Writing Assignment: Market Efficiency, Taxation, Trade, and Externalities

Name and Surname: Karibay Nazym

Practice Code: 12-P

Language: English

1. Market Efficiency & Total Surplus

Competitive markets allocate resources in a way that maximizes total surplus. The first step in understanding how
this is possible is to define the three main components of welfare economics: consumer surplus, producer surplus,
and total surplus. Consumer surplus is the difference between what a buyer is willing to pay and what they
actually pay. Producer surplus is the difference between the price a seller receives and the marginal cost of
producing the good. Total surplus is the sum of consumer and producer surplus; it measures the overall economic
well-being created by the market.

Equilibrium is reached in a perfectly competitive market where supply equals demand. At that point, the value
consumers place on the marginal unit, or marginal benefit, equates with the cost for producers to produce that
unit, or marginal cost. At that point, these two forces balance each other out, and no other allocation could
increase total surplus, which means the equilibrium is efficient. Moving away from equilibrium would either force
some consumers to pay more than their willingness to pay or force producers to sell below their cost, reducing
total surplus.

Efficiency is disrupted, however, when such market distortions as price ceilings, price floors, shortages, or
surpluses are introduced. If a price ceiling, such as rent control, is put below the equilibrium, it creates a shortage:
quantity demanded is greater than quantity supplied. While consumers pay lower prices, fewer units are available,
and mutually beneficial trades are lost. Similarly, a price floor-a minimum wage, for example-set above the
equilibrium leads to a surplus, where there are more people wanting to work than firms wanting to hire. Again,
mutually beneficial trades do not take place. In both instances, the intervention lowers total surplus because it has
stopped the market from reaching its equilibrium. This shows that competitive markets are indeed the most
effective means of allocating scarce resources.

2. Taxation & Deadweight Loss

To see how taxes act to drive a wedge between equilibrium price and quantity, suppose a per-unit tax is imposed
on gasoline. The government that imposes the tax takes in revenue because the tax drives a wedge between what
the buyers pay and what the sellers receive. Consumers pay a higher price, which reduces the quantity demanded.
Sellers receive a lower effective price (after paying the tax), which also reduces quantity supplied. Thus, the
equilibrium quantity will fall below its pre-tax level.

A tax induces deadweight loss because it prevents some mutually beneficial trades from occurring. Before the tax,
the equilibrium quantity reflected all units for which the buyer’s WTP exceeded the seller’s marginal cost. After
the tax, some of these transactions no longer occur. The value that buyers would have gained and the cost savings
producers would have enjoyed are lost to society. This loss is not transferred to the government as revenue—it
simply disappears. This gap is known as deadweight loss (DWL).
Elasticity is a major determinant of the size of DWL. If demand or supply is elastic, this means that consumers and
producers are quite sensitive to price changes. A tax leads to significant decreases in quantity, meaning that lots of
trades disappear, and the deadweight loss is large. If demand or supply is inelastic, then quantity changes
relatively little, fewer trades are lost, and the deadweight loss is smaller. Thus, the more elastic the curves, the
greater the inefficiency caused by taxation.

3. Gains from International Trade

Consider the following example of two countries, Kazakhstan and Japan, and two goods, wheat and automobiles.
Kazakhstan has the comparative advantage in wheat, for its opportunity cost of wheat production is low due to its
abundant farmland. Japan, however, has the comparative advantage in autos because of advanced technology and
productivity. One benefit of trade and comparative advantage is it means a country does not have to be absolutely
better at producing everything, but rather just have lower opportunity cost relative to another country.

When these countries trade, both benefit. Kazakhstan exports wheat and imports automobiles, allowing it to
specialize and produce more efficiently. Japan does the same by exporting cars and importing wheat. Both
countries can consume combinations of goods that lie beyond their domestic production possibilities frontiers-
something impossible without trade.

Arguments in favor of free trade are that this increases total surplus, permitting specialization and expanding
consumer choices at lower prices. On the other hand, one argument against free trade has to do with the infant
industry argument: new industries in one's home country may well need protection from foreign competition until
such time as these industries are strong enough to compete on the global scene. While this argument is
sometimes valid, it is frequently abused, and protection may not be removed after industries have reached
maturity. Overall, economic reasoning supports free trade because long-term gains exceed short-term costs.

4. Externalities & the Coase Theorem Externality arises when one person's action leads to costs or benefits
accruing to others without compensation. For instance, consider a factory polluting the environment near
residential areas. This is a negative externality because it means that the factory is not bearing the full social cost
of its production. The outcome from the market will see too much pollution compared to the socially optimal
quantity level. This is how market failure takes place. The Coase theorem says that private bargaining can remedy
an externality problem if property rights are well defined and the transaction costs are low. Here, the residents
and the factory can bargain. If the residents have the right to clean air, the factory may pay them for the right to
pollute. If the factory has the right to pollute, the residents may pay the factory to reduce emissions. Either way,
the outcome can be efficient since both parties have reason to reach a bargain that maximizes total surplus.
However, the Coase theorem does not usually work in reality because of several limitations: transaction costs may
be too high to allow bargaining, including legal fees, coordination costs, or negotiation expenses. Large numbers
of affected parties make coordination difficult; if thousands of residents are harmed by pollution, it becomes
highly impractical to agree on a single negotiation. The parties may have asymmetric information about the true
costs of damage, thus preventing efficient bargaining. Accordingly, while the Coase theorem provides an
extremely valuable insight, government intervention is usually required through taxes, regulations, or permits.

References :

Mankiw, N. G. (2021). Principles of Economics (9th ed.). Cengage Learning.