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Principles of Microeconomics, 1st Canadian Edition

Robert H. Frank, Cornell University
Ben S. Bernanke, Princeton University
Lars Osberg, Dalhousie University
Melvin Cross, Dalhousie University
Brian MacLean, Laurentian University

Efficiency and Exchange

Cyberlecture

This chapter introduces you to the concepts of Pareto efficiency and economic surplus. It also examines ways in which efficiency is reduced by the imposition of price controls and taxes.

What is Pareto efficiency?
Pareto efficiency occurs when no one can be made better off without making some else worse off. In a perfectly competitive market that is not Pareto efficient, a transaction that will make at least some people better off without harming others can always be found.
In perfectly competitive markets, if price is either above or below the equilibrium price, buyers and sellers can agree on a new price that benefits them both. The market will be Pareto efficient only when

the supply curve reflects the true marginal cost of production
the demand curve reflects the full marginal benefit of production to consumers
the price in the market is the equilibrium price

What is economic surplus?
A buyer captures economic surplus, called consumer surplus, when the price she pays for a product is less than the price she was willing to pay.
A firm captures economic surplus, called producer surplus, when the price it receives for a product is greater than the price it was willing to accept, or its reservation price.

the firm's reservation price is the opportunity cost of its resources used in production

Economic surplus is the sum of the consumer surplus and the producer surplus.

How is economic surplus calculated?
Consumer surplus is the area under the demand curve but above the price, from the vertical axis to the equilibrium quantity.

the formula for the area of a triangle — A = 1/2 bh — gives the consumer surplus where
Aº area
bº base of the triangle
hº height of the triangle

Producer surplus is the area above the supply curve but below the price, from the vertical axis to the equilibrium quantity.

the formula for the area of a triangle — A = 1/2 bh — gives the producer surplus

total economic surplus = consumer surplus + producer surplus

Practice Activity 1
Try answering some questions about economic surplus.

What are price ceilings?
A price ceiling is a maximum price imposed on a market by the government.

at the ceiling price, economic surplus is lost
- producers always lose economic surplus
- consumers may lose economic surplus

Income redistribution to low-income consumers may be a better solution to the high price of necessary products than price ceilings.

producers should be willing to pay some amount less than their lost producer surplus in income redistribution taxes

If the price ceiling is removed, economic surplus increases. It should be possible for both consumers and producers to be made better off by a division of the increased economic surplus.

Visit http://www.ncpa.org/ba/ba104.html and read what some Americans are saying about price controls and the state of the Canadian health care system. Do price ceilings really reduce the price consumers pay for health care services?

How does price elasticity affect economic surplus?
Total economic surplus in a market with a given demand elasticity is greater when the supply is less elastic.
The loss of economic surplus when price ceilings are imposed is less when the supply is less elastic.

What are price floors?
A price floor, or price support, is a minimum price imposed on a market by the government.

the higher-than-market price induces producers to produce too much
a surplus develops in the market
at the floor price, economic surplus is lost

Practice Activity 2
Try answering some questions about controlled prices.

What are first-come-first served policies?
First-come-first-served policies are used to reserve more of a product for sale than will be produced.

these policies are a non-market-based solution to the problem of excess demand
those who most want to purchase the product do not necessarily get the chance to do so

When airlines overbook flights because some passengers routinely don't show, the airline asks for volunteers to give up seats, and compensates them for the sacrifice.

this policy creates a market-based solution to the problem of excess demand
passengers most willing to give up their seat are compensated first
those who most want to catch the flight do get the chance to do so

Compensating volunteers for forgoing the opportunity to purchase a good that is in excess demand is a more efficient solution to the problem of excess demand.

Who really pays the tax imposed on the sale of a product?
If the demand for and supply of a good are typical of a perfectly competitive market, the consumer and the firm will share the burden of a tax. The consumer will pay a higher purchase price, and the firm will receive a lower revenue from the sale.

If the supply is infinitely elastic, the consumer will pay the entire tax through the increase in the price of the product.

How does a tax imposed on the sale of a product affect economic surplus?
Sales taxes reduce the total amount of economic surplus in a market. Both producers and consumers lose surplus.

If the tax revenue collected is used to return benefits to consumers and producers, then the loss in surplus is much less. This deadweight loss is economic surplus that is not returned to consumers or producers, and is lost because production is reduced.

Economic Naturalist
Why do inheritance taxes generate so much more passion than other types of taxes?

How does price elasticity affect the efficiency of a tax?
The deadweight loss in a market with a given supply elasticity is greater when the demand is more elastic.

the quantity demanded decreases more as the price increases

The price elasticity of demand for cigarettes is typically quite low. Visit http://kickbutt.org/learn/excise.html and discover what this anti-smoking group has found out about the price elasticity of demand for cigarettes and the effect that increased sales (excise) taxes on tobacco have had on smoking.

The deadweight loss in a market with a given demand elasticity is greater when the supply is more elastic.

Understanding Questions
Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.

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