Microeconomics Chapter 4

1. R. GLENN
HUBBARD
Microeconomics
FOURTH EDITION
ANTHONY PATRICK
O’BRIEN

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Economic Efficiency, Government
Price Setting, and Taxes
CHAPTER
4
Chapter Outline and
Learning Objectives
4.1 Consumer Surplus and
Producer Surplus
4.2 The Efficiency of
Competitive Markets
4.3 Government Intervention
in the Market: Price Floors
and Price Ceilings
4.4 The Economic Impact of
Taxes
APPENDIX: Quantitative
Demand and Supply Analysis

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Should the Government Control Apartment Rents?
• Rent control puts a legal limit on the rent that landlords can charge for an
apartment.
• Market-determined rents are usually far above controlled rents.
• Although rent control laws are intended to make housing more affordable for
people with low incomes, high-income people can end up benefiting.
• AN INSIDE LOOK AT POLICY on page 122 discusses a legal battle
between Oscar-winning actress Faye Dunaway and the landlord of her rent-
controlled New York City apartment.

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Does Rent Control Make It Easier for You to Find an Affordable Apartment?
Suppose you have job offers in two cities.
One factor in deciding which job to accept is whether you can find an affordable
apartment.
See if you can answer this question by the end of the chapter:
If one city has rent control, are you more likely to find an affordable apartment in
that city, or would you be better off looking for an apartment in a city without rent
control?
Economics in Your Life

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Price ceiling A legally determined maximum price that sellers may charge.
Price floor A legally determined minimum price that sellers may receive.
When the government imposes a price ceiling or a price floor, the amount of
economic surplus in a market is reduced.

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Distinguish between the concepts of consumer surplus and producer surplus.
4.1 LEARNING OBJECTIVE
Consumer Surplus and Producer Surplus

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Consumer surplus The difference between the highest price a consumer is
willing to pay for a good or service and the price the consumer actually pays.
Marginal benefit The additional benefit to a consumer from consuming one
more unit of a good or service.
Consumer Surplus

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Deriving the Demand Curve
for Chai Tea
With four consumers in the
market for chai tea, the
demand curve is
determined by the highest
price each consumer is
willing to pay.
For prices above $6, no
tea is sold because $6 is
the highest price any
consumer is willing to pay.
For prices of $3 and below,
every one of the four
consumers is willing to buy
a cup of tea.
Figure 4.1

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Measuring Consumer Surplus
Panel (a) shows the consumer surplus for Theresa, Tom, and Terri when the price of tea is
$3.50 per cup.
Theresa’s consumer surplus is equal to the area of rectangle A and is the difference between
the highest price she would pay—$6—and the market price of $3.50.
Tom’s consumer surplus is equal to the area of rectangle B, and Terri’s consumer surplus is
equal to the area of rectangle C.
Total consumer surplus in this market is equal to the sum of the areas of rectangles A, B, and
C, or the total area below the demand curve and above the market price.
In panel (b), consumer surplus increases by the shaded area as the market price declines
from $3.50 to $3.00.
Figure 4.2

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Total Consumer Surplus in the
Market for Chai Tea
The demand curve tells us that
most buyers of chai tea would
have been willing to pay more
than the market price of $2.00.
For each buyer, consumer
surplus is equal to the difference
between the highest price he or
she is willing to pay and the
market price actually paid.
Therefore, the total amount of
consumer surplus in the market
for chai tea is equal to the area
below the demand curve and
above the market price.
Consumer surplus represents
the benefit to consumers in
excess of the price they paid to
purchase the product.
Figure 4.3
The total amount of consumer surplus in a market is equal to the area below
the demand curve and above the market price.

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The demand curve shows the marginal benefit consumers received in 2006 from
subscribing to a broadband Internet service rather than using dialup or doing without
access to the Internet.
The area below the demand curve and above the $36 price line represents the difference
between the price consumers would have paid and the $36 they did pay.
The shaded area on the graph represents the total consumer surplus in the market for
broadband Internet service, which was estimated to be $890.5 million per month.
The Consumer Surplus from Broadband
Internet Service
Making
the
Connection
Your Turn: Test your understanding by doing related problem 1.9 at the end of this chapter.MyEconLab

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Marginal cost The additional cost to a firm of producing one more unit of a
good or service.
Producer surplus The difference between the lowest price a firm would be
willing to accept for a good or service and the price it actually receives.
Producer Surplus

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Measuring Producer Surplus
Panel (a) shows Heavenly
Tea’s producer surplus.
Producer surplus is the
difference between the
lowest price a firm would be
willing to accept and the
price it actually receives.
The lowest price Heavenly
Tea is willing to accept to
supply a cup of tea is equal
to its marginal cost of
producing that cup.
When the market price of
tea is $2.00, Heavenly
receives producer surplus of
$0.75 on the first cup (the
area of rectangle A), $0.50
on the second cup
(rectangle B), and $0.25 on
the third cup (rectangle C).
Figure 4.4a

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In panel (b), the total amount
of producer surplus tea
sellers receive from selling
chai tea can be calculated by
adding up for the entire
market the producer surplus
received on each cup sold.
In the figure, total producer
surplus is equal to the area
above the supply curve and
below the market price,
shown in red.
Measuring Producer Surplus
Figure 4.4b
The total amount of producer surplus in a market is equal to the area above the
market supply curve and below the market price.

