5Economic Efficiency, GovernmentPrice Setting, and TaxesChapter SummaryAlthough rent controls no longer in Australia, many governments around the world, such as Malaysia and the U.S., have placed ceilings on the maximum rent some landlords can charge for some apartments and houses. Governments also impose taxes in some markets. To understand the economic impact of government in markets it is necessary to understand consumer surplus and producer surplus.Consumer surplus is the dollar benefit consumers receive from buying goods and services at market prices less than the maximum prices they would be willing to pay. Producer surplus is the dollar benefit producers receive from selling goods and services at prices greater than the minimum prices they would be willing to accept. In a competitive market with no externalities the equilibrium price for a good or service occurs where the marginal cost of the last unit produced and sold is equal to the marginal benefit consumers receive from the last unit bought. At this same level of output, economic surplus, the sum of consumer and producer surplus, is maximized.Although price controls on rent no longer exist in Australia, there are many other examples of the government setting prices, such as the minimum wage in labour markets (a “floor price”). Compared to the competitive equilibrium, price ceilings and price floors reduce economic efficiency.A tax on the sale of a good or service also reduces economic efficiency. The burden of a tax (or tax incidence) is the degree to which consumers or producers actually pay the tax. The incidence of a tax depends on how responsive producers and consumers are to the price change caused by the tax.Learning ObjectivesWhen you finish this chapter you should be able to:1Understand the concepts of consumer surplus and producer surplus. Consumer surplus is the benefit consumers receive from paying a price lower than the maximum price they would be willing to pay. Producer surplus is the benefit a firm receives from selling a good or a service at a price higher than the minimum the firm would be willing to accept. Economic surplus is the sum of consumer surplus plus producer surplus.2Understand the concept of economic efficiency, and use a graph to illustrate how economic efficiency is reduced when a market is not in competitive equilibrium. An economically efficient outcome occurs when a competitive market equilibrium is reached. Maximum economic efficiency results when the marginal benefit received by consumers from the last unit bought equals the marginalEconomic efficiency, government price setting and taxes 66 cost to producers from selling the unit. Equilibrium in a competitive market results in the economically efficient output, where marginal benefit equals marginal cost.3Use demand and supply graphs to analyse the economic impact of price ceiling and floors. Though total economic surplus is maximised when a competitive market equilibrium is reached, individual consumers would rather pay a price lower than the equilibrium price and individual producers would rather charge a higher price. Producers or consumers who are dissatisfied with the equilibrium price can lobby government to legally require a different price. When the government intervenes it can aid sellers by requiring a price above equilibrium (a price floor) or it can aid consumers by requiring a price below equilibrium (a price ceiling). Price floors and ceilings reduce economic efficiency.4Use demand and supply graphs to analyse the economic impact of taxes. Whenever a government places a tax on a good or service, economic efficiency is reduced. Some of the reduction in economic surplus due to the tax becomes revenue for the government while the rest of the reduction is a deadweight loss, a net reduction in economic surplus that is not transferred to government or anyone. Chapter ReviewConsumer Surplus and Producer SurplusConsumer surplus is the difference between the highest price a consumer is willing to pay and the price the consumer actually pays. Producer surplus is the difference between the lowest price a firm would be willing to accept and the price it actually receives. Consumer and producer surplus represent the benefits consumers and producers receive from buying and selling a good or service in a market.Marginal benefit is the benefit from consuming one more unit of a good or service. The height of a market demand curve at a given quantity measures the marginal benefit to someone from consuming that quantity. Consumer surplus refers to the difference between this marginal benefit and the market price the consumer pays. Total consumer surplus is the difference between marginal benefit and price for all quantities bought by consumers. Total consumer surplus is equal to the area below the demand curve and above the market price. Marginal cost is the additional cost to a firm of producing one more unit of a good or service. The height of a market supply curve at a given quantity measures the marginal cost of this quantity. Producer surplus refers to the difference between this marginal cost and the market price the producer receives. Total producer surplus equals the area above the supply curve and below price for all quantities sold.Helpful Study HintYou probably have bought something you thought was a bargain. If you did, the differencebetween what you would have been willing to pay and what you did pay was your consumersurplus. Consumers