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Lecture Notes 6
Economic Efficiency And
Government Intervention

Prof. Geunyong Park

 Outline
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➢ Measuring Economic Efficiency

• Consumer Surplus (CS)
• Producer Surplus (PS)

➢ Government Intervention
• Price Controls and Production Quotas
• Import Quotas and Tariffs
• Excise Tax and Subsidy
 Motivation Example I
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➢ Suppose you are considering buying a particular automobile and that you
are willing to pay up to $150,000 for it. But you can buy that automobile
for $120,000 in the marketplace.

➢ Will you feel happy when you see the price is $120,000? And Why?
 Motivation Example II
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➢ Suppose that a shipbuilder can either build one ship in the upcoming year
or no ships at all. The firm would be willing to supply this ship as long as it
receives at least $50 million, the additional cost that the firm incurs if it
builds the ship.

➢ If the market price for ships of this type is $75 million, will the CEO feel
happy or not? And why?
 Consumer Surplus
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➢ Consumer surplus
difference between what a
consumer is willing to pay for
a good and the amount
actually paid.

➢ Consumer A would pay $10

for a good whose market price
is $5 and therefore enjoys a
benefit of $5.

➢ Consumer B enjoys a benefit

of $2, and Consumer C, who
values the good at exactly the
market price, enjoys no
benefit.
 Producer Surplus
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➢ Consumer surplus
the total profits of producers,
plus rents to capital.

➢ The benefit that lower-cost

producers enjoy by selling at
the market price is higher.

➢ Together, consumer and

producer surplus measure the
welfare benefit of a
competitive market.
 Welfare Effects of Price Controls
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➢ Welfare effects: gains and losses to

consumers and producers.

➢ Deadweight loss: net loss of total

(consumer plus producer) surplus.

➢ Price controls
The price of a good has been
regulated to be no higher than Pmax,
which is below the market-
clearing price P0.

➢ ∆ Consumer surplus = A-B

∆ Producer surplus = -A-C
Deadweight loss = -B-C
 Welfare Effects of Price Controls
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➢ If demand is sufficiently inelastic,

triangle B can be larger than
rectangle A. In this case,
consumers suffer a net loss from
price controls.
 Efficiency of Competitive Market
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➢ Total surplus is maximized at competitive market equilibrium. How does the

competitive market achieve economic efficiency? Invisible Hand!
➢ No central planner
Each consumer maximizes his/her own utility. Each firm maximizes its own profit.
➢ One price rule and “the right price”
Every consumer who is willing to pay more than the cost of producing extra
output is able to buy; every consumer who is not willing to pay the cost of the
extra output does not buy.

➢ Market failure
Situation in which an unregulated competitive market is inefficient because
prices fail to provide proper signals to consumers and producers.
➢ Externalities
➢ Lack of information
 Example: Minimum Wage
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➢ Although the market-clearing

wage is 𝑤0 , firms are not allowed
to pay less than 𝑤𝑚𝑖𝑛 .

➢ This is a price floor situation;

prices cannot fall below 𝑤𝑚𝑖𝑛 by
government mandate.

➢ This results in unemployment of an

amount 𝐿2 − 𝐿1 and a
deadweight loss given by
triangles B and C.
 Example: Minimum Wage
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➢ Supporters’ arguments:
 Help the poorest class
 Encourage people to join workforce rather than earning money by illegal means
 Increase work ethic

➢ Opponents’ arguments:
 Increase unemployment
 Increase labor cost (hurt small business more)
 Increase price inflation

➢ Still debating
Card and Krueger (1993), Harasztosi and Lindner (2019), Dustmann et al. (2022)
 Example: Minimum Wage
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 Price Supports
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➢ Price support
Price set by government above
free-market level and maintained
by governmental purchases of
excess supply.

➢ To maintain a price 𝑃𝑠 above the

market-clearing price 𝑃0 , the
government buys a quantity 𝑄𝑔 .

➢ The gain to producers is A + B +

D. The loss to consumers is A + B
(in terms of gain, - A - B).
 Price Supports
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➢ Cost to govt.
The cost to the government (which
is ultimately a cost to consumers) is

(𝑄2 − 𝑄1 )𝑃𝑠

➢ The total change in welfare is

∆𝐶𝑆 + ∆𝑃𝑆 + Cost to govt.

= 𝐷 − (𝑄2 − 𝑄1 )𝑃𝑠
 Production Quotas
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➢ To maintain a price 𝑃𝑠 above the

market-clearing price 𝑃0 , the
government can restrict supply to
𝑄1 .

➢ Output can be reduced by

incentives rather than by outright
quotas.

➢ For an incentive to work, it must

be at least as large as B + C + D,
which would be the additional
profit earned by planting, given
the higher price 𝑃𝑠 .
 Example: Taxi Medallions in NYC
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➢ The city of New York limits the number of taxis by issuing a limited number
of medallions. In 2011, there were 13,150 medallions in New York.

➢ In 1937, there were plenty of medallions to go around, so they had little

value. By 1947, the value of a medallion had increased to $2,500, by
1980 to $55,000, and by 2011 to $880,000!

