Chapter 4 Measure of Response Elasticities from Microeconomi.docx

Chapter 4: Measure of Response: Elasticities from
Microeconomics: Markets, Methods & Models by
Douglas Curtis and Ian Irvine is available under a Creative
Commons Attribution-NonCommercial-
ShareAlike 3.0 Unported license. © Lyryx Learning Inc.
http://lyryx.com/lscs/CurtisIrvine-Microeconomics-2015A.pdf
https://creativecommons.org/licenses/by-nc-sa/3.0/us/
Chapter 4
Measures of response: elasticities
In this chapter we will explore:
4.1 Responsiveness as elasticities
4.2 Demand elasticities and expenditure
4.3 The short run, the long run and inflation
4.4 Cross-price and income elasticities
4.5 Income elasticity of demand
4.6 Supply side responses
4.7 Tax incidence
4.8 Identifying the elasticity

4.1 Price responsiveness of demand
Put yourself in the position of an entrepreneur. One of your
many challenges is to price your
product appropriately. You may be Michael Dell choosing a
price for your latest computer, or
the local restaurant owner pricing your table d’hôte, or you may
be pricing your part-time snow-
shoveling service. A key component of the pricing decision is to
know how responsive your market
is to variations in your pricing. How we measure responsiveness
is the subject matter of this
chapter.
We begin by analyzing the responsiveness of consumers to price
changes. For example, consumers
tend not to buy much more or much less food in response to
changes in the general price level of
food. This is because food is a pretty basic item for our
existence. In contrast, if the price of
textbooks becomes higher, students may decide to search for a
second-hand copy, or make do with
lecture notes from their friends or downloads from the course
web site. In the latter case students
have ready alternatives to the new text book, and so their

expenditure patterns can be expected to
reflect these options, whereas it is hard to find alternatives to
food. In the case of food consumers
are not very responsive to price changes; in the case of
textbooks they are. The word ‘elasticity’
89
90 Measures of response: elasticities
that appears in this chapter title is just another term for this
concept of responsiveness. Elasticity
has many different uses and interpretations, and indeed more
than one way of being measured in
any given situation. Let us start by developing a suitable
numerical measure.
The slope of the demand curve suggests itself as one measure of
responsiveness: If we lowered
the price of a good by $1, for example, how many more units
would we sell? The difficulty with
this measure is that it does not serve us well when comparing
different products. One dollar may
be a substantial part of the price of your morning coffee and
croissant, but not very important if
buying a computer or tablet. Accordingly, when goods and

services are measured in different units
(croissants versus tablets), or when their prices are very
different, it is often best to use a percentage
change measure, which is unit-free.
The price elasticity of demand is measured as the percentage
change in quantity demanded, di-
vided by the percentage change in price. Although we introduce
several other elasticity measures
later, when economists speak of the demand elasticity they
invariably mean the price elasticity of
demand defined in this way.
The price elasticity of demand is measured as the percentage
change in quantity demanded,
divided by the percentage change in price.
The price elasticity of demand can be written in different forms.
We will use the Greek letter
epsilon, ε , as a shorthand symbol, with a subscript d to denote
demand, and the capital delta, ∆, to
denote a change. Therefore, we can write
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
εd =

%∆Q
%∆P
(4.1a)
=
∆Q/Q
∆P/P
(4.1b)
=
∆Q
∆P
×
P
Q
(4.1c)
Calculating the value of the elasticity is not difficult. If we are
told that a 10 percent price increase
reduces the quantity demanded by 20 percent, then the elasticity
value is
εd =
%∆Q
%∆P
=
−20%
10%

=−2
The negative sign denotes that price and quantity move in
opposite directions, but for brevity the
4.1. Price responsiveness of demand 91
negative sign is often omitted.
Consider now the data in Table 4.1 and the accompanying
Figure 4.1. This data reflect the demand
equation for natural gas that we introduced in Chapter 3: P=
10−Q. Note first that, when the price
and quantity change, we must decide what reference price and
quantity to use in the percentage
change calculation in Equation 4.1. We could use the initial or
final price-quantity combination, or
an average of the two. Each choice will yield a slightly different
numerical value for the elasticity.
The best convention is to use the midpoint of the price values
and the corresponding midpoint of
the quantity values. This ensures that the elasticity value is the
same regardless of whether we start
at the higher price or the lower price. Using the subscript 1 to
denote the initial value and 2 the
final value:

Average quantity = (Q1 +Q2)/2
Average price = (P1 +P2)/2
Price ($) Quantity Price elasticity Price elasticity Total
demanded (arc) (point) revenue ($)
(thousands
of cu ft.)
10.00 0 -9.0 −∞
8.00 2 -2.33 -4 16
6.00 4 -1.22 -1.5 24
5.00 5 -0.82 -1 25
4.00 6 -0.43 -0.67 24
2.00 8 -0.11 -0.25 16
0.00 10 0 0
Table 4.1: The demand for natural gas: elasticities and revenue
P0 = 10
ε =−9

High elasticity range (elastic)
Low elasticity range (inelastic)
ε =−0.11
Q0=10
Price
Quantity
8
5
5
2
Mid point of D: ε =−1
Figure 4.1: Elasticity variation with linear demand
In the high-price region of the demand curve the elasticity takes
on a high
value. At the mid-point of a linear demand curve the elasticity
takes on a
value of one, and at lower prices the elasticity value continues
to fall.
Using this rule, consider now the value of εd when price drops
from $10.00 to $8.00. The change
in price is $2.00 and the average price is therefore $9.00 [=

($10.00 + $8.00)/2]. On the quantity
side, demand goes from zero to 2 units (measured in thousands
of cubic feet), and the average
quantity demanded is therefore (0 + 2)/2 = 1. Putting these
numbers into the formula yields:
εd =
%∆Q
%∆P
=
−(2/1)
(2/9)
=−9
Note that the price has declined in this instance and thus ∆P is
negative. Continuing down the table
in this fashion yields the full set of elasticity values in the third
column.
The demand elasticity is said to be high if it is a large negative
number; the large number denotes
a high degree of sensitivity. Conversely, the elasticity is low if
it is a small negative number. High
and low refer to the size of the number, ignoring the negative
sign. The term arc elasticity is also
used to define what we have just measured, indicating that it
defines consumer responsiveness over

a segment or arc of the demand curve.
The arc elasticity of demand defines consumer responsiveness
over a segment or arc of the
demand curve.
It is helpful to analyze this numerical example by means of the
corresponding demand curve that
is plotted in Figure 4.1. It is a straight-line demand curve; but,
despite this, the elasticity is not
constant. At high prices the elasticity is high; at low prices it is
low. The intuition behind this
pattern is as follows: When the price is high, a given price
change represents a small percentage
change, whereas the resulting percentage quantity change will
be large. The large percentage
quantity change results from the fact that, at the high price, the
quantity consumed is small, and,
therefore, a small number goes into the denominator of the
percentage quantity change. In contrast,
when we move to a lower price range on the demand function, a
given absolute price change is
large in percentage terms, and the resulting quantity change is

smaller in percentage terms.
Extreme cases
The elasticity decreases in going from high prices to low prices.
This is true for most non-linear
demand curves also. Two exceptions are when the demand curve
is horizontal and when it is
vertical.
When the demand curve is vertical, no quantity change results
from a change in price from P1 to
P2, as illustrated in Figure 4.2. Therefore, the numerator in
Equation 4.1 is zero, and the elasticity
has a zero value.
Q0
Dv
P1 Dh
D′
Price
Quantity
P2
Infinite
elasticity

Large
elasticity
Zero
elasticity
Figure 4.2: Limiting cases of price elasticity
When the demand curve is vertical (Dv), the elasticity is zero: a
change
in price from P1 to P2 has no impact on the quantity demanded
because
the numerator in the elasticity formula has a zero value. When
D becomes
more horizontal the elasticity becomes larger and larger at Q0,
eventually
becoming infinite.
In the horizontal case, we say that the elasticity is infinite,
which means that any percentage price
change brings forth an infinite quantity change! This case is
also illustrated in Figure 4.2 using
the demand curve Dh. As with the vertical demand curve, this is
not immediately obvious. So
consider a demand curve that is almost horizontal, such as D′
instead of Dh. In this instance, we

can achieve large changes in quantity demanded by
implementing very small price changes. In
terms of Equation 4.1, the numerator is large and the
denominator small, giving rise to a large
elasticity. Now imagine that this demand curve becomes ever
more elastic (horizontal). The same
quantity response can be obtained with a smaller price change,
and hence the elasticity is larger.
Pursuing this idea, we can say that, as the demand curve
becomes ever more elastic, the elasticity
value tends towards infinity.
Using information on the slope of the demand curve
The elasticity formula, Equation 4.1 part (c), indicates that we
could also compute the elasticity
values using information on the slope of the demand curve,
∆Q/∆P, multiplied by the appropriate
price-quantity ratio. (Note that, even though we put price on the
vertical axis, the slope of the
demand curve is ∆Q/∆P, as explained in Chapter 3; ∆P/∆Q is the
inverse of this slope, or the
slope of the inverse demand function.) Consider the price
change from $10.00 to $8.00 again.
Columns 1 and 2 indicate that ∆Q/∆P = -2/$2.00, or by simply
looking at the equation for the

demand curve we can see that its slope is -1. Choosing again the
midpoint values for price and
quantity yields P/Q = $9.00/1. Therefore the elasticity is
εd = (∆Q/∆P) =−1× (9.00/1.00) =−9
Knowing the slope of the demand curve can be very useful in
establishing elasticity values when
the demand curve is not linear, or when price changes are
miniscule, or when the curve intersects
the axes. Let us consider each of these cases in turn.
A non-linear demand curve is illustrated in Figure 4.3. If price
increases from P0 to P1, then over
that range we can approximate the slope by the ratio (P1
−P0)/(Q1 −Q0). This is, essentially, an
average slope over the range in question that can be used in the
formula, in conjunction with an
average price and quantity of these values.
Price
Quantity
P2
C

Q2
P0
A
Q0
P1
B
Q1
Figure 4.3: Non-linear demand curves
When the demand curve is non-linear the slope changes with the
price.
Hence, equal price changes do not lead to equal quantity
changes: The
quantity change associated with a change in price from P0 to P1
is smaller
than the change in quantity associated with the same change in
price from
P0 to P2.
When a price change is infinitesimally small the resulting
estimate is called a point elasticity
of demand. This differs slightly from the elasticity in column 3
of Table 4.1. In that case, we
computed the elasticity along different segments or arcs of the
demand function. In Table 4.1, the

point elasticity at the point P = $8.00 is
εd = (∆Q/∆P) =−1× (8.00/2.00) =−4
The first term in this expression states that quantity changes by
1 unit for each $1 change in price,
and the second term states that the elasticity is being evaluated
at the price-quantity combination
P = $8 and Q = 2. The value of the point elasticity at each price
value listed in Table 4.1 is given
in column 4. The arc elasticity values in column 3 span a price
range, whereas the point elasticities
correspond exactly to each price value.
The point elasticity of demand is the elasticity computed at a
particular point on the demand
curve.
This point elasticity formula can also be applied to the non-
linear demand curve in Figure 4.3.
If we wished to compute this elasticity exactly at P2, we could
draw a tangent to the function at
C and evaluate its slope. This slope could then be used in
conjunction with the price-quantity
combination (P2,Q2) to evaluate εd at that point.

