Economic
Efficiency
Chapter 10
Slides by Pamela L. Hall
Western Washington University
©2005, Southwestern
Introduction


Underlying debate between capitalism and socialism is economic
efficiency as a necessary condition for maximizing social welfare
In a capitalist system, if an economy or market is operating efficiently
 Increase in demand for a commodity will result in increase in market price

• Provides incentive for firms to increase supply
If an economy or market is operating inefficiently, limited resources are
not allocated to their most productive markets
 Will reduce level of commodities available and decrease society’s welfare

Aim in this chapter is to develop a criterion for measuring economic
efficiency
 Can then evaluate perfectly competitive price system in terms of this
criterion and government intervention into markets
2
Introduction

Define firm economic efficiency in terms of technological, allocative, and
scale efficiency
 Consumer and producer surplus are measures of economic efficiency
• Sum, total surplus, is used as a surrogate for measuring economic efficiency
 Perfectly competitive market will, without government involvement, maximize
total surplus



• Resulting in economic efficiency
Deadweight loss is a measure of economic inefficiency
We investigate government-established ceiling prices and black market
We discuss market price supports
 Consider inefficiencies of these supports along with output controls and
target prices

• Imposition of a tax can distort prices and result in economic inefficiencies
Derive deadweight loss associated with output and sales taxes
 Show that amount of tax borne by firms and consumers depends on
elasticity of supply and demand
3
Introduction


We conclude with a discussion on inefficiency of trade
restrictions
 Deriving deadweight loss associated with tariffs and quotas
 Discussing market effects of tariffs versus quotas
Applied economists evaluate effect various government
policies and programs have on economic efficiency
 Estimate price and other market effects from various programs in
terms of efficiently allocating resources
 Suggest changes or alternative policies and programs that may
result in same objectives with an improvement in resource allocation
• For example, providing tax breaks for businesses located in
economically depressed areas provides an incentive for businesses to
relocate in these areas

Stimulates private job training and employment
4
Economic-Efficiency Criteria


Firm that efficiently allocates its resources can
improve its position
For firm economic efficiency, three criteria are
required
 Technological efficiency
• Firms are using production processes that yield highest output
levels for a given set of inputs

Assumed all firms are technologically efficient
 Allocative efficiency
• Firms minimize costs for a given level of output

Requires using least-cost combination of inputs for a given level of
output
 Input prices per marginal product of all inputs are equal
5
Economic-Efficiency Criteria

Scale efficiency
 Requires output price to equal SMC
• What consumers or society are willing to pay for an additional unit of
output must equal what it costs society to produce this additional unit of
output





Output price is how much society is willing to pay for an additional unit of
output
SMC is cost to society for producing this additional output
If p > SMC, society is willing to pay more than it costs for additional output
 Efficiency is improved if more resources are allocated to production of
this output
If p < SMC, reduction in cost from producing less of output is more than
willingness-to-pay for output
 Efficiency is improved if fewer resources are allocated to production of
this output
Perfectly competitive market meets these three criteria for
economic efficiency
6
Favorable Features Of Perfect
Competition

Consumers’ preferences are reflected in marketplace
 Called consumer sovereignty
• If there is an increase in demand for a commodity, market price will increase



Provides incentives for firms to increase output and satisfy increased demand
No government agency is required to determine level of demand and supply
Society’s resources are also allocated in most efficient manner
 Firms attempting to satisfy some increase in demand purchase more inputs
 Thus, resources naturally flow in direction of consumer preferences


Assuming flexible input and output prices, full employment of all
resources is assured
Individuals who firmly believe in free market see these favorable
features of perfect competition as very important
 They see a very limited, if any, role for central government in markets
• Instead, decentralizing decisions rests power of decision making in hands of
those individual agents directly impacted by decisions

In perfectly competitive markets, firms will respond to consumer
preferences
7
Unfavorable Features of Perfect
Competition

Results in incomplete reflection of
consumers’ desires
 Does not measure consumers’ desires for
collective or public goods
• Commodities where consumption by one consumer
does not reduce consumption of same commodity by
another consumer

