Session 4

Economic Efficiency

A Snapshot

In a free, unregulated market system, market forces

establish equilibrium prices and exchange quantities.

While equilibrium conditions may be efficient, it may

be true that not everyone is satisfied.

One of the roles of economists is to use their theories

to assist in the development of policies.

Controls on Prices

Are usually enacted when policymakers believe the

market price is unfair to buyers or sellers.

Result in government-created price ceilings and

floors.

Price Ceiling

A legal maximum on the price at which a good can be sold.

Price Floor

A legal minimum on the price at which a good can be sold.

Price Ceiling: Rent Control

Rental
Price of
Apts.

Consider a common example of

rent control
Rent controls are ceilings placed
on the rents that landlords may
charge their tenants.

Rs.1000

The goal of rent control policy is

to help the poor by making
housing more affordable.

D
500

We begin by showing the market for

apartments in equilibrium (before the
government imposes any price
controls).

Quantity
of Apts.

Price Ceiling: Rent Control

A price ceiling above the
equilibrium price is not binding.
The market clears at Rs.1000
and the price ceiling is
ineffective.

Rental
Price of
Apts.

Rs.1200
Rs.1000

Just because landlords are allowed to charge

Rs.1200 rent doesnt mean they will if
they do, they wont be able to rent all of
their apartments a surplus will result,
causing downward pressure on the price
(rent). Theres no law that prevents the
price (rent) from falling, so it does fall until
the surplus is gone and equilibrium is
reached (at P = Rs.1000 and Q = 500).

D
500

Quantity
of Apts.

Price Ceiling: Rent Control

The eqm price (Rs.1000) is above
the ceiling and therefore illegal.
The ceiling is a binding constraint on
the price, and causes a shortage.

Rental
Price of
Apts.

Rs.1000

The actual quantity of apartments

Rs.800
rented equals 250, and there is a
shortage equal to 500 (the difference
between the quantity demanded, 750,
and the quantity supplied, 250.

Shortage
250

500

D
750

Quantity
of Apts.

Price Ceiling: Rent Control

In the long run, supply and demand
are more price-elastic. So, the
shortage is larger. WHY??

Rental
Price of
Apts.

Rs.1000

Quick Activity:

Rs.800

For a product, supply and demand

functions are estimated as follows:
Qs = 300 + 10P
Qd = 500 15P.
If the government fixes a price ceiling of
Rs.15 for the product, then what will be
its impact on the market.

Shortage
100

500

D
900 Quantity
of Apts.

Price Ceiling: Rent Control

Who gains from this arrangement? The people who are able to get
housing at low rents.

But the unsatisfied demand shows up in various ways. First, landlord

charges high deposits. Secondly, illegal transactions take place in the
form of charging high rents without issuing corresponding receipts.
Landlords also might use their discretion to screen applicants, for
example, some landlords might rent out flats only to vegetarians.

In the long run, the smaller value from housing as an asset might
discourage landlords from providing adequate maintenance services.
It is not uncommon to see houses in dilapidated conditions when rent
control act is enforced vigorously. Over time, funds are switched to
other types of investment and less funds are deployed in the housing
industry, thus shifting the supply curve to the left, and aggravating
the initial condition of excess demand.

Price Floor: Minimum Wage

Now we switch gears and look at the
effects of a price floor. We illustrate
this concept using the example of the
minimum wage.
The price of labor is more
commonly known as the wage, which
we measure on the vertical axis of
our supply-demand diagram. Along
the horizontal axis, we measure the
quantity of labor (number of
workers). The demand for unskilled
labor comes from firms. The supply
comes from workers.

Rs.50

D
500

We focus on unskilled labor because

the minimum wage is not relevant
for higher skilled, higher wage
workers.

Price Floor: Minimum Wage

A price floor below the eqm price is not
binding has no effect on the market
outcome.

At a wage of Rs.40, the quantity of unskilled

workers that firms wish to hire exceeds the Rs.50
quantity of unskilled workers that are
Rs.40
looking for jobs, resulting in shortages.
But the minimum wage law does not stop
the wage from rising above Rs.40. So, in
response to this shortage, the wage will rise
until the shortage disappears which occurs
at the equilibrium wage of Rs.50. The
equilibrium wage is perfectly legal when the
price floor (i.e. minimum wage) is below it.