Next, note that when a demand curve intersects the horizontal
axis the elasticity value is zero,
regardless of the slope. Using Figure 4.1, we can see that this is
because the price in the P/Q
component of the elasticity formula equals zero at the
intersection point Q0. Hence P/Q = 0 and
the elasticity is therefore zero. Likewise, when approaching an
intersection with the vertical axis,
defined by the point P0 in Figure 4.1, the denominator in the
P/Q component becomes very small,
making the P/Q ratio very large. As we get ever closer to the
vertical axis, this ratio becomes
correspondingly larger, and therefore we say that the elasticity
approaches infinity.
Elastic and inelastic demands
While the elasticity value falls as we move down the demand
curve, an important dividing line
occurs at the value of -1. This is illustrated in Table 4.1, and is
a property of all straight-line
demand curves. Disregarding the negative sign, demand is said
to be elastic if the price elasticity
is greater than unity, and inelastic if the value lies between
unity and 0. It is unit elastic if the
value is exactly one.
Demand is elastic if the price elasticity is greater than unity. It

is inelastic if the value lies between
unity and 0. It is unit elastic if the value is exactly one.
Economists frequently talk of goods as having a “high” or “low”
demand elasticity. What does this
mean, given that the elasticity varies throughout the length of a
demand curve? It signifies that, at
the price usually charged, the elasticity has a high or low value.
For example, your weekly demand
for coffee at Starbucks might be unresponsive to variations in
price around the value of $2.00, but
if the price were $4, you might be more responsive to price
variations. Likewise, when we stated
at the beginning of this chapter that the demand for food tends
to be inelastic, we really mean that
at the price we customarily face for food, demand is inelastic.
Determinants of price elasticity
Why is it that the price elasticities for some goods and services
are high and for others low? One
answer lies in tastes: If a good or service is a basic necessity in
one’s life, then price variations
have minimal effect and these products have a relatively
inelastic demand.
A second answer lies in the ease with which we can substitute

alternative goods or services for
the product in question. The local music school may find that
the demand for its instruction is
responsive to the price charged for lessons if there are many
independent music teachers who can
be hired directly by the parents of aspiring musicians. If Apple
had no serious competition, it could
price the products higher than in the presence of Samsung,
Google etc. The ease with which we
can substitute other goods or services is a key determinant. It
follows that a critical role for the
marketing department in a firm is to convince buyers of the
uniqueness of the firm’s product.
Where product groups are concerned, the price elasticity of
demand for one product is necessarily
higher than for the group as a whole: Suppose the price of one
tablet brand alone falls. Buyers
would be expected to substitute towards this product in large
numbers – its manufacturer would
find demand to be highly responsive. But if all brands are
reduced in price, the increase in demand

for any one will be more muted. In essence, the one tablet
whose price falls has several close
substitutes, but tablets in the aggregate do not.
Finally, there is a time dimension to responsiveness, and this is
explored in Section 4.3.
Using price elasticities
Knowledge of elasticity values is useful in calculating the price
change required to eliminate a
shortage or surplus. For example, shifts in the supply of
agricultural products can create surpluses
and shortages. Because of variations in weather conditions, crop
yields cannot be forecast accu-
rately. In addition, on account of the low elasticity of demand
for such products, low crop yields
can increase prices radically, and bumper harvests can have the
opposite impact.
Consider Figure 4.4. Econometricians tell us that the demand
for foodstuffs is inelastic, so let
us operate in the lower (inelastic) part of this demand, D. A
change in supply conditions (e.g. a
shortage of rain and a poorer harvest) shifts the supply from S1
to S2 with the consequence that the
price increases from P1 to P2. In this illustration the price
increase is substantial. In contrast, with

a relatively flat, or elastic, demand, D′, through the initial point
A, the shift in the supply curve
has a more moderate impact on the price (from P1 to P3), but a
relatively larger impact on quantity
traded.
D
D′
S2 S1
Price
Quantity
P1
A
Q1
P2
Q2
P3
Q3

Figure 4.4: The impact of elasticity on quantity fluctuations
In the lower part of the demand curve D, where demand is
inelastic, e.g.
point A, a shift in supply from S1 to S2 induces a large
percentage increase
in price, and a small percentage decrease in quantity demanded.
In contrast,
for the demand curve D′ that goes through the original
equilibrium, the
region A is now an elastic region, and the impact of the supply
shift is
contrary: the %∆P is smaller and the %∆Q is larger.
4.2 Price elasticity and expenditure
In Figure 4.5, we examine the expenditure or revenue impact of
a price reduction in two ranges
of a linear demand curve. Expenditure, or revenue, is the
product of price times quantity. It is,
therefore, the area of a rectangle in a price/quantity diagram.
From position A, a price reduction
from PA to PB has two impacts. It reduces the revenue that
accrues from those QA units already
being sold; the negative sign between PA and PB marks this
reduction. But it increases revenue

through additional sales from QA to QB. The area marked with
a positive sign between QA and QB
denotes this increase. Will the extra revenue caused by the
quantity increase outweigh the loss in
revenue associated with each unit sold before the price was
reduced? It turns out that at high prices
the positive impact outweighs the negative impact. The intuitive
reason is that the existing sales
are small and, therefore, we lose a revenue margin on a very
limited quantity. The net impact on
total expenditure of the price reduction is positive.
4.2. Price elasticity and expenditure 99
Price
0
Quantity
PE
E
QE
PC
C
QC
PB

B
QB
PA
A
QA
Elastic
range
Inelastic
range
(−)
(+)
(−)
(+)
Figure 4.5: Price elasticity and revenue
When the price falls from PA to PB, expenditure changes from
PAAQA0 to
PBBQB0. In this elastic region expenditure increases, because
the loss in
revenue on existing units (−) is less than the revenue gain (+)
due to the
additional units sold. The opposite occurs in the inelastic region
CE.

In contrast, move now to point C and consider a further price
reduction from PC to PE . There is
again a dual impact: a loss of revenue on existing sales, and a
gain due to additional sales. But in
this instance the existing sales QC are large, and therefore the
loss of a price margin on these sales
is more significant than the extra revenue that is generated by
the additional sales. The net effect is
that total expenditure falls.
So if revenue increases in response to price declines at high
prices, and falls at low prices, there
must be an intermediate region of the demand curve where the
composite effects of the price
change just offset each other, and no change in revenue results
from a price change. It transpires
that this occurs at the midpoint of the linear demand curve. Let
us confirm this with the help of our
example in Table 4.1.
The fourth column of the table contains the point elasticities of
demand, and the final column
defines the expenditure on the good at the corresponding prices.
Point elasticities are very precise;
they are measured at a point rather than over a range or an arc.
Note next that the point on this linear

demand curve where revenue is a maximum corresponds to its
midpoint—where the elasticity is
unity. This is no coincidence. Price reductions increase revenue
so long as demand is elastic,
but as soon as demand becomes inelastic such price declines
reduce revenues. When does the
value become inelastic? Clearly, where the unit elasticity value
is crossed. This is illustrated in
Figure 4.6, which defines the relationship between total revenue
(T R), or total expenditure, and
quantity sold in Table 4.1. Total revenue increases initially with
quantity, and this increasing
quantity of sales comes about as a result of lower prices. At a
quantity of 5 units the price is $5.00.
This price-quantity combination corresponds to the mid-point of
the demand curve.
Revenue
Quantity
Rev= $16
8

Rev= $25
5
Revenue a maximum
where elasticity is unity
Figure 4.6: Total revenue and elasticity
Based upon the data in Table 4.1, revenue increases with
quantity sold up to
sales of 5 units. Beyond this output, the decline in price that
must accom-
pany additional sales causes revenue to decline.
We now have a general conclusion: In order to maximize the
possible revenue from the sale of a
good or service, it should be priced where the demand elasticity
is unity.
Does this conclusion mean that every entrepreneur tries to find
this magic region of the demand
curve in pricing her product? Not necessarily: Most businesses
seek to maximize their profit rather
than their revenue, and so they have to focus on cost in addition
to sales. We will examine this
interaction in later chapters. Secondly, not every firm has
control over the price they charge; the

price corresponding to the unit elasticity may be too high
relative to their competitors’ choices of
price. Nonetheless, many firms, especially in the early phase of
their life-cycle, focus on revenue
growth rather than profit, and so, if they have any power over
their price, the choice of the unit-
elastic price may be appropriate.
Elasticity values are sometimes more informative than diagrams
and figures. To see why, consider
Figure 4.4 again. Since the demand curve, D, has a “vertical”
profile, we tend to think of such a
demand as being less elastic than one with a more “horizontal”
profile, D′. But that demand curve
could be redrawn with the scale of one or both of the axes
changed. By using bigger spacing for
quantity units (or smaller spacing for the pricing units), a
demand curve with a vertical profile could
be transformed into one with a horizontal profile! But elasticity
calculations do not deceive. The
numerical values are always independent of how we mark off
units in a diagram. Consequently,
when we see a demand curve with a vertical profile, we can
indeed say that it is less elastic than
a “flatter” demand curve in the same region of the figure. But

we cannot form such a conclusion
when comparing demand curves for different goods with
different units and scales. The beauty of
elasticity lies in its honesty!
4.3. The time horizon and inflation 101
4.3 The time horizon and inflation
The price elasticity of demand is frequently lower in the short
run than in the long run. For example,
a rise in the price of home heating oil may ultimately induce
consumers to switch to natural gas or
electricity, but such a transition may require a considerable
amount of time. Time is required for
decision-making and investment in new heating equipment. A
further example is the elasticity of
demand for tobacco. Some adults who smoke may be seriously
dependent and find quitting almost
impossible. But if young smokers, who are not yet addicted,
decide to quit on account of the higher
price, then over a long period of time the percentage of the
population that smokes will decline.
The full impact may take decades! So when we talk of the short
run and the long run, there is no

