You are on page 1of 11

10/5/2015

Todays Topic

The Efficiency of
Markets and the
Costs of Taxation

Key Concepts

Recall that markets create value


Can we measure the value that is
created?
Value to consumers and to producers

When markets are interfered with


(taxes, subsidies, price floors, price
ceilings) how much of this value is
lost?

Consumer Surplus

Consumer Surplus
Producer Surplus
Deadweight losses
The deadweight loss of taxation

If the actual price of the textbook is $151,


which buyer(s) will purchase the book?

What if the price is $125?

10/5/2015

Consumer Surplus

Using Demand to Illustrate


Consumer Surplus

Consumer surplus
Difference between willingness to pay for a good and
the price actually paid to get the good

At price = $151
Only Beanie buys the book.
He gets $49 worth of consumer surplus.

Why dont Mitch and Frank buy the book?

Consumer Surplus, Graphically

Consumer Surplus, Graphically

10/5/2015

Consumer Surplus

Producer Surplus

The difference between your WTP


and the price you actually pay

If price > cost, then producer makes a


surplus, or a profit
Willingness to Sell (WTS)

Producer Surplus

Producer Surplus
Seller

Willingness to sell
tutoring services

Beanie
Mitch
Frank

$30 / hour
$20 / hour
$10 / hour

Willingness to sell determined by:


Direct costs
Opportunity costs

Question:
If the market price of tutoring is $25, which sellers will
choose to tutor?

Seller

Willingness to sell
tutoring services

Beanie
Mitch
Frank

$30 / hour
$20 / hour
$10 / hour

Producer surplus
Difference between willingness to sell a good and the
price actually received for that good
At price = $25
Mitch and Frank decide to tutor.
Frank gets $15 worth of producer surplus per
hour.
Mitch gets $5 worth of producer surplus per hour.
Why doesnt Beanie tutor?

10/5/2015

Using Supply to Illustrate


Producer Surplus

Producer Surplus, Graphically

Producer Surplus, Graphically

Consumer and Producer


Surplus
Consumer surplus graphically:
The height of the demand curve is our maximum
willingness to pay for that unit of the good.
Consumer surplus is the area below the demand
curve and above the price, for all units purchased.

Important concept:
You can only get consumer surplus on units that you
actually buy!
CS is NOT the entire area under the demand curve.

10/5/2015

Consumer and Producer


Surplus
Producer surplus graphically:
The height of the supply curve is the firms lowest
price it is willing to accept to sell that unit of the good.
Producer surplus is the area above the supply curve
and below the price, for all units sold.

Important concept:
The firm can only get producer surplus on units that it
actually sells!
PS is NOT the entire area above the supply curve.

Market Efficiency
Total surplus (or social welfare) measures the
overall welfare of the society.
Total surplus = CS + PS

In free markets with voluntary trade:


Consumers buy until their willingness to pay is equal
to the market price.
Suppliers sell until their willingness to sell is equal to
the market price.

Efficiency
Occurs when total surplus is maximized in a market

CS and PS for a Gallon of Milk

Taxation, Welfare, and


Deadweight Loss
Why do we pay taxes?
Pay for public goods, police, roads,
schools, etc.

Types of taxes
Income, payroll, corporate, sales,
excise, estate

Excise tax
A tax on a specific good; alcohol,
tobacco, gasoline, for example

Tax incidence
Refers to the party (consumers or
producers) who bears the tax burden

10/5/2015

Tax on Sellers

Tax on Buyers

End Result

Deadweight Loss

If a tax is levied on a business:

On the previous graphs, the tax had a


price and quantity effect.

The firm will attempt to raise prices to pass


some of the burden to consumers.

If a tax is levied on consumers:


Some of the burden is passed to producers
since the market price falls.

Incidence
Whether the tax is levied on the producer or
consumer, the end incidence result is the
same!

Prices increased.
Quantity traded decreased.

Deadweight loss:
A cost to society in the form of less economic
welfare resulting from the tax.
Caused by the decrease in the amount of
trade that is occurring.