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Consumer surplus measures the net benefit to consumers from participating in
a market rather than the total benefit.
Consumer surplus in a market is equal to the total benefit received by
consumers minus the total amount they must pay to buy the good or service.
Similarly, producer surplus measures the net benefit received by producers
from participating in a market.
Producer surplus in a market is equal to the total amount firms receive from
consumers minus the cost of producing the good or service.
What Consumer Surplus and Producer Surplus Measure

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Understand the concept of economic efficiency.
4.2 LEARNING OBJECTIVE
The Efficiency of Competitive Markets

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Marginal Benefit Equals Marginal Cost Only at Competitive Equilibrium
In a competitive market,
equilibrium occurs at a
quantity of 15,000 cups
and a price of $2.00 per
cup, where marginal
benefit equals marginal
cost.
This is the economically
efficient level of output
because every cup has
been produced where
the marginal benefit to
buyers is greater than
or equal to the marginal
cost to producers.
Figure 4.5
Equilibrium in a competitive market results in the economically efficient level of
output, where marginal benefit equals marginal cost.

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Economic surplus The sum of consumer surplus and producer surplus.
Economic Surplus Equals the
Sum of Consumer Surplus
and Producer Surplus
The economic surplus in a
market is the sum of the
blue area, representing
consumer surplus,
and the red area,
representing producer
surplus.
Figure 4.6
Economic efficiency A market outcome in which the marginal benefit to
consumers of the last unit produced is equal to its marginal cost of production and
in which the sum of consumer surplus and producer surplus is at a maximum.
Equilibrium in a competitive market results in the greatest amount of economic
surplus, or total net benefit to society, from the production of a good or service.

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Figure 4.7 When a Market Is Not in Equilibrium, There Is a Deadweight Loss
Economic surplus is maximized when a market is in competitive equilibrium.
When a market is not in equilibrium, there is a deadweight loss.
When the price of chai tea is $2.20 instead of $2.00, consumer surplus declines from an
amount equal to the sum of areas A, B, and C to just area A.
Producer surplus increases from the sum of areas D and E to the sum of areas B and D.
At competitive equilibrium, there is no deadweight loss.
At a price of $2.20, there is a deadweight loss equal to the sum of areas C and E.
Deadweight loss The reduction in economic surplus resulting from a market
not being in competitive equilibrium.

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Explain the economic effect of government-imposed price floors and price ceilings.
4.3 LEARNING OBJECTIVE
Government Intervention in the Market:
Price Floors and Price Ceilings

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Price Floors: Government Policy in Agricultural Markets
Figure 4.8
The Economic Effect of a Price Floor
in the Wheat Market
If wheat farmers convince the
government to impose a price floor of
$3.50 per bushel, the amount of wheat
sold will fall from 2.0 billion bushels per
year to 1.8 billion.
If we assume that farmers produce 1.8
billion bushels, producer surplus then
increases by the red rectangle A—which
is transferred from consumer surplus—
and falls by the yellow triangle C.
Consumer surplus declines by the red
rectangle A plus the yellow triangle B.
There is a deadweight loss equal to the
yellow triangles B and C, representing
the decline in economic efficiency due to
the price floor.
In reality, a price floor of $3.50 per
bushel will cause farmers to expand their
production from 2.0 billion to 2.2 billion
bushels, resulting in a surplus of wheat.

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Price Floors in Labor Markets: The Debate over
Minimum Wage Policy
Making
the
Connection
Supporters of the
minimum wage see it as
a way of raising the
incomes of low-skilled
workers.
Opponents argue that it
results in fewer jobs and
imposes large costs on
small businesses.
Whatever the extent of
employment losses from
the minimum wage,
because it is a price
floor, it will cause a
deadweight loss.
Your Turn: Test your understanding by doing related problem 3.12 at the end of this chapter.MyEconLab

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Price Ceilings: Government Rent Control Policy in Housing Markets
Figure 4.9
The Economic Effect of a Rent Ceiling
Without rent control, the equilibrium
rent is $1,500 per month.
At that price, 2,000,000 apartments
would be rented.
If the government imposes a rent
ceiling of $1,000, the quantity of
apartments supplied falls to 1,900,000,
and the quantity of apartments
demanded increases to 2,100,000,
resulting in a shortage of 200,000
apartments.
Don’t Let This Happen to You
Don’t Confuse “Scarcity” with “Shortage”
There is no shortage of most scarce goods.
Your Turn: Test your understanding by doing related problem 3.15 at the end of this chapter.MyEconLab

