Welfare economics: asses how well the economy allocates its scarce
resources in accordance with the goals of efficiency and equity.
1. Efficiency: How well the economies resources are used and
2. Equity: how society’s goods and rewards are/ should be,
distributed among its different members and how the associate costs
should be assigned.
Consumer and producer surplus
Consumer surplus: Distance between market price and individual
valuation (relates to the demand side of the market)
Supplier surplus: excess of market price over the reservation price of
the supplier. (relates to the supply side of the market)
The suppliers and demanders are willing to participate in this
market because they earn this surplus.
Computing total surplus
The sum of each participant’s surplus in defines the total surplus in the
Consumer surplus is the difference between the demand curve and the
equilibrium price (forming a triangle) Computed as half the base X
CS = (demand value – price) = ½ X base X perpendicular height
CS = ½ X 500 X 5 = 1250
Efficient market outcomes
Efficient market: Maximizes the sum of producer and consumer
The market mechanism, in which suppliers and demanders
freely trade, leaves no scope for additional trades that would improve
the well-being of participants.
Taxation and efficiency Tax wedge: tax wedge is placed between the price consumers must
pay and the price that the supplier receives. The price received by the
supplier is lower than that paid by the buyer by the amount of the tax
Two burdens associated with tax
1. Revenue burden: the amount of tax revenue paid by the market
participants and received by the government.
2. Excess burden (dead weight loss): component of the economic
surplus that is not transferred to the government in the form of tax
revenue. It is the component of consumer and producer surpluses
forming a net loss to the whole economy.
Distortions: Impact of taxes and other influences that result in an
efficient use of the economy’s recourses.
Elasticity is important in determining the size of the dead weight loss.
Triangle ABC forms the area of deadweight loss.
A wage tax
When income tax is imposed, the net wage falls. Less labour is
supplied because the net wage is lower. The government now
generates tax revenue. A larger reduction in labour supply is generally
accompanied by a bigger excess burden.
Market failures Negative externalities
Externality: impact individuals who are not participants in the market
in question. The effects of the externalities may not be captured in the
Markets characterized by externalities are not efficient.
An externality creates a divergence between private costs/ benefits
and social costs/ benefits. This is represented on a graph by the
difference between the cost to the supplier and the full cost of society.
As output increases the external cost per unit rises, because the
difference between the two supply curves increases with output. Corrective tax: Seek to direct the market towards a more efficient
output. A corrective tax is imposed on the production of the good that
causes the externality; with the appropriate increase in the price,