For example, national defense
• Public goods jointly impact all consumers

Private goods only impact consumer who purchases and
consumes commodity
8
Unfavorable Features of Perfect
Competition

Joint-impact characteristic of public goods hampers
market’s ability to allocate resources for its
production
 Thus, some consumers may not purchase any amount of

a public good, while other consumers do purchase it
However, nonpurchasers will derive utility from public
good purchased by other consumers
• Called a free-rider problem
• Results in a misallocation of resources
• One justification for government intervention is to correct this
misallocation by government supplying public goods
9
Unfavorable Features of Perfect
Competition

Inadequate measure of social costs and benefits
 Externality
• Commodity that affects households’ utility functions or firms’ production
functions

But is out of the control of affected household or firm
 For example, a mill’s air pollution that affects a household is an
externality
 Problem with externalities is market only considers production cost
• Without also considering social cost, resources are potentially
misallocated
 When externalities exist in an economy, perfect competition provides
no method of correcting possible differences between social and
private costs resulting from these externalities
• Role for government is to correct any differences between private and
social costs
10
Unfavorable Features of Perfect
Competition

Insufficient incentive for progress
 In a system where technological advances can be quickly duplicated
by competing firms
• Limited incentive for firms to allocate resources toward innovation
 In many cases government provided resources for research and
development in industries that are close to perfectly competitive
model
• For example, in United States, land grant universities are funded by
federal and state governments for agricultural research and education

Level or magnitude of government involvement depends on
 How much weight is put on favorable features compared with
unfavorable features of perfect competition
• If an individual is a capitalist, she would discount the unfavorable
•
features of perfect competition and advocate a limited role for
government
A socialist sees unfavorable features of perfect competition as major
concerns

Suggests a major role for government for correcting these market failures
11
Consumer Surplus


Measure of net benefit a consumer receives from
being able to purchase a commodity at a particular
price
At a fundamental level, only consumer’s
preferences matter for measuring a consumer’s
welfare
 Such a measure is difficult to interpret as there is no
unique way to measure a consumer’s utility

As an alternative, consumer welfare is measured
as
 Difference between maximum amount a consumer would
be willing to pay and what actually is paid
12
Consumer Surplus

Per-unit price of a commodity measures
consumers’ marginal value of commodity
(marginal utility of consumption)
 Additional utility consumers receive from
consuming an additional unit of a commodity
• Total utility or benefit consumers obtain from
consuming a commodity at level Qe is area under
market demand curve from zero to Qe
13
Consumer Surplus

Consumer surplus measures difference between
total benefits from consumption of a commodity and
expenditure on commodity
 CS(Qe) = U(Qe) - peQe
• Illustrated in Figure 10.1


Area 0ABQe is total utility, U(Qe)
Actual expenditure for Qe is area 0peBQe
 CS(Qe) is the difference: peAB = 0ABQe - 0peBQe
• Consumers are willing to pay over $10 for the first units

But only have to pay actual market price of $5
 Receive a surplus of marginal utility
 Measured as marginal consumer surplus over and above what
they pay for these first units
14
Figure 10.1 Consumer surplus
15
Consumer Surplus

Given a negatively sloping market demand curve
 As quantity demanded increases
• Price consumers are willing to pay for an additional unit of a
commodity declines
• Marginal consumer surplus will continue to decline


Consumers will continue to purchase commodity up to Qe
 Price consumers are willing to pay for additional units is equal
to market price
 At this point, marginal consumer surplus is zero
 Consumers are indifferent in terms of purchasing the
commodity or not
Beyond this equilibrium quantity, consumers’ willingness to pay is
less than market price
 Results in negative marginal consumer surplus
 Consumers will forgo any additional purchases because such
purchases will result in a loss in surplus (welfare)
16
Consumer Surplus

