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Efficiency and Deadweight Loss

Efficiency and Deadweight Loss. AP Economics Mr. Bordelon. Total Surplus. Calculating Total Surplus. Total surplus is found by adding consumer and producer surplus. Total surplus represents the total benefit to society from the production and consumption of the good. Gains from Trade.

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Efficiency and Deadweight Loss

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  1. Efficiency and Deadweight Loss AP Economics Mr. Bordelon

  2. Total Surplus

  3. Calculating Total Surplus • Total surplus is found by adding consumer and producer surplus. • Total surplus represents the total benefit to society from the production and consumption of the good.

  4. Gains from Trade • Any time a consumer makes a purchase from a producer, a trade has been made and both parties expect to gain. • Gains from trade are represented by consumer and producer surplus. • At market equilibrium price and quantity, total surplus is the sum of the CS and PS triangles.

  5. Go Go Gadget Traders! 7 buyers for 7 sellers for 7 products...Buyers won’t pay a price above what they’re WTP, and sellers won’t accept a price that lies below their production cost. Uh oh.

  6. Go Go Gadget Traders! • Buyer 1 and Seller A should be able to find a price that allows both to be happy. • Buyer 2 and Seller B should be able to find a price that allows both to be happy. • But Buyer 7 and Seller G are going to leave fairly unhappy. • At $6, 5 will be bought and sold at the same price. Why is this important?

  7. Go Go Gadget Traders! • In a competitive market, we assume that all of these trades are going to be made at $6. How much CS and PS has been earned?

  8. Go Go Gadget Traders! What’s the Total CS?

  9. Go Go Gadget Traders! What is Total PS?

  10. Go Go Gadget Traders! • Total CS = $10 • Total PS = $10 • Total Surplus $20 • Note: CS and PS are not always equal, just the result of this example. • Key Point: At market equilibrium price and quantity, total surplus is the sum of the CS and PS triangles.

  11. Market Efficiency • A market is efficient if, once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off.

  12. Market Efficiency • Market equilibrium, however, is just one way of deciding who consumes a good and who sells a good. • Reallocation of consumption among consumers • Reallocation of sales among sellers • Changes in quantity traded

  13. Market Efficiency • Shane was smart. As the Economic Minister of Keynesia, Shane decided that maybe he could do a better job in making sure the buying and selling of gadgets goes the right way.

  14. Market EfficiencyReallocation of Consumption • Buyer 1 has a WTP=$10, gets a gadget at P of $6, and earns $4 CS. • Buyer 7 has a WTP=$4, not willing to pay $6, so doesn’t buy. • Shane thinks this is unfair. He thinks Buyer 7 gets a gadget and Buyer 1 does not. • Is this a problem?

  15. Market EfficiencyReallocation of Consumption Think about it in terms of CS.

  16. Market EfficiencyReallocation of Consumption Lost CS = $4 from Buyer 1 Lost CS = $4 - $6 = $2 from Buyer 7 (“gained” CS) Total Lost CS = $4 + $2 = $6 Result: Lowers total CS

  17. Market EfficiencyReallocation of Sales • Seller A is able to sell at $6 and earn $4 of PS. • Seller G can not sell his because production cost of $8 exceeds market price. • Shane decides Seller G should get to sell and Seller A should not. • Is this a problem?

  18. Market EfficiencyReallocation of Sales Think about it in terms of PS.

  19. Market EfficiencyReallocation of Sales Lost PS = $4 from Seller A Lost PS = $6 - $8 = -$2 from Seller G (“gained” PS) Total Lost PS = $4 + $2 = $6 Result: Lowers total PS

  20. Market EfficiencyChanges in Quantity Traded • Shane believes that there should be less than 5 gadgets traded. • Shane, “I do declare,” waving a fan haughtily against his face, “I do declare, only 3 gadgets should be traded at $6.” • Lost CS from Buyers 4 and 5 = $1 + 0 = $1 • Lost PS from Sellers D and E = $1 + 0 = $1 • Total lost surplus = $2

  21. Market EfficiencyChanges in Quantity Traded • No wait, Shane changes his mind. He now believes more than 5 should be sold. • After two gin rickies, the heat just makes all Shane hot and flustered. Flickering his fan even further, “No, I think 7 gadgets should be traded at $6. Sigh...my heart’s all a flutter.” • Lost CS from Buyers 6 and 7 = ($5 - $6) + ($4 - $6) = -$3 • Lost PS from Sellers F and G = ($6 - $7) + ($6 - $8) = -$3 • Total lost surplus = $6

  22. Reallocation ofConsumption Among Consumers • According to this graph, Ana is willing to buy a textbook at $35, and Bob at $25. • Equilibrium price is $30. • According to the market outcome, Ana would receive the book.

  23. Reallocation ofConsumption Among Consumers • Assume the textbook committee at UCF decides to ignore the market outcome and try to increase total surplus by selling books to different customers. • This will result in a reduction of total consumer surplus. Why?

  24. Reallocation ofConsumption Among Consumers • $35 - $25 = $10 (lost CS) • Consumer surplus declines by $10, and by extension so does total surplus. • We lost $5 from Ana based on WTP. • We lost $5 from Bob because he was not willing to pay market price. • Market equilibrium gives us the highest possible CS by ensuring those who consume the good are those who most value it.

  25. Reallocation ofConsumption Among Consumers • Any time you reallocate a good among consumers always means taking away the good from someone who values it more and giving it to someone who values it less. • Result: Reduction of total consumer surplus.