simple rule for defining how long the long run actually is in
terms of months or years. In some
cases, adjustment may be complete in weeks, in other cases
years.
In Chapter 2 we distinguished between real and nominal
variables. The former adjust for inflation;
the latter do not. Suppose all nominal variables double in value:
Every good and service costs
twice as much, wage rates double, dividends and rent double,
etc. This implies that whatever
bundle of goods was previously affordable is still affordable.
Nothing has really changed. Demand
behaviour is unaltered by this doubling of all prices and all
incomes.
How do we reconcile this with the idea that own-price
elasticities measure changes in quantity
demanded as prices change? Keep in mind that elasticities
measure the impact of changing one
variable alone, holding constant all of the others. But when all
variables are changing simultane-
ously, it is incorrect to think that the impact on quantity of one
price or income change is a true
measure of responsiveness or elasticity. The price changes that
go into measuring elasticities are

therefore changes in relative prices.
4.4 Cross-price elasticities
The price elasticity of demand tells us about consumer
responses to price changes in different
regions of the demand curve, holding constant all other
influences. One of those influences is the
price of other goods and services. A cross-price elasticity
indicates how demand is influenced by
changes in the prices of other products.
The cross-price elasticity of demand is the percentage change in
the quantity demanded of a
product divided by the percentage change in the price of
another.
In mathematical form we write the cross price elasticity of the
demand for x due to a change in the
price of y as
εd(x,y) =
%∆Qx
%∆Py
.

For example, if the price of cable-supply TV services declines,
by how much will the demand for
satellite-supply TV services change? The cross-price elasticity
may be positive or negative. When
the price of movie theatre tickets rises, the demand for Home
Box Office movies rises, and vice
versa. In this example, we are measuring the cross-price
elasticity of demand for HBO movies with
respect to the price of theatre tickets. These goods are clearly
substitutable, and this is reflected in
a positive value of this cross-price elasticity: The percentage
change in video rentals is positive in
response to the increase in movie theatre prices. The numerator
and denominator in the equation
above have the same sign.
Suppose that, in addition to going to fewer movies, we also eat
less frequently in the restaurant
beside the movie theatre. In this case, the cross-price elasticity
relating the demand for restaurant
meals to the price of movies is negative—an increase in movie
prices reduces the demand for
meals. The numerator and denominator in the cross-price
elasticity equation are opposite in sign.

In this instance, the goods are complements.
4.5 The income elasticity of demand
In Chapter 3 we stated that higher incomes tend to increase the
quantity demanded at any price. To
measure the responsiveness of demand to income changes, a
unit-free measure exists: the income
elasticity of demand. The income elasticity of demand is the
percentage change in quantity
demanded divided by a percentage change in income.
The income elasticity of demand is the percentage change in
quantity demanded divided by a
percentage change in income.
Let us use the Greek letter eta, η , to define the income
elasticity of demand and I to denote income.
Then,
ηd =
%∆Q
%∆I
As an example, if monthly income increases by 10 percent, and
the quantity of magazines pur-
chased increases by 15 percent, then the income elasticity of
demand for magazines is 1.5 in value
(= 15%/10%). The income elasticity is generally positive, but

not always – let us see why.
4.5. The income elasticity of demand 103
Normal, inferior, necessary, and luxury goods
The income elasticity of demand, in diagrammatic terms, is a
percentage measure of how far the
demand curve shifts in response to a change in income. Figure
4.7 shows two possible shifts.
Suppose the demand curve is initially the one defined by D, and
then income increases. If the
demand curve shifts to D1 as a result, the change in quantity
demanded at the existing price is
(Q1−Q0). However, if instead the demand curve shifts to D2,
that shift denotes a larger change in
quantity (Q2 −Q0). Since the shift in demand denoted by D2
exceeds the shift to D1, the D2 shift
is more responsive to income, and therefore implies a higher
income elasticity.
P0
D D1 D2
Price
Quantity
A

Q0
B
Q1
C
Q2
Figure 4.7: Income elasticity and shifts in demand
At the price P0, the income elasticity measures the percentage
horizontal
shift in demand caused by some percentage income increase. A
shift from
A to B reflects a lower income elasticity than a shift to C. A
leftward shift
in the demand curve in response to an income increase would
denote a neg-
ative income elasticity – an inferior good.
In this example, the good is a normal good, as defined in
Chapter 3, because the demand for it
increases in response to income increases. If the demand curve
were to shift back to the left in
response to an increase in income, then the income elasticity
would be negative. In such cases the
goods or services are inferior, as defined in Chapter 3.

Finally, we need to distinguish between luxuries, necessities,
and inferior goods. A luxury good or
service is one whose income elasticity equals or exceeds unity.
A necessity is one whose income
elasticity is greater than zero but less than unity. These
elasticities can be understood with the
help of Equation 4.1 part (a). If quantity demanded is so
responsive to an income increase that
the percentage increase in quantity demanded exceeds the
percentage increase in income, then the
value is in excess of 1, and the good or service is called a
luxury. In contrast, if the percentage
change in quantity demanded is less than the percentage
increase in income, the value is less than
unity, and we call the good or service a necessity.
A luxury good or service is one whose income elasticity equals
or exceeds unity.
A necessity is one whose income elasticity is greater than zero
and less than unity.
Luxuries and necessities can also be defined in terms of their
share of a typical budget. An income

elasticity greater than unity means that the share of an
individual’s budget being allocated to the
product is increasing. In contrast, if the elasticity is less than
unity, the budget share is falling.
This makes intuitive sense—luxury cars are luxury goods by
this definition because they take up a
larger share of the incomes of the rich than of the poor.
Inferior goods are those for which there exist higher-quality,
more expensive, substitutes. For
example, lower-income households tend to satisfy their travel
needs by using public transit. As
income rises, households normally reduce their reliance on
public transit in favour of automobile
use. Inferior goods, therefore, have a negative income elasticity:
in the income elasticity equation
definition, the numerator has a sign opposite to that of the
denominator. As an example: in the
recession of 2008/09 McDonalds continued to remain profitable
and increased its customer base –
in contrast to the more up-market Starbucks. This is a case
where expenditure increased following
a decline in income, yielding a negative income elasticity of
demand.

Inferior goods have negative income elasticity.
Lastly, note that while inferior products may be considered a
special type of necessity, inferior
goods technically have a negative income elasticity, whereas
necessities have positive elasticity
values.
Empirical research indicates that goods like food and fuel have
income elasticities less than 1;
durable goods and services have elasticities slightly greater than
1; leisure goods and foreign holi-
days have elasticities very much greater than 1.
Income elasticities are useful in forecasting the demand for
particular services and goods in a
growing economy. Suppose real income is forecast to grow by
15 percent over the next five years. If
we know that the income elasticity of demand for iPhones is
2.0, we could estimate the anticipated
growth in demand by using the income elasticity formula: since
in this case η = 2.0 and %∆I = 15
it follows that 2.0 = %∆Q/15%. Therefore the predicted demand
change must be 30%.
4.6 Elasticity of supply
Now that we have developed the various dimensions of
elasticity on the demand side, the anal-

ysis of elasticities on the supply side is straightforward. The
elasticity of supply measures the
4.7. Elasticities and tax incidence 105
responsiveness of the quantity supplied to a change in the price.
The elasticity of supply measures the responsiveness of quantity
supplied to a change in the
price.
εs =
%∆Q
%∆P
The subscript s denotes supply. This is exactly the same formula
as for the demand curve, except
that the quantities now come from a supply curve. Furthermore,
and in contrast to the demand
elasticity, the supply elasticity is generally a positive value
because of the positive relationship
between price and quantity supplied. The more elastic, or the
more responsive, is supply to a
given price change, the larger will be the elasticity value. In
diagrammatic terms, this means
that “flatter” supply curves have a greater elasticity than more

“vertical” curves at a given price
and quantity combination. Numerically the flatter curve has a
larger value than the more vertical
supply – try drawing a supply diagram similar to Figure 4.2.
Technically, a completely vertical
supply curve has a zero elasticity and a horizontal supply curve
has an infinite elasticity – just as
in the demand cases.
As always we keep in mind the danger of interpreting too much
about the value of this elasticity
from looking at the visual profiles of supply curves.
4.7 Elasticities and tax incidence
Elasticity values are critical in determining the impact of a
government’s taxation policies. The
spending and taxing activities of the government influence the
use of the economy’s resources. By
taxing cigarettes, alcohol and fuel, the government can restrict
their use; by taxing income, the
government influences the amount of time people choose to
work. Taxes have a major impact on
almost every sector of the Canadian economy.
To illustrate the role played by demand and supply elasticities
in tax analysis, we take the example

of a sales tax. These can be of the specific or ad valorem type.
A specific tax involves a fixed dollar
levy per unit of a good sold (e.g., $10 per airport departure). An
ad valorem tax is a percentage
levy, such as Canada’s Goods and Services tax (e.g., 5 percent
on top of the retail price of goods
and services). The impact of each type of tax is similar, and we
will use the specific tax in our
example below.
A layperson’s view of a sales tax is that the tax is borne by the
consumer. That is to say, if no sales
tax were imposed on the good or service in question, the price
paid by the consumer would be the
same net of tax price as exists when the tax is in place.
Interestingly, this is not always the case.
The study of the incidence of taxes is the study of who really
bears the tax burden, and this in turn
depends upon supply and demand elasticities.
Tax Incidence describes how the burden of a tax is shared
between buyer and seller.

