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Economic Efficiency
Economic Efficiency
♦ Perfectly competitive equilibrium attains economic
efficiency.
♦ Deadweight Loss
Government Interventions
♦ Price Ceilings and Floors
♦ Excise Tax
Consumer Surplus: Review
Q
Q*
Producer Surplus: Review
Definition: The net benefit to the producer from
supplying a product.(i.e. the amount that a firm
actually receives from selling a good net of the
minimum amount the firm must receive to be willing
to supply)
P ♦ The area under an ordinary
S supply curve: the cost from
P* certain production
♦ The area under the market
price and above an ordinary
supply curve provides a
measure of producer surplus.
Q
Q*
Total surplus = CS + PS
Price
Consumer Surplus S
P*
Producer Surplus D
Q* Quantity
Price Underproduction
Consumer Surplus
S
Ph
Producer Surplus D
Q Q* Quantity
Price Overproduction
P*
Q* Q Quantity
Perfectly Competitive Equilibrium Attains
Economic Efficiency
Total surplus is maximized at competitive market
equilibrium.
How does the competitive market achieve economic
efficiency? “Invisible Hand”!
♦ No central planner: Each consumer maximizes his/her own
utility. Each firm maximizes its own profit.
♦ One price rule and “the right price”: Every consumer who is
willing to pay more than the cost of producing extra output is
able to buy; every consumer who is not willing to pay the cost of
the extra output does not buy.
Economic Efficiency and Deadweight Loss
Price Ceilings
♦ The maximum legal price that can be charged
♦ Examples:
Gasoline prices in the 1970s
Rent control in New York City
Price Floors
♦ The minimum legal price that can be charged
♦ Examples:
Minimum wage
Agricultural price supports
Welfare Without Price Restrictions
Price CS S
P*
PS
Quantity
Q*
Impact of a Price Ceiling
Price S
P*
P Ceiling
Shortage D
Qs Qd Quantity
Q*
Impact of a Price Ceiling
Price CS S
Deadweight Loss
P*
P Ceiling
Shortage D
PS
Qs Qd Quantity
Q*
Impact of a Price Floor
Price
Surplus S
PF
P*
Qd Q* QS Quantity
Impact of a Price Floor
Price
CS Surplus S
PF
Deadweight Loss
P*
PS D
Qd Q* QS Quantity
Comments on minimum wage
Supporters Opponents
♦ Help the poorest class ♦ Increase unemployment
♦ Encourage people to join ♦ Benefit some workers at
workforce rather than the expense of the poorest
pursuing money through and least productive
illegal means. ♦ Increase labor cost (hurt
♦ Increase work ethic small business more)
♦ Remove low pay jobs and ♦ Jobs move to low-labor-
encourage automation cost areas.
Minimum wage in Singapore
No minimum wage in Singapore
Parliament debate in 2011: overwhelming majority of
MPs did not support minimum wage law to help low-
skilled and low-wage workers.
The MP for Bishan-Toa Payoh, Ms Josephine Teo,
pointed out that to be meaningful, a minimum wage must
force some employers to pay more than the market rate.
“Companies that do not wish to engage in the illegal
practice (of paying below minimum wage) and find it too
costly to operate in Singapore will close shop or
relocate.”
Excise Tax
P S’
CS S
T
Deadweight Loss
A
Pd
P*
Tax
Ps
D
Q1 Q* Q
PS
When the tax is paid by sellers
P
CS S
Deadweight Loss
Pd
P*
Tax
Ps
B
T
D
Q1 Q* Q
PS
When the tax is paid by buyers
P S’
S
T
A It does not matter if we shift
Pd the supply or the demand
curve: The market outcome is
P*
the same!
Ps
B T
D
Q1 Q* Q
Who bears the tax burden?
P S’
S
Increase in
T Consumers bear most
consumers’ price
Pd of the tax burden.
P*
Ps
Decrease in
producers’ price
D
Q2 Q* Q
If demand is relatively elastic at (P*, Q*)
P S’
S
Increase in
T Producers bear most
consumers’ price
of the tax burden.
Pd
P*
Decrease in
producers’ price Ps
D
Q3 Q* Q
Incidence of a tax depends on the price
elasticity of demand and supply
If demand is less elastic than supply at the
competitive equilibrium, the tax will have a larger
impact on consumers’ price.
If demand is more elastic than supply at the
competitive equilibrium, the tax will have a larger
impact on producers’ price.
The side of the market that is relatively less sensitive
to price changes will bear larger portion of the tax.
Impact of taxes on alcohol and tobacco?
“Pass-through” rule
ΔP d η ΔQ s / Q s ΔQ d / Q d
= where η= ,ε =
ΔP s
ε ΔP / P
s s
ΔP d / P d
♦ η, ε is the own price elasticity of supply and demand,
respectively.
Proof (optional):
♦ Consider equilibrium (P*,Q*), Ps = Pd = P*, Qs = Qd = Q*
♦ A tax increases Pd and decreases Ps. Both Qs and Qd drop.
♦ For market to clear, the change in quantity demanded and
supplied should be the same. ΔQ s / Q* =ΔQ d / Q *
♦ Thus η ΔP d
/ P d
ΔP d
= =
ε ΔP s / P s ΔP s
Example: Incidence of a Tax