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Lecture 18

CS100 Lecture 18: Chapter 8

Computer Science
Course Code
Alexandra Boutros

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Chapter 7 Consumers, Producers, Market Efficiency
allocation of resources refers to:
how much of each good is produced?
which producers produce it
which consumers consume it
Welfare economics:
the study of how the allocation of resources affects economic well-being
A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that
WTP measures how much the buyer values the good
marginal buyer, the buyer who would leave the market if P were any higher.
Consumer surplus is the amount a buyer is willing to pay minus the buyer actually pays:
Total CS equals the area under the demand curve above the price, from 0 to Q
Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).
Includes cost of all resources used to produce good, including value of the seller’s time.
A seller will only produce and sell the good if the price exceeds his or her cost.
Hence, cost is a measure of willingness to sell.
marginal seller, the seller who would leave the market if the price were any lower.
Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost.
PS = P cost
Total PS equals the area above the supply curve under the price, from 0 to Q.

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Total surplus = CS + PS = value to buyers cost to sellers
TS measures the total gains from trade in a market
An allocation of resources is efficient if it maximizes total surplus
Raising or lowering the quantity of a good would not increase total surplus.
The goods are being produced by the producers with lowest cost.
The goods are being consumed by the buyers who value them most highly
Efficiency means making the pie as big as possible.
In contrast, equity refers to whether the pie is divided fairly
Is the “free” market equilibrium allocation of resources efficient? Does it maximize total
The eq’m Q maximizes total surplus;
The goods are produced by the producers with lowest cost; and
The goods are consumed by the buyers who value them most highly.
These observations lead to three insights about market outcomes:
1. Free markets allocate the supply of goods to the buyers who value them most highly, as
measured by their willingness to pay;
2. Free markets allocate the demand of goods to the sellers who can produce them at least
cost; and
3. Free markets produce the quantity of goods that maximizes the sum of consumer and
producer surplus.
The height of the supply curve is the marginal seller's cost.

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In the real world, sometimes there are market failures, when unregulated markets fail to allocate
resources efficiently. Causes:
1. market power a single buyer or seller can influence the market price, e.g.
2. externalities side effects of transactions,
e.g. pollution
Chapter 8 - Taxes
Tax generates revenue: Tax$ x QuantityTax
we use the tools of welfare economics to measure the gains and losses from a tax.
We will determine consumer surplus (CS), producer surplus (PS), tax revenue, and total
surplus with and without the tax.
Tax revenue is included in total surplus, because tax revenue can be used to provide
services such as roads, police, public education, etc.
With no tax, total surplus = Consumer Surplus + Producer Surplus
With Tax: CS + PS + Tax Revenue
DWL Dead Weight Loss amount lost from the surplus due to market distortion (ex. tax)
The losses to buyers and sellers exceed the revenue raised by government.
What determines the size of the DWL???
The gov’t needs tax revenue so it must tax some goods
o gov’t should tax the goods or services with the smallest DWL
size of DWL depends on the elasticities of supply and demand
o Supply/Demand inelastic = DWL due to tax is small
o Supply/Demand elastic = DWL due to tax is large
Increasing size of tax?
o Doubling the tax can increase the DWL more than 2x
o When tax rates are low, raising them doesn’t cause much harm, and lowering
them doesn’t bring much benefit.
o When tax rates are high, raising them is very harmful, and cutting them is very
If tax is raised too high, you can end up with a loss in tax revenue
The Laffer curve shows the relationship between the size of the tax and tax revenue.
The more inelastic curve pays the larger portion of the tax.
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