If equilibrium price increases from pe to p'e
 Difference in consumers’ willingness to pay and what

they actually pay (consumer surplus) is reduced
• Area pep'eBC illustrated in Figure 10.2
Equilibrium level of consumption where marginal
consumer surplus is zero is reduced from Qe to Q'e
• Results in an additional loss in consumer surplus

Area CBD
 Total loss in consumer surplus, resulting in a reduction in
consumer surplus from peAD to p'eAB, is pe p'eBD

Reduction in price yields an increase in consumer
surplus
17
Figure 10.2 Change in consumer surplus
resulting from a price change
18
Consumer Surplus


Centrally planned economies will often consider subsidizing prices on
highly inelastic commodities such as food and housing in an effort to
boost consumer welfare
If they are interested in maximizing consumer welfare for a commodity
 Price would be zero and associated consumer surplus (welfare) would be
represented by entire area under demand curve

• 0AE in Figure 10.2
However, limited resources prevent society from maximizing consumer
surplus across all commodities
 Occurs at global bliss

Society must maximize social welfare subject to resource constraints
 Necessary condition for maximizing social welfare
• Economy must operate efficiently

Requires consideration of consumer surplus and welfare of producers (producer
surplus)
19
Producer Surplus

Producer surplus (PS) at equilibrium price and quantity is
 Pure profit plus total fixed cost
• PS(Qe) =  + TFC

Pure profit at equilibrium price and quantity is
  = TR(Qe) – STC(Qe)

Producer surplus is
 PS(Qe) = TR(Qe) – STC(Qe) + TFC

Ultimately, producer surplus is also measured as total revenue minus total
variable cost
 PS(Qe) = TR(Qe) – STVC(Qe)
• Illustrated in Figure 10.3

Total revenue, TR, is represented by area 0peAQe and STVC by area
0(SAVCe)BQe
 Difference between these areas is PS(Qe) [shaded area (SAVCe)peAB]
 Equivalent to area below price, pe, and above SMC(Qe)
• See Figure 10.4
20
Figure 10.3 Producer surplus as total revenue
minus short run total variable cost
21
Figure 10.4 Producer surplus: the area below
price and above the marginal cost curve
22
Producer Surplus

Area below SMC curve is STVC

Area above SMC and below price—producer surplus—is
 PS(Qe) = TR(Qe) – STVC(Qe)
• TR(Qe) is area 0peBQe

Producer surplus is difference between minimum amount a
firm would be willing to sell a given output, SAVC, and amount
they actually sell the units for
 Firms are indifferent between selling a unit of output or not
• When p = SAVC (start of Stage II)
• At any price above SAVC, firms are earning a per-unit surplus of p - SAVC

Per-unit surplus is firm’s marginal producer surplus
 Summing this marginal producer surplus for a given output level yields
firm’s welfare gain from supplying this output (producer surplus)
23
Producer Surplus

If equilibrium price decreases from pe to p'e
 Difference in amount firms are willing to receive for a commodity and
what they actually are paid (producer surplus) is reduced by area p'e
peCD
• Illustrated in Figure 10.5


Equilibrium level of output where marginal producer surplus
is zero is reduced from Qe to Q'e
 Results in an additional loss in producer surplus
A price enhancement yields an increase in producer surplus
 Examples of price enhancements
• Government price supports that attempt to increase firms’ producer
surplus (corporate welfare) by maintaining or enhancing output price

However, such price supports will reduce consumer surplus
24
Figure 10.5 Change in producer surplus
resulting from a change in price
25
Total Surplus and Economic
Efficiency


Government policies affecting output price or alternative
market structures will either increase consumer surplus and
decrease producer surplus or vice-versa
Such shifts in surplus often come at the price of an overall
reduction in sum of consumer and producer surplus
 Called deadweight loss (or excess burden)
• Decrease in total surplus that is not transferred to some other agent


Measure of loss in efficiency associated with a government policy or market
structure
Economic efficiency in a market may be defined where sum
of producer and consumer surplus is maximized (where
there is no deadweight loss)
 Sum of consumer and producer surplus (total surplus) is maximized
in a perfectly competitive market
• See Figure 10.6
26
Figure 10.6 Perfectly competitive equilibrium,
maximizing consumer plus producer surplus
27
Ceiling Prices

