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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 legal-
market 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 per-
unit 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
70
 Sum of deadweight loss areas ABC and DRF is market inefficiency
associated with a tariff
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 ceiling-
priced 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

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