Chapter 4

ECON 202:
Principles of
Microeconomics
Chapter 4:
Economic Efficiency,
Government Price Setting and
Taxes
Economic Efficiency, Government Price
Setting and Taxes
1. Introduction
2. Consumer surplus
3. Producer surplus.
4. Efficiency of competitive markets.
5. Price floors and price ceilings.
6. Economic impact of taxes.
ECON 202: Princ. of Microeconomics Economic Efficiency, Government Price Setting and Taxes 2
1. Introduction
Under perfect competition a market without intervention
reaches equilibrium:
The quantity of goods consumers are willing to buy equals the
quantity of goods firms are willing to sell.
In real world, government intervenes markets:
Price ceilings
Price floors
Taxes
What are the consequences of interventions?

Consumer, producer and economic surpluses
2. Consumer Surplus
Demand curves show willingness of consumers to

purchase a product at different prices.
Another way to see the demand curve:
Demand curve shows at each point what is the additional
benefit to a consumer in the market from consuming one
more unit.
Demand curve depicts the marginal benefit at different
prices.
2. Consumer Surplus
Example: 4 consumers in the chai tea market.
2. Consumer Surplus
Highest price willing to pay for
Price an used car ($m)
1st unit 2nd unit
Chico 10 6
Harpo 8 7
10 Groucho 5 3
8
7
6
5
1 2 3 4 5 6 Quantity
2. Consumer Surplus
Difference between highest price a consumer is willing to
pay (benefit received from consumption) and price that
actually pays.
How much would you pay for a piece of handicraft?
How to estimate Consumer Surplus in a market?
Demand curves.
2. Consumer Surplus
Total CS = $2.5 + $1.5 + $.5 = $4.5 Total CS = $3 + $2 + $1 = $6
2. Consumer Surplus
Usually there are many consumer in markets, and
demand curves are smooth lines.
CS is area below curve and above price.
$4.00
Total CS:
($2 x 15,000) ÷ 2 = $15,000
3. Producer Surplus
What are the supply curves showing to us?
The willingness of firms to supply a product at different prices.
What this “willingness” depends on?
Firms observe price in the market, compare it with production
costs and decide to produce or not.
Then, willingness to supply depends on cost of production.
When are firms willing to supply an extra unit?

Only when they recover the additional cost of producing that last
unit.
When price is higher or equal to marginal cost
3. Producer Surplus
Supply Curve
Market price
Market price
Market price
Supply curve is also the marginal cost curve.

Marginal cost increases as more resources are used.
Supply curves are usually upward sloping.
3. Producer Surplus
Difference between the lowest price a firm would be
willing to accept (marginal cost) and the price it actually
receives.
$0.25
Total PS = $.75 + $.50 + $.25 = $1.5 Total PS = ($1.75 x $15,000) ÷ 2 = $13,125
What Consumer Surplus and Producer
Surplus Measure
Consumer surplus measures the net benefit to
consumers from participating in a market rather than the
total benefit.
The net benefit equals the total benefit received by consumers
minus the total amount they must pay to buy the good.
Producer surplus measures the net benefit received by
producers from participating in a market
Total amount firms receive from consumers minus the cost of
producing the good.
4. Efficiency of Competitive Markets
Marginal benefit equals marginal cost only at competitive
equilibrium.
Economic Surplus is the sum of consumer surplus and
producer surplus.
In a competitive market, economic surplus is at
maximum when the market is in equilibrium.
Deadweight loss: The reduction in economic surplus

resulting from a market not being in competitive
equilibrium.
Consumer Surplus measures the benefit to consumers
from buying a particular good.
Producer Surplus measures the benefit to firms from
selling a particular good.
Then, Economic Surplus is the best measure we have of
the benefit to society from the production of a good.
Equilibrium in a competitive market results in the
greatest amount of total net benefit to society, from the
production of a good or service.
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.
5. Government Intervention in the Market
Consumers and firms can ask the government to legally
change the prices set in the competitive markets.
Rent control apartments
Price floor in agricultural markets
Minimum wage
What is the effect of these interventions in the markets?
Price floors
Government policy in agricultural markets
Price ceilings
Government rent control policy in housing markets
5. Government Intervention in the Market
When the government imposes price floors or price
ceilings:
Some people win.
Some people lose.
There is a loss of economic efficiency.
5. Economic Impact of Taxes
Government uses taxes to collect money or to
discourage the consumption of some goods.
What is the impact of taxes on economic efficiency?
Federal tax of $1-per-pack on cigarettes, paid by sellers.
Imposition of taxes reduce Consumer Surplus and
Producer Surplus.
Part of this reduction goes to government as tax
revenue.
The rest is lost: deadweight loss.
True burden of a tax is not only tax paid, but also the
deadweight loss.
Excess burden of the tax
A tax is efficient if it imposes a small excess burden
relative to the tax revenue it raises.
Who actually pays a tax?
Whoever is legally required to pay the tax is not
necessarily who actually bears the burden of the tax.
Actual division of the burden of the tax: tax incidence
Consumers pay 8 cents, producers 2 cents.