Consider Figures 4.8 and 4.9, which define an imaginary market
for inexpensive wine. Let us
suppose that, without a tax, the equilibrium price of a bottle of
wine is $5, and Q0 is the equilibrium
quantity traded. The pre-tax equilibrium is at the point A. The
government now imposes a specific
tax of $4 per bottle. The impact of the tax is represented by an
upward shift in supply of $4:
Regardless of the price that the consumer pays, $4 of that price
must be remitted to the government.
As a consequence, the price paid to the supplier must be $4 less
than the consumer price, and this is
represented by twin supply curves: one defines the price at
which the supplier is willing to supply,
and the other is the tax-inclusive supply curve that the
consumer faces.
D St
S
Price
Quantity
Pt = 8
B
Qt

P0 = 5
A
Q0
Pts = 4
C
$4=tax
Figure 4.8: Tax incidence with elastic supply
The imposition of a specific tax of $4 shifts the supply curve
vertically by
$4. The final price at B (Pt) increases by $3 over the
equilibrium price at
A. At the new quantity traded, Qt , the supplier gets $4 per unit
(Pts), the
government gets $4 also and the consumer pays $8. The greater
part of
the incidence is upon the buyer, on account of the relatively
elastic supply
curve: his price increases by $3 of the $4 tax.
The introduction of the tax in Figure 4.8 means that consumers
now face the supply curve St . The
new equilibrium is at point B. Note that the price has increased
by less than the full amount of the

tax—in this example it has increased by $3. This is because the
reduced quantity at B is provided
at a lower supply price: The supplier is willing to supply the
quantity Qt at a price defined by C
($4), which is lower than A ($5).
4.7. Elasticities and tax incidence 107
So what is the incidence of the $4 tax? Since the market price
has increased from $5 to $8, and the
price obtained by the supplier has fallen by $1, we say that the
incidence of the tax falls mainly
on the consumer: the price to the consumer has risen by three
dollars and the price received by the
supplier has fallen by just one dollar.
Consider now Figure 4.9, where the supply curve is less elastic,
and the demand curve is un-
changed. Again the supply curve must shift upward with the
imposition of the $4 specific tax.
But here the price received by the supplier is lower than in
Figure 4.8, and the price paid by the
consumer does not rise as much – the incidence is different. The
consumer faces a price increase
that is one-quarter, rather than three-quarters, of the tax value.

The supplier faces a lower supply
price, and bears a higher share of the tax.
D
St S
Price
Quantity
P0 = 5
A
Q0
Pt = 6
B
Qt
Pts = 2
C
$4=tax
Figure 4.9: Tax incidence with inelastic supply
The imposition of a specific tax of $4 shifts the supply curve
vertically by
$4. The final price at B (Pt) increases by $1 over the no-tax
price at A. At the
new quantity traded, Qt , the supplier gets $2 per unit (Pts), the
government

gets $4 also and the consumer pays $6. The greater part of the
incidence is
upon the supplier, on account of the relatively inelastic supply.
We can draw conclude from this example that, for any given
demand, the more elastic is supply, the
greater is the price increase in response to a given tax.
Furthermore, a more elastic supply curve
means that the incidence falls more on the consumer; while a
less elastic supply curve means the
incidence falls more on the supplier. This conclusion can be
verified by drawing a third version
of Figure 4.8 and 4.9, in which the supply curve is horizontal –
perfectly elastic. When the tax is
imposed the price to the consumer increases by the full value of
the tax, and the full incidence falls
on the buyer. While this case corresponds to the layperson’s
intuition of the incidence of a tax,
economists recognize it as a special case of the more general
outcome, where the incidence falls
on both the supply side and the demand side.
These are key results in the theory of taxation. It is equally the
case that the incidence of the
tax depends upon the demand elasticity. In Figure 4.8 and 4.9

we used the same demand curve.
However, it is not difficult to see that, if we were to redo the
exercise with a demand curve of a
different elasticity, the incidence would not be identical. At the
same time, the general result on
supply elasticities still holds. We will return to this material in
Chapter 5.
Statutory incidence
In the above example the tax is analyzed by means of shifting
the supply curve. This implies
that the supplier is obliged to charge the consumer a tax and
then return this tax revenue to the
government. But suppose the supplier did not bear the
obligation to collect the revenue; instead
the buyer is required to send the tax revenue to the government.
If this were the case we could
analyze the impact of the tax by reducing the market demand
curve by the $4. This is because
the demand curve reflects what consumers are willing to pay,
and when suppliers are paid in the
presence of the tax they will be paid the buyers’ demand price

minus the tax that the buyers must
pay. It is not difficult to show that whether we move the supply
curve upward (to reflect the
responsibility of the supplier to pay the government) or move
the demand curve downward, the
outcome is the same – in the sense that the same price and
quantity will be traded in each case.
Furthermore the incidence of the tax, measured by how the price
change is apportioned between
the buyers and sellers is also unchanged.
Tax revenues and tax rates
It is useful to relate elasticity values to the policy question of
the impact of higher or lower taxes on
government tax revenue. Consider a situation in which a tax is
already in place and the government
considers increasing the rate of tax. Can an understanding of
elasticities inform us on the likely
outcome? The answer is yes. Suppose that at the initial tax
inclusive price demand is inelastic. We
know immediately that a tax rate increase that increases the
price must increase total expenditure.
Hence the outcome is that the government will get a higher
share of an increased total expenditure.

In contrast, if demand is elastic at the initial tax-inclusive price
a tax rate increase that leads to a
higher price will decrease total expenditure. In this case the
government will get a larger share of
a smaller pie – not as valuable from a tax revenue standpoint as
a larger share of a larger pie.
4.8 Identifying demand and supply elasticities
Elasticities are very useful pieces of evidence on economic
behaviour. But we need to take care in
making inferences from what we observe in market data. Upon
observing price and expenditure
changes in a given market, it is tempting to infer that we can
immediately calculate a demand
elasticity. But should we be thinking about supply elasticities?
Let us look at the information
needed before rushing into calculations.
4.8. Identifying demand and supply elasticities 109
In order to identify a demand elasticity we need to be sure that
we have price and quantity values
that lie on the same demand curve. And if we do indeed observe
several price and quantity pairs
that reflect a market equilibrium on a demand curve, then it

must be the case that those combi-
nations are caused by a shifting supply curve. Consider Figure
4.10. Suppose that we observe a
series of prices and accompanying quantities traded in three
consecutive months, and we plot these
combinations to yield points A, B, C in panel (a) of the figure.
If these points are market equilibria,
and if they lie on the same demand curve, it must be the case
that the supply curve has shifted. That
is, if we can draw a single demand curve through these points,
as in panel (b), the only way that
they each reflect demand conditions is for the supply curve to
have shifted to create these points as
equilibria in the market.
Sa Sb
Sc
D
Price
Quantity
Price
Quantity
(a) (b)

A A
B B
C C
Figure 4.10: Identifying elasticities
In order to establish that points such as A, B and C in Panel (a)
lie on the
same demand curve, we must know that the supply curve alone
has shifted
in such a way as to result in these equilibrium price-quantity
combinations,
as illustrated in Panel (b).
Exactly the same logic holds if we can infer that market
equilibrium points all lie on the same
supply curve. In that case the demand curve must have shifted
in order to be able to identify the
points as belonging to the supply curve.
This challenge is what we call the identification problem in
econometrics. Frequently new combi-
nations of price and quantity reflect shifts in both the supply
curve and demand curve, and we need
to call upon the econometricians to tell us what shifts are taking
place in the market.

110 Key Terms
KEY TERMS
Price elasticity of demand is measured as the percentage change
in quantity demanded, di-
vided by the percentage change in price.
Arc elasticity of demand defines consumer responsiveness over
a segment or arc of the de-
mand curve.
Point elasticity of demand is the elasticity computed at a
particular point on the demand
curve.
Demand is elastic if the price elasticity is greater than unity. It
is inelastic if the value lies
between unity and 0. It is unit elastic if the value is exactly one.
Cross-price elasticity of demand is the percentage change in the
quantity demanded of a
product divided by the percentage change in the price of
another.
Income elasticity of demand is the percentage change in
quantity demanded divided by a

percentage change in income.
Luxury good or service is one whose income elasticity equals or
exceeds unity.
Necessity is one whose income elasticity is greater than zero
and is less than unity.
Inferior goods have a negative income elasticity.
Elasticity of supply is defined as the percentage change in
quantity supplied divided by the
percentage change in price.
Tax Incidence describes how the burden of a tax is shared
between buyer and seller.
Exercises 111
EXERCISES FOR CHAPTER 4
Exercise 4.1. Consider the information in the table below that
describes the demand for movie
rentals from your on-line supplier Instant Flicks.
Price per movie ($) Quantity demanded Total revenue Elasticity
of demand
2 1200
3 1100

4 1000
5 900
6 800
7 700
8 600
(a) Either on graph paper or a spreadsheet, map out the demand
curve.
(b) In column 3, insert the total revenue generated at each price.
(c) At what price is total revenue maximized?
(d) In column 4, compute the elasticity of demand
corresponding to each $1 price reduction,
using the average price and quantity at each state.
(e) Do you see a connection between your answers in parts (c)
and (d)?
Exercise 4.2. Your fruit stall has 100 ripe bananas that must be
sold today. Your supply curve is
therefore vertical. From past experience, you know that these
100 bananas will all be sold if the
price is set at 40 cents per unit.
(a) Draw a supply and demand diagram illustrating the market
equilibrium price and quantity.

(b) The demand elasticity is -0.5 at the equilibrium price. But
you now discover that 10 of
your bananas are rotten and cannot be sold. Draw the new
supply curve and calculate the
percentage price increase that will be associate with the new
equilibrium, on the basis of
your knowledge of the demand elasticity.
Exercise 4.3. University fees in the State of Nirvana have been
frozen in real terms for 10 years.
During this period enrolments increased by 20 percent.
112 Exercises
(a) Draw a supply curve and two demand curves to represent the
two equilibria described.
(b) Can you estimate a price elasticity of demand for university
education in this market?
(c) In contrast, during the same time period fees in a
neighbouring state increased by 60 percent
and enrolments increased by 15 percent. Illustrate this situation
in a diagram.
Exercise 4.4. Consider the demand curve defined by the
information in the table below.
Price of movies Quantity demanded Total revenue Elasticity of

demand
2 200
3 150
4 120
5 100
(a) Plot the demand curve to scale and note that it is non-linear.
(b) Compute the total revenue at each price.
(c) Compute the arc elasticity of demand for each price
segment.
Exercise 4.5. The demand curve for seats at the Drive-in
Delight Theatre is given by P = 48−
0.2Q. The supply of seats is given by Q = 40.
(a) Plot the supply and demand curves to scale, and estimate the
equilibrium price.
(b) At this equilibrium point, calculate the elasticities of
demand and supply.
(c) The owner has additional space in his theatre, and is
considering the installation of more
seats. He then remembers from his days as an economics student
that this addition might not
necessarily increase his total revenue. If he hired you as a
consultant, would you recommend

to him that he install additional seats or that he take out some of
the existing seats and install
a popcorn concession instead? [Hint: You can use your
knowledge of the elasticities just
estimated to answer this question.]
(d) For this demand curve, over what range of prices is demand
inelastic?
Exercise 4.6. Waterson Power Corporation’s regulator has just
allowed a rate increase from 9 to
11 cents per kilowatt hour of electricity. The short run demand
elasticity is -0.6 and the long run
demand elasticity is -1.2.
(a) What will be the percentage reduction in power demanded in
the short run?
Exercises 113
(b) What will be the percentage reduction in power demanded in
the long run?
(c) Will revenues increase or decrease in the short and long
runs?
Exercise 4.7. Consider the own- and cross-price elasticity data
in the table below.
% change in price

CDs Magazines Cappuccinos
CDs -0.25 0.06 0.01
Magazines -0.13 -1.20 0.27% change in quantity
Cappuccinos 0.07 0.41 -0.85
(a) For which of the goods is demand elastic and for which is it
inelastic?
(b) What is the effect of an increase in the price of CDs on the
purchase of magazines and
cappuccinos? What does this suggest about the relationship
between CDs and these other
commodities; are they substitutes or complements?
(c) In graphical terms, if the price of CDs or the price of
cappuccinos increases, illustrate how
the demand curve for magazines shifts.
Exercise 4.8. You are responsible for running the Speedy Bus
Company and have information
about the elasticity of demand for bus travel: The own-price
elasticity is -1.4 at the current price.
A friend who works in the competing railway company also tells
you that she has estimated the
cross-price elasticity of train-travel demand with respect to the
price of bus travel to be 1.7.

