Chapter 10

TERMS

Consumer/producer surplus
economic efficiency - exchange/production
dead weight loss
tax
price ceiling/floor
equity/efficiency

What is the link between efficiency, equity and policy? First we need to examine the notion of consumer and producer surplus.

Consumer surplus we have already discussed - it's the additional benefit captured by consumers who pay a price that is lower than the price they were willing to pay - on the graph it is the triangle between the price line, the demand curve and the Y axis.

Recall that the demand curve represents people's marginal willingness to pay for a good. There are some people who are willing to pay a lot for a good, but they are able to buy it more cheaply, because of market forces. Or another way to think about it is that most consumers will pay more for the first unit of a good than they will pay for subsequent units.

At the same time, there are some suppliers who would have been willing to supply some goods more cheaply than the market price (generally because their costs are lower), so they are getting more than they would have been willing to sell their goods for.

Producer surplus is an equivalent concept - it is additional earnings that a producer gets, over his/her production cost. Since some units of production are cheaper to produce than others (because of MC), producers capture some PS. On the graph this is the triangle between the price line, the supply curve and the Y axis.

On the graph we see then that there are two areas, one under the demand curve and above the price, the other above the supply curve and below the price, which we can think of as a bonus to both consumers and producers. Economists call these two areas consumer (CS) and producer surplus (PS).

We can calculate C and PS using the following equations:

CS=½ * (p_o – p_e) * q_e

where p_o is the price where the Demand curve crosses the Y axis.

PS=½ * (p_e – p₀₀) * q_e

where p₀₀ is the price where the Supply curve crosses the Y axis.

A market is defined as economically efficient if all costs and benefits are reflected in the S and D curves and the market is in equilibrium. (After the midterm we will talk about the case where the S and D curves do NOT adequately reflect all costs and benefits.) This is the case where consumer and producer surplus are maximized and there is no lost C and PS.

Let's look at this issue using real numbers.

Going back to our earlier example about hotdogs (remember we had Betty, Juan and Frances, for now we will concentrate on Juan and Frances) where WP is willingness to pay, MB is marginal benefit (also marginal willingness to pay), CS is consumer surplus.

Assuming that the market price of hotdogs is $.75, we can graph and then calculate C and PS.

P	Supply	Demand before	Demand after (in-class)
2.50	180	0	0
2.25	160	0	10
2.00	140	0	20
1.75	120	0	30
1.50	100	10	40
1.25	80	20	50
1.00	60	30	60
0.75	40	40	70
0.50	20	50	80
0.25	0	60	90
0	-	70	100

In this case, to p_o = 1.75, p_e = .75, q_e = 40, so [ ½ (1.75-.75) * 40] = 20 = CS

p_o = .25, p_e = .75, q_e = 40, so [ ½ (.75-.25) * 40] = 10 = PS

The difference between the cost of production and the price received is the PS. This is the area above the supply curve and below the price.

Given that CS is a function of a given price (if you don't know the price you can't calculate CS), every time the price changes CS changes. PS also changes.

So let's look at the situation when the price rises.

What if Demand shifts? (We will do this for an in-class exercise.

Can you think of any examples of markets where there is no consumer surplus and instead sellers get it all?

What conditions would probably have to exist?

Economists argue that allowing the market to guide the distribution of goods and services is 'efficient.' This leads to the maximum total surplus (the sum of CS and PS).

Under an economically efficiently outcome, market forces determine price and quantity and the lowest cost producers supply goods to the market, while the consumers who are willing to pay the most purchase those goods. What might be wrong with this model? What is one of the determinants of 'willingness to pay?' What examples do we have where the market breaks down.

Why do economists USUALLY BUT NOT ALWAYS think taxes are inefficient.

One way to graph the impact of a tax is to add the tax to the supply curve. Suppose a tax of $0.50 is imposed in this market.

P w/out tax	P w/ tax	Supply
2.00	2.50	140
1.75	2.25	120
1.50	2.00	100
1.25	1.75	80
1.00	1.50	60
0.75	1.25	40
0.50	1.00	20
0.25	0.75	0
0	0.50	0

The quantity supplied stays the same, since the price to the producer is the same (before tax price)

How do we show a tax on a graph? (see hand-out)

What happens to the equilibrium? Will the same price be charged and the same quantity be bought and sold?

What happens to CS and PS when there are taxes?

Part of the CS and PS is kept by the consumers and producers, part is taken by the government and part is lost.

The part that is lost is called the 'dead weight loss (DWL).'

Because of this DWL, taxes are seen to be economically nefficient.

When is it necessary to put a tax or to use some other policy intervention to alter the market equilibrium?

When markets are not efficient to begin with.

When policy makers are concerned about other issues, such as equity.

Because policy makers have to fund some things which the private sector will not fund on its own.

What role does elasticity play in this.

SEE HAND-OUTS for illustration of C and PS and how different elasticities impact both revenues and the reduction in Q consumed.

In the case where demand is elastic, a tax will lead to a large drop in Q, and the government revenues collected will be small.

In the case where demand is inelastic, a tax will lead to a small drop in Q and the government will be able to collect more revenues.

What other economic interventions MAY cause a loss of efficiency (anything that moves us away from the equilibrium.)

Price ceiling is another example-

What happens to C and PS in this case?

We have actually seen the notion of efficiency earlier in the course as well - when we looked at the PPC.
Being inside the PPC is defined as economically inefficient as well - not using all your resources.

Economic efficiency can thus be defined in various ways:
1. production efficiency - whether one is using one's resources fully - illustrated by the PPC
2. exchange efficiency - this is illustrated both the S and D curves we have just looked at, and by the example of the PPC and free trade

efficiency is not the only goal of economics though - equity- how fair something is, in particular, how it impacts different groups (consumers vs. producers, or rich and poor consumers) may also be an issue. The government/society may be concerned about income distribution, or poverty for instance, and may feel that efficiency, if it leads to extreme inequality, may not be desirable. (we will look later in the semester at some examples of tensions between equity and efficiency.)