Chapter 7
Efficiency and Exchange
The Domain of Markets
• Markets are usually a good way to organize
economic activity
• Markets don’t always provide socially
efficient outcomes
• Government intervention can in some cases
improve market efficiency
Market Equilibrium and
• Pareto efficient (or just efficient)
– Is a situation where there is no change possible
that will help some people without harming
– Exists when an economy has reached a point
where reallocating resources must harm one in
order to help another
– Occurs at equilibrium of perfectly competitive
Economic Surplus
• Total economic surplus
– The sum of all the individual economic
surpluses gained by buyers and sellers
participating in the market
– Consumer Surplus
– Producer Surplus
• Consumer Surplus
– Economic surplus gained by the buyers of a product
– Measured by the difference between their reservation
price and and the price they pay
• Producer Surplus
– Economic surplus gained by the sellers of a product
– Measured by the difference between the price they
receive and their reservation price
Fig. 7.4 A Market with “Digital”
Supply and Demand Curves
Fig. 7.5 Consumer and Producer
Fig. 7.6 Supply and Demand in the
Market for Milk
Fig. 7.7 Total Economic Surplus in
the Market for Milk
Figure 7.4
Economic Surplus in an Unregulated
Market for Home Heating Oil
Economic Surplus and Efficiency
• Equilibrium price and quantity maximize
the total economic surplus
– Total economic surplus would be lower at any
other price and quantity combination
– I.E., waste occurs at any other price and
quantity combination
Figure 7.5
The Waste Caused by Price Controls
Other Goals
• An equitable (fair) income distribution is a
desirable goal for many
• Efficiency should be a very important goal
– Efficiency enables us to achieve all other goals
to the fullest possible extent
– Efficiency minimizes waste
• However, if the choice is between an
efficient but unfair outcome and an
inefficient but fair outcome, what should we
Taxes on Goods
• Reasons:
– Raise revenue for government activity
– Modify market outcomes
• Kinds
– Specific or excise, in dollars per unit (gasoline)
– Ad valorem, percent of price (sales tax)
– Lump sum, (license fee)
Three Questions
• How does the imposition of the tax affect
equilibrium price and quantity?
• Who pays the tax? Buyers or sellers?
• What is the effect of the tax on the
economic surplus?
Effect of an Excise Tax
• Can be viewed as an addition to cost or a
reduction in average revenue. Same result.
• Consider the imposition of a tax of $1 per
pound on potatoes. This will increase
marginal cost by $1 and raise the supply
curve by $1. The supply curve shifts to the
Figure 7.11
The Effect of a Tax on the Equilibrium
Quantity and Price of Potatoes
Effect in the Short Run
• The shift in supply causes the equilibrium
price to increase from $3 to $3.5 and output
to decline from three million pounds to 2.5
million pounds.
• Note that the equilibrium price did not
increase by the amount of the tax. This is
a key observation.
Taxes and Efficiency
• What happens to the price of a good when
the government imposes a tax on it?
– Most people believe that the price of the item
will rise by the amount of the tax.
• However, this will not happen in the short
run unless demand curve is vertical or the
supply curve is horizontal. In the long run,
the price will increase by the amount of the
tax in a perfectly competitive industry.
Figure 7.12
The Effect of a Tax on Sellers of a Good
with Infinite Price Elasticity of Supply
Who Bears the Burden of the Tax?
• It depends on the slopes of the demand and
supply curves. In our example, consumers
paid 50 cents more and producers received
50 cents less.
• Ceteris paribus, the steeper the demand
curve, the greater will be the burden on the
consumer. Likewise in the case of the
Taxes and Economic Surplus
• Deadweight loss
– The reduction in economic surplus that results
from a policy
– A tax distorts the signal that free prices send
Figure 7.13
The Market for Potatoes
without Taxes
Figure 7.14
The Effect of a $1/pound
Tax on Potatoes
Figure 7.15
The Deadweight Loss
Caused by a Tax
Taxes, Responsiveness, and
• Deadweight loss is minimized if taxes are
imposed on goods and services that are not
very responsive to price.
• Example on the supply side: land
• Example on the demand side: salt ( and
cigarettes, gasoline)
Taxes, External Costs, and
• Taxing reduces the equilibrium quantity
• Therefore, taxing activities that people tend
to pursue to excess can actually increase
total economic surplus (e.g., activities that
cause pollution)