differ in the value they place on the same item but typically pay the sameprice for the item. Those who value the item most receive the most consumer surplus. Since themarginal cost of producing a product rises as more is produced, and price will equal marginalcost for the last unit of output produced and sold in a competitive market, price must be greaterthan the marginal cost of all other units of output. Be sure that you understand Figures 5.2 and5.3 (pages 131 and 133 respectively) and the explanation of these figures in the textbook.67 Chapter 5The Efficiency of Competitive MarketsWhen equilibrium is reached in a competitive market the marginal benefit equals the marginal cost of the last unit sold. This is an economically efficient outcome. If less than the equilibrium output were produced, the marginal benefit of the last unit bought would exceed the marginal cost. If more than equilibrium quantity were produced, the marginal benefit of this last unit would be less than its marginal cost.Economic surplus is the sum of consumer and producer surplus. A deadweight loss is the reduction in economic surplus that results when a market is not in competitive equilibrium. Economic efficiency is a market outcome in which the marginal benefit to consumers of the last unit produced is equal to its marginal cost of production and where the sum of consumer and producer surplus is at a maximum.Helpful Study HintFigure 5.6 (pages 136) illustrates the deadweight loss from production at a non-equilibrium pointin a competitive market. You should understand that when the quantity of chai tea cups is sold is14,000 instead of 15,000 there is a loss of both producer and consumer surplus.Government Intervention in the Market: Price Floors and Price CeilingsThough the total benefit to society is maximized at a competitive market equilibrium, individual consumers would be better off if they could pay a lower than equilibrium price and individual producers would be better off if they could sell at a higher than equilibrium price. Consumers and producers sometimes lobby government to legally require a market price different from the equilibrium price.A price floor is a legally determined minimum price that sellers may receive. A price floor encourages producers to produce more output than consumers want to buy at the floor price. The surplus (equal to the quantity supplied minus the quantity demanded) at the floor price is often bought by the government. The government may also pay farmers to take some land out of cultivation. The marginal cost of production exceeds the marginal benefit and there is a deadweight loss which reflects a decline in efficiency due to the price floor. For example, the Australian government for many years imposed price floors on many agricultural products, including wool. For wool, the resultant stockpile that the government had to buy at this inflated price took many years to clear.A price ceiling is a legally determined maximum price that sellers may charge. Price ceilings are meant to help consumers who lobby for a price ceiling after a sharp increase in the price of an item on which they spend a significant amount of their budgets (for example, rent and petrol). At the ceiling price the quantity demanded is greater than the quantity supplied so that the marginal benefit of the last item sold (the quantity supplied) exceeds the marginal cost of producing it. Price ceilings result in a deadweight loss and a reduction of economic efficiency. Price ceilings create incentives for black markets. A black market refers to buying and selling at prices that violate government price regulations.Economic efficiency, government price setting and taxes 68 Helpful Study HintAn interesting question to consider is why politicians in some countries maintain agriculturalprice supports, despite the significant costs paid by their constituents for these programs. Sinceeach individual incurs a small fraction of the total cost, it is hardly worth the trouble to register acomplaint to these politicians. However, the benefits of price floors are concentrated among afew producers who have a strong incentive to lobby for the continuation of these price supports.Politicians act rationally by ignoring the interests of those who pay for these programs.With respect to price ceilings, you may be swayed by the argument that it is justified because itsintent is to help low income consumers afford these products. Though some low incomeconsumers may be among those who buy the product, there is no guarantee of this. Suppose youwere a landlord who owned a flat that is subject to rent control. As a result of this low price forthe flat there are five potential tenants for the one flat. They include a male university student, aschool teacher with a pet dog, a low income retail worker with a spouse and two children, adoctor and a lawyer. Which one would you choose?The Economic Impact of TaxesGovernment taxes on goods and services reduce the quantity produced. A tax imposed on producers of a product will shift the supply curve up by the amount of the tax. Consumers pay a higher price for the product and there will be a loss of consumer surplus. Because the price producers receive after the tax is paid falls there is also a loss of producer surplus. There is also a deadweight loss because of the tax. Whether a tax is levied on consumers or producers does not affect the tax incidence. Tax incidence is the actual