Taxes, Efficiency, and Matching Markets

Tax Incidence and Market Surplus

• Pre-Tax Equilibrium:

  • Initial equilibrium is established at market clearing price $P^*$ and quantity $Q^*$.
  • Consumer Surplus ($\text{CS}$) before taxation is the area below the active demand curve and above $P^*$, encompassing areas $a, b, c, d$.
  • Producer Surplus ($\text{PS}$) before taxation is the area above the supply curve and below $P^*$, encompassing areas $e, f, g, h, i$.
  • The initial market achieves allocative efficiency with zero deadweight loss ($\text{DWL}$).

• Post-Tax Market Adjustments:

  • Imposing a per-unit tax shifts the supply curve back and to the left from $S$ to $S'$, reflecting an increase in input costs.
  • Equilibrium price increases to $P'$ and equilibrium quantity falls to $Q'$.
  • Consumer surplus decreases to area $a$.
  • Producer surplus decreases to areas $b, e, h$.
  • Government tax revenue equals the vertical per-unit tax multiplied by the new transacted quantity $Q'$, covering areas $c, f, i$.
  • Deadweight loss generated by the tax equals areas $d$ (lost consumer surplus) and $g$ (lost producer surplus).
  • Cross-border tax differentials (e.g., low cigarette taxes in Missouri versus high taxes in Illinois) create black market resale incentives such as illegal bootlegging across the JB Bridge.

Productive and Allocative Efficiency

• Productive Efficiency:

  • Occurs when goods and services are manufactured using the lowest cost or fewest possible resources along the supply curve.
  • Competitive firms routinely replicate cost-effective and high-margin production models (e.g., energy drinks like Budweiser's Flip 180, hard seltzers, and chicken sandwiches across McDonald's, Chick-fil-A, Jack in the Box, and Burger King).
  • Luxury goods (e.g., a limited edition $\$30{,}000$ Louis Vuitton purse versus Aldi $10\text{¢}$ or grocery plastic bags) deviate from lowest-cost production to maintain status and trademark distinction.

• Allocative Efficiency:

  • Occurs when goods are distributed to the consumers who value them most and are willing and able to pay the highest reservation price.
  • Secondary and resale markets facilitate allocative efficiency by transferring commodities from lower-valuing holders to highest-valuing buyers.

Organ Allocation, Matching Markets, and Market Repugnance

• Deadweight Loss in Prohibited Markets:

  • Humans possess two kidneys but require only one to survive, creating a biological surplus.
  • Outlawing commercial organ sales prevents mutually beneficial voluntary transactions, yielding deadweight loss by denying organs to individuals with renal failure.

• Alvin Roth and Paired Kidney Exchange:

  • Alvin Roth designed the New England Kidney Exchange matching system to circumvent the legal ban on monetary organ compensation.
  • The system matches incompatible donor-patient pairs in simultaneous multi-party laparoscopic extractions and transplants.
  • The algorithm earned Roth a Nobel Memorial Prize and was subsequently applied to medical school residency match programs.

• Economic Repugnance:

  • Formulated in Roth's book Who Gets What and Why, repugnance describes transactions that societal or cultural norms forbid even when both transacting parties would voluntarily agree (e.g., commercial body part sales or selling a horse for ritual slaughter).
  • Repugnance acts as an institutional barrier that prevents allocative efficiency.

Questions & Discussion

• Defining Consumer Surplus:

  • Question: What is the operational definition of consumer surplus?
  • Response: The area below the demand curve and above the market clearing price.

• Defining Producer Surplus:

  • Question: What is the operational definition of producer surplus?
  • Response: The difference between the producer's reservation price (the minimum price they are willing and able to sell for, represented by the supply curve) and the market price.

• Impact of Tax Increases on Consumption:

  • Question: What is the price of a pack of cigarettes, and how would doubling it impact purchases?
  • Response: Steven stated that Chinese cigarettes currently cost approximately $\$25$ per pack. Doubling the price to $\$50$ via taxation would cause buyers to drop out of the market, demonstrating the reduction in consumer surplus and transacted quantity.

• Tuesday Class Logistics:

  • Question: Can a student take lunch from the room on Tuesday if they come to campus?
  • Response: No formal class will be held on Tuesday; the lunch may be taken freely.