ECON 130 - Public Policy Slides 2

Market Efficiency

When resources are used so that no one can be made better off without making someone else worse off.

Production Efficiency

When there is no way to reallocate production to produce the same output with fewer resources.

Consumption Efficiency (Pareto Optimal)

When no alternative allocation can make someone better off without making someone else worse off.

Competitive Market Equilibrium

Ensures goods go to consumers who value them most and are produced by firms with the lowest costs.

Price Mechanism

Allocates resources efficiently through prices that signal value and cost to buyers and sellers.

Consumer Surplus

The area between the demand curve and the price; measures buyers’ net benefit (willingness to pay minus price).

Producer Surplus

The area between the price and the supply curve; measures sellers’ net benefit (price minus cost).

Welfare (Total Surplus)

The sum of consumer and producer surplus.

Deadweight Loss

The loss of total surplus when market output differs from the efficient quantity.

When does DWL occur?

When the quantity produced is not equal to the efficient equilibrium quantity Q*.

Adam Smith’s Invisible Hand

The idea that self-interested actions of individuals and firms lead to socially optimal (efficient) outcomes.

Information Requirement for Efficiency

Consumers only need to know their preferences, budget, and price; firms only need their cost and the market price.

Market Demand (for Rival Goods)

Found by horizontally summing individual demand curves (adding quantities at each price).

Rivalrous Goods

Goods that can’t be consumed by more than one person at the same time (e.g., food, clothing).

Non-rivalrous Goods

Goods that one person can consume without reducing availability for others (e.g., national defense, public radio).

Market Supply

Obtained by summing individual firms’ supply curves horizontally.

Industry Supply Curve

Flatter than an individual firm’s curve because it aggregates many producers.

Price Floor

A legally imposed minimum price (e.g., agricultural price supports).

Price Ceiling

A legally imposed maximum price (e.g., rent control).

Subsidy

A government payment to producers or consumers that lowers the effective price.

Tax

A government-imposed payment that drives a wedge between buyer and seller prices.

Quantity Restriction

A policy limiting the number of units that can be sold (e.g., taxi medallions).

Price Support Program

Government purchases excess supply to maintain a minimum price.

Price Target Program

Government pays producers the difference between the market price and the target price (deficiency payment).

Consequences of Farm Subsidies

Payments often go to high-income farmers; total subsidies exceed welfare spending for poor families.

Rent Control Effects

Leads to housing shortages, poor maintenance, discrimination, reduced construction, and restricted mobility.

Why does rent control reduce quality?

Landlords have less incentive to maintain or build units under price caps.

Alternative to Rent Control – Subsidies

Directly assist tenants without distorting the housing market.

Alternative to Rent Control – Zoning Reform

Increases housing supply by relaxing construction restrictions.

Excise (Quantity) Tax

Levied per unit (e.g., 50¢ per gallon); creates a price wedge where Pd = Ps + t.

Value (Ad Valorem) Tax

Levied as a percentage of price (e.g., 2.4% sales tax); Pd = (1 + τ) Ps.

Tax Incidence

The distribution of the economic burden of a tax between buyers and sellers.

Key Point About Tax Burden

It depends on changes in PD and PS, not on who legally pays the tax.

Elasticity and Tax Burden

Who bears more of the tax depends on the relative elasticities of supply and demand.

Perfectly Elastic Supply

Consumers bear the entire tax burden (price to buyers rises by the full tax).

Perfectly Inelastic Supply

Producers bear the entire tax burden (price received falls by the full tax).

Three Graphical Views of a Tax

Shift supply up/left, shift demand down/left, or show a wedge equal to the tax size.

What does “efficiency” mean in economics?

Using resources so that no reallocation can make someone better off without harming another.

Why do only some consumers buy in equilibrium?

Because only those who value the good more than its price will purchase.

What ensures that production happens at lowest cost?

Firms with marginal cost below price produce; others exit.

What is deadweight loss a sign of?

Market inefficiency.

How does the invisible hand achieve social good?

Through self-interested actions aligning with efficient outcomes.

How are market demand and supply derived?

By horizontally summing individual demand or supply curves.

What kind of goods are rivalrous vs non-rivalrous?

Rival: private goods (food, clothes); Non-rival: public goods (national defense).

What is the welfare formula?

Welfare = Consumer Surplus + Producer Surplus.

What happens when a price floor is set above equilibrium?

Creates a surplus of goods.

What happens when a price ceiling is set below equilibrium?

Creates a shortage of goods.

What determines who bears the tax burden?

Relative elasticities of supply and demand.

Why are farm subsidies controversial?

They mainly benefit wealthy farmers and cost more than social welfare programs.

Why do economists oppose rent control?

It leads to shortages, poor housing quality, and inefficiency.