(a) As an economic analyst, would you advocate an increase or
decrease in the price of bus
tickets if you wished to increase revenue for Speedy?
(b) Would your price decision have any impact on train
ridership?
Exercise 4.9. A household’s income and restaurant visits are
observed at different points in time.
The table below describes the pattern.
114 Exercises
Income ($) Restaurant visits Income elasticity of demand
16,000 10
24,000 15
32,000 18
40,000 20
48,000 22
56,000 23
64,000 24
(a) Construct a scatter diagram showing quantity on the vertical
axis and income on the hori-

zontal axis.
(b) Is there a positive or negative relationship between these
variables?
(c) Compute the income elasticity for each income increase,
using midpoint values.
(d) Are restaurant meals a normal or inferior good?
Exercise 4.10. Consider the following three supply curves: P =
2.25Q; P = 2+2Q; P = 6+1.5Q.
(a) Draw each of these supply curves to scale, and check that, at
P = $18, the quantity supplied
in each case is the same.
(b) Calculate the (point) supply elasticity for each curve at this
price.
(c) Now calculate the same elasticities at P = $12.
(d) One elasticity value should be unchanged. Which one?
Exercise 4.11. The demand for bags of candy is given by P =
48−0.2Q, and the supply by P = Q.
(a) Illustrate the resulting market equilibrium in a diagram.
(b) If the government now puts a $12 tax on all such candy
bags, illustrate on a diagram how the
supply curve will change.
(c) Compute the new market equilibrium.

(d) Instead of the specific tax imposed in part (b), a percentage
tax (ad valorem) equal to 30
percent is imposed. Illustrate how the supply curve would
change.
(e) Compute the new equilibrium.
Exercises 115
Exercise 4.12. Consider the demand curve P = 100−2Q. The
supply curve is given by P = 30.
(a) Draw the supply and demand curves to scale and compute
the equilibrium price and quantity
in this market.
(b) If the government imposes a tax of $10 per unit, draw the
new equilibrium and compute the
new quantity traded and the amount of tax revenue generated.
(c) Is demand elastic or inelastic in this price range?
Exercise 4.13. In Exercise 4.12: As an alternative to shifting the
supply curve, try shifting the
demand curve to reflect the $10 tax being imposed on the
consumer.
(a) Solve again for the price that the consumer pays, the price
that the supplier receives and the

tax revenue generated.
(b) Compare your answers with the previous question; they
should be the same.
Exercise 4.14. The supply of Henry’s hamburgers is given by P
= 2+0.5Q; demand is given by
Q = 20.
(a) Illustrate and compute the market equilibrium.
(b) A specific tax of $3 per unit is subsequently imposed and
that shifts the supply curve to
P = 5+0.5Q. Solve for the equilibrium price and quantity after
the tax.
(c) Who bears the burden of the tax in parts (a) and (b)?
Chapter 5: Welfare Economics and Externalities from
Microeconomics: Markets, Methods & Models by
Douglas Curtis and Ian Irvine is available under a Creative
Commons Attribution-NonCommercial-
ShareAlike 3.0 Unported license. © Lyryx Learning Inc.
http://lyryx.com/lscs/CurtisIrvine-Microeconomics-2015A.pdf
Chapter 5

Welfare economics and externalities
In this chapter we will explore:
5.1 Equity and efficiency
5.2 Consumer and producer surplus
5.3 Efficient market outcomes
5.4 Taxation surplus and efficiency
5.5 Market failures – externalities
5.6 Other market failures
5.7 Environment and climate change
5.8 Equity, justice and efficiency
5.1 Equity and efficiency
In modern mixed economies, markets and governments together
determine the output produced
and also who benefits from that output. In this chapter we
explore a very broad question that
forms the core of welfare economics: Are markets a good way
to allocate scarce resources in
view of the fact that they not only give rise to inequality and
poverty, but also fail to capture
the impacts of productive activity on non-market participants?

Mining impacts the environment,
traffic results in road fatalities, alcohol and tobacco cause
premature deaths and prescription pills
are abused. These products all generate secondary impacts
beyond their stated objective. We
frequently call these external effects. The analysis of markets in
this larger sense involves not
just positive economics; appropriate policy is additionally a
normative issue because policies can
impact the various participants in different ways and to
different degrees. Welfare economics,
therefore, deals with both normative and positive issues.
Welfare economics assesses how well the economy allocates its
scarce resources in accordance
with the goals of efficiency and equity.
117
118 Welfare economics and externalities
Political parties on the left and right disagree on how well a
market economy works. Canada’s
New Democratic Party emphasizes the market’s failings and the
need for government interven-

tion, while the Progressive Conservative Party believes,
broadly, that the market fosters choice,
incentives, and efficiency. What lies behind this disagreement?
The two principal factors are ef-
ficiency and equity. Efficiency addresses the question of how
well the economy’s resources are
used and allocated. In contrast, equity deals with how society’s
goods and rewards are, and should
be, distributed among its different members, and how the
associated costs should be apportioned.
Equity deals with how society’s goods and rewards are, and
should be, distributed among its
different members, and how the associated costs should be
apportioned.
Efficiency addresses the question of how well the economy’s
resources are used and allocated.
Equity is also concerned with how different generations share
an economy’s productive capabili-
ties: more investment today makes for a more productive
economy tomorrow, but more greenhouse
gases today will reduce environmental quality tomorrow. These
are inter-generational questions.
Climate change caused by global warming forms one of the
biggest challenges for humankind at

the present time. As we shall see in this chapter, economics has
much to say about appropriate
policies to combat warming. Whether pollution-abatement
policies should be implemented today
or twenty years from now involves considerations of equity
between generations. Our first task is
to develop an analytical tool which will prove vital in assessing
and computing welfare benefits
and costs – economic surplus.
5.2 Consumer and producer surplus
An understanding of economic efficiency is greatly facilitated
as a result of understanding two
related measures: consumer surplus and producer surplus.
Consumer surplus relates to the demand
side of the market, producer surplus to the supply side.
Producer surplus is also termed supplier
surplus. These measures can be understood with the help of a
standard example, the market for
city apartments.
Table 5.1 and Figure 5.1 describe the hypothetical data. We
imagine first a series of city-based
students who are in the market for a standardized downtown
apartment. These individuals are not

identical; they value the apartment differently. For example,
Alex enjoys comfort and therefore
places a higher value on a unit than Brian. Brian, in turn, values
it more highly than Cathy or Don.
Evan and Frank would prefer to spend their money on
entertainment, and so on. These valuations
are represented in the middle column of Table 5.1, and also in
Figure 5.1 with the highest valuations
closest to the origin. The valuations reflect the willingness to
pay of each consumer.
5.2. Consumer and producer surplus 119
Demand
Individual Demand valuation Surplus
Alex 900 400
Brian 800 300
Cathy 700 200
Don 600 100
Evan 500 0
Frank 400 0
Supply

Individual Reservation value Surplus
Gladys 300 200
Heward 350 150
Ian 400 100
Jeff 450 50
Kirin 500 0
Lynn 550 0
Table 5.1: Consumer and supplier surpluses
$900
Alex
Brian
Cathy
Don
Frank
$300
Gladys
Heward

Ian
Jeff
Lynn
Evan
Kirin
Rent
Quantity
Equilibrium
price=$500.
Figure 5.1: The apartment market
Demanders and suppliers are ranked in order of the value they
place on an
apartment. The market equilibrium is where the marginal
demand value of
Evan equals the marginal supply value of Kirin at $500. Five
apartments
are rented in equilibrium.
On the supply side we imagine the market as being made up of
different individuals or owners,
who are willing to put their apartments on the market for
different prices. Gladys will accept less
rent than Heward, who in turn will accept less than Ian. The

minimum prices that the suppliers are
willing to accept are called reservation prices or values, and
these are given in the lower part of
Table 5.1. Unless the market price is greater than their
reservation price, suppliers will hold back.
By definition, as stated in Chapter 3, the demand curve is made
up of the valuations placed on the
good by the various demanders. Likewise, the reservation values
of the suppliers form the supply
curve. If Alex is willing to pay $900, then that is his demand
price; if Heward is willing to put his
apartment on the market for $350, he is by definition willing to
supply it for that price. Figure 5.1
therefore describes the demand and supply curves in this
market. The steps reflect the willingness
to pay of the buyers and the reservation valuations or prices of
the suppliers.
In this example, the equilibrium price for apartments will be
$500. Let us see why. At that
price the value placed on the marginal unit supplied by Kirin
equals Evan’s willingness to pay.
Five apartments will be rented. A sixth apartment will not be
rented because Lynne will let her
apartment only if the price reaches $550. But the sixth potential

demander is willing to pay only
$400. Note that, as usual, there is just a single price in the
market. Each renter pays $500, and
therefore each supplier also receives $500.
The consumer and supplier surpluses can now be computed.
Note that, while Don is willing to
pay $600, he actually pays $500. His consumer surplus is
therefore $100. In Figure 5.1, we can
see that each consumer’s surplus is the distance between the
market price and the individual’s
valuation. These values are given in the final column of the top
half of Table 5.1.
5.2. Consumer and producer surplus 121
Consumer surplus is the excess of consumer willingness to pay
over the market price.
Using the same reasoning, we can compute each supplier’s
surplus, which is the excess of the
amount obtained for the rented apartment over the reservation
price. For example, Heward obtains
a surplus on the supply side of $150, while Jeff gets $50.
Heward is willing to put his apartment on
the market for $350, but gets the equilibrium price/rent of $500

