ECONOMIC SECOND EDITION in MODULES S Paul Krugman Robin Wells with Margaret Ray and David Anderson MODULE 14 50 Efficiency and Deadweight Loss Krugman Wells The meaning and importance of total surplus and how it can be used to illustrate efficiency in markets How taxes affect total surplus and can create deadweight loss 3 of 32 Total Surplus The total surplus generated in a market is the total net gain to consumers and producers from trading in the market It is the sum of the producer and the consumer surplus The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity 4 of 32 Total Surplus Price of book S Consumer surplus Equilibrium price 30 E Producer surplus D 0 1 000 Quantity of books Equilibrium quantity 5 of 32 The Gains from Trade The previous graph shows that both consumers and producers are better off because there is a market in this good i e there are gains from trade These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self sufficient 6 of 32 The Efficiency of Markets Claim The maximum possible total surplus is achieved at market equilibrium The market equilibrium allocates the consumption of the good among potential consumers and sales of the good among potential sellers in a way that achieves the highest possible gain to society Any change from the market equilibrium reduces total surplus 7 of 32 The Efficiency of Markets 1 Reallocate consumption among consumers take the good away from buyers who would have purchased the good in the market equilibrium and give it to potential consumers who wouldn t have bought it in equilibrium 2 Reallocate sales among sellers take sales away from sellers who would have sold the good in the market equilibrium and instead compel potential sellers who would not have sold the good in equilibrium to sell it 3 Change the quantity traded compel consumers and producers to transact either more or less than the equilibrium quantity 8 of 32 Reallocating Consumption Lowers Consumer Surplus Price of book Loss in consumer surplus if the book is taken from Ana and given to Bob S A 35 30 E B 25 D 0 1 000 Quantity of books 9 of 32 Reallocating Sales Lowers Producer Surplus Price of book S Y 35 E 30 25 X Loss in producer surplus if Yvonne is made to sell the book instead of Xavier D 0 1 000 Quantity of books 10 of 32 Changing the Quantity Lowers Total Surplus Price of book 35 Loss in total surplus if the transaction between Ana and Xavier is prevented A 25 Y Loss in total surplus if the transaction between Yvonne and Bob is forced E 30 S X B D 0 1 000 Quantity of books 11 of 32 The Efficiency of Markets 1 It allocates consumption of the good to the potential buyers who value it the most as indicated by the fact that they have the highest willingness to pay 2 It allocates sales to the potential sellers who most value the right to sell the good as indicated by the fact that they have the lowest cost 3 It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale so that all transactions are mutually beneficial 4 It ensures that every potential buyer who doesn t make a purchase values the good less than every potential seller who doesn t make a sale so that no mutually beneficial transactions are missed 12 of 32 Equity and Efficiency There is often a trade off between equity and efficiency policies that promote equity often come at the cost of decreased efficiency policies that promote efficiency often result in decreased equity This is often the debate about taxation A tax that rises more than in proportion to income is a progressive tax A tax that rises less than in proportion to income is a regressive tax A tax that rises in proportion to income is a proportional tax 13 of 32 The Effects of Taxes on Total Surplus An excise tax is a tax on sales of a good or service Excise taxes raise the price paid by buyers reduce the price received by sellers Excise taxes also drive a wedge between the two Examples Excise tax levied on sales of taxi rides and excise tax levied on purchases of taxi rides 14 of 32 The Supply and Demand for Hotel Rooms in Potterville Price of hotel room 140 120 S 100 Equilibrium price E 80 B 60 D 40 20 0 5 000 10 000 15 000 Quantity of hotel rooms Equilibrium quantity 15 of 32 An Excise Tax Imposed on Hotel Owners Price 140 120 Supply curve shifts upward by the amount of the tax S A S 100 Excise tax 40 per room 2 1 E 80 60 D B 40 20 0 5 000 10 000 15 000 Quantity of hotel rooms 16 of 32 An Excise Tax Imposed on Hotel Guests Price 140 120 100 Excise tax 40 per room A Demand curve shifts downward by the amount of the tax S E 80 60 D 1 B 40 20 0 D 2 5 000 10 000 15 000 Quantity of hotel rooms 17 of 32 Price Elasticities and Tax Incidence The incidence of a tax is a measure of who really pays it Who really bears the tax burden does not depend on who officially pays the tax The wedge between the demand price and supply price becomes the government s tax revenue 18 of 32 An Excise Tax Paid Mainly by Consumers Price of gasoline per gallon 2 95 Excise tax 1 per gallon Tax burden falls mainly on consumers When the price elasticity of demand is low and the price elasticity of supply is high the burden of an excise tax falls mainly on consumers S 2 00 1 95 D 0 Quantity of gasoline gallons 19 of 32 An Excise Tax Paid Mainly by Producers Price of parking space S 6 50 6 00 When the price elasticity of demand is high and the price elasticity of supply is low the burden of an excise tax falls mainly on producers D Excise tax 5 per parking space Tax burden falls mainly on producers 1 50 0 Quantity of parking spaces 20 of 32 Price Elasticities and Tax Incidence When the price elasticity of demand is higher than the price elasticity of supply an excise tax falls mainly on producers When the price elasticity of supply is higher than the price elasticity of demand an excise tax falls mainly on consumers So elasticity not who officially pays the tax determines the incidence of an excise tax 21 of 32 The Revenue from an Excise Tax Price of hotel room The tax revenue collected is Tax revenue 40 per room 5 000 rooms 200 000 140 120 A S 100 Excise tax 40 per room 80 60 D B The …