Microeconomics

Eighth Edition

Chapter 4
Economic Efficiency,
Government Price Setting,
and Taxes
Chapter Outline
4.1 Consumer Surplus and Producer Surplus
4.2 The Efficiency of Competitive Markets
4.3 Government Intervention in the Market: Price Floors
and Price Ceilings
4.4 The Economic Effect of Taxes
Appendix: Quantitative Demand and Supply Analysis
What Do Food Riots in Venezuela and the
Rise of Uber in the U.S. Have in Common?
25 years ago, Venezuelans enjoyed
the highest standard of living in Latin
America; but by 2017, 90% lived in
poverty, and people fought over food
supplies.
In many U.S. cities, operating a taxi
requires a permit from the city
government; but ride-sharing apps
Uber and Lyft disrupted the taxi
market, decreasing the value of
these permits.
Both situations involve governments
trying to alter prices.
4.1 Consumer Surplus and Producer
Surplus
Distinguish between the concepts of consumer surplus and producer surplus.

Surplus (noun): Something that remains above what is

used or needed

Economists use the idea of “surplus” to refer to the benefit that people
derive from engaging in market transactions.
• Consumer surplus is the difference between the highest price a
consumer is willing to pay for a good or service and the actual price
the consumer pays.
• Producer surplus is the difference between the lowest price a firm
would be willing to accept for a good or service and the price it
actually receives.
Figure 4.1 Deriving the Demand Curve
for Chai Tea (1 of 2)

Suppose four people are

each interested in buying
a cup of chai tea.
We can characterize them
by the highest price they
are willing to pay.
At prices above $6, no
chai tea will be sold.
At $6, one cup will be
sold, etc.
Figure 4.1 Deriving the Demand Curve
for Chai Tea (2 of 2)
How much benefit do the
potential tea consumers derive
from this market?
That depends on the price and
their marginal benefit, the
additional benefit to a
consumer from consuming one
more unit of a good or service.
If the price is low, many of the
consumers benefit.
If the price is high, few (if any)
of the consumers benefit.
Figure 4.2 Measuring Consumer
Surplus (1 of 3)
If the price of tea is $3.50 per
cup, Theresa, Tom, and Terri will
buy a cup.
Theresa was willing to pay $6.00;
a cup of chai tea is “worth” $6.00
to her. She gets it for $3.50, so
she derives a net benefit of
$6.00 − $3.50 =
$2.50.

Area A represents this net benefit,

and is known as Theresa’s
consumer surplus in the chai tea
market.
• Notice that the area A is
$2.50 × 1 =$2.50
Figure 4.2 Measuring Consumer
Surplus (2 of 3)
Tom and Terri also obtain
consumer surplus, equal to
$1.50 (area B) and $0.50
(area C).
The sum of the areas of
rectangles A, B, and C is
the consumer surplus in the
chai tea market.
• This area can be
described as the area
below the demand curve,
above the price that
consumers pay.
Figure 4.2 Measuring Consumer
Surplus (3 of 3)
If the price falls to $3.00,
Theresa, Tom, and Terri
each gain an additional
$0.50 of consumer surplus.
Tim is indifferent between
buying the cup and not; his
well-being is the same either
way.
• The overall consumer
surplus remains the area
below the demand curve,
above the (new) price.
Figure 4.3 Total Consumer Surplus in
the Market for Chai Tea
The market for chai tea is
larger than just our four
consumers.
• With many consumers, the
market demand curve looks
like “normal”: a straight line.

Consumer surplus in this

market is defined in just the
same way: the area below the
demand curve, above price.
The graph shows consumer
surplus if price is $2.00.
Apply the Concept: Consumer Surplus
From Uber (1 of 2)

Access to ride-sharing service from Uber is beneficial for

consumers.
• We can measure just how beneficial it is by estimating
the consumer surplus derived in the market.

What would we need to know in order to do this?

• The demand curve for Uber’s services
• The price of Uber’s services
Apply the Concept: Consumer Surplus
From Uber (2 of 2)
Five economists analyzed 6
months of Uber rides in New
York, San Francisco, Chicago,
and Los Angeles in 2015 to
estimate the demand curve for
Uber rides.
111 million rides were taken,
with an average price of $13.30.