for it. Hence his surplus is $150.
Supplier or producer surplus is the excess of market price over
the reservation price of the
supplier.
It should now be clear why these measures are called surpluses.
The suppliers and demanders are
all willing to participate in this market because they earn this
surplus. It is a measure of their gain
from being involved in the trading.
Computing the surpluses
The sum of each participant’s surplus in the final column of
Table 5.1 defines the total surplus in
the market. Hence, on the demand side a total surplus arises of
$1000 and on the supply side a
value of $500.
However, we do not always think of demand and supply
functions in terms of the steps illustrated in
Figure 5.1. Usually there are so many participants in the market
that the differences in reservation
prices on the supply side and willingness to pay on the demand
side are exceedingly small, and so
the demand and supply curves are drawn as continuous lines. So
let us see how to compute the

surpluses where the forms of the demand and supply curves are
known. Let the equations for the
curves be given by
Demand: P = 1000−100Q
Supply: P = 250+50Q
To find the market equilibrium, the two functions are equated
and solved:
1000−100Q = 250+50Q ⇒ 1000−250 = 50Q+100Q ⇒ 750 =
150Q
Therefore,
Q = 750/150 = 5.
At a quantity traded of five units, we can find the corresponding
price by substituting it into the
demand or supply function; the resulting equilibrium price is
$500. In this example we have
deliberately used two functions that yield the same equilibrium
as the apartment example, and
these functions are illustrated in Figure 5.2.
$900

A
$1000
Demand$300
$250
C
Supply
Rent
Quantity
$500
B E
Equilibrium
price=$500.
Figure 5.2: Measuring surplus
With the linear demand and supply curves that assume the good
is divisible
the consumer surplus is AEB and the supplier surplus is BEC.
This exceeds
the surplus computed as the sum of rectangular areas beneath
the bars and
above the price. The same reasoning carries over to producer
surplus.
The consumer surplus (CS) is the difference between the

demand curve and the equilibrium price
(ABE), and is computed by using the standard formula for the
area of a triangle—half the base
multiplied by the perpendicular height, and this yields a value
of $1250.
CS = (Demand value−price) = area ABE
= (1/2)×5×$500 = $1250
The suppliers’ surplus is the area BEC. This is computed as:
PS = (price− reservation value) = area BEC
= (1/2)×5×$250 = $625
5.3. Efficient market outcomes 123
Before progressing it is useful to note that the numerical values
we obtain here differ slightly from
the values in Table 5.1. The reason is straightforward to see: the
area under the demand curve
is slightly greater than the sum of the several rectangular areas,
each associated with one market
participant. This is equally true on the supply side.
The total surplus that arises in the market is the sum of
producer and consumer surpluses.

5.3 Efficient market outcomes
The definition of the surplus measures is straightforward: Once
we have the demand and supply
curves, the area between each one and the equilibrium price can
be calculated. With straight-line
functions, these areas involve triangles. But where does the
notion of market efficiency enter? Let
us pursue the example.
In addition to these city apartments, there are many others in
the suburbs that do not have the
desirable “proximity to downtown” characteristic. There are
also many more demanders in the
market for living space than the number who rented at $500 in
the city. Who are these other
individuals? Clearly they place a lower value on city apartments
than the individuals who are
willing to pay at least $500.
The equilibrium price of $500 in Figure 5.1 has two
implications. First, individuals who place a
lower value on a city apartment must seek accommodation
elsewhere. Second, suppliers who have
a reservation price above the equilibrium price will not
participate. This implies that an efficient

market maximizes the sum of producer and consumer surpluses.
Here is why.
An efficient market maximizes the sum of producer and
consumer surpluses.
Instead of a freely functioning market, imagine that the city
government rents all apartments from
suppliers at the price of $500 per unit, but decides to allocate
the apartments to tenants in a lottery
(we can imagine the government getting the money to pay for
the apartments from tax revenue).
By doing this, many demanders who place a low value on a city
apartment would end up living in
one, and other individuals, who were not so fortunate in the
lottery, would not obtain an apartment,
even if they valued one highly. Suppose, then, that Frank gets
an apartment in the lottery and Cathy
does not. This outcome would not be efficient, because there are
further gains in surplus to be had.
Frank and Cathy can now strike a private deal so that both gain.
If Frank agrees to sublet to Cathy at a price between their
respective valuations of $400 and $700—
say $600—he will gain $200 and she will gain $100. This is
because Frank values the apartment
only at $400, but now obtains $600. Cathy values it at $700 but

pays only $600. The random
allocation of apartments, therefore, is not efficient, because
further gains from trade are possible.
In contrast, the market mechanism, in which suppliers and
demanders freely trade, leaves no scope
for additional trades that would improve the well-being of
participants.
It is frequently useful to characterize market equilibrium in
terms of the behaviour of marginal
participants—the very last buyer and the very last supplier, or
the very last unit supplied and
demanded. In addition, we will continue with the assumption
that the supply curve represents the
full cost of each unit of production. It follows that, at the
equilibrium, the value placed on the last
unit purchased (as reflected in the demand curve) equals the
cost of supplying that unit. If one
more unit were traded, we can see from Figure 5.2 that the
value placed on that additional unit (as
represented by the demand curve) would be less than its cost of
production. This would be a poor

use of society’s resources. Phrased another way, resources
would not be used efficiently unless the
cost of the last unit equaled the value placed on it.
Before applying the concept of efficiency, and the surpluses it
embodies, students should note
that we have invoked some assumptions. For example, if
individual incomes change, the corre-
sponding market demand curve changes, and any market
equilibrium will then depend on the new
distribution of incomes.
5.4 Taxation, surplus and efficiency
Despite enormous public interest in taxation and its impact on
the economy, it is one of the least
understood areas of public policy. In this section we will show
how an understanding of two
fundamental tools of analysis—elasticities and economic
surplus—provides powerful insights into
the field of taxation.
We begin with the simplest of cases, the federal government’s
goods and services tax (GST) or
the provincial governments’ sales taxes (PST). These taxes
combined vary by province, but we
suppose that a typical rate is 13 percent. Note that this is a

percentage, or ad valorem, tax, not a
specific tax of so many dollars per unit traded. Figure 5.3
illustrates the supply and demand curves
for some commodity. In the absence of taxes, the equilibrium
E0 is defined by the combination
(P0,Q0).
5.4. Taxation, surplus and efficiency 125
F
S
St
B
D
Price
Quantity
P0
E0
Q0
Pt
Et
Qt

Pts
A
Tax
wedge
Figure 5.3: The efficiency cost of taxation
The tax shifts S to St and reduces the quantity traded from Q0
to Qt . At Qt
the demand value placed on an additional unit exceeds the
supply valuation
by EtA. Since the tax keeps output at this lower level, the
economy can-
not take advantage of the additional potential surplus between
Qt and Q0.
Excess burden = deadweight loss = AEtE0.
A 13-percent tax is now imposed, and the new supply curve St
lies 13 percent above the no-tax
supply S. A tax wedge is therefore imposed between the price
the consumer must pay and the
price that the supplier receives. The new equilibrium is Et , and
the new market price is at Pt . The
price received by the supplier is lower than that paid by the
buyer by the amount of the tax wedge.
The post-tax supply price is denoted by Pts.

There are two burdens associated with this tax. The first is the
revenue burden, the amount of tax
revenue paid by the market participants and received by the
government. On each of the Qt units
sold, the government receives the amount (Pt −Pts). Therefore,
tax revenue is the amount PtEtAPts.
As illustrated in Chapter 4, the degree to which the market price
Pt rises above the no-tax price P0
depends on the supply and demand elasticities.
A tax wedge is the difference between the consumer and
producer prices.
The revenue burden is the amount of tax revenue raised by a
tax.
The second burden of the tax is called the excess burden. The
concepts of consumer and producer
surpluses help us comprehend this. The effect of the tax has
been to reduce consumer surplus
by PtEtE0P0. This is the reduction in the pre-tax surplus given
by the triangle P0BE0. By the
same reasoning, supplier surplus is reduced by the amount
P0E0APts; prior to the tax it was P0E0F.
Consumers and suppliers have therefore seen a reduction in
their well-being that is measured by

these dollar amounts. Nonetheless, the government has
additional revenues amounting to PtEtAPts,
and this tax imposition therefore represents a transfer from the
consumers and suppliers in the
marketplace to the government. Ultimately, the citizens should
benefit from this revenue when it
is used by the government, and it is therefore not considered to
be a net loss of surplus.
However, there remains a part of the surplus loss that is not
transferred, the triangular area EtE0A.
This component is called the excess burden, for the reason that
it represents the component of the
economic surplus that is not transferred to the government in
the form of tax revenue. It is also
called the deadweight loss, DWL.
The excess burden, or deadweight loss, of a tax is the
component of consumer and producer
surpluses forming a net loss to the whole economy.
The intuition behind this concept is not difficult. At the output
Qt , the value placed by consumers
on the last unit supplied is Pt (=Et), while the production cost
of that last unit is Pts (= A). But
the potential surplus (Pt −Pts) associated with producing an

additional unit cannot be realized,
because the tax dictates that the production equilibrium is at Qt
rather than any higher output.
Thus, if output could be increased from Qt to Q0, a surplus of
value over cost would be realized
on every additional unit equal to the vertical distance between
the demand and supply functions D
and S. Therefore, the loss associated with the tax is the area
EtE0A.
In public policy debates, this excess burden is rarely discussed.
The reason is that notions of
consumer and producer surpluses are not well understood by
non-economists, despite the fact that
the value of lost surpluses can be very large. Numerous studies
have attempted to estimate the
excess burden associated with raising an additional dollar from
the tax system. They rarely find
that the excess burden is less than 25 percent. This is a sobering
finding. It tells us that if the
government wished to implement a new program by raising
additional tax revenue, the benefits of
the new program should be 25 percent greater than the amount
expended on it!
The impact of taxes and other influences that result in an
inefficient use of the economy’s resources

are frequently called distortions. The examples we have
developed in this chapter indicate that
distortions can describe either an inefficient output being
produced, as in the taxation example, or
an inefficient allocation of a given output, as in the case of
apartments being allocated by lottery.
A distortion in resource allocation means that production is not
at an efficient output, or a given
output is not efficiently allocated.
5.4. Taxation, surplus and efficiency 127
Elasticities and the excess burden
We suggested above that elasticities are important in
determining the size of the deadweight loss
of a tax. Going back to Figure 5.3, suppose that the demand
curve through E0 were more elastic
(with the same supply curve, for simplicity). The post-tax
equilibrium Et would now yield a lower
Qt value and a price between Pt and P0. The resulting tax
revenue raised and the magnitude of the
excess burden would differ because of the new elasticity.
A wage tax

