person is willing to pay for a
good
A demand curve is a marginal benefit
curve – price measures a consumer’s
marginal benefit
– the area underneath the D curve measures
total benefits
Consumer Surplus
Consumer surplus is equal to the
difference between the buyer’s willingness
to pay and the actual price paid
Consumer surplus measures the net
benefits from consumption
If consumer surplus increases, then
consumers are better off
Benefits to consumers
P Qd
8 1
7 2
Assume the
6 3 equilibrium price is $5
5 4
4 5
3 6
2 7
Benefits and D Curve
P
8 Demand reflects the
maximum price consumers
are willing to pay
The D curve captures the
5
total benefits to consumers
4 Q
Benefits to consumers
P Qd $ Paid Con Surplus

8 1 5 3
7 2 5 2
6 3 5 1
5 4 5 0
Total 20 + 6
Total benefit = 26
Benefits and D Curve
P Consumer surplus is the
8 area below the demand
curve and above the
market price.
5
Amount paid
4 Q
How a change in price affects
consumer surplus
Price
A
Supply
Initial
consumer
surplus
P1 C
B
Demand
0 Q1 Quantity
consumer surplus
Price
A
Supply
Initial S
consumer
surplus
P1 C
B
P2 E
D
Demand
0 Q1 Q2 Quantity
consumer surplus
Price
A
Supply
Initial S
consumer
Increase in consumer
surplus
C
P1
B surplus
P2 E
D
Demand
0 Q1 Q2 Quantity
Supply, Marginal Cost, and
Producer Surplus
Do producers receive a similar

surplus?
The cost of one more unit of a good or
service is its marginal cost, which reflects
the minimum price that a firm is willing to
accept.
A supply curve is a marginal cost curve.
Supply & Producer Surplus
Price Producer
P QsReceived Surplus
1 0 - -
2 1 5 3
3 2 5 2
4 3 5 1
5 4 5 0
Total $20 $6
Producer surplus is the difference

between the price the producer
receives & the marginal cost
Producer surplus is measured by the
area below the price and above the
supply curve.
P
S
5 producer receives $20
4 Q
P
S
producer surplus = $6
5
Cost of production = $14
4 Q
producer surplus
Price
Supply
P1
Initial
producer
surplus
Demand
0 Q1 Quantity
producer surplus
Price
Supply
P2
P1
Initial
producer
surplus
D
Demand
0 Q1 Q2 Quantity
producer surplus
Price
Increase in producer Supply
surplus
P2
P1
Initial
producer
surplus
D
Demand
0 Q1 Q2 Quantity
Economic Efficiency
The economic well-being of a society is
measured as the sum of consumer surplus and
producer surplus
Total surplus = consumer + producer surplus
Economic efficiency is attained when the
allocation of resources MAXIMISES total
surplus.
Total Surplus
Price
Consumer Surplus
Supply
Equilibrium
Where is total
price surplus maximised?
Producer Surplus
Demand
0 Equilibrium Quantity
quantity
Total Surplus
Price
Consumer Surplus
Supply
Equilibrium TS
price = MAX only
at
EQUILIBRIUM
Producer Surplus
Demand
0 Equilibrium Quantity
quantity
Sources of Inefficiency
What happens if the market is not in
equilibrium?
Total economic surplus is not maximised
– there will be a decrease in economic
efficiency
This decrease in total surplus is called a
DEADWEIGHT LOSS
Under & Overproduction
Price
Deadweight
Supply
loss
underproduction
overproduction
Demand
0 Qe Quantity
Review
Gayle decides that she would pay as much as
$2000 for a new laptop computer. She buys the
computer and realises a consumer surplus of
$700. How much did Gayle pay for her
computer?
A. $700
B. $1300
C. $2000
D. $2700
Review
Steven is willing to pay $250 to see Taylor
Swift in concert. The ticket price is $150 but
all tickets have sold. He buys a ticket from a
scalper for $200. Steven’s consumer surplus
is:
A. $0.
B. $50.
C. $100.
D. $150.
Review
Interest in the World Cup boosts the
demand for football shoes. As a result, the
equilibrium price of football shoes _____,
the equilibrium quantity of football shoes
sold _____, and producer surplus _____.
A. Increases, increases, increases
B. Increases, increases, decreases
C. Decreases, decreases, decreases
D. Decreases, increases, increases
Chapter 5
Applications
The effects of
• price controls
• taxes
Price Controls
These are price restrictions imposed