➢ If the city were to issue another 7,000 medallions for a total of about
20,000, demand and supply would equilibrate at a price of about
$350,000 per medallion– still a lot.

➢ The entry of Uber, Lyft, and other “ride-share” services have taken a good
deal of business away from traditional taxi cabs, reducing the demand for
medallions.
 Example: Taxi Medallions in NYC
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➢ New York limits the quantity to

13,150, so the supply curve
becomes vertical (𝑆 → 𝑆′) and
intersects demand at $880k, the
market price of a medallion in
2011.

➢ By 2016, the demand curve had

shifted to the left (𝐷2011 → 𝐷2016 )
because the entry of Uber and Lyft,
so the price of a medallion fell to
$500k.
 Example: Taxi Medallions in NYC
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 Import Quotas and Tariffs
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➢ Import quota: Limit on the

quantity of a good that can be
imported.
Tariff: Tax on an imported good.

➢ In a free market, the domestic

price equals the world price 𝑃𝑤 .

A total 𝑄𝑑 is consumed, of which

𝑄𝑠 is supplied domestically and
the rest imported.

When imports are eliminated, the

price is increased to 𝑃0 .
 Import Quotas and Tariffs
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➢ When imports are reduced, the

domestic price is increased from
𝑃𝑤 to 𝑃∗. This can be achieved by
a quota, or by a tariff 𝑃∗ − 𝑃𝑤 .

➢ If a tariff is used, the government

gains D, the revenue from the
tariff. The net domestic loss is B +
C.

➢ If a quota is used instead,

rectangle D becomes part of the
profits of foreign producers, and
the net domestic loss is B + C + D.
 Example: Sugar Quota
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➢ In recent years, the world price U.S. production: 17.9 billion pounds
of sugar has been between 10
U.S. consumption: 24 billion pounds
and 28 cents per pound, while
the U.S. price has been 30 to U.S. price: 27 cents per pound
40 cents per pound. Why? World price 17 cents per pound

➢ By restricting imports, the U.S. government protects the $4 billion domestic

sugar industry, which would virtually be put out of business if it had to
compete with low-cost foreign producers. This policy has been good for U.S.
sugar producers, but bad for consumers.

U.S. supply : QS = - 8.95 + 0.99P

U.S. demand : QD = 31.20 - 0.27P
 Example: Sugar Quota
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➢ At the world price of 17 cents per

pound, about 26.7
billion pounds of sugar would
have been consumed in 2016, of
which all but 8 billion pounds
would have been imported.

➢ Restricting imports to 6.1 billion

pounds caused the U.S. price to
go up by 10 cents.
 Example: Sugar Quota
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➢ The cost to consumers, A + B + C

+ D, was about $2.5 billion.

➢ The gain to domestic producers

was trapezoid A, about $1.3
billion.

➢ Rectangle D, $610 million, was a

gain to those foreign producers
who obtained quota allotments.

➢ Triangles B and C represent the

deadweight loss of about $631
million.
 Tax and Subsidy
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➢ 𝑃𝑏 is the price (including the tax)

paid by buyers. 𝑃𝑠 is the price
that sellers receive, less the tax.

➢ Here the burden of the tax is

split evenly between buyers and
sellers.
Buyers lose A + B.
Sellers lose D + C.

➢ The government earns A + D in

revenue. The deadweight loss is
B + C.
 The Impact of Tax or Subsidy
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➢ (a) If demand is very inelastic relative to supply, the burden of the tax falls mostly
on buyers.
(b) If demand is very elastic relative to supply, it falls mostly on sellers.
➢ we can calculate the percentage of the tax that is
“passed through” to consumers: Pass-through fraction = |𝐸𝑠 | /(|𝐸𝑠 | + |𝐸𝐷 |).
 Example: Tax on Gasoline
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➢ The price of gasoline at the

pump increases from $3.00 per
gallon to $3.45, and the
quantity sold falls from 140 to
130 bg/yr.

➢ Annual revenue from the tax is

(1.00)(130) = $130 billion
(areas A + D).

➢ The two triangles show the

deadweight loss of $5 billion
per year.
 Example: Tax on Robots
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➢ The installation of industrial

robots has been tripled from
166k to 517k in the last decade
(2011-2021).
Especially, China experienced a
tenfold increase during the same
period (23k → 243k).

➢ At the same time, there is a

growing concern that robots will
displace human labor in the
production process.
 Example: Tax on Robots
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Source: Acemoglu, Manera, and Restrepo (2020)

➢ During the last three decades, tax on physical equipment, including industrial robots,
has been halved in the US, while tax on labor income has been stable.
➢ The robot installation has been rapidly raised in the US, simultaneously.
 Example: Tax on Robots
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➢ Many people, including Bill Gates, suggest that the governments should tax
robots at a rate similar to what we have taxed the workers.

➢ The opponents of robot tax, including Larry Summers (formal U.S. Ministry
of Finance), argues that the tax will interrupt innovation and technological
progress.

➢ What will happen if the governments levy taxes on robots? What factors
will determine the effects?
➢ The elasticity of labor demand to robot taxes
➢ The complementarity between human labor and robots
➢ The price elasticity of robot demand