D
500

Price Floor: Minimum Wage

W

Now, the minimum wage exceeds the

equilibrium wage. The equilibrium wage
(or any wage below Rs.60) is illegal.
Rs.60
In this case, the actual wage will be Rs.60.
It will not be lower, because any lower wage Rs.50
is illegal. It will not be higher, because at
any higher wage, the surplus would be even
greater. The actual number of unskilled
workers with jobs equals 400. 550 want
jobs, but firms are only willing to hire 400,
leaving a surplus (i.e. unemployment) of
150 workers.
A surplus of anything especially labor
represents wasted resources.

Surplus

D
400 500 550

Price Floor: Minimum Wage

When the government decrees the minimum wage act, there is

excess supply of labour. Since some workers would have been
willing to work for lower wages, a contract system of wages
tends to develop. Workers are employed for smaller periods or
in smaller numbers, so that the minimum wage provision does
not apply, or they are not paid other benefits like medical
benefits, PF, gratuity, etc.

In the longer run, employers might switch to more machineintensive processes to economize on labour costs.

Taxes

The govt levies taxes on many goods & services to raise

revenue to pay for national defense, public schools, etc.

The govt can make buyers or sellers pay the tax.

The tax can be a % of the goods price, or a specific amount

for each unit sold.

For simplicity, we analyze per-unit taxes only.

Tax incidence is the manner in which the burden of
a tax is shared among participants in a market.

Taxes on Sellers: Market for Pizza

Consider the market for pizza

Price of
Pizza

Rs.10

We begin by showing the market for

pizza in equilibrium (before the
government imposes any taxes).

D
500

Quantity
of Pizza

Taxes on Sellers: Market for Pizza

Price of
The government makes sellers pay a
Pizza
Rs.1.50 on each pizza they sell. The
new supply curve (in red, labeled S2)
reflects sellers supply as a function of
Pb = Rs.11
the after-tax price.

S
2

S1

Taxes

Rs.10
Ps = Rs.9.50

Making sellers pay a Rs.1.50 tax on each unit

they sell is equivalent to a Rs.1.50 increase
in the cost of producing each pizza. Anything
that increases production costs causes the S
curve to shift up: In order for sellers to be
willing to supply the same quantity as before,
they must receive a higher price to
compensate them for the increase in their
costs.

D
430

500

Quantity
of Pizza

Taxes on Sellers: Market for Pizza

Define supply price Ps as the price
that the seller actually receives
after paying the tax, and demand
price Pb as the price that the
buyers ultimately pay.
Thus Ps = Pb - t

Price of
Pizza

S
2

Pb = Rs.11
Rs.10
Ps = Rs.9.50

Taxes

The government will collect the tax revenue

equal to the tax per pizza multiplied by the
number of pizzas sold, which is equal to 645.
Consumers will pay a higher price of Rs.11
per pizza. Although the sellers appear to be
receiving a higher price per pizza, in reality,
after they have paid the tax, the price they
receive falls from Rs.10 to Rs.9.50 per pizza.

S1

D
430

500

Quantity
of Pizza

Quick Activity
Consider the demand function Qd = 10 P and the supply
function Qs = P. Suppose the government levies a tax of 10
paise per unit on the sellers.
(a) How will the imposition of the tax going to affect the
equilibrium price and quantity?
(b) How is the burden of tax shared between buyers and
sellers?
(c) How will your result alter if the taxes are imposed on
the buyers (and not sellers)?

Tax Incidence and Elasticity

What determines tax incidence?

It is elasticity specifically, the price elasticities of

supply and demand
Two Possibilities:

supply is more price-elastic than demand

demand is more price-elastic than supply

Case 1:
Supply is more price-elastic than demand

Sellers are relatively more responsive to changes

in price, and the supply curve is less steep than
the demand curve.
Buyers have relatively fewer alternatives, so they
have to eat most of the price increase caused by
the imposition of the tax.

