Economic Efficiency, Government Price Setting, and Taxes
4.1 Consumer Surplus and Producer Surplus
Surplus (noun): Something that remains above what is used or needed.
Consumer surplus: The difference between the highest price a consumer is willing to pay for a good or service and the actual price the consumer pays.
Represents the net benefit consumers receive from market participation.
Calculated as the total benefit received by consumers (in dollars) minus the amount paid for the good or service.
Producer surplus: The difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives.
Represents the net benefit producers receive from market participation.
Calculated as the total amount firms receive from consumers minus the cost of providing the good or service.
Marginal benefit is the additional benefit to a consumer from consuming one more unit of a good or service.
Consumer Surplus: Deriving the Demand Curve
The amount of benefit potential tea consumers derive from the market depends on price and their marginal benefit.
Consider four people interested in buying chai tea, each with a different maximum willingness to pay.
At prices above $6, no chai tea is sold.
At $6, one cup is sold, and so on.
Measuring Consumer Surplus
If the price of tea is $3.50 per cup, Theresa, Tom, and Terri will buy a cup.
Theresa was willing to pay $6.00, so she derives a net benefit (consumer surplus).
Tom and Terri also obtain consumer surplus.
The sum of these areas is the consumer surplus in the chai tea market.
This area is below the demand curve, above the price that consumers pay.
If the price falls to $3.00, Theresa, Tom, and Terri each gain additional consumer surplus.
Tim is indifferent between buying the cup and not.
The overall consumer surplus remains the area below the demand curve, above the new price.
Total Consumer Surplus in the Market
With many consumers, the market demand curve is a straight line.
Consumer surplus is defined as the area below the demand curve, above the price.
Total consumer surplus is shown when the price is $2.00.
Consumer Surplus Example
Access to ride-sharing service from Uber is beneficial for consumers.
We can measure how beneficial it is by estimating the consumer surplus derived in the market.
We need to know the demand curve for Uber’s services and the price of Uber’s services.
Five economists analyzed 6 months of Uber rides in New York, San Francisco, Chicago, and Los Angeles in 2015 to estimate the demand curve for Uber rides.
111 million rides were taken, with an average price of $13.30.
Measuring Producer Surplus
Heavenly Tea is a producer of chai tea.
When the market price of tea is $2.00, Heavenly Tea receives producer surplus on each cup sold.
The total amount of producer surplus tea sellers receive can be calculated by adding up the individual producer surplus received on every cup sold.
Total producer surplus is equal to the area above the supply curve and below the market price of $2.00.
Marginal cost: The additional cost to a firm of producing one more unit of a good or service.
4.2 The Efficiency of Competitive Markets
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 in which the sum of consumer surplus and producer surplus is at a maximum.
Efficiency in a Market
A market is efficient if all trades take place where the marginal benefit exceeds the marginal cost, and no other trades take place.
A market is efficient if it maximizes the sum of consumer surplus and producer surplus (i.e. the total net benefit to consumers and firms), known as the economic surplus.
Marginal Benefit vs. Marginal Cost
The demand curve describes the marginal benefit of each additional cup of tea, while the supply curve describes the marginal cost of each additional cup of tea.
If the quantity is too low, the value to consumers of the next unit exceeds the cost to producers.
If the quantity is too high, the cost to producers of the last unit is greater than the value consumers derive from it.
Only at the competitive equilibrium is the last unit valued by consumers and producers equally—economic efficiency.
Economic Surplus
The figure shows the economic surplus (the sum of consumer surplus and producer surplus) in the market for chai tea.
At the competitive equilibrium quantity, the economic surplus is maximized.
The two concepts of economic efficiency result in the same level of output.
The reduction in economic surplus resulting from a market not being in competitive equilibrium is known as deadweight loss.
Deadweight loss can be thought of as the amount of inefficiency in a market.
In competitive equilibrium, deadweight loss is zero.
4.3 Government Intervention in the Market: Price Floors and Price Ceilings
One option a government has for affecting a market is the imposition of a price ceiling or a price floor.
Price ceiling: A legally determined maximum price that sellers may charge.
Price floor: A legally determined minimum price that sellers may receive.
Price ceilings and floors in the U.S. are uncommon, but include:
Minimum wages
Rent controls
Agricultural price controls
Economic Effect of a Price Floor
The equilibrium price in the market for wheat is $6.50 per bushel; 2.0 billion bushels are traded at this price.
If wheat farmers convince the government to impose a price floor of $8.00 per bushel, quantity traded falls to 1.8 billion bushels.