A final example will illustrate how the concerns of economists
over the magnitude of the DWL are
distinct from the concerns expressed in much of the public
debate over taxes. Figure 5.4 illustrates
the demand and supply for a certain type of labour. On the
demand side, the analysis is simplified
by assuming that the demand for labour is horizontal, indicating
that the gross wage rate is fixed,
regardless of the employment level. On the supply side, the
upward slope indicates that individuals
supply more labour if the wage is higher. The equilibrium E0
reflects that L0 units of labour are
supplied at the gross, that is, pre-tax wage W0.
S
Wt Dt
W0 D
Wage
Labour
E0
L0
B

Et
Lt
Wage tax
Excess burden
= deadweight loss
= BE0Et
Figure 5.4: Taxation and labour supply
The demand for labour is horizontal at W0. A tax on labour
reduces the
wage paid to Wt . The loss in supplier surplus is the area
W0E0EtWt . The
government takes W0BEtWt in tax revenue, leaving BE0Et as
the DWL of
the wage tax.
An income tax is now imposed. If this is, say, 20 percent, then
the net wage falls to 80 percent
of the gross wage in this example, given the horizontal demand
curve. The new equilibrium Et is
defined by the combination (Wt ,Lt). Less labour is supplied
because the net wage is lower. The

government generates tax revenue of (W0−Wt ) on each of the
Lt units of labour now supplied, and
this is the area W0BEtWt . The loss in surplus to the suppliers
is W0E0EtWt , and therefore the DWL
is the triangle BE0Et . Clearly the magnitude of the DWL
depends upon the supply elasticity.
Whereas the DWL consequence of the wage tax is important for
economists, public debate is more
often focused on the reduction in labour supply and production.
Of course, these two issues are
not independent. A larger reduction in labour supply is
generally accompanied by a bigger excess
burden.
5.5 Market failures – externalities
The consumer and producer surplus concepts we have developed
are extremely powerful tools of
analysis, but the world is not always quite as straightforward as
simple models indicate. For ex-
ample, many suppliers generate pollutants that adversely affect
the health of the population, or
damage the environment, or both. The term externality is used
to denote such impacts. External-
ities impact individuals who are not participants in the market
in question, and the effects of the

externalities may not be captured in the market price. For
example, electricity-generating plants
that use coal reduce air quality, which, in turn, adversely
impacts individuals who suffer from
asthma or other lung ailments. While this is an example of a
negative externality, externalities can
also be positive.
An externality is a benefit or cost falling on people other than
those involved in the activity’s
market. It can create a difference between private costs or
values and social costs or values.
We will now show why markets characterized by externalities
are not efficient, and also show how
these externalities might be corrected or reduced. The essence
of an externality is that it creates a
divergence between private costs/benefits and social
costs/benefits. If a steel producer pollutes the
air, and the steel buyer pays only the costs incurred by the
producer, then the buyer is not paying
the full “social” cost of the product. The problem is illustrated
in Figure 5.5.
5.5. Market failures – externalities 129

R
S (Private supply cost)
K
S f (Full social supply cost)
U
D
Price
Quantity of
electricity
P0
E0
Q0
P∗
E∗
A
V
Q∗
Figure 5.5: Negative externalities and inefficiency
A negative externality is associated with this good. S measures
private costs,

whereas S f measures the full social cost. The socially optimal
output is Q
∗ ,
not the market outcome Q0. Beyond Q
∗ the real cost exceeds the demand
value; therefore Q0 is not an efficient output. A tax that
increases P to P
∗
and reduces output is one solution to the externality.
Negative externalities
In Figure 5.5, the supply curve S represents the cost to the
supplier, whereas S f (the full cost)
reflects, in addition, the cost of bad air to the population. Of
course, we are assuming that this
external cost is ascertainable, in order to be able to characterize
S f accurately. Note also that this
illustration assumes that, as power output increases, the external
cost per unit rises, because the
difference between the two supply curves increases with output.
This implies that low levels of
pollution do less damage: Perhaps the population has a natural
tolerance for low levels, but higher
levels cannot be tolerated easily and so the cost is greater.
Despite the externality, an efficient level of production can still

be defined. It is given by Q∗ , not
Q0. To see why, consider the impact of reducing output by one
unit from Q0. At Q0 the willingness
of buyers to pay for the marginal unit supplied is E0. The
(private) supply cost is also E0. But from
a societal standpoint there is a pollution/health cost of AE0
associated with that unit of production.
The full cost, as represented by S f , exceeds the buyer’s
valuation. Accordingly, if the last unit of
output produced is cut, society gains by the amount AE0,
because the cut in output reduces the
excess of true cost over value.
Applying this logic to each unit of output between Q0 and Q
∗ , it is evident that society can increase
its well-being by the dollar amount equal to the area E∗ AE0, as
a result of reducing production.
Next, consider the consequences of reducing output further from
Q∗ . Note that pollution is being
created here, and environmentalists frequently advocate that
pollution should be reduced to zero.
However, an efficient outcome may not involve a zero level of

pollution! If the production of power
were reduced below Q∗ , the loss in value to buyers, as a result
of not being able to purchase the
good, would exceed the full cost of its production.
If the government decreed that, instead of producing Q∗ , no
pollution would be tolerated, then soci-
ety would forgo the possibility of earning the total real surplus
equal to the area UE∗ K. Economists
do not advocate such a zero-pollution policy; rather, we
advocate a policy that permits a “tolera-
ble” pollution level – one that still results in net benefits to
society. In this particular example, the
total cost of the tolerated pollution equals the area between the
private and full supply functions,
KE∗ VR.
As a matter of policy, how is this market influenced to produce
the amount Q∗ rather than Q0?
One option would be for the government to intervene directly
with production quotas for each
firm. An alternative would be to impose a corrective tax on the
good whose production causes the
externality: With an appropriate increase in the price,
consumers will demand a reduced quantity.

In Figure 5.5 a tax equal to the dollar value VE∗ would shift
the supply curve upward by that
amount and result in the quantity Q∗ being traded.
A corrective tax seeks to direct the market towards a more
efficient output.
We are now venturing into the field of environmental policy,
and this is explored in the following
section. The key conclusion of the foregoing analysis is that an
efficient working of the market
continues to have meaning in the presence of externalities. An
efficient output level still maximizes
economic surplus where surplus is correctly defined.
Positive externalities
Externalities of the positive kind enable individuals or
producers to get a type of ‘free ride’ on
the efforts of others. Real world examples abound: When a large
segment of the population is
inoculated against disease, the remaining individuals benefit on
account of the reduced probability
of transmission.
A less well recognized example is the benefit derived by many
Canadian firms from research and
development (R&D) undertaken in the United States. Professor

Dan Treffler of the University of
Toronto has documented the positive spillover effects in detail.
Canadian firms, and firms in many
other economies, learn from the research efforts of U.S. firms
that invest heavily in R&D. In the
same vein, universities and research institutes open up new
fields of knowledge, with the result
that society at large, and sometimes the corporate sector, gain
from this enhanced understanding
of science, the environment, or social behaviours.
5.5. Market failures – externalities 131
The free market may not cope any better with these positive
externalities than it does with nega-
tive externalities, and government intervention may be
beneficial. For example, firms that invest
heavily in research and development would not undertake such
investment if competitors could
have a complete free ride and appropriate the fruits. This is why
patent laws exist, as we shall see
later in discussing Canada’s competition policy. These laws
prevent competitors from copying the
product development of firms that invest in R&D. If such

protection were not in place, firms would
not allocate sufficient resources to R&D, which is a real engine
of economic growth. In essence,
the economy’s research-directed resources would not be
appropriately rewarded, and thus too little
research would take place.
While patent protection is one form of corrective action,
subsidies are another. We illustrated
above that an appropriately formulated tax on a good that
creates negative externalities can reduce
demand for that good, and thereby reduce pollution. A subsidy
can be thought of as a negative tax.
Consider the example in Figure 5.6.
S
D (Private value)
D f (Full social value)
Price
Quantity
P0
Q0 Q
∗

P∗
Figure 5.6: Positive externalities - the market for flu shots
The value to society of vaccinations exceeds the value to
individuals: the
greater the number of individuals vaccinated, the lower is the
probability of
others contracting the virus. D f reflects this additional value.
Consequently,
the social optimum is Q∗ which exceeds Q0.
Individuals have a demand for flu shots given by D. This
reflects their private valuation – their
personal willingness to pay. But the social value of flu shots is
greater. When a given number
of individuals are inoculated, the probability that others will be
infected falls. Additionally, with
higher rates of inoculation, the health system will incur fewer
costs in treating the infected. There-
fore, the value to society of any quantity of flu shots is greater
than the sum of the values that
individuals place on them.
Let D f reflects the full social value of any quantity of flu shots.
If S is the supply curve, the socially

optimal, efficient, market outcome is Q∗ . How can we
influence the market to move from Q0 to
Q∗ ? One solution is a subsidy that would reduce the price from
P0 to P
∗ . Rather than shifting the
supply curve upwards, as a tax does, the subsidy would shift the
supply downward, sufficiently
to intersect D at the output Q∗ . In some real world examples,
the value of the positive externality
is so great that the government may decide to drive the price to
zero, and thereby provide the
inoculation at a zero price. For example, children typically get
their MMR shots (measles, mumps,
and rubella) free of charge.
5.6 Other market failures
There are other ways in which markets can fail to reflect
accurately the social value or social cost
of economic activity. Profit seeking monopolies, which restrict
output in order to increase profits,
create inefficient markets, and we will see why in the chapter
on monopoly. Or the market may
not deal very well with what are called public goods. These are