10/5/2015

Deadweight Losses

Deadweight Loss, Graphically

Due to misallocation of resources


Recall Comparative Advantage and how we
learned that more value can be created with the
right allocation of production
In markets the best allocation involves having the
lowest opportunity cost producers be active in the
markets (on the lower left part of the Supply curve)

In markets we are also looking at allocating the


goods to the consumers with the highest value
https://www.youtube.com/watch?v=va6nRaZ9eRg&
feature=youtu.be

Tax Revenues and


Deadweight Loss

Incidence Depends on
Elasticities
Tax incidence is the same no matter
who the tax is levied on.
Elasticity of demand and supply can change tax incidence,
though.

Inelastic demand consumers still buy


the same amount
Most tax revenues

Elastic demand consumers avoid


some of the tax by reducing demand
Less tax revenues

Should we tax elastic or inelastic


markets?

10/5/2015

More Elastic Demand

Perfectly Elastic Demand

Inelastic Demand

Balancing Deadweight Loss


and Tax Revenues
Must ask: What is the purpose of tax?
Gain tax revenues?
Or decrease production or consumption of good
(perhaps to reduce pollution)?

Ireland, 2002
15 cent tax on plastic bags
Purpose was to curb litter,
encourage recycling
Plastic bag use fell by 90%

It was very elastic


Not much tax revenues.

10/5/2015

Deadweight Loss and Tax Revenue


Small Tax

Deadweight Loss and Tax Revenue


Medium Tax

Larger Tax
Revenues but also
larger DWL

Small Tax
Revenue and
Small DWL

Deadweight Loss and Tax Revenue


Large Tax

Further increases in
taxes can actually
decrease tax revenues
but DWL still increases

Excise Tax Summary


1. The total welfare is the same, whether a tax is
levied on the consumer or the producer.
2. A tax on a good with inelastic demand or supply
generates the maximum amount of revenue.
3. The deadweight loss of a tax is larger when
demand and supply are more elastic.
4. The incidence of a tax is determined by the
relative balance between the elasticity of supply
and the elasticity of demand.

10/5/2015

Summary

Summary

Total surplus (social welfare) is the combined


benefits that all members of society enjoy from
undertaking an activity.

Whenever an allocation of resources


maximizes total surplus, the result is
said to be efficient.
Equity refers to the fairness of the
distribution of the benefits among the
members of a society.

Total surplus = CS + PS

Markets maximize consumer and producer


surplus, provide goods and services to buyers
who value them most, and reward sellers who
can produce goods and services at the lowest
cost.

Efficiency does not imply equity.

As a result, markets create the largest amount of


social welfare possible.

Summary
Deadweight loss is the cost to society
created by tax inefficiencies.
The amount of revenue a tax generates is
maximized when the good that is taxed is
inelastic.
The Laffer curve provides a limit on the
expansion of taxation.

Practice What You Know


The height of the demand curve at any quantity
can be thought of as the ___________.
a.
b.
c.
d.

willingness to buy
willingness to sell
consumer surplus
producer surplus

Tax revenues peek at moderate rates, where


the trade-off from higher taxes is exactly offset
by the loss of economic activity.

10

10/5/2015

Practice What You Know


The difference between the price the good was
sold at and the minimum price the firm would
have accepted for the good is called
a.
b.
c.
d.

willingness to sell.
product markup.
producer surplus.
price-cost margin.

Practice What You Know


If the government wants to create tax revenues
without generating any deadweight loss, what
type of good should they tax?
a.
b.
c.
d.

a good with a perfectly elastic demand


a good with a relatively elastic demand
a good with a perfectly inelastic demand
a good with a relatively inelastic demand

Practice What You Know


Deadweight loss can be thought of as surplus
that is transferred from producers or
consumers and given to __________.
a.
b.
c.
d.

the government
competitors in other markets
taxpayers
nobody

Homework: Two assignments


due Oct 11 @ 10 pm
Norton Smart Works
Post-quiz chapter 6
Pre-quiz chapter 7

11

You might also like