Microeconomics
Eighth Edition
Updated Edition
Chapter 4
Economic Efficiency,
Government Price Setting,
and Taxes
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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.
What do these two situations have
in common? Both situations
involve governments trying to alter
prices.
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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.
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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.
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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.
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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
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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.
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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.
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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 total
consumer surplus if price is
$2.00.
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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
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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
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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.
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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).
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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
the individual producer
surplus received on every
cup sold.
Total producer surplus is
equal to the area above
the supply curve and
below the market price of
$2.00.
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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.
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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 surplus and producer surplus (i.e. the total
net benefit to consumers and firms), known as the
economic surplus.
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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.
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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.
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Figure 4.6 Economic Surplus Equals the Sum
of Consumer Surplus and Producer Surplus
The figure shows the
economic surplus (the
sum of consumer surplus
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!
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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.
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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.
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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.
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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 U. S. are uncommon, but include:
• Minimum wages
• Rent controls
• Agricultural price controls
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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
bushels.
Area A is the surplus transferred
from consumers to producers.
Economic surplus is reduced by
area B + C, the deadweight loss.
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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.
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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.
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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.
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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.
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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 switch.
• These markets may alleviate some of the deadweight
loss by allowing additional apartments to be rented, but
buyers and sellers lose valuable legal protections.
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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.
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Apply the Concept: Should the Government
Limit Price Gouging During an Emergency? (1 of 4)
In early 2020, as the Covid-19 pandemic spread through
the United States, people flocked to supermarkets and
pharmacies to buy hand sanitizer, disinfectant wipes, and
toilet paper.
By March, these products had largely disappeared from
store shelves. People who hoped to buy them on Amazon
or eBay found that sellers were charging prices far above
normal.
For instance, sellers on Amazon were charging $99.95 for
large bottles of hand sanitizer that normally sell for $9.95.
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Apply the Concept: Should the Government Limit
Price Gouging During an Emergency? (2 of 4)
The graph shows the
hypothetical market for hand
sanitizer in early 2020.
In the short run, without
price controls the price will
rise to Point A.
The winners from no price
controls were the sellers;
the losers were the
consumers.
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Apply the Concept: Should the Government
Limit Price Gouging During an Emergency? (3 of 4)
• In the medium run, suppliers
will adjust to the higher
demand for hand sanitizer and
produce more units.
• The price will go from $3.99 to
$5.99, and quantity will
increase from Q1 to Q3.
• Marginal costs will increase
initially.
• A price gouging law would
have kept supply from
increasing.
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Apply the Concept: Should the Government
Limit Price Gouging During an Emergency? (4 of 4)
• What happens in the long run in the hand sanitizer
market?
– We would expect producers to respond to the new
higher demand for hand sanitizers with permanently
higher output.
– Price would eventually settle back to the pre-
pandemic level of $3.99 per bottle.
– This assumes the marginal cost of production does
not permanently increase and goes back to pre-
pandemic levels.
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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.
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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 U.S. Federal government imposes an
excise tax of 18.4 cents per gallon of gasoline as of
2021.
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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 .
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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.
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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).
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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.
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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.
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Tax Incidence: Who Actually Pays 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”…
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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 .
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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.
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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.
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What Determines 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.
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Apply the Concept: The Burden of the
Social Security Tax (1 of 2)
The Federal Insurance Contributions Act (F ICA) 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.
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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.
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