CS = Area of shaded triangle

1
(111 million − 0) × ($65.17 − $13.30)
2
= $2.88 billion per year
Producer Surplus
Producer surplus can be thought of in much the same
way as consumer surplus.
• It is the difference between the lowest price a firm
would accept for a good or service and the price it
actually receives.

What is the lowest price a firm would accept for a good or

service?
• The marginal cost of producing that good or service.

Marginal cost: the additional cost to a firm of producing

one more unit of a good or service.
Figure 4.4 Measuring Producer Surplus (1 of 2)

Heavenly Tea is a (very

small) producer of chai tea.
When the market price of
tea is $2.00,
Heavenly Tea receives
producer surplus of $0.75
on the first cup (the area of
rectangle A), $0.50 on the
second cup (rectangle B),
and $0.25 on the third cup
(rectangle C).
Figure 4.4 Measuring Producer Surplus (2 of 2)

The total amount of producer

surplus tea sellers receive
from selling chai tea can be
calculated by adding up for
the entire market the
producer surplus received on
each cup sold.
Total producer surplus is
equal to the area above the
supply curve and below the
market price of $2.00.
What Do Consumer Surplus and
Producer Surplus Measure?

Consumer surplus measures the net benefit to consumers

from participating in a market rather than the total benefit.
• Consumer surplus in a market is equal to the total benefit
received by consumers (measured in dollars) minus the
total amount they must pay to buy the good or service.

Similarly, producer surplus measures the net benefit

received by producers from participating in a market.
• Producer surplus in a market is equal to the total amount
firms receive from consumers minus the cost of providing
the good or service.
4.2 The Efficiency of Competitive Markets
Explain the concept of economic efficiency.

We can think about efficiency in a market in two ways:

1. A market is efficient if all trades take place where the

marginal benefit exceeds the marginal cost, and no
other trades take place.
2. A market is efficient if it maximizes the sum of
consumer and producer surplus (i.e. the total net
benefit to consumers and firms), known as the
economic surplus.
Figure 4.5 Marginal Benefit Equals Marginal
Cost Only at the Competitive Equilibrium (1 of 2)

Recall that the demand

curve describes the
marginal benefit of each
additional cup of tea, while
the supply curve describes
the marginal cost of each
additional cup of tea.
If the quantity is too low,
the value to consumers of
the next unit exceeds the
cost to producers.
Figure 4.5 Marginal Benefit Equals Marginal
Cost Only at the Competitive Equilibrium (2 of 2)

If the quantity is too

high, the cost to
producers of the last unit
is greater than the value
consumers derive from
it.
Only at the competitive
equilibrium is the last
unit valued by
consumers and
producers equally—
economic efficiency.
Figure 4.6 Economic Surplus Equals the Sum of
Consumer Surplus and Producer Surplus

The figure shows the

economic surplus (the sum
of consumer and producer
surplus) in the market for
chai tea.
At the competitive
equilibrium quantity, the
economic surplus is
maximized.
Our two concepts of
economic efficiency
result in the same level
of output!
Economic Efficiency
Since our two ideas of economic efficiency coincide, we
are in a position to define economic efficiency:
Economic efficiency: A market outcome in which the
marginal benefit to consumers of the last unit produced is
equal to its marginal cost of production and in which the
sum of consumer surplus and producer surplus is at a
maximum.
Figure 4.7 When a Market Is Not in
Equilibrium, There Is a Deadweight Loss (1 of 2)

When the price of chai tea is

$2.20 instead of $2.00,
consumer surplus declines from
an amount equal to the sum of
areas A, B, and C to just area A.
Producer surplus increases from
the sum of areas D and E to the
sum of areas B and D.
Economic surplus decreases by
the sum of areas C and E.
Figure 4.7 When a Market Is Not in
Equilibrium, There Is a Deadweight Loss (2 of 2)

The reduction in economic

surplus resulting from a
market not being in
competitive equilibrium is
known as deadweight
loss.
Deadweight loss can be
thought of as the amount of
inefficiency in a market. In
competitive equilibrium,
deadweight loss is zero.
4.3 Government Intervention in the
Market: Price Floors and Price Ceilings
Explain the economic effect of government-imposed price floors and price ceilings.

One option a government has for affecting a market is the imposition of a

price ceiling or a price floor.