What happens if are the consumers legally required to
pay the tax instead of producers?
Quantitative Analysis
Demand and Supply Equations
QD = 3,000,000 – 1,000 P
QS = – 450,000 + 1,300 P
Equilibrium condition: QD = QS
Solving:
3,000,000 – 1,000 P = –450,000 + 1,300 P
3,450,000 = 2,300 P
P = 3,450,000 ÷ 2,300
Pe = $1,500
To find quantity of equilibrium, we replace Pe in any
equation:
QD = 3,000,000 – 1,000*(1,500)
QDe = 1,500,000
QS = – 450,000 + 1,300*(1,500)
QS = – 450,000 + 1,950,000
QSe = 1,500,000
With the demand and supply equation we can find the
intercepts in the vertical axis by replacing Q by zero.
Demand: (0) = 3,000,000 – 1,000P
1,000P = 3,000,000
P = 3,000,000 ÷ 1,000
P = 3,000
Supply: (0) = – 450,000 + 1,300P

1,300P = 450,000
P = 450,000 ÷ 1,300
P = 346.15
In the same way, for every price or quantity given, we
can find the corresponding quantity or price along the
curve, just by plugging the known value in the equation
QD = 3,000,000 – 1,000P
(10,000) = 3,000,000 – 1,000P
1,000P = 3,000,000 – 10,000 = 2,990,000
P = 2,990,000 ÷ 1,000
P = 2,990
QS = – 450,000 + 1,300P
QS = – 450,000 + 1,300(1,000)
QS = 1,300,000 – 450,000
QS = 850,000
Consumer Surplus = (1,500 x 1,500,000) ÷ 2 = $1,125,000,000

Producer Surplus = (1,154 x 1,500,000) ÷ 2 = $ 865,500,000
Consumer Surplus = $1,125,000,000 + A – B

= $1,125,000,000 + ($425,000,000) – ($211,250,000)
= $1,338,750,000
Producer Surplus = $865,500,000 – C – A
= $865,500,000 – ($162,500,000) – ($425,000,000)
= $278,000,000
Deadweight Loss = B + C = $211,250,000 + $162,500,000
= $373,750,000
ECON 202:
Principles of
Microeconomics
Chapter 4:
Economic Efficiency,
Government Price Setting and
Taxes

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ECON 202:

What are the consequences of interventions?

Demand curves show willingness of consumers to

Example: 4 consumers in the chai tea market.

Total CS = $2.5 + $1.5 + $.5 = $4.5 Total CS = $3 + $2 + $1 = $6

When are firms willing to supply an extra unit?

Supply curve is also the marginal cost curve.

Total PS = $.75 + $.50 + $.25 = $1.5 Total PS = ($1.75 x $15,000) ÷ 2 = $13,125

Deadweight loss: The reduction in economic surplus

What is the effect of these interventions in the markets?

Consumers pay 8 cents, producers 2 cents.

Supply: (0) = – 450,000 + 1,300P

Consumer Surplus = (1,500 x 1,500,000) ÷ 2 = $1,125,000,000

Consumer Surplus = $1,125,000,000 + A – B

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Chapter 4

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Chapter 4

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ECON 202:

 What are the consequences of interventions?

 Demand curves show willingness of consumers to

 Example: 4 consumers in the chai tea market.

Total CS = $2.5 + $1.5 + $.5 = $4.5 Total CS = $3 + $2 + $1 = $6

 When are firms willing to supply an extra unit?

 Supply curve is also the marginal cost curve.

Total PS = $.75 + $.50 + $.25 = $1.5 Total PS = ($1.75 x $15,000) ÷ 2 = $13,125

 Deadweight loss: The reduction in economic surplus

 What is the effect of these interventions in the markets?

 Consumers pay 8 cents, producers 2 cents.

Supply: (0) = – 450,000 + 1,300P

Consumer Surplus = (1,500 x 1,500,000) ÷ 2 = $1,125,000,000

Consumer Surplus = $1,125,000,000 + A – B

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What are the consequences of interventions?

Demand curves show willingness of consumers to

Example: 4 consumers in the chai tea market.

When are firms willing to supply an extra unit?

Supply curve is also the marginal cost curve.

Deadweight loss: The reduction in economic surplus

What is the effect of these interventions in the markets?

Consumers pay 8 cents, producers 2 cents.