on a market.
Are usually enacted when
policymakers believe the market
price is unfair to buyers or sellers.
Result in government-created price
ceilings and price floors.
Price Ceilings & Price Floors
Price Ceiling
◦ A legally established maximum
price at which a good can be sold.
Price Floor
◦ A legally established minimum
price at which a good can be sold.
Price Ceilings
To be effective, a price ceiling MUST be
set below the equilibrium price
Price ceilings are common in rental
markets
Price ceilings create a SHORTAGE
because Qd > Qs
Price ceilings result in black markets
Price ceilings are INEFFICIENT because
they decrease total surplus
Price ceiling in the rental market
Price (dollars
per month) S
black market
price
$2000
$1500
Rent control
price ceiling
$1000
Shortage of
apartments
D
0 1 900 000 2 000 000 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
34
Price ceiling in the rental market
Price (dollars
per month) S
black market
price
$2000
Deadweight loss
A B =B+C
$1500
D C Rent control
price ceiling
$1000
E Shortage of
apartments
D
0 1 900 000 2 000 000 2 100 000 Quantity
(apartments per month
35
Price Floors
To be effective a price floor MUST be
set above the equilibrium
A price floor will create a SURPLUS
because Qs > Qd
Price floors are common in agricultural
markets e.g. minimum wool price
Price floors are also inefficient (they
create a deadweight loss)
Price floor in the wheat market
Price
S
Price floor
Surplus wheat
$3.50
$3.00
D
0 1.8 2.0 2.2 Quantity
37
Price floor in the wheat market
Price
S
Price floor
A Surplus wheat
$3.50
B C
$3.00 Deadweight loss
=C+D
D
E
D
0 1.8 2.0 2.2 Quantity
38
Taxes
Governments levy taxes on goods and
services to raise revenue for public
purposes.
Taxes reduce market activity.
When a good is taxed, the quantity sold
is smaller; the price is higher
A tax creates a wedge between buyer
and seller
Taxes
Taxes can be levied on buyers or sellers
A tax on sellers will decrease supply
A tax on buyers will decrease demand
Example: The excise tax on petrol =
$0.40
Should the tax be imposed on buyers or
sellers?
Does it matter?
Tax Levied on Petrol Sellers
Price the
Price consumers S2 40 cents per litre tax shifts
pay after the the supply curve up.
tax
S1
$1.45
Why doesn’t the

1.10 price rise by $0.40
1.05 to $1.50?
Price the
sellers
receive after
the tax Demand
0 140 150 Quantity (millions of
litres per year)
41
Tax Levied on Petrol Buyers
Price
S
Price the
consumers $1.45
pay after
the tax
40 cents tax shifts the

1.10 demand curve down.
1.05
Price the
sellers
receive after D2 D1
the tax
litres)
42
Taxes
Does a tax on buyers have the same
effects as a tax on sellers??
Yes! – they are equivalent
Tax incidence – Who pays more of
the tax – the buyer or the seller?
It depends on . . . elasticity
Tax Incidence – Inelastic Demand
Price S2
S1
$1.45
The tax = $0.40

1.10 Buyers pay 35c
1.05 Sellers pay 5c
Why is the incidence
on the buyer?
Demand
litres per year)
44
Tax Incidence – Elastic Demand
Price S2
S1
The tax = $0.40

