Transcript Slide 1

CHAPTER
Consumers, Producers,
and the Efficiency of Markets
Economics
PRINCIPLES OF
N. Gregory Mankiw
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these questions:
 What is consumer/producer surplus? How are they
related to the demand/supply curves?
 How do they relate to identifying the best market
outcomes?
 What is deadweight loss?
 How do these concepts relate to mechanisms, like
taxes, that are artificially imposed upon the
marketplace?
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Welfare Economics
 Recall, the allocation of resources refers to:
 how much of each good is produced
 which producers produce it
 which consumers consume it
 Welfare economics studies how the allocation
of resources affects economic well-being.
 First, we look at the well-being of consumers.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Willingness to Pay (WTP)
A buyer’s willingness to pay for a good is the
maximum amount the buyer will pay for that good.
WTP measures how much the buyer values the good.
name
WTP
Anthony $250
Chad
175
Flea
300
John
125
Example:
4 buyers’ WTP
for an iPod
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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WTP and the Demand Curve
P
$350
$300
P
Qd
$250
$200
$301 & up
0
251 – 300
1
$150
176 – 250
2
$100
$50
126 – 175
3
0 – 125
4
$0
Q
0
1
2
3
4
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing
to pay minus the amount the buyer actually pays:
CS = WTP – P
name
WTP
Anthony $250
Suppose P = $260.
Flea’s CS = $300 – 260 = $40.
Chad
175
Flea
300
The others get no CS because
they do not buy an iPod at this
price.
John
125
Total CS = $40.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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CS and the Demand Curve
P
Flea’s WTP
$350
$300
Anthony’s WTP
$250
$200
Instead, suppose
P = $220
Flea’s CS =
$300 – 220 = $80
Anthony’s CS =
$250 – 220 = $30
$150
Total CS = $110
$100
$50
$0
Q
0
1
2
3
4
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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CS and the Demand Curve
P
The lesson:
Total CS equals
the area under
the demand curve
above the price,
from 0 to Q.
$350
$300
$250
$200
$150
$100
$50
$0
Q
0
1
2
3
4
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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CS with Lots of Buyers & a Smooth D Curve
CS is the area b/w
P and the D curve,
from 0 to Q.
Recall: area of
a triangle equals
½ x base x height
Height =
$60 – 30 = $30.
So,
CS = ½ x 15 x $30
= $225.
P
The demand for shoes
$ 60
50
h
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Cost and the Supply Curve
 Cost is the value of everything a seller must give
up to produce a good (i.e., opportunity cost).
 Includes cost of all resources used to produce
good, including value of the seller’s time.
 Example: Costs of 3 sellers in the lawn-cutting
business.
name
cost
Jack
$10
Janet
20
Chrissy
35
A seller will produce and sell
the good/service only if the
price exceeds his or her cost.
Hence, cost is a measure of
willingness to sell.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Producer Surplus
PS = P – cost
P
$40
Producer surplus (PS):
the amount a seller
is paid for a good
minus the seller’s cost
$30
$20
$10
$0
Q
0
1
2
3
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Producer Surplus and the S Curve
PS = P – cost
P
$40
Chrissy’s
cost
$30
Janet’s
cost
$20
Jack’s cost
$10
$0
Q
0
1
2
3
Suppose P = $25.
Jack’s PS = $15
Janet’s PS = $5
Chrissy’s PS = $0
Total PS = $20
Total PS equals the
area above the supply
curve under the price,
from 0 to Q.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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How a Lower Price Reduces PS
If P falls to $30,
PS = ½ x 15 x $15
= $112.50
60
Two reasons for
the fall in PS.
40
2. Fall in PS due to
remaining sellers
getting lower P
P
50
1. Fall in PS
due to sellers
leaving market
S
30
20
10
Q
0
0
5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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CS, PS, and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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The Market’s Allocation of Resources
 In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.
 Is the market’s allocation of resources desirable?
Or would a different allocation of resources make
society better off?
 To answer this, we use total surplus as a measure
of society’s well-being, and we consider whether
the market’s allocation is efficient.
(Policymakers also care about equality, though are
focus here is on efficiency.)
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Efficiency
Total
= (value to buyers) – (cost to sellers)
surplus
An allocation of resources is efficient if it maximizes
total surplus. Efficiency means:
 The goods are consumed by the buyers who
value them most highly.
 The goods are produced by the producers with the
lowest costs.