Result

Greater burden borne by buyers (Pharmaceuticals)

Case 2:
Demand is more price-elastic than supply

buyers are relatively more price-sensitive, and the demand

curve is less steep than the supply curve.
Buyers have relatively more alternatives, so they can avoid
most of the tax. Sellers are less flexible, so they have to
eat a greater share of the price increase caused by the
tax.

Result

Greater burden borne by sellers (Luxury

Hospitality Sector)

Example
Who pays the luxury tax?

Demand for Mercedes (and other luxury items) is priceelastic: if the price of Mercedes rises, rich consumers can
easily avoid the tax by spending their millions on some
other luxury car.
Supply of Mercedes is less elastic, especially in the short
run. It is difficult for the companies that build Mercedes to
re-tool their factories and reeducate their workers to
produce some other product.
Hence, companies that build Mercedes (and companies that
sell other luxury items) pay most of the tax, and the rich
pay relatively little of it.

Welfare Implications

Consumer Surplus
A buyers willingness
to pay (WTP) for a good
is the maximum amount
the buyer will pay for
that good.

WTP measures how

much the buyer values
the good.

Example:
4 buyers WTP for a
smartphone

name
Anthony

WTP
$250

Chad

175

Flea

300

John

125

Consumer Surplus
Q: If price of a smartphone is $200, who will buy
the smartphone, and what is quantity
demanded?
A: Anthony & Flea will buy the smartphone, Chad
& John will not.
Hence, Qd = 2
when P = $200.

Consumer Surplus
Derive the
demand
schedule:

who buys

P
$301 & up
251 300

nobody
Flea

Qd
0
1

176 250

Anthony, Flea

126 175

Chad, Anthony,
Flea

John, Chad,
Anthony, Flea

0 125

Consumer Surplus
This D curve looks like a staircase
with 4 steps one per buyer.
If there were a huge no. of buyers,
as in a competitive market, there
would be a huge no. of very tiny steps
and it would look more like
a smooth curve.

$350
$300
$250
$200
$150
$100
$50
$0
0

Consumer Surplus
Consumer surplus is the amount a buyer is
willing to pay minus the amount the buyer actually
pays:

CS = WTP P
Suppose P = $260.
Fleas CS = $300 260 = $40.
The others get no CS as they do not buy a smartphone at this price.
Total CS = $40.

Consumer Surplus
Fleas WTP

$350
$300

P = $260
Fleas CS =
$300 260 = $40

$250
$200

Total CS = $40

$150
$100
$50
$0
0

Consumer Surplus
The lesson:
Total CS
equals the
area under
the demand
curve above
the price, from
0 to Q.

Fleas WTP

$350
$300

Anthonys WTP

$250
$200

Suppose P = $220
Fleas CS =
$300 220 = $80

$150

Anthonys CS =

$100
$50

$250-220 = $30
Total CS = $110

$0
0

Consumer Surplus
P
CS

is the area
b/w P and the D
curve, from 0 to Q.
Recall:

area of
a triangle equals
x base x height
Height

=
60 30 = 30.
So,

CS = x 15 x 30
= 225.

60

The demand for shoes

50
h
40
30

Pairs of shoes

20
10

Q
0

5 10 15 20 25 30

Consumer SurplusP
If P rises to 40,
CS = x 10 x 20
= 100.

Two

reasons for the

fall in CS.

2. Fall in CS due to
remaining buyers
paying higher P

60

The demand for shoes

50

1. Fall in CS due to
buyers leaving
market

40
30
20
10

Q
0

5 10 15 20 25 30

Producer Surplus
1)

Producer surplus is the analogous measure for producers.

Some producers are producing units at a cost just equal to
the market price.

2)

Other units, however, could be produced for less than the

market price, and would still be produced and sold even if
the market price was lower. Producers therefore enjoy a
benefit a surplus from selling these units.

3)

For each unit, the producers surplus is the difference

between the market price the producer receives and the
marginal cost of producing this unit.

Producer Surplus
P

Suppose P =40.

60

The supply of shoes

50

At Q = 15, the
marginal sellers
40
cost is 30, and his
producer surplus is 30
10.
20

Pairs of shoes

10
0

Q
0

5 10 15 20 25 30

Producer Surplus P
PS is the area b/w
P and the S curve,
from 0 to Q.