$1.20
Buyers pay 10c of tax
1.10 Sellers pay 30c of tax
Why is the incidence
on the seller?
0.80 Demand

litres per year)
45
The Incidence of a Tax
Who pays more of the tax – the buyer or
the seller?
The incidence of a tax will fall more on the
buyer when demand is more INELASTIC
compared to supply
The incidence of a tax will fall more on the
seller when demand is more ELASTIC
compared to supply
Taxes are generally applied to goods with a
low elasticity of demand (alcohol, tobacco,
petrol) – why?
Taxes and Efficiency
What about the efficiency of a tax?
◦ How does a tax affect consumer &
producer surplus?
◦ Will total surplus increase or decrease?
Taxes increase the price paid by
consumers, decrease the price received
by sellers & decrease quantity sold
But what happens to the tax $?
After a tax, consumers will pay
more and consume less
Consumer surplus will decrease
After a tax, producers will receive
less and sell less
Producer surplus will decrease
Effect of tax on efficiency
Price S2
Amount by which
consumer surplus
S1
decreases
$1.45
1.10 Amount by which

1.05 producer surplus
decreases
Demand
litres per year)
49
But the tax raises revenue which is re-
spent in the economy
Does the tax revenue equal the loss in
consumer and producer surplus?
No . . . It is less
The tax results in a deadweight loss – a
decrease in total surplus
Effect of tax on efficiency
Price S2
S1
$1.45
Deadweight
loss
1.10
1.05
Tax
revenue
Demand
litres per year)
51
Determinants of Deadweight
Loss
Will the DWL from a tax be big or

small?
It depends on ELASTICITY
The more elastic are demand and
supply, the larger will be the decline
in equilibrium quantity and the
larger the deadweight loss.
In panel (a), the deadweight-loss is large because
demand is relatively elastic.
In panel (b), the deadweight-loss is much smaller
because demand is now relatively inelastic.
Taxes
What goods should we tax?
Objective should be to
◦ MAXIMISE TAX REVENUE and
◦ MINIMISE the DEADWEIGHT LOSS
Therefore
tax goods that are relatively
INELASTIC
Review
In an effort to keep the nation warm, the
Tony Abbott places a price ceiling of $100 in
the market for winter jackets. What would
be the black market price?
A) $100 per jacket
B) $120 per jacket
C) $130 per jacket
D) $90 per jacket
Review
In an effort to keep the nation warm, the
Tony Abbott places a price ceiling of $100 in
the market for winter jackets. What would
be the black market price?
A) $100 per jacket
B) $120 per jacket
C) $130 per jacket
D) $90 per jacket
Review
According to the figure, the existence of a
minimum wage in the market for low-skilled
workers results in:
A. an increase in wages and
employment.
B. an increase in wages but
lower employment.
C. a decrease in wages
but higher employment.
D. a decrease in wages and
employment.
Review
Producing more than the market’s equilibrium
quantity of apples means that:
A.an additional apple would add more to
society’s cost that to its benefit.
B.consumer surplus will be higher than
otherwise would be the case.
C.total surplus will be higher than otherwise
would be the case.
D.an additional apple would add more to
society’s benefit that to its cost.
Review
Assume that a new tax is levied on a good and the
government uses the funds to build statues of Tony
Abbott. In this case there would be:
A. an increase in consumer surplus to consumers of
the taxed good.
B. an increase in producer surplus to producers of
the taxed good.
C. a probable increase in the welfare of society that
exceeded the deadweight loss from the tax.
D. None of the above would occur.

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Review

Suppose the price elasticity of demand for your

Does the market achieve an

P Qd $ Paid Con Surplus

Do producers receive a similar

Producer surplus is the difference

5 producer receives $20

These are price restrictions imposed

Why doesn’t the

40 cents tax shifts the

The tax = $0.40

The tax = $0.40

0 110 150 Quantity (millions of

1.10 Amount by which

Will the DWL from a tax be big or

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