division of the burden of the tax between buyers and sellers. Tax incidence is determined by the degree to which the market price rises as a result of a tax. This, in turn, is determined by the willingness of suppliers to change the quantity of the good or service they offer and the willingness of consumers to change their quantity demanded as a result of the tax.Appendix: Quantitative Demand and Supply AnalysisQuantitative analysis supplements the use of demand and supply curves with equations. An example of the demand and supply for apartments in a city isQ S = - 450,000 + 1,300PQ D = 3,000,000 – 1,000PQ D and Q Sare the quantity demanded and quantity supplied of apartments per month, respectively. At the competitive market equilibrium quantity demanded equals quantity supplied:Q D = Q S or3,000,000 – 1,000P = - 450,000 + 1,300P69 Chapter 5Rearranging terms and solving for P yields the price at which quantity demanded equals the quantity supplied. This is the equilibrium price.3,450,000P==$1,5002,300Substituting the equilibrium price into the equation for either demand or supply yields the equilibrium quantity. Q D= 3,000,000 – 1,000P = 3,000,000 – 1,000(1,500) = 1,500,000Q S = - 450,000 + 1,300P = - 450,000 + 1,300 (1,500) = 1,500,000The demand equation can be used to determine the price at which the quantity demanded is zero. Q D = 0 = 3,000,000 – 1,000P3,000,000P==$3,0001,000 The supply equation can be used to determine the price at which the quantity supplied equals zero.Q S = 0 = - 450,000 + 1,300P-4,500,000P==$346.151,300Helpful Study HintThe equations highlight an oddity of demand and supply analysis. The dependent variable inmost graphs is the “Y variable,” or the variable measured along the vertical axis, while theindependent or “X variable” is measured along the horizontal axis. Economists assume thatprice changes cause changes in quantity so the dependent variable appears on the left handside of the demand and supply equations. In turn, the coefficient of the price terms in theseequations equals the change in quantity divided by a one unit change in price (ΔQ/ΔP). Butprice appears on the vertical axis and quantity on the horizontal axis in demand and supplydiagramsEconomic efficiency, government price setting and taxes 70 Calculating Consumer Surplus and Producer SurplusDemand and supply equations can be used to measure consumer and producer surplus. Figure 5A.1 (page 156) uses a graph to illustrate demand and supply. Because the demand curve is linear, consumer surplus is equal to the area of the blue triangle in Figure 5A.1. The area of a triangle is ½ multiplied by the base of the triangle multiplied by the height of the triangle, or½ x (1,500,000) x (3000 – 1,500) = $1,125,000,000.Producer surplus is calculated in a similar way. Producer surplus is equal to the area above the supply curve and below the line representing market price. The supply curve is a straight line, so produce surplus equals the area of the right triangle:½ x (1,500,000) x (1,500 – 346) = $865,500,000Producers surplus in the market for rental apartments is therefore about $865 million.We can use this same type of analysis to measure the impact of rent control on consumer surplus, producer surplus and economic efficiency. For instance, suppose the city imposes a rent ceiling of $1000 per month. Figure 5A.2 can help guide us as we measure the impact. First, we can calculate the quantity of apartments that will actually be rented by substituting the rent ceiling of $1000 into the supply equation:Q S = –450,000 + (1,300 × 1,000) = 850,000We also need to know the price on the demand curve when the quantity of apartments is 850,000.We can do this by substituting 850,000 for quantity in the demand equation and solving for price:850,000 = 3,000,000 – 1,000PP= = $2,150Compared with its value in competitive equilibrium, consumer surplus has been reduced by a value equal to the area of yellow triangle B, but increased by a value equal to the area of blue rectangle A. The area of yellow triangle B is1⁄2 × (1,500,000 – 850,000) × (2,150 – 1,500) = $211,250,000and the area of blue rectangle A is base multiplied by height, or($1,500 – $1,000) × (850,000) = $425,000,000The value of consumer surplus in competitive equilibrium was $1,125,000,000. As a result of the rent ceiling it will be increased to($1,125,000,000 + $425,000,000) – $211,250,000 = $1,338,750,000Compared with its value in competitive equilibrium, producer surplus has been reduced by a value equal to the area of yellow triangle C plus a value equal to the area of the blue rectangle. The area of the yellow triangle C is 1⁄2 × (1,500,000 – 850,000) × (1,500 – 1,000) = $162,500,00071 Chapter 5We have already calculated the area of blue rectangle A as $425,000,000. The value of producer surplus in competitive equilibrium was $865,500,000. As a result of the rent ceiling it will be reduced to$865,500,000 – $162,500,000 – $425,000,000 = $278,000,000The loss of economic efficiency, as measured by the deadweight loss, is equal to the value represented by the areas of yellow triangles B and C, or$211,250,000 + $162,500,000 = $373,750,000.Solved ProblemThe textbook includes two Solved Problems in Chapter 5 to support learning objectives 3 (“Use demand and supply graphs to analyse the economic impact of price ceilings and price floors”) and 4 (“Use demand and supply graphs to analyse the economic impact of taxes”). Here is an additional Solved Problem that