An established price maximum where selling price
is not allowed to rise above it
 Effect of a ceiling price on market for rental housing is
illustrated in Figure 10.7
• Price pe is free-market price for housing
• Without a ceiling price, quantity supplied of housing is Qe at pe


Consumer surplus is area peAB
Producer surplus is area CpeB
• Imposing a ceiling price above market equilibrium price

Imposes no constraint on market and has no market effect
28
Figure 10.7 Ceiling price
29
Ceiling Prices

When ceiling price is set below free-market price, pe, will
affect market allocation of commodities
 With pc below pe, market price cannot increase to its free-market
level
• Objective of government policy
 However, a housing shortage may be reason for high rents
• When ceiling price, pc, reduces quantity supplied from Qe to QcS and
increases quantity demanded to QcD



Even greater housing shortage results
Consumer surplus with a ceiling price of pc is pcADE, and producer surplus
is Cpc E
As a direct result of ceiling price, there is a loss in efficiency
 Measured by difference in total surplus under a free market and a
market with a ceiling price
• Deadweight loss is area EDB
30
Ceiling Prices

Pseudo-triangle, EDB, in Figure 10.7
 Illustrates deadweight loss that appears in many models
that result in efficiency loss


Deadweight triangles are called Harberger triangles
As a result of ceiling price, consumers capture part
of producer surplus and lose surplus FDB
 If net effect, pcpeFE - FDB, is positive
• Consumers gain in welfare by taking some of the surplus from
producers

This gain can make ceiling-price legislation very popular among
voters
 Even if it results in market inefficiencies
31
Ceiling Prices

Politicians who favor ceiling prices may assume that a perfectly inelastic
market supply curve
 Quantity supplied is not responsive to a price change

In Figure 10.8, consumer surplus at free-market price is peAB, and
producer surplus is 0peBQe
 Ceiling price results in no efficiency loss, so there is no deadweight loss
• Consumers capture part of producer surplus, pcpeBC


Effect of ceiling price is to shift more of surplus to consumers by taking surplus away
from producers.
Although when SQ,p = 0 total surplus remains unchanged, there is still
a problem
 Quantity demanded is still greater than quantity supplied
• Some consumers who are willing and able to rent housing at ceiling price are
unable to find a vacancy

Results in a loss of satisfaction, measured by consumer surplus that would be gained if
housing were supplied
 In Figure 10.7, this is area EDG
 In Figure 10.8, it is area CBE
32
Figure 10.8 Ceiling price with
Q,pS = 0
33
Allocation Problem


Consumers who are unable to purchase a commodity
present one of the major problems with a ceiling-price policy
Problem is how to allocate available supply
 A ceiling price results in consumers wanting to purchase more than
is being offered for sale

In a free market, this problem does not exist
 Market automatically allocates supply in such a way that quantity
supplied equals quantity demanded

Without a free market, some other mechanism is required
 Generally means that government determines the policy for
allocation
34
First-Come–First-Served

Without government rationing, a ceiling price results in allocation
mechanism called first-come–first-served
 Those consumers who are first to purchase commodity are able to purchase


it
Once commodity is exhausted, remaining consumers who want to purchase
it are unable to do so
Major problem with first-come–first-served is waiting lines
 Results in lost productivity
 Labor waiting in line is not productive

First-come–first-served is also not an efficient allocation method
 Agents with highest willingness-to-pay will not necessarily receive

commodity
What generally happens is some consumers will pay other consumers to
wait in line for them
• Effect of this is to raise price of commodity
• Information market generally develops
35
Black Markets




Civil disobedience can also occur when QcD > QcS
There will always be market forces pushing price above
ceiling price
Laws and penalties restricting these market forces are
required
However, there will generally be some consumers willing to
engage in illegal activities
 Purchase a commodity above ceiling price
 Some firms willing to supply commodity at a price above legal limit
• Called a black market

