ECON1101 Study Guide - Final Guide: Pareto Efficiency, Mira-Bhayandar Municipal Corporation, Price Ceiling
The Interactions of People in Markets
Total Surplus
o Total Surplus = CS + PS
o Q* is the effiiet output leel here MB=MC ad total surplus is leel.
o At any other level of output, total surplus is reduced.
o Deadweight Loss (DWL) - the reduction in total surplus due to an inefficient quantity.
Efficiency
• Pareto efficiency – a situation where you cannot make someone better off without making
someone else worse off.
• Pareto improvement – can make someone better off without anyone worse off.
Three Conditions for Economic Efficiency:
Competitive Market Outcomes
are Efficient if:
1. Output
Efficiency
• Produce up to point where MB=MC.
• If not, shift production to lowest MC
producer and produce at lower cost.
• If the MC of the last item produced is
greater than the MB then too much is
being produced, vise versa.
• At a market equilibrium
Q* = (MB = MC) = P*
2.
Production
Efficiency
o MC should be equal for all producers.
o If not, shift consumption to highest
MB consumer and get more total
benefits.
o At market equilibrium,
MC for all producers is
the same because they
all face the same price
→ P = MC.
3.
Consumption
Efficiency
• MB should be same for all consumers,
so no improvement for one without
harming the other would be possible.
• If the MBs were not equal then there
could be a gain for some people with
no loss for anyone else.
• If so, shift consumption to highest MB
consumer and get more total benefit.
• All consumers face the
same market price and
consume where P = MB.
Informational Advantage of Price Mechanism
• Competitive markets lead to efficient but not necessarily equitable outcomes.
• Economic efficiency leads to maximum total surplus, i.e. realise all possible gains from trade.
• Efficiency – gettig the surplus or eooi pie as ig as possile.
• Relies largely on positive analysis.
• Equity – diidig the eooi pie fairl.
• Involves normative judgements.
Application to Price Ceiling
• Gov. imposes a price ceiling or maximum price below P* → leads to excess demand and a
lower market quantity (QM).
• At max P: excess demand = Q1 – Q2.
• At Q2 or QM: MB > MC.
• Consumers who still purchase good do so at a lower price.
• Increase in their CS = A.
• Consumers who no longer purchase good, lost CS = B.
• Total change in CS = A - B.
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• Producers who still produce now receive a lower price decrease in their PS = A.
• Producers who no longer produce (higher cost producers) lost PS = C.
• Total change in PS = -A – C.
• Change in total surplus = change in CS + change in PS = (A – B) + (-A – C) = -B – C =
deadweight loss.
• Inefficiency of price ceiling linked to MB > MC at resulting output and leads to a reduction in
total surplus.
• The loss i P“ eeeds gais i C“.
• However, if demand curve is inelastic, change in CS = A - B < 0.
Impact of the Excise Tax
o Excise tax - tax on a good or service.
o Let Pb = price buyers pay.
o Let Ps = price sellers receive.
o Pb > Ps due to tax.
o Specific tax - a fixed dollar tax per unit of good, eg: unleaded petrol - for each unit of
unleaded petrol you pay 39.6c of tax.
• Pb = Ps + t
o Ad valorem tax - tax leved as a fixed percentage of the value of the good.
• Pb = (1 + t) Ps
o No difference in market quantity or prices if tax is collected from suppliers or demanded.
o Producer tax - tax adds to MC of supplying goods.
o Consumption tax - tax lowers MB of consuming goods.
Determining the Market Quantity
• Market equilibrium quantity with tax t is where:
1. Demand equals supply: Qt = QD (at Pb) = Qs (at Ps)
2. Price difference equals tax: Pb - Ps = t
Welfare Impact of a tax
o Impact on Consumers - pay more Pb >P* and consume less.
• CS (before) = A + B + C
• CS (after) = A
• Change in CS = - B - C
o Impact on Producers - lower price received Ps < P* and produce less.
• PS (before) = D + E + F
• PS (after) = F
• Change in PS = -D - E
o Government surplus (GS) = collect tax revenues.
• GS = t x Qt = B + D
o Change in Total Surplus = Change in CS + Change in Producer Surplus + Gov. Surplus
• = -B - C - D - E + B + D
• = -C - E = Excess Burden of Taxation (DW Loss)
• Qt (< Q*): MB > MC
Economic Incidence of Tax
• Tax incidence - the allocation of the burden of the tax between buyer and seller.
• Elastic S and Inelastic D compared to Inelastic S and Elastic D →.
• Tax borne more by the side of the market which is less price sensitive (i.e. less elastic).
• Inelastic D and Elastic S = greater rise in price.
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Document Summary
Efficiency: pareto efficiency a situation where you cannot make someone better off without making someone else worse off, pareto improvement can make someone better off without anyone worse off, output. Three conditions for economic efficiency: produce up to point where mb=mc. If not, shift production to lowest mc producer and produce at lower cost. If the mc of the last item produced is greater than the mb then too much is being produced, vise versa: mc should be equal for all producers. Mb consumer and get more total benefits: mb should be same for all consumers, so no improvement for one without harming the other would be possible. If the mbs were not equal then there could be a gain for some people with no loss for anyone else. If so, shift consumption to highest mb consumer and get more total benefit. Competitive market outcomes are efficient if: at a market equilibrium.
