From Efficiency to Market Distortions

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^ Key Concept: Perfect competition

The main attraction of markets in economics is that they can achieve significant, even dramatic, net benefits through voluntary exchange between buyers and sellers, producers and consumers. If these markets exhibit what economists call perfect competition, they will maximize net benefits and be Pareto optimal. For perfect competition, however, there must be (a) many small suppliers (so that they cannot influence price), (b) many consumers (also so that they cannot influence price), (c) producers able to freely enter and exit the industry, (d) a homogeneous commodity (so that all firms' products are perfect substitutes), (e) perfect information among all participants, and (f) no externalities.

This, of course, is a tall order. Some standard exceptions include a monopoly (one supplier) or oligopoly (a few suppliers) where the supplier's decisions can influence the market price, giving them an incentive to reduce supply in order to raise the price and increase their profits. The absence of full information can also reduce efficiency, for example, in the market for used cars where buyers are uncertain about the quality of the product. And, of course, the problems caused by environmental externalities, which are the focus of this book.

We want to concentrate on two issues here. First, how government policies can create market distortions and, second, how we measure the size or extent of the inefficiency created. Government policies that create market distortions include taxes, subsidies, and quotas. Markets can be a little inefficient or a lot inefficient. We measure the level of inefficiency using the notion of deadweight loss. Deadweight loss is the difference between the net benefits actually achieved and the maximum net benefits possible with an efficient allocation (at Q*).

Let's take a simple example where government limits, say, the amount of steel that can be produced to Qmax. In figure 3.10 we see that this amount falls short of the amount that would be supplied at the competitive market equilibrium. At the Pareto optimum the total net benefit would equal the areas A + B, but with the supply restriction the net benefit is only equal to the area A. The deadweight loss, therefore, is equal to B, the shaded area.

Let's take another example, say, where government subsidizes milk production by paying farmers a direct subsidy, S, for every gallon produced. The supply curve shifts down by the amount of the subsidy because the marginal private cost (MPC), which includes the subsidy, is lower than the marginal social cost (MSC), which is the "true" cost to society, including the cost to taxpayers who ultimately pay the subsidy. This is described in figure 3.11.

Notice that the change in market price from P1 to P2 is less than the amount of the subsidy (P1 - S is below P2). If demand were fixed at Q1 , the price might decline by the full amount of the subsidy and consumers would reap their entire benefit. This would occur only if the demand curve were vertical. Because the

Production Quota Deadweight Loss
■ FIGURE 3.10 Deadweight loss with a quota limit on steel

lower price encourages higher demand, and this increased demand puts upward pressure on prices, the new market equilibrium occurs at Q2 where supply increased to meet that demand. As a result, some of the benefits of the subsidy end up being transferred to producers because of the market adjustments that lead to a new equilibrium price at P2. So who gets the subsidy? Both producers and consumers get a part of it, and the shares depend on the relative slopes of the demand and supply curves. Economists will refer to the "incidence" of a subsidy when they talk about who actually ends up benefiting from it. The same concept and term is used for taxes to recognize that even though a tax may be levied on producers (or consumers), markets will adjust in response to the shift in supply (or demand) caused by the tax, and these market adjustments will determine the "incidence of the tax," meaning who really ends up paying for it.

A third example involves a distortion of the demand curve, such as when there is an excise tax, T, paid by consumers at the time of purchase. Knowing they will have to pay a tax, consumers will recognize that the cost is going to be higher or, alternatively, that the marginal benefit, when the value of the tax is subtracted, will be less than it would be if there were no tax. Whether the consumer thinks of this as a higher cost or a lower benefit, demand will be lowered for a given (pretax) sticker

Demand Curve Efficiency Lost
■ FIGURE 3.11 Subsidy in milk production

price. We can represent this as a downward shift in the demand curve as in figure 3.12 by the amount of the tax, T, so that the demand curve with the tax is below the untaxed demand curve. Consumers who would have been willing to pay $1 without a tax will now be willing to pay only $0.80 if they know they will be obligated to pay an additional 200 tax, so that the market equilibrium occurs at QT.