For example, currently in United States, a considerable black market exists
for exotic animals
 Endangered species such as Chinese alligator and Komodo dragon
have a black market price of as much as $15,000 and $30,000,
respectively
36
Black Markets


Black-market price and output, when a ceiling price
is established, are illustrated in Figure 10.9
Black-market supply curve is AQSB
 Lies to left of and increases more steeply than legalmarket supply curve, QS
• In a black market sellers incur greater costs and risks than in a
legal market


Higher costs may be in form of hiding production or sales or paying
government officials not to prosecute them for their illegal activities
The greater the cost of operation in black market, the steeper the
supply curve
37
Figure 10.9 Black-market price
and quantity for a ceiling price
38
Black Markets

Black-market demand curve is represented by
BQDB
 Curve’s lower endpoint is at B rather than C
• Even at legal ceiling price of pc, some potential buyers will not
buy in black market


At ceiling price pc quantity demanded in black market is not total
unsatisfied demand AC, but a smaller quantity AB
Quantity traded in black market is QB - Qc, and
quantity traded in legal market is Qc
 Total quantity traded is QB
 As a result of increased supply from black market,
consumer and producer surplus are both increased
• Reduces a portion of deadweight loss associated with ceiling
pricing
39
Efficiency Versus Equity

A ceiling-price policy is concerned with equity (the distribution of income)
 Designed to provide consumers greater purchasing power or real income


However, ceiling-price policy also affects market efficiency
Alternative solution to equity problem is a direct redistribution of income
 Various taxing policies and subsidy programs can be designed to redistribute
it

• Do not directly remove ability of free markets to allocate commodities
Once a ceiling price is established and market reacts by reducing
quantity supplied
 Becomes politically unpopular to remove ceiling price
 By not yielding in first place to political pressure to establish a ceiling
• Governments can avoid highly unpopular act of having to resend it
40
Support Prices


Established price minimum (floor) below which selling price is not
allowed to fall
Setting a support price below free-market equilibrium price has no effect
 Figure 10.10 illustrates support price, ps, with a free-market equilibrium
price, pe, and quantity, Qe
• Results in quantity supplied being greater than quantity demanded
• Maintaining this support price requires a government agency to purchase surplus
supply


And keep it out of market
Consumer surplus is reduced and producer surplus is increased
 Consumer surplus for free market is represented by area peAC with



producer surplus DpeC
Support price increases commodity price from pe to ps
Reduces consumer surplus to psAB
Producer surplus increases from DpeC to DpsE
41
Figure 10.10 Support price
42
Support Prices

Major objective of most support prices is to increase
producers’ profits
 In Figure 10.10 producer profits increase by pe psEC
 Producers capture some of consumer surplus, pe psBC, and receive
additional surplus, BEC
 Cost to taxpayers is value of commodity surplus that must be
purchased—area QSDBEQSS

Support price results in production of commodity beyond
quantity demanded
 Surplus production is stored
• Usually with intention of releasing it in times of drastic reductions in
supply

Producers do not support such releases due to negative effect on
commodity price
 Surpluses are seldom released in times of a supply shortfall
43
Support Prices


Result in an economy producing more of a commodity than society
demands
For example, U.S. agricultural policy
 In past century, most major U.S. agricultural commodities received some
type of price support
• Agricultural interests justify support prices in terms of parity


Parity in agriculture is a price of an agricultural commodity that gives the commodity a
purchasing power equivalent to what it had in a previous base year
 Slutsky-type compensation for producers of agricultural commodities
Contends that even if relative worth of an agricultural sector is declining
 Relative income within this sector should be maintained
 Generally, as an economy develops, relatively fewer resources need to be

allocated to production of agricultural commodities
Agricultural sectors’ relative worth, in terms of resource allocation and
commodities produced, decline relative to other sectors
• If any sector’s relative worth is declining, it is difficult to justify why its relative
income should be maintained

For national security reasons nations may attempt to maintain an agricultural sector
larger than a free market would provide
44
Acreage Controls