Area A is the surplus transferred from consumers to producers.
Economic surplus is reduced by area B + C, the deadweight loss.
If farmers do not realize they will not be able to sell all of their wheat, they will produce 2.2 billion bushels.
This results in a surplus, or excess supply of 400 million bushels of wheat.
Price Floors in Labor Markets
Supporters of the minimum wage see it as a way of raising the incomes of low-skilled workers.
Opponents argue that it results in fewer jobs and imposes large costs on small businesses.
Assuming the minimum wage does decrease employment, it must result in a deadweight loss for society.
Economic Effect of a Rent Ceiling
Without rent control, the equilibrium rent is $2,500 per month; At that price, 2,000,000 apartments would be rented.
If the government imposes a rent ceiling of $1,500, the quantity of apartments supplied falls to 1,900,000
The quantity of apartments demanded increases to 2,100,000, resulting in a shortage of 200,000 apartments.
Producer surplus is transferred from landlords to renters. There is a deadweight loss.
Illicit Markets and Peer-to-Peer Sites
The shortage of apartments may lead to an illicit market—a market in which buying and selling take place at prices that violate government price regulations.
Landlords might switch from long-term to short-term rentals in order to avoid rent controls.
Peer-to-peer rental sites such as Airbnb have facilitated this switch.
These markets may alleviate some of the deadweight loss by allowing additional apartments to be rented, but buyers and sellers lose valuable legal protections.
When a government imposes price controls: Some people are made better off, some people are made worse off, and the economy generally suffers, as deadweight loss will generally occur.
Price Gouging
In early 2020, as the Covid-19 pandemic spread through the United States, people flocked to supermarkets and pharmacies to buy hand sanitizer, disinfectant wipes, and toilet paper; by March, these products had largely disappeared from store shelves.
People who hoped to buy them on Amazon or eBay found that sellers were charging prices far above normal. For instance, sellers on Amazon were charging $99.95 for large bottles of hand sanitizer that normally sell for $9.95.
In the short run, without price controls the price will rise.
Winners from no price controls were the sellers; the losers were the consumers.
In the medium run, suppliers will adjust to the higher demand for hand sanitizer and produce more units.
The price will change, and quantity will increase.
Marginal costs will increase initially.
A price gouging law would have kept supply from increasing.
In the long run: We would expect producers to respond to the new higher demand for hand sanitizers with permanently higher output; Price would eventually settle back to the pre-pandemic level.
Positive and Normative Analysis
Economic analysis can demonstrate that price ceilings and price floors decrease economic efficiency.
Because this is a normative question, it does not have a right or wrong answer; it depends on our values and judgments. It is possible to value the gains from these policies more than the losses.
4.4 The Economic Effect of Taxes
Taxes are the most important method by which governments fund their activities.
Per-unit taxes: Taxes assessed as a particular dollar amount on the sale of a good or service, as opposed to a percentage tax.
Example: The U.S. Federal government imposes an excise tax of 18.4 cents per gallon of gasoline as of 2021.
Taxes on Cigarettes
Without the tax, market equilibrium occurs at point A.
The equilibrium price of cigarettes is $6.00 per pack, and 4 billion packs of cigarettes are sold per year.
A $1.00-per-pack tax on cigarettes will cause the supply curve for cigarettes to shift up by $1.00.
The supply curve shifted up by $1.00, the amount of the tax.
If firms were willing to sell 4 billion packs at a price of $6.00 before the tax, the price needs to be exactly $1.00 higher in order to convince them to still sell 4 billion packs.
This is because firms’ marginal costs effectively increased by $1.00 per unit, the value of the tax.
The new equilibrium is reached.
The tax increases the price paid by consumers.
Producers receive a price, but after paying the $1.00 tax, they are left with less.
The government will receive tax revenue.
Some consumer surplus and some producer surplus will become tax revenue for the government, and some will become deadweight loss.
Efficiency of Taxes
In the “public finance” literature, economists refer to the deadweight loss from a tax as its excess burden.
Given that we want to raise tax revenue, what makes one tax preferred over another?
A tax is efficient if it imposes a small excess burden relative to the tax revenue it raises.
Economists can advise policymakers about which taxes are the most efficient.
Tax Incidence
Tax incidence: The actual division of the burden of a tax between buyers and sellers in a market.
Important observation: not “whoever has the legal obligation to pay the tax.”
The price consumers pay rises.
The price sellers receive falls.