supports another of the chapter’s learning objectives.Solved Problem 4-3: Consumer and Producer Surplus for the National Football League (Gridiron) Sunday TicketSupports Learning Objective 5.1: Understand the concepts of consumer surplus and producer surplus Making the Connection 5.1 explained consumer surplus using the example of customers of DirecTV and the DISH Network, both providers of satellite television in the United States. But only DirecTV offers its customers the option of subscribing to the NFL Sunday Ticket. In 2005 subscribers to this service paid $219 for the right to watch every regular season NFL Sunday game broadcast except for those games played on Sunday evenings. For fans that have moved to cities that don’t broadcast their favourite team’s games, this option is very attractive. Local television stations offer games played by teams with the most local interest. A long-time fan of the New York Giants or Denver Broncos who moved to Illinois would likely have to settle for watching the Chicago Bears most Sunday afternoons – unless he had signed up for the DirecTV NFL Sunday Ticket.Team Marketing Report estimated that the 2004 average ticket price for NFL games for all teams was $54.75 and the per-game average Fan Cost (this includes four average price tickets, four small soft drinks two small beers, four hot dogs, two game programs, parking and two adult size caps) was about $320. Each NFL team plays eight regular-season games in their home stadium.a.Estimate the value of consumer surplus for the NFL Sunday Ticket for a representative fan.b.Estimate the value of producer surplus for the NFL Sunday Ticket.Source: Economic efficiency, government price setting and taxes 72 Solving the ProblemStep 1: Review the chapter material. Since this problem concerns consumer and producer surplus you may want to review the section “Consumer and Surplus and Producer Surplus” that begins on page 130 in the textbook.S tep 2: Identify the maximum price a consumer would pay for the NFL Sunday Ticket. The consumers who benefit most from the NFL Sunday Ticket are those who have the strongest demand to watch their favourite team play on Sundays. Assume that an average season ticket holder found out prior to fall 2005 that he was being transferred by his employer to a location that required him to forego season tickets for himself and three other family members. Using the Team Marketing estimate he would save $320 for each home game that he and his family would no longer attend. Therefore, his total saving would be $320 x 8 = $2,580. This is an estimate of the maximum price he would pay for the NFL Sunday Ticket. (Note that he would also be able to watch his team’s away games but would probably be able to view these games from his home at no additional cost if he had not moved).Step 3: Estimate the value of consumer surplus. For the average season ticket holder and his family an estimate of the consumer surplus is: $2,580 - $219 = $2,361. Note that each family member who no longer attended home games can watch these games at home.Step 4: Identify the minimum price DirecTV would accept for the NFL Sunday Ticket.The NFL Package is offered to existing DirecTV customers as an additional viewing option. Therefore, only trivial additional costs are incurred by DirecTV. The customer’s billing must be adjusted to reflect this option and the service must be “switched on” for this customer. Assume that these costs and an economic profit sufficient to compensate DirecTV for offering this service is $30. Assume that the marginal cost is zero so that the minimum price DirecTV would accept for the NFL Sunday Ticket is $0.Step 5: Estimate the value of producer surplus.Since DirecTV receives $219 for the NFL Sunday Ticket its producer surplus for this customer is $219 $0 = $219.Self-Test(Answers are provided at the end of the Self-Test.)Multiple-Choice Questions1. What is the name of a legally determined maximum price that sellers may charge?a. A price ceiling.b. A price floor.c. Marginal benefit.d. Consumer surplus.2. Which of the following is the definition of producer surplus?a. The additional benefit to a consumer from consuming one more unit of a good or service.b. The additional cost to a firm of producing one more unit of a good or service.c. The difference between the highest price a consumer is willing to pay and the price theconsumer actually pays.d. The difference between the lowest price a firm would have been willing to accept and the priceit actually receives.73 Chapter 53. Which of the following is the definition of marginal cost?a. The additional benefit to a consumer from consuming one more unit of a good or service.b. The difference between the highest price a consumer is willing to pay and the price theconsumer actually pays.c. The additional cost to a firm of producing one more unit of a good or service.d. The difference between the lowest price a firm would have been willing to accept and the priceit actually receives.4. Refer to the figure below. The graph shows an individual’s demand curve for tea. At a price of twodollars, the consumer is willing to buy five cups of tea per week. More precisely, what does this mean?a. It means that marginal benefit equals marginal cost when five cups are consumed.b. It means that the total cost of consuming five cups is $2.00.c. It means that the marginal cost of producing five cups is $2.00.d. It means that the marginal benefit of consuming the fifth