Agricultural Adjustment Act (AAA) in 1933 was
established under Franklin D. Roosevelt’s New
Deal program
 Attempted to control farm prices by reducing supply of

basic crops (wheat, cotton, rice, tobacco, corn, hogs,
dairy)
Empowered Secretary of Agriculture to
• Fix marketing quotas for major farm products
• Take surplus production off market
• Reduce production of crops by offering producers payments in
return for voluntarily reducing crop acreage
45
Acreage Controls


Partly due to AAA, farm prices increased by 85%
from 1932 to 1937
Programs as acreage controls avoid problem of
surpluses
 Designed to raise agricultural prices by limiting acreage

on which certain crops can be grown
Acreage controls assume a relatively inelastic demand
curve for agricultural products
• Increase in price and associated decrease in quantity result in
increased TR and profit
 If demand is elastic, TR will fall
• Farmers would need to be paid to reduce acreage
46
Acreage Controls

Acreage controls are where reduced supply results in supply curve
shifting leftward
 Illustrated in Figure 10.11

• Decreases quantity and increases price
• Consumer surplus is reduced
• Producer surplus is increased
Inefficiency of acreage controls is represented by deadweight loss
 Shaded area EBC

Generally, acreage controls require farmers to take some land out of
production
 However, producers will generally take marginal, relatively unproductive land
out of production and
• Increase their labor and other variable inputs, including pesticides and fertilizers,
in an attempt to maintain production
 Supply curve may not shift to left as much as policy intended
47
Figure 10.11 Acreage controls
48
Target Prices

In early 1960s price supports on major commodities were dropped
 Farmers’ incomes were protected by direct payments on fixed quantities of
products

A target price promises producers a deficiency payment
 Equal to difference between target price and market price
 Producers will produce output QSt
• Decreases price from pe to p1 for consumers
• Producer surplus is increased
• Consumer surplus increases
 Difference in price consumers pay and price producers receive
• Paid to producers by government
• Called deficiency payment
 Loss in efficiency is shaded area BDE
• However, increased agricultural production from target pricing provides an abundant
supply of relatively low-cost agricultural products
49
Figure 10.12 Target price
50
Target Prices

Once established, subsidies are extremely difficult
to remove
 In 1996, U.S. Congress passed Freedom to Farm Act
• Eliminated agricultural subsidies in favor of fixed payments to
farmers
• However, legislation failed to decrease payments to farmers
 By 2000 aid to farmers was over $22 billion—three times

1996 level
A new federal farm bill in 2002 abandoned 1996 goal of
reducing farm payments and generally increased
subsidies
51
Subsidies

United States continues to subsidize disposal of
surplus farm products under Public Law 480 (Food
for Peace) program
 Began in 1954 to dispose of surplus agricultural products


as a direct result of commodity price supports
Export enhancement program established in 1985 is
another subsidy for U.S. farm products to compete with
subsidized products from other countries
A target price is a form of a government subsidy
(negative of a tax) on a commodity
52
Subsidies

With a subsidy, government generally sets some price level
that consumers will pay for commodity
 Then subsidizes firms to a level where they will satisfy quantity
demanded at this price
 Results in same efficiency losses as a target price

Problems arise when subsidies are removed
 Firms must cut back on production, given the lower price
 In short run, may result in price dropping to below SAVC for some
firms
• Forcing these firms to shut down

Adjustment process can be hard on an economy where a
large share of industry had been subsidized and all
subsidies are removed at once
 Significant short-run unemployment of resources may occur
53
Taxes

Opposite of a subsidy is a commodity tax on a firm’s output
 May be either an output tax (quantity tax)
• Such as an excise tax


Generally levied by states on commodities such as cigarettes, motor fuel, distilled
spirits, wine, and beer
Conventionally, an excise tax is a tax per physical unit (per pack of cigarettes, per
gallon of motor fuel, or per ounce of alcohol)
 Varies by state
 For example, in July 2002 cigarette excise tax was highest in New York at $1.50
per pack
 Compared with only $0.03 in Kentucky
 Or a sales tax
• Value tax or ad valorem tax
• Levied on retail purchases
• Varies by state