 Raising or lowering the quantity of a good
would not increase total surplus.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Evaluating the Market Equilibrium
Market eq’m:
P = $30
Q = 15,000
Total surplus
= CS + PS
Is the market eq’m
efficient?
P
60
S
50
40
CS
30
PS
20
10
D
Q
0
0
5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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Does Eq’m Q Maximize Total Surplus?
The market
eq’m quantity
maximizes
total surplus:
At any other
quantity,
can increase
total surplus by
moving toward
the market eq’m
quantity.
P
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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The free market vs. central planning
 Suppose resources were allocated not by the
market, but by a central planner who cares about
society’s well-being.
 To allocate resources efficiently and maximize total
surplus, the planner would need to know every
seller’s cost and every buyer’s WTP for every good
in the entire economy.
 This is impossible, and why centrally-planned
economies are never very efficient.
CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS
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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 good’s price,
or a specific amount for each unit sold.
 For simplicity, we analyze per-unit taxes only.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
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EXAMPLE 3: The Market for Pizza
Eq’m
w/o tax
P
S1
$10.00
D1
500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Q
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A Tax on Buyers
The
price
buyers
pay
Hence,
a tax
on buyers
is
nowthe
$1.50
higher
than
shifts
D curve
down
the
market
price
by the
amount
ofP.
the tax.
Effects of a $1.50 per
unit tax on buyers
P
P would have to fall
by $1.50 to make
$10.00
buyers willing
to buy same Q
as before.
$8.50
E.g., if P falls
from $10.00 to $8.50,
buyers still willing to
purchase 500 pizzas.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
S1
Tax
D1
D2
500
Q
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A Tax on Buyers
New eq’m:
Effects of a $1.50 per
unit tax on buyers
Q = 450
Sellers
receive
PS = $9.50
Buyers pay
PB = $11.00
P
PB = $11.00
S1
Tax
$10.00
PS = $9.50
Difference
between them
= $1.50 = tax
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
D1
D2
450 500
Q
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The Incidence of a Tax:
how the burden of a tax is shared among
market participants
In our
example,
buyers pay
$1.00 more,
P
PB = $11.00
S1
Tax
$10.00
PS = $9.50
sellers get
$0.50 less.
D1
D2
450 500
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Q
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A Tax on Sellers
The tax effectively raises
sellers’ costs by
P
$1.50 per pizza.
$11.50
Sellers will supply
500 pizzas
only if
P rises to $11.50,
to compensate for
this cost increase.
Effects of a $1.50 per
unit tax on sellers
S2
Tax S1
$10.00
Hence, a tax on sellers shifts the
S curve up by the amount of the tax.
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
D1
500
Q
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A Tax on Sellers
New eq’m:
Effects of a $1.50 per
unit tax on sellers
Q = 450
Buyers pay
PB = $11.00
Sellers
receive
PS = $9.50
P
PB = $11.00
S2
S1
Tax
$10.00
PS = $9.50
Difference
between them
= $1.50 = tax
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
D1
450 500
Q
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The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!
What matters
is this:
A tax drives
a wedge
between the
price buyers
pay and the
price sellers
receive.
P
PB = $11.00
S1
Tax
$10.00
PS = $9.50
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
D1
450 500
Q
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Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand
It’s easier
for sellers
than buyers
to leave the
market.
P
Buyers’ share
of tax burden
PB
S
Tax
Price if no tax
Sellers’ share
of tax burden
So buyers
bear most of
the burden
of the tax.
PS
D
Q
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
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Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply
P
Buyers’ share
of tax burden
S
PB
Price if no tax
Sellers’ share
of tax burden
It’s easier
for buyers
than sellers
to leave the
market.
Tax
PS
Sellers bear
most of the
burden of
the tax.
D
Q
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
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CASE STUDY: Who Pays the Luxury Tax?
 1990: Congress adopted a luxury tax on yachts,
private airplanes, furs, expensive cars, etc.
 Goal of the tax: raise revenue from those
who could most easily afford to pay –
wealthy consumers.
 But who really pays this tax?
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
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CASE STUDY: Who Pays the Luxury Tax?
The market for yachts
P
Buyers’ share
of tax burden
Demand is
price-elastic.
S
In the short run,
supply is inelastic.
PB
Tax
Sellers’ share
of tax burden
PS
D
Q
SUPPLY, DEMAND, AND GOVERNMENT POLICIES
Hence,
companies
that build
yachts pay
most of
the tax.
