sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part VII

Consumers, Produ ers, and the E� ien y of

Markets

Welfare E onomi s: The study of how the allo ation of resour es a�e ts e onomi well-being. Utilizes e onomi

analysis to determine whether the allo ation of resour es is e� ient or not.

Consumer Surplus and the Willingness to Pay �

� Willingness to Pay: The maximum amount that a buyer will pay for a good.

� Ea h individual has a di�erent level that they are willing to pay for goods and will be indi�erent about buying

a good if the pri e is exa tly equal to their willingness to pay.

� If we analyze the demand urve with relation to the pri e, we an determine the onsumer surplus.

� Consumer Surplus: The amount a buyer is willing to pay for a good minus the amount the buyer a tually

pays for it.

Example with 4 individuals:

� The area below the demand urve and above the pri e measures the onsumer surplus in a market.

� As the pri e is lowered, the bene�ts to onsumers ontinues to in rease. This is due to there being more

distan e (bene�t) between what the onsumer is willing to pay and what is the pri e a tually is.

When a standard demand urve is used, the levels of onsumer surplus for di�erent individuals an be determined:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� Consumer surplus is a good way to measure individual bene�t � Willingness to pay - pri e in the market

measures per eived bene�t for ea h individual.

� However, if there is so ietal harm involved (su h as in the heroin market), onsumer surplus will not be the

best measure of overall well-being.

Produ er Surplus and the Willingness to Sell:

� Cost: The value of everything that a seller must give up to produ e a good. The ost an be viewed as a

measure of the willingness of the produ er to sell. If the pri e is below this ost, the seller will not want

to sell and for any pri e above, the seller will be in lined to do so.

� This ost should also in lude any asso iated opportunity osts.

� If the pri e is exa tly equal to the ost/willingness to sell, the seller will be indi�erent between selling the

good or not.

� Produ er Surplus: The amount a seller is paid for a good minus the seller's ost of providing it.

Example with 4 Sellers:

� The area above the supply urve and below the pri e measures the produ er surplus in the market.

� As the pri e rises, the bene�ts to produ ers ontinues to in rease. This is due to there being more distan e

(bene�t) between what the produ er is willing to sell and what is the pri e a tually is.

When a standard supply urve is used, the varying levels of produ er surplus in an e onomy an be

determined in the same fashion as onsumer surplus/standard demand urve:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Market E� ien y

For the sake of an argument, imagine that there is a benevolent so ial planner who is all-knowing, all-powerful,

and well-intentioned. This so ial planner understand that the onsumer surplus is the bene�t that onsumers

re eive from intera ting in the market and produ er surplus is the bene�t that sellers re eive. We an look at the

relationship between variables as so:

� Consumer surplus = Value to buyers - Amount paid by buyers

� Produ er surplus = Amount re eived by sellers - Cost to sellers

� Total surplus = (Value to buyers - Amount paid by buyers) + (Amount re eived by sellers - Cost to sellers)

� The amount paid by buyers is equal too the amount re eived by sellers.

� We an de�ne Total Surplus as Value to buyers - Cost to sellers.

E� ien y: The property of a resour e allo ation of maximizing the total surplus re eived by all members to so iety

Equality: The property of distributing e onomi property uniformly among the members of so iety.

We an use surplus analysis to determine whether or not we have an e� ient allo ation. When surplus is

maximized, the maximum amount of mutually bene� ial trades between onsumers and produ ers o ur. Thus, all

buyers who are willing to pay more than the pri e and all of the sellers who are willing to sell for less than the pri e

are satis�ed intera ting with ea h other in the market:

The following observations an be made regarding market out omes:

1. Free markets allo ate the supply of goods to the buyers who value them most highly, as measured by their

willingness to pay.

2. Free markets allo ate the demand for goods to the sellers who an produ e them at the lowest ost.

3. Free markets produ e the quantity of goods that maximizes the sum of onsumer and produ er surplus (the

same out ome as the so ial planner situation).