Common method for state and local governments to obtain revenue
Have effect of increasing cost to consumers for purchasing a commodity
54
Taxes

Per-unit tax, t, is equal to per-unit price of a commodity
times sales-tax percentage
 For example, a 5% sales tax on a $1.00 item results in a per-unit tax,
t, of $0.05
• Illustrated in Figure 10.13

Shifts supply curve leftward
 Equilibrium quantity decreases from Qe to Qt
• Firms receive pf per unit of output and consumers pay pc
• Difference is amount of tax per unit of output

Consumer and producer surplus is reduced
 Government collects area pf pcBD in total tax revenue
• Net loss in producer plus consumer surplus is DBC

Deadweight loss as a result of sales tax
55
Figure 10.13 Sales tax, T
56
Taxes

Tax revenue collected by government may
be used to finance public goods
 As long as net benefits from these public goods
exceed deadweight loss from sales tax
• Welfare is improved as a result of tax

Sales tax is borne by both consumers and
producers
 Share of sales tax borne by consumers and
producers depends on elasticities of supply and
demand
57
Taxes


Per-unit tax t is difference between price consumers pay, pc,
and price firms receive
Same output and prices will occur with a shift in demand
curve
 Illustrated in Figure 10.14
• Welfare effects are the same, and portion of tax borne by consumers
and producers is the same

Does not matter whether tax is collected by producers with a
resulting supply curve shift or paid by consumers with a
resulting demand curve shift
 However, sales taxes are generally collected by firms, considering
lower transaction costs of collection from firms
58
Figure 10.14 Investigating the effect of a perunit sales tax, T, by shifting the demand curve
59
Taxes

If demand curve is perfectly inelastic
 Results in per-unit tax borne totally by consumers (Figure
10.15)


If demand is perfectly elastic
 Results in per-unit tax borne totally by firms
If supply curve is perfectly inelastic
 Results in per-unit tax borne totally by firms (Figure


10.16)
In long run, as supply becomes more elastic, producers’
share of sales tax is reduced
If supply is perfectly elastic
 All of tax is shifted to consumers
60
Figure 10.15 Sales tax with a
perfectly inelastic demand curve …
61
Figure 10.16 Sales tax with a
perfectly inelastic supply curve …
62
Trade Restrictions


International trade restrictions on steel and other products
result in market inefficiencies
Generally result of policymakers trying to discourage
domestic consumers from purchasing foreign instead of
domestic commodities
 Increases domestic production
• Decreases reliance on foreign production
 Maintains foreign currency reserves for purchase of foreign
commodities deemed of higher value by government

Such trade-restriction policies are costly in form of market
inefficiencies
 However, in name of national security, they are very common
63
Trade Restrictions

Illustration of market inefficiency associated with
trade restrictions
 Consider a country with an unrestricted free market for a

commodity
• Assume country has no influence on world price
Equilibria with and without international markets are
depicted in Figure 10.17
• With no international trade, point D, country’s domestic
equilibrium price and quantity are pe and Qe
• Assuming world price, pW, is below this domestic price

With international trade domestic price will then fall to this world
price
 Increases quantity demanded from Qe to Q1
 Reduces domestic quantity supplied from Qe to Q2
64
Figure 10.17 Free trade
65
Trade Restrictions

With a domestic supply of Q2, excess demand is
supplied by imports from foreign firms
 International trade results in an increase in consumer

surplus
• Area pWpeDF
• Welfare gain for consumers within this country
Area pWpeDA is a transfer of some producer surplus from
producers to consumers within this country
• Price producers receive for their output falls from pe to pW

Directly depresses producers’ profit
 This fall in price is a gain for consumers within this
country
• They gain all lost producer surplus and all of pure increase in
welfare from free trade, area ADF
66
Trade Restrictions