• Price ceiling: A legally determined maximum price that sellers may

charge.

• Price floor: A legally determined minimum price that sellers may receive.

Price ceilings and floors in the USA are uncommon, but include:

• Minimum wages

• Rent controls

• Agricultural price controls

Figure 4.8 The Economic Effect of a Price
Floor in the Wheat Market (1 of 2)
The equilibrium price in the
market for wheat is $6.50 per
bushel; 2.0 billion bushels are
traded at this price.
If wheat farmers convince the
government to impose a price
floor of $8.00 per bushel,
quantity traded falls to 1.8 billion.
Area A is the surplus transferred
from consumers to producers.
Economic surplus is reduced by
area B + C, the deadweight loss.
Figure 4.8 The Economic Effect of a Price
Floor in the Wheat Market (2 of 2)

Unfortunately, the situation

may be even worse:
• If farmers do not realize
they will not be able to
sell all of their wheat,
they will produce 2.2
billion bushels.
• This results in a surplus,
or excess supply, of 400
million bushels of wheat.
Apply the Concept: Price Floors in Labor
Markets
Supporters of the minimum
wage see it as a way of raising
the incomes of low-skilled
workers.
Opponents argue that it results
in fewer jobs and imposes
large costs on small
businesses.
Assuming the minimum wage
does decrease employment, it
must result in a deadweight
loss for society.
Figure 4.9 The Economic Effect of a
Rent Ceiling (1 of 2)
Without rent control, the equilibrium
rent is $2,500 per month.
At that price, 2,000,000 apartments
would be rented.
If the government imposes a rent
ceiling of $1,500, the quantity of
apartments supplied falls to
1,900,000…
and the quantity of apartments
demanded increases to
2,100,000…
resulting in a shortage of 200,000
apartments.
Figure 4.9 The Economic Effect of a
Rent Ceiling (2 of 2)
Producer surplus equal to the
area of the blue rectangle A is
transferred from landlords to
renters.
There is a deadweight loss
equal to the areas of yellow
triangles B and C.
This deadweight loss
corresponds to the surplus that
would have been derived from
apartments that are no longer
rented.
Black Markets and Peer-to-Peer Sites
The shortage of apartments may lead to a black market—a
market in which buying and selling take place at prices that
violate government price regulations.
Alternatively, landlords might switch from long-term to short-
term rentals in order to avoid rent controls; peer-to-peer
rental sites such as Airbnb have facilitated this.
• These markets may alleviate some of the deadweight loss
by allowing additional apartments to be rented, but buyers
and sellers lose valuable legal protections.
The Results of Government Price
Controls
It is clear that when a government imposes price controls:
• Some people are made better off,
• Some people are made worse off, and
• The economy generally suffers, as deadweight loss will
generally occur.
Apply the Concept: Price Controls Lead
to Economic Crisis in Venezuela (1 of 2)

Under former president Hugo Chavez, Venezuela seized

land and “redistributed” it to low-income Venezuelans,
many of whom had no experience in farming.
With the resulting dramatic decrease in food supply,
upward pressure on food prices resulted.
This was unpopular with the increasingly poor Venezuelan
citizens, who asked for help from the government.
The government obliged with price controls (price ceilings)
on food.
Apply the Concept: Price Controls Lead
to Economic Crisis in Venezuela (2 of 2)
The price controls resulted in
a thriving black market for
many foods and groceries.
The graph shows the late
2016 market for cornmeal,
with a controlled price of
Bs190, and a black market
price of B s 3,500.
The winners from the
controlled price were the
black market sellers; the
losers were the consumers.
Positive and Normative Analysis of Price
Ceilings and Price Floors

Economic analysis can demonstrate that price ceilings and

price floors decrease economic efficiency. Does this mean
they are bad?
• Because this is a normative question, it does not have a
right or wrong answer; it depends on our values and
judgments. It is possible to value the gains from these
policies more than the losses.
4.4 The Economic Effect of Taxes
Analyze the economic effect of taxes.