Tax on Gasoline Paid by Buyers
If buyers have the legal obligation to pay the 10-cent-tax on gasoline, the price they pay, the price sellers receive, and the quantity traded all remain the same.
The tax incidence does not depend on who has the legal obligation to pay the tax.
Determinants of Tax Incidence
The incidence of the tax is determined by the relative slopes of the demand and supply curves.
A steep demand curve means that buyers do not change how much they buy when the price changes; this results in them taking on much of the burden of the tax.
A shallow demand curve means that buyers change how much they buy a lot when the price changes; then they could not be forced to accept as much of the burden of the tax.
Similar analysis applies for sellers.
Social Security Tax
The Federal Insurance Contributions Act (FICA) tax is 15.3 percent of wages and funds Social Security and Medicare; by law, employers pay half (7.65 percent), as do workers.
Who really ends up with most of the burden of this tax?
The answer depends on who is less sensitive to changes in wages: employers (buyers of labor) or workers (sellers of labor).
Workers are relatively insensitive to their wages; that is, they don’t change their hours-of-work decision much when their wages change.
So, workers end up with most of the burden of this tax.
Whether firms or workers have the legal obligation to pay the tax, workers end up with most of the tax burden.
Appendix: Quantitative Demand and Supply Analysis
Use quantitative demand and supply analysis.
Suppose that the demand for apartments in New York City is and the supply of apartments is:
In equilibrium, we know: (This is known as the equilibrium condition.)
Solving for the Equilibrium
We use these to find the equilibrium rent and quantity.
Find the equilibrium quantity of apartments rented: or We have found the equilibrium price and quantity; we can insert this on a demand and supply graph.
To complete the graph, let’s find the y-intercepts of the demand and supply curves, by setting: equal to zero.
Calculating the Economic Effect of Rent Controls
Suppose the city imposes a rent ceiling of $1,500 per month.
Calculate the quantity of apartments that will be rented:
Find the price on the demand curve when the quantity of apartments is 950,000.
Now the graph can guide our numerical estimates of the economic effects of the rent controls.
Triangles B + C represent the deadweight loss. Area B is: Area C is: So, the deadweight loss is $845 + 650 = $1,495 million.
Consumers lose area B ($845 million) but gain the area of rectangle A.
So, consumer surplus changes from $2,531.25 million to:
Producers lose area A ($950 million) and area C ($650 million); they originally had a surplus of $1,947.375 million, so now producer surplus is:
Summary of Computations
The following table summarizes the results of the analysis (the values are in millions of dollars):
Consumer Surplus Competitive Equilibrium Rent Control $ 2,531 $ 2,636
Producer Surplus Competitive Equilibrium Rent Control $ 1,947 $ 347
Deadweight Loss Competitive Equilibrium Rent Control $ 0 $ 1,495
I am unable to physically add images or directly explain them due to the limitations of my current text-based format. However, I can describe typical graphs associated with each concept to help you visualize them:
Consumer Surplus and Producer Surplus:
Graph: A standard supply and demand curve. The consumer surplus is represented by the area below the demand curve and above the market price. The producer surplus is the area above the supply curve and below the market price. The equilibrium point, where supply meets demand, indicates economic efficiency.
Consumer Surplus: Deriving the Demand Curve:
Graph: A step-wise demand curve. This shows individual willingness to pay for a product (like chai tea). Each step represents a consumer and their maximum price. This illustrates how different consumers derive benefit based on their willingness to pay versus the market price.
Total Consumer Surplus in the Market:
Graph: Illustrates total consumer surplus with a linear demand curve. The area below the demand curve and above the market price is shaded to represent the total surplus.
Price Floors:
Graph: Supply and demand curves, with a horizontal line above the equilibrium price representing the price floor. The area between the equilibrium and the new quantity traded shows the deadweight loss, and the rectangle indicates the surplus transferred from consumers to producers.
Rent Ceilings:
Graph: Illustrates market distortions due to rent control. The supply and demand curves show a horizontal line below the equilibrium price, which represents the rent ceiling. The area illustrates the shortage of apartments and the deadweight loss due to inefficient allocation.
Taxes on Cigarettes:
Graph: A typical supply and demand diagram where the supply curve shifts upward by the amount of the tax. The areas show changes in consumer surplus, producer surplus, tax revenue, and deadweight loss, helping to visualize the impact of the tax.
For a more detailed understanding, it would be beneficial to view actual images of these graphs. Consider searching for these graphs online or referring to your textbook for visual examples. If you provide more specific questions about interpreting these graphs, I can certainly help!