Introduction of low commodity prices through opening of
domestic markets to international trade can severely harm
domestic industries
In an effort to avoid damaging its domestic industries
 Countries may adopt protectionist policies with programs designed
for restricting trade

Common forms of trade restrictions are
 Tariffs
• Tax on imports that directly increases price of imported commodities
 Quotas
• Restriction on volume of an imported commodity

Effects on price and quantity imported are same for both
tariff and quota trade restrictions
 Illustrated in Figure 10.18
67
Figure 10.18 Tariff or quota trade
restrictions
68
Tariffs



With a tariff of t per unit of commodity imported
 Price of imports will rise
Small size of this country results in its imports having no
effect on world price
 All the tariff is borne by country’s consumers
World supply curve facing these consumers is perfectly
elastic
 Consumers facing higher price will decrease their quantity
demanded for commodity
• With an associated welfare loss in consumer surplus

Represented by area pWpRRF in Figure 10.18
 Loss in consumer surplus is partially offset by a gain in producer
surplus
69
Tariffs

Tariff increases domestic price of commodity
 Domestic producers respond by increasing quantity supplied from Q2
to Q4
• This increase maximizes domestic producers’ increase in producer
surplus

Area pWpRBA
 Gain in producer surplus is a transfer of some consumer surplus to
producers
 An additional amount of lost consumer surplus is transferred from
consumers to government
• Government collects revenue generated from tariff

Area CBRD
 Not all of the loss in consumer surplus from the trade restriction is
transferred
• Remainder is deadweight loss

Sum of deadweight loss areas ABC and DRF is market inefficiency
associated with a tariff
70
Quotas

If an import quota is set at level of imports resulting from
levying tariff
 Quota as a trade restriction has a very similar effect as a tariff
• Q3 - Q4 in Figure 10.18
 Domestic price, output, and consumption are all the same
• Results in same efficiency loss, represented as deadweight loss areas
ABC and DRF in Figure 10.18

However, with a quota trade restriction, government does
not collect any revenue
 Loss in consumer surplus, area CBRD, is transferred to agents who
are given rights to supply Q3 - Q4 of imports
• Rather than to government
 These agents could be foreign producers or import agents who
purchase foreign commodities for domestic consumption
71
Free Trade


Trade negotiations under General Agreement of Tariffs and
Trade (GATT) and free-trade zones such as European
Common Market and North American Free Trade
Agreement (NAFTA)
 Have either eliminated or greatly reduced trade tariffs and quotas
However, governments still attempt various protectionist
measures
 For example, under guise of food safety or environmental protection,
a country may refuse entry of foreign commodities or require
expensive testing before entry is allowed

Such trade restrictions can be investigated with same model
employed for tariffs
72
Spillover Efficiency Loss

A general economic application occurs when governments
attempt to address higher domestic prices that result from
protecting domestic industries
 By placing ceiling prices on commodities
• Introduces further government restrictions on market with additional cost
in terms of market inefficiencies


The extreme, where most if not all markets are severely restricted, yields a
centrally planned economy
This chapter has measured efficiency loss associated with
market interventions in a partial-equilibrium framework
 Ignoring spillover effects price changes have on other markets
• Not necessary to consider spillover effects into undistorted free markets
when measuring deadweight loss
73
Spillover Efficiency Loss

Price and quantity changes in undistorted free markets do
not affect efficiency
 Marginal utility of consumption is equal to marginal cost of production
• No loss in efficiency

In contrast, if one market is affected by some distortion,
there may be spillover efficiency losses in other markets
 As an example, consider how a tariff on one commodity can spill
over into market for another commodity distorted by a ceiling price
• Illustrated in Figure 10.19


In absence of a tariff on a substitute commodity, a ceiling price will reduce
market price from free-market equilibrium pe to ceiling price of pc
 Deadweight loss is area EDB
A tariff on a substitute commodity will shift demand curve to right for ceilingpriced commodity, from QD to QD'
 Resulting deadweight loss is increased by area DGHB
74
Figure 10.19 Spillover deadweight loss,
ceiling price with a tariff …
75