  26. Reallocation ofSales Among Sellers • According to this graph, Xavier’s production cost is $25, while Yvonne’s is $35. • Equilibrium price is $30. • According to the market outcome, Xavier would sell the book, but Yvonne would not.

  27. Reallocation ofSales Among Sellers • Assume the textbook committee at UCF decides to ignore the market outcome and try to increase total surplus by forcing a seller to otherwise provide a book that would exceed cost. • This will result in a reduction of total producer surplus. Why?

  28. Reallocation ofSales Among Sellers • $35 - $25 = $10 (lost PS) • Producer surplus declines by $10, and by extension, so does total surplus. • We lost $5 from Xavier based on his more efficient production cost. • We lost $5 from Yvonne because she couldn’t meet production cost without exceeding market price. • Market equilibrium gives us the highest possible PS by ensuring those who sell the good are those who most value the right to sell it.

  29. Reallocation ofSales Among Sellers • Any time you reallocate sales among sellers always means taking away the sale from someone who can meet production cost and giving it to someone who can not. • Result: Reduction of total producer surplus.

  30. Changes in the Quantity Traded • According to this graph, Ana would be able to purchase the book given her WTP, and Xavier would be able to sell it given his cost. • Bob and Yvonne, however, would not.

  31. Changes in the Quantity Traded • Assume the textbook committee at UCF decides to ignore the market outcome and try to increase total surplus by forcing students to trade either more or fewer books than the market price. • This will result in a reduction of total producer surplus. Why?

  32. Changes in the Quantity Traded • To reduce sales, the committee would have to prevent a transaction that would have occurred in market equilibrium, that between Ana and Xavier. • $35 - $25 = $10 (lost TS)

  33. Change in the Quantity Traded • Any time you prevent any sale that would have occurred in the market equilibrium means you take away a mutually beneficial transaction. • Result: Reduction of total surplus.

  34. Changes in the Quantity Traded • Similarly, if we forced Bob and Yvonne to make a deal, we would also lose total surplus. • $5 from Yvonne because she couldn’t meet cost. • $5 from Bob because he is not WTP. • $35 - $25 = $10 (lost TS)

  35. Change in the Quantity Traded • Any time you force a transaction among buyers and sellers who are unwilling to meet at market equilibrium, the transaction you create is not mutually beneficial. • Result: Reduction of total surplus.

  36. Market Efficiency • Key point: Once the market has reached equilibrium, there is no other way to increase gains from trade. Any of the above solutions reduce total surplus and reduce efficiency.

  37. Market Efficiency • Efficient markets perform four functions: • Allocates consumption of good to potential buyers who most value it, as they have the highest willingness to pay. • Allocates sales to potential sellers who most value right to sell good, as they have lowest cost. • Ensures every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial. • 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.

  38. Equity and Efficiency • Policies that promote equity often come at the cost of decreased efficiency, and policies that promote efficiency often result in decreased equity. • Proponents of taxes that redistribute income from the rich to the poor argue about fairness. • Opponents of taxes focus on making the economy more efficient, which in turn ensures fairness. • But fairness of what?

  39. Equity and Efficiency • Types of Taxes • Progressive tax. Tax that increases more than in proportion to income. High-income taxpayers pay a larger percentage of their income than low-income taxpayers. • Regressive tax. Tax that increases less than proportion to income. High-income taxpayers pay a smaller percentage of their income than low-income taxpayers. • Proportional tax. Tax that rises in proportion to income. All taxpayers pay same percentage of their income.

  40. Effects of Taxes on Total Surplus • Excise tax. Tax on sales of a particular good or service. • Lump-sum tax. Tax that is the same for everyone regardless of any actions people take.

  41. Escape from L.A. • Calculate CS and PS, and TS.

  42. Escape from L.A. • CS = ½($3)($1 million) = $1.5 million • PS = ½($2)($1 million) = $1 million • TS: $2.5 million

  43. Escape from L.A. • Mayor Snake Plissken imposes a $1 tax on gas sellers on every gallon sold. Ep is $2. • For sellers to continue to sell 1 million per day, they must receive $3 per gallon because $1 must be given to Snake. • Supply curve shifts upward by $1, the amount of the tax.

  44. Escape from L.A. • After the tax, only 800K gallons are supplied with the price at $2.60. • Price received by sellers is $1.60 because they have to send $1 to Snake. • Tax wedge created between price buyers pay ($2.60) and price sellers actually receive ($1.60)

  45. Escape from L.A. • Consumers are paying 60 cents more than before, and sellers are getting 40 cents less than before.

  46. Effect of an Excise Taxon Quantities and Prices • Assume that in Orlando, in the absence of taxes, equilibrium price of a room is $80 and equilibrium quantity is $10,000. • Orlando imposes an excise tax of $40/night on hotel rooms.

  47. Effect of an Excise Taxon Quantities and Prices • If we stay at Ep, how much does the hotel owner get? • This would mean that hotel owners would be less willing to supply rooms at that price. Why?

  48. Effect of an Excise Taxon Quantities and Prices • Pre-tax. Hotel owners are willing to supply 5,000 rooms at $60. • Post-tax. Hotel owners are willing to supply 5,000 rooms, but only at $100. Why?

  49. Effect of an Excise Taxon Quantities and Prices • In order for hotel owners to be willing to supply the same quantity post-tax as they would have pre-tax, they must receive an additional $40 per room, the amount of the tax. • Supply curve shifts up by the amount of the tax.

  50. Effect of an Excise Taxon Quantities and Prices • At every Qs, Ps has increased by $40. Equilibrium moves to A, $100 market price for 5,000 rooms. • Pd is $100, but suppliers only get $60. Why?

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