Taxes are the most important method by which governments

fund their activities.
We will concentrate on per-unit taxes: taxes assessed as a
particular dollar amount on the sale of a good or service, as
opposed to a percentage tax.
Example: The US Federal government imposes a 18.4
cents per gallon tax on gasoline sales, as of 2019.
 Figure 4.10 The Effect of a Tax on the
Market for Cigarettes (1 of 4)
Without the tax, market
equilibrium occurs at point A.
The equilibrium price of
cigarettes is $6.00 per pack, and
4 billion packs of cigarettes are
sold per year.
A $1.00-per-pack tax on
cigarettes will cause the supply
curve for cigarettes to shift up by
$1.00, from S1 to S2 .

NOTE: The Price on the Y-axis is the price paid without the tax
Figure 4.10 The Effect of a Tax on the
Market for Cigarettes (2 of 4)
The supply curve shifted up by
$1.00, the amount of the tax.
If firms were willing to sell 4
billion packs at a price of $6.00
before the tax, the price needs
to be exactly $1.00 higher in
order to convince them to still
sell 4 billion packs.
• This is because firms’
marginal costs effectively
increased by $1.00 per unit,
the value of the tax.
Figure 4.10 The Effect of a Tax on the
Market for Cigarettes (3 of 4)
The new equilibrium
occurs at point B;
quantity sold falls to 3.7
billion packs.
The tax increases the
price paid by consumers
to $6.90 per pack.
Producers receive a
price of $6.90 per pack
(point B), but after paying
the $1.00 tax, they are
left with $5.90 (point C).
Figure 4.10 The Effect of a Tax on the
Market for Cigarettes (4 of 4)
The government will
receive tax revenue equal
to the green shaded box.
Some consumer surplus
and some producer
surplus will become tax
revenue for the
government, and some
will become deadweight
loss, shown by the yellow-
shaded area.
What Makes One Tax Better Than
Another?

In the “public finance” literature, economists refer to the

deadweight loss from a tax as its excess burden.
Given that we want to raise tax revenue, what makes one
tax preferred over another?
• A tax is efficient if it imposes a small excess burden
relative to the tax revenue it raises.
• Economists can advise policymakers about which taxes
are the most efficient.
Figure 4.11 The Incidence of a Tax on
Gasoline (1 of 2)

With no tax on gasoline, the price would be $2.50 per gallon, and 144
billion gallons of gasoline would be sold each year.

• A 10-cents-per-gallon excise tax shifts up the supply curve from S1 to S2 .

Figure 4.11 The Incidence of a Tax on
Gasoline (2 of 2)

• The price consumers pay rises from $2.50 to $2.58.

• The price sellers receive falls from $2.50 to $2.48.

Therefore, consumers pay 8 cents of the 10-cents-per-gallon tax

on gasoline, and sellers pay 2 cents.
Tax Incidence: Who Actually Pays for a
Tax?

In the market for gasoline, the buyers effectively paid 80

percent of the 10-cents-per-gallon tax, and sellers paid 20
percent.
• This is referred to as the tax incidence: the actual
division of the burden of a tax between buyers and
sellers in a market.

What determines this tax incidence?

• Important observation: not “whoever has the legal
obligation to pay the tax”…
Figure 4.12 The Incidence of a Tax on
Gasoline Paid by Buyers

If buyers have the legal obligation to pay the 10 cent tax on gasoline, the price
they pay, the price sellers receive, and the quantity traded all remain the same.

• The tax incidence does not depend on who has the legal obligation to pay
the tax.
What Does Determine the Tax Incidence?

The incidence of the tax is determined by the relative

slopes of the demand and supply curves.
A steep demand curve means that buyers do not change
how much they buy when the price changes; this results in
them taking on much of the burden of the tax.
A shallow demand curve means that buyers change how
much they buy a lot when the price changes. Then they
could not be forced to accept as much of the burden of the
tax.
• Similar analysis applies for sellers.
Apply the Concept: The Burden of the
Social Security Tax (1 of 2)
The Federal Insurance Contributions Act (FICA) tax is 15.3
percent of wages, and funds Social Security and Medicare. By
law, employers pay half (7.65 percent), as do workers.
• Who really ends up with most of the burden of this tax?