The height of this

triangle is
40 15 = 25.

So,
PS = x b x h
= x 25 x 25
= 312.50

The supply of shoes

60

50
40
30
h
20
10
0

Q
0

5 10 15 20 25 30

Producer Surplus P
If P falls to $30,
PS = x 15 x $15
= $112.50

Two

reasons for
the fall in PS.
2. Fall in PS due to
remaining sellers
getting lower P

60
50

1. Fall in PS
due to sellers
leaving market

40
30
20
10
0

Q
0

5 10 15 20 25 30

Consumer Surplus and Producer Surplus

What Consumer Surplus and Producer Surplus
Measure
Consumer surplus measures the
benefit to consumers from
participating in a market, and
producer surplus measures the
benefit to producers from
participating in a market.

The Efficiency of Competitive Markets

Economic Surplus

Economic Surplus Equals the

Sum of Consumer Surplus and
Producer Surplus

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 produced is
equal to its marginal cost of production,
and where the sum of consumer surplus
and producer surplus is at a maximum.

PRICE SUPPORTS
price support: Price set by
government
above
freemarket level and maintained
by governmental purchases
of excess supply.

When a Market Is Not

in Equilibrium, there
is a Deadweight Loss
Deadweight loss The
reduction in economic
surplus resulting from a
market not being in
competitive equilibrium.

PRICE SUPPORTS

Price Supports

To maintain a price Ps above the

market-clearing price P0, the
government buys a quantity Qg.
The gain to producers is A + B +
D. The loss to consumers is A +
B.
The cost to the government is the
speckled rectangle, the area of
which is Ps(Q2 Q1).

Total change in welfare: CS + PS Cost to Govt. = D (Q2 Q1)Ps

Supporting the Price of Wheat: An Example

2014 Supply: QS = 1800 + 240P
2014 Demand: QD = 3550 266P

The Wheat Market in 2014

To increase the price to

$3.70, the government
must buy a quantity of
wheat Qg.
By buying 122 million
bushels of wheat, the
government increased
the market-clearing
price from $3.46 per
bushel to $3.70.

2014 Total demand: QDT = 3550 266P + Qg

Qg= 506P 1750
Qg= (506)(3.70) 1750 = 122 million bushels
Loss to consumers = A + B = $624 million
Cost to the government = $3.70 x 122 million = $451.4 million
Total cost of the program = $624 million + $451.4 million = $1075 million
Gain to producers = A + B + C = $638 million

THE IMPACT OF A TAX

Tax of a certain amount of money per unit sold.
Pb is the price (including the
tax) paid by buyers. Ps is the
price that sellers receive, less
the tax.
Here the burden of the tax is
split evenly between buyers
and sellers.
Buyers lose A + B.
Sellers lose D + C.
The government earns A + D
in revenue.
The deadweight loss is B + C.

Market clearing requires four conditions to be satisfied after the tax is in place:
QD = QD(Pb)
QS = QS(Ps)
QD = QS
Pb Ps = t

THE IMPACT OF A TAX

QD = 150 25Pb
QS = 60 + 20Ps
QD = QS
Pb Ps = 1.00

Effect of a $1-per-gallon tax:

(Demand)
(Supply)
(Supply must equal demand)
(Government must receive $1.00/gallon)

150 25Pb = 60 + 20Ps

Pb = Ps + 1.00
150 25(Ps + 1) = 60 + 20Ps
20Ps + 25Ps = 150 25 60
45Ps = 65, or Ps = 1.44
Q = 150 (25)(2.44) = 150 61, or Q = 89 bg/yr
Annual revenue from the tax tQ = (1.00)(89) = $89 billion per year
Deadweight loss: (1/2) x ($1.00/gallon) x (11 billion gallons/year = $5.5 billion
per year

Gasoline demand: QD = 150 25P

Gasoline supply: QS = 60 + 20P
Impact of $1 Gasoline Tax

The price of gasoline at

the pump increases from
$2.00 per gallon to
$2.44, and the quantity
sold falls from 100 to 89
bg/yr.
Annual revenue from the
tax is (1.00)(89) = $89
billion (areas A + D).
The two triangles show
the deadweight loss of
$5.5 billion per year.