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Price Ceilings: Government Rent Control Policy in Housing Markets
Figure 4.9
The Economic Effect of a Rent Ceiling
Without rent control, the equilibrium
rent is $1,500 per month.
At that price, 2,000,000 apartments
would be rented.
If the government imposes a rent
ceiling of $1,000, the quantity of
apartments supplied falls to 1,900,000,
and the quantity of apartments
demanded increases to 2,100,000,
resulting in a shortage of 200,000
apartments.
Producer surplus equal to the area of
the blue rectangle A is transferred from landlords to renters,
and there is a deadweight loss equal to the areas of yellow triangles B and C.
Black market A market in which buying and selling take place at prices that
violate government price regulations.

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Solved Problem 4.3
What’s the Economic Effect of a Black Market for Apartments?
Suppose that competition among tenants results in the black market rent rising to $2,000
per month. Use a graph showing the market for apartments, noting any differences in
consumer surplus, producer surplus, and deadweight loss.
Solving the Problem
Step 1: Review the chapter
material.
Step 2: Draw a graph similar
to Figure 4.9, with the addition
of the black market price.
Step 3: Analyze the changes
from Figure 4.9.
Producer surplus has increased
by an amount equal to
rectangles A and E, and
consumer surplus has declined
by the same amount.
Deadweight loss is equal to triangles B and C, the same as in Figure 4.9.
The remaining consumer surplus is the blue triangle D.
Eventually, the market could even end up at the competitive equilibrium.
Your Turn: For more practice, do related problem 3.14 at the end of this chapter.MyEconLab

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The Results of Government Price Controls:
Winners, Losers, and Inefficiency
When the government imposes price floors or price ceilings, three important
results occur:
• Some people win.
• Some people lose.
• There is a loss of economic efficiency.
Positive and Normative Analysis of Price Ceilings and Price Floors
Our analysis of rent control and of the federal farm programs in this chapter is
positive analysis. Whether these programs are desirable or undesirable is a
normative question.
Whether the gains to the winners more than make up for the losses to the
losers and decline in economic efficiency is a matter of judgment and not strictly
an economic question.

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Analyze the economic impact of taxes.
4.4 LEARNING OBJECTIVE
The Economic Impact of Taxes

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The Effect of Taxes on Economic Efficiency
Figure 4.10
The Effect of a Tax on the
Market for Cigarettes
Without the tax, market
equilibrium occurs at point A.
The equilibrium price of
cigarettes is $4.00 per pack,
and 4 billion packs of cigarettes
are sold per year.
A $1.00-per-pack tax on
cigarettes will cause the supply
curve for cigarettes to shift up
by $1.00, from S1 to S2.
The new equilibrium occurs at
point B.
The price of cigarettes will increase by $0.90, to $4.90 per pack, and the quantity sold will fall to
3.7 billion packs.
The tax on cigarettes has increased the price paid by consumers from $4.00 to $4.90 per pack.
Producers receive a price of $4.90 per pack (point B), but after paying the $1.00 tax, they are
left with $3.90 (point C).
The government will receive tax revenue equal to the green shaded box.
Some consumer surplus and some producer surplus will become tax revenue for the
government, and some will become deadweight loss, shown by the yellow-shaded area.

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Determining Tax Incidence on a Demand and Supply Graph
Figure 4.11
The Incidence of a Tax on
Gasoline
With no tax on gasoline, the
price would be $3.00 per
gallon, and 144 billion
gallons of gasoline would be
sold each year.
A 10-cents-per-gallon excise
tax shifts up the supply curve
from S1 to S2,
raises the price consumers
pay from $3.00 to $3.08,
and lowers the price sellers
receive from $3.00 to $2.98.
Therefore, consumers pay 8
cents of the 10-cents-per-
gallon tax on gasoline, and
sellers pay 2 cents.
Tax incidence The actual division of the burden of a tax between buyers and
sellers in a market.

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Solved Problem 4.4
When Do Consumers Pay All of a Sales Tax Increase?
Your Turn: For more practice, do related problem 4.7 at the end of the chapter.MyEconLab
Solving the Problem
Step 1: Review the chapter
material.
Step 2: Draw a graph like
Figure 4.11 to illustrate the
circumstances when consumers
will pay all of an increase in a
sales tax.
Step 3: Use the graph to evaluate
the situation.
The graph shows that consumers
will pay all of an increase in a sales
tax only if the demand curve is a
vertical line.
Because the demand curve for gasoline is not a vertical line, this is an unrealistic scenario.
A student makes the following statement: “If the federal government raises the sales tax on
gasoline by $0.25, then the price of gasoline will rise by $0.25. Consumers can’t get by
without gasoline, so they have to pay the whole amount of any increase in the sales tax.”
Under what circumstances will the student’s statement be true?