cup is $2.00.5. Refer to the graph below. The graph shows the market demand for satellite TV service. If the marketprice is $81, which consumers receive consumer surplus in this market?a. Those willing to pay something less than $81.b. Those willing to pay exactly $81.c. Those willing to pay more than $81.d. All of the above.Economic efficiency, government price setting and taxes 746. Refer to the graph below. How much is the marginal cost of producing the 50th cup?a. $100.00b. $0.20c. $2.00d. None of the above. There is insufficient information to answer the question.7. Precisely what does producer surplus measure?a. The total benefit to producers from participating in the market.b. The net benefit to producers from participating in the market.c. The marginal cost of production.d. The efficiency of competitive markets.8. Refer to the graph below. When should the level of output be reduced in order to increase economicefficiency?a. If 14,000 cups were produced.b. If 15,000 cups were produced.c. If 16,000 cups were produced.d. Never. Output should always increase in order to increase economic efficiency.9. When a competitive market is in equilibrium, what is the economically efficient level of output?a. Any output level where marginal benefit is greater than marginal cost.b. Any output level where marginal cost is greater than marginal benefit.c. The output level where marginal cost is equal to marginal benefit.d. Any of the above. Any output level can be efficient or inefficient.10. Refer to the graph below. Assume this is a competitive market. Which of the following does not existwhen the price is $2.00?a. Economic efficiency.b. Economic surplus.c. A deadweight loss.d. Competitive equilibrium.11. Refer to the graph below. Which area equals producer surplus when price is $2.20?a. Area E.b. Area C + E.c. Area D + E.d. Area B + D.12. Refer to the graph below. After a price of $3.50 is imposed by the government in this market, whatmeaning do we give to area B + C?a. Producer surplus transferred to consumers.b. Additional consumer surplus to existing consumers in the market.c. A deadweight loss.d. A surplus of wheat.13. Refer to the graph below. According to this graph, the existence of a minimum wage in the market forlow-skilled workers results in:a. A shortage of workers.b. A surplus of workers.c. Neither a shortage nor a surplus of workers.d. A scarcity of workers.14. Refer to the graph below. After the rent control is imposed, which area represents a deadweight loss?a. Ab. A + B + Cc. B + Cd.An area other than A, B, or C.15. Which of the following terms corresponds to buying and selling at prices that violate government priceregulations?a.Price conspiracy.b.Scalping.petitive market.d.Black market.16. Refer to the graph below. When a black market for rent-controlled apartments develops, what is thearea of deadweight loss?a. None. The deadweight loss disappears.b. B + Cc. A + Ed. D17. The term tax incidence refers to:a.The analysis of who loses as a result of a tax.b.The amount of revenue collected by the government from a tax.c.The actual division of the burden of a tax.d.The actual versus the desired impact of a tax burden.18. Refer to the graph below. What area corresponds to the excess burden from the tax?a.The dark grey area.b.The light grey area.c.The sum of the dark grey and light grey areas.d.An area not shown on this graph.19. Refer to the graph below. What area corresponds to the revenue collected by the government from thetax?a. The dark grey area.b. The light grey area.c. The sum of the dark grey and light grey areas.d. An area not shown on this graph.20. Refer to the graph below. In each of the graphs below, a curve has shifted as a result of a new socialsecurity tax. In which graph do the workers pay the social security tax?a.In the graph on the left.b.In the graph on the right.c.In both cases.d.In neither case.Short Answer Questions1Some economists oppose raising the minimum wage because they believe this would lead to a significant increase in unemployment among low-skilled workers. Is there an alternative to a higher minimum wage to raise the incomes of the working poor? Why do some economists favour raising the minimum wage?2Federal and state governments periodically raise taxes on cigarettes. Politicians often argue that these tax increases discourage smoking. What other motive is there for raising taxes on cigarettes?3One effect of rent control in New York City is a reduction in the number of apartment buildings. If rent control were eliminated, would this result in an increase in the number of apartment buildings and lower rents for apartment dwellers?4Price floors have previously been imposed in markets for agricultural products such as wool and wheat.Surplus products are bought by the government to maintain the floor price. These surplus products must be stored in some location. As an alternative to storage, suppose a program was established to distribute surplus these agricultural products freely to the elderly and poor. Would this eliminate the government’s storage problem?5. In the U.S., the government has made several attempts to reduce agricultural surpluses that result fromprice floors. One such attempt was a program that paid farmers to reduce the amount of land they devoted to planting crops subject to price floors. What was the reason for the failure of this program?(Hint: Use one of the “three important ideas” from Chapter 1 to answer this question.)。