The revenues from the tax are generally assumed to be used for some government purpose (such as funding education or providing other public goods).5 In that case then there is a reduction in consumer surplus owing to the shift down in the demand curve, but also a transfer of revenues to the government equal to the difference between D and D - T from 0 to QT (the striped area). The shaded area represents the deadweight loss, the portion of the net benefit that would have existed without the tax, but that isn't now a part of consumer surplus, producer surplus, or government revenues.

Government Revenue Deadweight Loss
■ FIGURE 3.12 Excise tax, deadweight loss, and revenue transfer

5We could also represent this whole situation by a shift up in the supply curve by the amount of the tax, indicating that the price to consumers is the "after-tax" price including the tax. Either of these can depict the same situation: shifting the supply curve up by the tax is equivalent to shifting the demand curve down by the same amount.

Key Concept: Marginal excess burden

The deadweight loss may be large or small depending on how producers and consumers respond (if the shaded triangle is big or small compared with the amount of revenue). The marginal excess burden is the additional deadweight loss created for every dollar of additional revenue generated by a tax. Inefficiencies or deadweight losses also occur when there are other causes of a divergence between social and private benefits or costs. Graphs similar to figures 3.11 and 3.12 will be used later on to evaluate environmental situations involving public goods or externalities.

We can evaluate the size of the social gains and losses quantitatively if we have estimates of the marginal (social) benefits and marginal (social) cost curves. For example, if demand for video games can be represented (in dollars) as MB = 30 - (2/3) x Q (where Q is in thousands) and supply can be represented as a constant marginal cost of MC = $10, then we can represent this in the figure 3.13. If these estimates of supply and demand were based on actual data, then we could estimate the net benefit from this market as the area of the triangle ABC, or 2- x ($20 x 30,000) = $300,000 (area = 1- base x height of the triangle).

Price 30

40 (thousands)

■ FIGURE 3.13 Measuring deadweight loss

Now suppose that video games were banned entirely. What would be the loss to society of eliminating all production and consumption of video games? The loss would be the elimination of the $300,000 in net benefits. The net benefits would go to zero, instead of the maximum of $300,000 at Q* = 30. This example is the same as the earlier examples except that the distortion created by government results in the elimination of the market entirely, rather than just a distortion that keeps it from finding the optimal point (in this case, Q = 30).

There is one more important distinction that we need to be clear about in the case of a government policy: the difference between a deadweight loss and a transfer. A transfer takes payments from one group of people and makes them available to a different group. Since one group gains what the other group lost, the transferred amount does not represent a deadweight loss. Let's look at one more example. What would happen if, instead of a ban, a $10 tax on video games was introduced? In that case, the price would go up to $20, and quantity demanded would decline to 17,000 units. The consumer surplus would be reduced from the area of the triangle ABC to the area of the triangle AEF. So is the deadweight loss equal to ABC - AEF? No. The reason is that only the shaded triangle FGC is considered to be the distortion or deadweight loss caused by the tax. The other portion, the plaid-patterned rectangle EFBG, is a "transfer" from consumers to government: it represents the amount of revenue generated by the tax, $10 x 17,000 = $170,000. From society's perspective, only the deadweight loss is a "social cost"; the other change is a transfer that represents a private cost (of tax payments) for producers and an equal benefit (tax revenues) that government has available for other purposes (e.g., they could just be returned to all citizens in a tax rebate).

Well, you did it. In the past two chapters you've covered much of the basics of microeconomics—although in abbreviated form.

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Responses

  • debra
    What is deadweight loss in environmental economics?
    8 years ago
  • aydin
    Why are there loss in net benefits?
    8 years ago
  • Paul
    How is taxation create market distortions?
    6 years ago

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