The answer depends on who is less sensitive to changes in

wages: employers (buyers of labor) or workers (sellers of
labor).
• Workers are relatively insensitive to their wages; that is,
they don’t change their hours-of-work decision much when
their wages change.
• So workers end up with most of the burden of this tax.
Apply the Concept: The Burden of the
Social Security Tax (2 of 2)
The panels illustrate
an imaginary $1.00
per hour Social
Security tax.
Whether firms or
workers have the
legal obligation to
pay the tax, workers
end up with most of
the tax burden.
Appendix: Quantitative Demand and
Supply Analysis
Use quantitative demand and supply analysis.

Suppose that the demand for apartments in New York City is

=Q D 4,750,000 − 1,000P
and the supply of apartments is
QS =
− 1,000,000 + 1,300P
In equilibrium, we know
Q D = QS

(This is known as the equilibrium condition.)

Solving for the Equilibrium Rent and
Quantity

=Q D 4,750,000 − 1,000P
QS =
−1,000,000 + 1,300P
Q D = QS

We use these to find the equilibrium rent and quantity:

4,750,000 − 1,000P =
− 1,000,000 + 1,300P
5,750,000 = 2,300P
P = 5,750,000 / 2,300
= $2,500
 Figure 4A.1 Graphing Supply and
Demand Equations (1 of 3)
Find the equilibrium quantity of
apartments rented:
=
QD 4,750,000 − 1,000P
= 4,750,000 − 1,000(2,500)

Or = 2,250,000

QS =
−1,000,000 + 1,300P
= −1,000,000 + 1,300(2,500)
= 2,250,000
We have found the equilibrium price
and quantity; we can insert this on a
demand and supply graph.
 Figure 4A.1 Graphing Supply and
Demand Equations (2 of 3)
To complete the diagram, let’s find
the y-intercepts of the demand and
supply curves, by setting
Q D and QS equal to zero:
=
QD 4,750,000 − 1,000P
=
0 4,750,000 − 1,000P
P = 4,750,000 / 1,000

= $4,750
QS =
−1,000,000 + 1,300P
0 =
−1,000,000 + 1,300P
P =
− 1,000,000 / −1,300
= $769.33
Figure 4A.1 Graphing Supply and
Demand Equations (3 of 3)
Now we can calculate estimated
consumer and producer surplus,
using the triangle area formula:
1
Area = (base)(height)
2
1
CS (2.25)(4,750 − 2,500)
2
= $2531.25 million
1
PS (2.25)(2,500 − 769)
2
= $1947.375 million
 Figure 4A.2 Calculating the Economic
Effect of Rent Controls (1 of 4)
Suppose the city imposes a rent ceiling of
$1,500 per month. Calculate the quantity
of apartments that will be rented:

QS =
− 1,000,000 + 1,300P
=
− 1,000,000 + 1,300(1,500)
= 950,000

Find the price on the demand curve when

the quantity of apartments is 950,000:

=Q D 4,750,000 − 1,000P
=
950,000 4,750,000 − 1,000P
P=
− 3,800,000 / ( −1,000)
= $3,800
Figure 4A.2 Calculating the Economic
Effect of Rent Controls (2 of 4)
Now the diagram can guide our numerical
estimates of the economic effects of the
rent controls.

Triangles B + C represent the deadweight

loss. Area B is:
1
× (2,250,000 − 950,000) ×
2
(3,800 − 2,500) =$845 million

Area C is:
1
× (2,250,000 − 950,000) ×
2
(2,500 − 1,500) =$650 million

So the deadweight loss is

845 + 650 = $1,495 million.
Figure 4A.2 Calculating the Economic
Effect of Rent Controls (3 of 4)
Consumers lose area B
($845 million) but gain the
area of rectangle A:

(2,500 − 1,500) × (950,000)

= $950 million

So consumer surplus
changes from $2531.25
million to:

(2531.25 + 950) − 845

= $2636.25 million
Figure 4A.2 Calculating the Economic
Effect of Rent Controls (4 of 4)
• Producers lose area A
($950 million) and area
C ($650 million); they
originally had a surplus
of $1947.375 million, so
now producer surplus is:

1947.375 − (950 + 650)

= $347.375 million
Summary of Computations
The following table summarizes the results of the analysis
(the values are in millions of dollars):

Consumer Surplus Producer Surplus Deadweight Loss

Competitive Rent Competitive Rent Competitive Rent
Equilibrium Control Equilibrium Control Equilibrium Control
$ 2,531 $ 2,636 $ 1,947 $ 347 $0 $ 1,495