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The Effects of a Tax
P
Eq’m with no tax:
Price = PE
Quantity = QE
Eq’m with
tax = $T per unit:
Buyers pay PB
Sellers receive PS
Size of tax = $T
S
PB
PE
PS
D
Quantity = QT
QT
APPLICATION: THE COSTS OF TAXATION
QE
Q
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The Effects of a Tax
P
Revenue from tax:
$T x QT
Size of tax = $T
S
PB
PE
PS
D
QT
APPLICATION: THE COSTS OF TAXATION
QE
Q
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The Effects of a Tax
 Next, we apply welfare economics to measure
the gains and losses from a tax.
 We determine consumer surplus (CS),
producer surplus (PS), tax revenue,
and total surplus with and without the tax.
 Tax revenue can fund beneficial services
(e.g., education, roads, police)
so we include it in total surplus.
APPLICATION: THE COSTS OF TAXATION
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The Effects of a Tax
P
Without a tax,
CS = A + B + C
PS = D + E + F
Tax revenue = 0
Total surplus
= CS + PS
=A+B+C
+D+E+F
A
S
B
PE
D
C
E
D
F
QT
APPLICATION: THE COSTS OF TAXATION
QE
Q
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The Effects of a Tax
With the tax,
CS = A
PS = F
Tax revenue
=B+D
Total surplus
=A+B
+D+F
P
A
PB
S
B
D
C
E
PS
D
F
The tax reduces
total surplus by
C+E
APPLICATION: THE COSTS OF TAXATION
QT
QE
Q
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The Effects of a Tax
P
C + E is called the
deadweight loss
(DWL) of the tax,
the fall in total
surplus that
results from a
market distortion,
such as a tax.
A
PB
S
B
D
C
E
PS
D
F
QT
APPLICATION: THE COSTS OF TAXATION
QE
Q
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About the Deadweight Loss
P
Because of the tax,
the units between
QT and QE are not
sold.
The value of these
units to buyers is
greater than the cost
of producing them,
PB
S
PS
D
so the tax prevents
some mutually
beneficial trades.
APPLICATION: THE COSTS OF TAXATION
QT
QE
Q
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What Determines the Size of the DWL?
 Which goods or services should govt tax
to raise the revenue it needs?
 One answer: those with the smallest DWL.
 When is the DWL small vs. large?
Turns out it depends on the price elasticities
of supply and demand.
 Recall:
The price elasticity of demand (or supply)
measures how much QD (or QS) changes
when P changes.
APPLICATION: THE COSTS OF TAXATION
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DWL and the Elasticity of Supply
When supply
is inelastic,
P
it’s harder for firms
to leave the market
when the tax
reduces PS.
So, the tax only
reduces Q a little,
and DWL is small.
S
Size
of tax
D
Q
APPLICATION: THE COSTS OF TAXATION
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DWL and the Elasticity of Supply
The more elastic is
supply,
the easier for firms
to leave the market
when the tax
reduces PS,
the greater Q falls
below the surplusmaximizing quantity,
P
S
Size
of tax
the greater the DWL.
APPLICATION: THE COSTS OF TAXATION
D
Q
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ACTIVE LEARNING
3
Discussion question
 The government must raise tax revenue to pay
for schools, police, etc. To do this, it can either
tax groceries or meals at fancy restaurants.
 Which should it tax?
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The Effects of Changing the Size of the Tax
 Policymakers often change taxes, raising some
and lowering others.
 What happens to DWL and tax revenue when
taxes change? We explore this next….
APPLICATION: THE COSTS OF TAXATION
42
DWL and the Size of the Tax
Initially, the tax is
T per unit.
Tripling the tax
causes the DWL
to more than
triple.
P
new
DWL
S
T
3T
D
initial
DWL
Q3
APPLICATION: THE COSTS OF TAXATION
Q1
Q
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Revenue and the Size of the Tax
P
PB
PB
When the
tax is larger,
increasing it
causes tax
revenue to fall.
S
3T
2T
D
PS
PS
Q3
APPLICATION: THE COSTS OF TAXATION
Q2
Q
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Revenue and the Size of the Tax
The Laffer curve
Tax
shows the
revenue
relationship
between
the size of the tax
and tax revenue.
The Laffer curve
Tax size
APPLICATION: THE COSTS OF TAXATION
45