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part VIII

Appli ation: The Costs of Taxation

The Deadweight Loss of Taxation:

As demonstrated in part VI, whether a tax is levied on buyers or sellers, the result is the same: buyers and

sellers both bear some portion of the tax (The tax in iden e for both parties is the same regardless of who

the tax is levied on). It is the orresponding elasti ity (of supply or demand) that determines whi h party bears

a larger portion of the tax. The logi driving this pro ess is that an entity with more elasti attributes has more

�exibility. Thus, the tax will negatively impa t this party less. The following �gure demonstrates how a tax inserts

a �wedge� between supply and demand. The result is a lower level of quantity as ompared to the equilibrium level.

How a Tax A�e ts Market Parti ipants:

� Taxes will a�e t the buyers, the sellers, and the government.

� Government will olle t revenue from the taxes. If T is the size of the tax and Q is the quantity of the good

sold:

� Tax Revenue: T * Q

� Sin e the government olle ts T dollars worth of tax per unit of good sold.

� The bene�ts of a tax (roads, poli e, publi edu ation, et .) are paid for by the tax revenue � Tax revenue

will represent the bene�ts of the tax for government and those who bene�t from pubi proje ts:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� The square represents the tax revenue. We an use our previously learned on epts of onsumer and produ er

surplus to demonstrate the overall a�e t of the tax:

� As demonstrated above, a tax auses the pri e paid by buyers to in rease and the pri e paid by sellers to fall.

� Thus, there will be a de rease in both onsumer surplus and produ er surplus.

� The tax makes buyers and sellers worse o� and makes the government better o�

� However, the losses to buyers and sellers from a tax ex eed the revenue gained by the government.

� Deadweight Loss: The fall in total surplus that results from a market distortion su h as a tax.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Deadweight Losses and the Gains from Trade:

Consider the following example. Joe leans Jane's house ea h week for $100. The opportunity ost of Joe's time

is $80 and the value of a lean house to Jane is $120. Thus, both re eive a $20 bene�t from the deal. The total

surplus is $40. If a $50 tax is levied on the market, there is no way that Joe and Jane ould ontinue to trade and

both be better o�. The most Jane is willing to pay is $120. However, Joe would only be paid $70 in this ase and

would hoose not to trade. If Joe was to re eive his opportunity ost of $80, then Jane would have to pay $130 �

More then her maximum willingness to pay. No trade o urs in this situation and there is a $40 loss in surplus.

This is a purely $40 dollar deadweight loss: Taxes ause deadweight losses be ause they prevent buyers

and sellers from realizing some of the gains of trade. We an see how there will be marginal losses to our

e onomy by looking at the overall supply and demand pi ture:

The Determinants of the Deadweight Loss:

� We an demonstrate how the elasti ity of demand or supply has a strong impa t on the deadweight loss of

the tax:

� By holding the size of the tax and the elasti ity of demand onstant, we an determine the e�e t of elasti ity

of supply on deadweight loss:

When supply is relatively inelasti , the deadweight loss of a tax is small.

When supply is relatively elasti , the deadweight loss of a tax is large.

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� By holding the size of the tax and the elasti ity of supply onstant, we an determine the e�e t of elasti ity

of demand on deadweight loss.

When demand is relatively inelasti , the deadweight loss of a tax is small.

When demand is relatively elasti , the deadweight loss of a tax is large.

� Taxes raise the pri e paid by onsumers indu ing them to onsume less.

� Taxes lower the pri e re eived by sellers indu ing them to produ e less.

� When demand or supply are relatively elasti , the response by onsumers and/or sellers will be strong.

Thus, the orresponding deadweight loss will also be strong.

Deadweight Loss and Tax Revenue as Taxes Vary:

Poli ymakers onsistently need to determine the orre t size of taxes. An interesting relationship o urs between

the size of the tax and the orresponding sizes of the deadweight loss and tax revenue. When the tax is small, the

DWL will be small and the tax revenue will be medium sized. As the tax in reases in size, the DWL will ontinue

to grow. However, though tax revenue will in rease for a will; eventually the level of quantity will be redu ed to

the point where tax revenue starts to de rease:

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