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Does It Make a Difference Whether the Government Collects a Tax
from Buyers or Sellers?
Figure 4.12
The Incidence of a Tax on
Gasoline Paid by Buyers
With no tax on gasoline, the
demand curve is D1.
If a 10-cents-per-gallon tax is
imposed that consumers are
responsible for paying, the
demand curve shifts down by
the amount of the tax, from D1
to D2.
In the new equilibrium,
consumers pay a price of
$3.08 per gallon, including the
tax.
Producers receive $2.98 per
gallon.
This is the same result we
saw when producers were
responsible for paying the tax.

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Is the Burden of the Social Security Tax Really
Shared Equally between Workers and Firms?
Making
the
Connection
Your Turn: Test your understanding by doing related problems 4.8 and 4.9 at the end of this chapter.MyEconLab
The burden of the tax falls almost entirely on workers in both panels.
The forces of demand and supply working in the labor market, and not Congress,
determine the incidence of the tax.

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Does Rent Control Make It Easier for You to Find an Affordable
Apartment?
At the beginning of the chapter, we posed the following question:
If you have two job offers in different cities, one with rent control and one
without, will you be more likely to find an affordable apartment in the city with
rent control?
Although rent control can keep rents lower than they might otherwise be, it can
also lead to a permanent shortage of apartments. You may have to search for a
long time to find a suitable apartment, and landlords may even ask you to give
them payments “under the table,” which would make your actual rent higher
than the controlled rent. Finding an apartment in a city without rent control
should be much easier, although the rent may be higher.
Economics in Your Life

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The effect of rent control laws on the supply of affordable apartments.
AN
INSIDE
LOOK
AT POLICY
. . . and the Rent-Controlled Apartment Goes
to . . . Actress Faye Dunaway!

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Quantitative Demand and Supply AnalysisAppendix
Use quantitative
demand and supply
analysis.
LEARNING OBJECTIVE
Demand and Supply Equations
SD
QQ 
Suppose that the demand for apartments in New York City is
QD=3,000,000−1,000P and the supply of apartments is QS=−450,000+1,300P.
Equilibrium condition:
Solve for the equilibrium monthly apartment rent:
PP 300,1000,450000,1000,000,3 
P300,2000,450,3 
500,1$
300,2
000,450,3
P

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and:
PQ 000,1000,000,30D

000,3$
000,1
000,000,3
P
PQ 300,1000,4500S

15.346$
300,1
000,450



P
Calculate the values for rent by setting QD and QS equal to zero and solving for
price:
Find the equilibrium quantity of apartments rented:
000,500,1)500,1(000,1000,000,3D
Q
000,500,1)500,1(300,1000,450S
Q

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Figure 4A.1
Graphing Supply and Demand
Equations
After statistically estimating
supply and demand equations,
we can use the equations to
draw supply and demand curves.
In this case, the equilibrium rent
for apartments is $1,500 per
month, and the equilibrium
quantity of apartments rented is
1,500,000.
The supply equation tells us that
at a rent of $346, the quantity of
apartments supplied will be zero.
The demand equation tells us
that at a rent of $3,000, the
quantity of apartments
demanded will be zero.
The areas representing
consumer surplus and producer
surplus are also indicated on the
graph.

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Calculating Consumer Surplus and Producer Surplus
Suppose the city imposes a rent ceiling of $1,000 per month. Calculate the
quantity of apartments that will actually be rented:
000,850)000,1300,1(000,450S
Q
Find the price on the demand curve when the quantity of apartments is
850,000:
P000,1000,000,3000,850 
150,2$
000,1
000,150,2



P

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Figure 4A.2
Calculating the Economic Effect of Rent
Controls
Once we have estimated equations for
the demand and supply of rental
housing, a diagram can guide our
numeric estimates of the economic
effects of rent control.
Consumer surplus falls by an amount
equal to the area of the yellow triangle B
and increases by an amount equal to
the area of the blue rectangle A.
The difference between the values of
these two areas is $213,750,000.
Producer surplus falls by an amount
equal to the area of the blue rectangle A
plus the area of the yellow triangle C.
The value of these two areas is
$587,500,000.
The remaining producer surplus is equal
to the area of triangle D, or
$278,000,000.
Deadweight loss is equal to the area of
triangle B plus the area of triangle C, or
$373,750,000.

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Consumer Surplus Producer Surplus Deadweight Loss
Competitive
Equilibrium
Rent
Control
Competitive
Equilibrium
Rent
Control
Competitive
Equilibrium
Rent
Control
$1,125 $1,338.75 $865.50 $278 $0 $373.75
The following table summarizes the results of the analysis (the values are in
millions of dollars):