goods, like radio and television
service, national defence, or health information: with such
goods and services many individuals
can be supplied with the same good at the same total cost as one
individual. We will address this
problem in our chapter on government. And, of course, there are
international externalities that
cannot be corrected by national governments because the
interests of adjoining states may differ:
One economy may wish to see cheap coal-based electricity
being supplied to its consumers, even
if this means acid rain or reduced air quality in a neighbouring
state. Markets may fail to supply
an “efficient” amount of a good or service in all of these
situations. Global warming is perhaps the
best, and most extreme, example of international externalities
and market failure.
5.7 Environmental policy and climate change
The 2007 recipients for the Nobel Peace Prize were the United
Nation’s Intergovernmental Panel
on Climate Change (IPCC), and Al Gore, former vice president
of the United States. The Nobel
committee cited the winners “for their efforts to build up and
disseminate greater knowledge about

man-made climate change, and to lay the foundations for the
measures that are needed to counteract
such change.” While Al Gore is best known for his efforts to
bring awareness of climate change to
the world, through his book and associated movie (An
Inconvenient Truth), the IPCC is composed
of a large, international group of scientists that has worked for
many years in developing a greater
understanding of the role of human activity in global warming.
Reports on the extent and causes
of the externality that we call global warming are now plentiful.
The IPCC has produced several
reports at this point; a major study was undertaken in the UK
under the leadership of former World
Bank Chief Economist Sir Nicholas Stern. Countless scientific
papers have been published on the
subject.
5.7. Environmental policy and climate change 133
Greenhouse gases
The emission of greenhouse gases (GHGs) is associated with a
wide variety of economic activities

such as coal-based power generation, oil-burning motors, wood-
burning stoves, etc. The most
common GHG is carbon dioxide. The gases, upon emission,
circulate in the earth’s atmosphere
and, if their build-up is excessive, prevent sufficient radiant
heat from escaping. The result is a slow
warming of the earth’s surface and air temperatures. It is
envisaged that such temperature increases
will, in the long term, increase water temperatures, possibly
cause glacial melting, with the result
that water levels worldwide may rise. In addition to the
possibility of higher water levels (which
the IPCC estimates will be about one foot by the end of the 21st
century), oceans may become
more acidic, weather patterns may change and weather events
may become more variable and
severe. The changes will be latitude-specific and vary by
economy and continent, and ultimately
will impact the agricultural production abilities of certain
economies.
Greenhouse gases that accumulate excessively in the earth’s
atmosphere prevent heat from es-
caping and lead to global warming.
While most scientific findings and predictions are subject to a

degree of uncertainty, there is little
disagreement in the scientific community on the very long-term
impact of increasing GHGs in the
atmosphere. There is some skepticism as to whether the
generally higher temperatures experienced
in recent decades are completely attributable to anthropogenic
activity since the industrial revolu-
tion, or whether they also reflect a natural cycle in the earth’s
temperature. But scientists agree
that a continuance of the recent rate of GHG emissions will
ultimately lead to serious climatic
problems. And since GHG emissions are strongly correlated
with economic growth, the very high
rate of economic growth in many large-population economies
such as China and India mean that
GHGs could accumulate at a faster rate than considered likely
in the 1990s.
This is an area where economic, atmospheric and environmental
models are used to make predic-
tions. We have just one earth and humankind has never
witnessed current GHG emission patterns
and trends. Consequently the methodology of this science is
strongly model based. Scientists at-
tempt to infer something about the relationship between

temperature and climate on the one hand
and carbon dioxide concentrations in the atmosphere on the
other, using historical data. Data values
are inferred by examining ice cores and tree rings from eons
past. Accordingly, there is a degree
of uncertainty regarding the precise impact of GHG
concentrations on water levels, temperatures,
and extreme weather events.
The consensus is that, in the presence of such uncertainty, a
wise strategy would involve controls
on the further buildup of gases, unless the cost of such a policy
was prohibitive.
GHGs as a common property
A critical characteristic of GHGs is that they are what we call in
economics a ‘common property’:
every citizen in the world ‘owns’ them, every citizen has equal
access to them, and it matters little
where these GHGs originate. Consequently, if economy A
reduces its GHG emissions, economy
B may simply increase their emissions rather than incur the cost
of reducing its emissions also.

Hence, economy A’s behaviour goes unrewarded. This is the
crux of international agreements – or
disagreements. Since GHGs are a common property, in order for
A to have the incentive to reduce
emissions, it needs to know that B will act correspondingly.
The Kyoto Protocol
The world’s first major response to climate concerns came in
the form of the United Nations–
sponsored Earth Summit in Rio de Janeiro in 1992. This was
followed by the signing of the
Kyoto Protocol in 1997, in which a group of countries
committed themselves to reducing their
GHG emissions relative to their 1990 emissions levels by the
year 2012. Canada’s Parliament
subsequently ratified the Kyoto Protocol, and thereby agreed to
meet Canada’s target of a 6 percent
reduction in GHGs relative to the amount emitted in 1990.
On a per-capita basis, Canada is one of the world’s largest
contributors to global warming, even
though Canada’s percentage of the total is just 2 percent. Many
of the world’s major economies
refrained from signing the Protocol—most notably China, the
United States, and India. Canada’s

emissions in 1990 amounted to approximately 600 giga tonnes
(Gt) of carbon dioxide; but by the
time we ratified the treaty in 2002, emissions were about 25%
above that level. Hence the signing
was somewhat meaningless, in that Canada had virtually a zero
possibility of attaining its target.
The target date of 2012 has come and gone; and the leaders of
the world economy, at their meeting
in Copenhagen failed to come up with a new agreement that
would have greater force. In 2012 the
Rio+20 summit was held – in Rio once again, with the objective
of devising a means of reducing
GHG emissions.
The central challenge in this area is that developed economies
are those primarily responsible for
the buildup of GHGs in the post industrial revolution era.
Developing economies, however, do not
accept that the developed economies should be free to continue
to emit GHGs at current levels,
while the developing economies should be required to limit
theirs at a much lower level.
To compound difficulties, there exists strong skepticism in
some economies regarding the urgency

to implement limits on the growth in emissions.
Canada’s GHG emissions
An excellent summary source of data on Canada’s emissions
and performance during the period
1990-2010 is available on Environment Canada’s web site. See:
Environment Canada – National Inventory Report – GHG
sources and sinks in Canada 1990-2010.
Canada, like many economies, has become more efficient in its
use of energy (the main source of
GHGs) in recent decades—its use of energy per unit of total
output has declined steadily. On a per
capita basis Canada’s emissions amounted to 23.5 tonnes in
2005, and dropped to 20.3 by 2010.
This improvement in efficiency means that Canada’s GDP is
now less energy intensive. The quest
for increased efficiency is endless, if economic growth is to
continue at rates that will satisfy the
world’s citizens and more broadly the impoverished world. The
critical challenge is to produce
more output while using not just less energy per unit of output,
but to use less energy in total

While Canada’s energy intensity (GHGs per unit of output) has
dropped by a very substantial
amount – 27% between 1990 and 2010 – overall emissions
increased by almost 20%. Further-
more, while developed economies have increased their
efficiency, it is the world’s efficiency that
is ultimately critical. By outsourcing much our its
manufacturing sector to China, Canada and
the West have offloaded some of their most GHG-intensive
activities. But GHGs are a common
property resource.
Canada’s GHG emissions also have a regional aspect: the
production of oil and gas, which has
created considerable wealth for all Canadians (and contributed
to the appreciation of the Cana-
dian dollar in the last decade), is both energy intensive and
concentrated in a limited number of
provinces (Alberta, Saskatchewan and more recently
Newfoundland and Labrador).
GHG Measurement
GHG atmospheric concentrations are measured in parts per
million (ppm). Current levels in the
atmosphere are below 400 ppm, and long-term levels above 500

could lead to serious economic
and social disruption. In the immediate pre-industrial revolution
era concentrations were in the
250 ppm range. Hence 500 ppm represents the ‘doubling’ factor
that is so frequently discussed in
the media.
GHGs are augmented by the annual additions to the stock
already in the atmosphere, and at the
same time they decay—though very slowly. GHG-reduction
strategies that propose an immediate
reduction in emissions are more costly than those aimed at a
more gradual reduction. For example,
a slower investment strategy would permit in-place production
and transportation equipment to
reach the end of its economic life rather than be scrapped and
replaced ‘prematurely’. Policies that
focus upon longer term replacement are therefore less costly.
While not all economists and policy makers agree on the time
scale for attacking the problem, most
agree that, the longer major GHG reduction is postponed, the
greater the efforts will have to be in

the long term—because GHGs will build up more rapidly in the
near term.
A critical question in controlling GHG emissions relates to the
cost of their control: how much of
annual growth might need to be sacrificed in order to get
emissions onto a sustainable path? Again
estimates vary. The Stern Review proposed that, with an
increase in technological capabilities, a
strategy that focuses on the relative near-term implementation
of GHG reduction measures might
cost “only” a few percentage points of the value of world
output. If correct, this may not be an
inordinate price to pay for risk avoidance in the longer term.
Nonetheless, such a reduction will require particular economic
policies, and specific sectors will
be impacted more than others.
Economic policies for climate change
There are three main ways in which polluters can be controlled.
One involves issuing direct con-
trols; the other two involve incentives—in the form of pollution
taxes, or on tradable “permits” to
pollute.

To see how these different policies operate, consider first
Figure 5.7. It is a standard diagram
in environmental economics, and is somewhat similar to our
supply and demand curves. On the
horizontal axis is measured the quantity of environmental
damage or pollution, and on the vertical
axis its dollar value or cost. The upward-sloping damage curve
represents the cost to society of
each additional unit of pollution or gas, and it is therefore
called a marginal damage curve. It
is positively sloped to reflect the reality that, at low levels of
emissions, the damage of one more
unit is less than at higher levels. In terms of our earlier
discussion, this means that an increase in
GHGs of 10 ppm when concentrations are at 300 ppm may be
less damaging than a corresponding
increase when concentrations are at 500 ppm.
Marginal
damage
Marginal
abatement cost

Pollution
cost
Pollution
quantityQ∗
Figure 5.7: The optimal quantity of pollution
Q∗ represents the optimal amount of pollution. More than this
would in-
volve additional social costs because damages exceed abatement
costs. Co-
versely, less than Q∗ would require an abatement cost that
exceeds the re-
duction in damage.
The marginal damage curve reflects the cost to society of an
additional unit of pollution.
The second curve is the abatement curve. It reflects the cost of
reducing emissions by one unit,
and is therefore called a marginal abatement curve. This curve
has a negative slope indicating
that, as we reduce the total quantity of pollution produced, the
cost of further unit reductions rises.
This shape corresponds to reality. For example, halving the
emissions of pollutants and gases from
automobiles may be achieved by adding a catalytic converter
and reducing the amount of lead in

gasoline. But reducing those emissions all the way to zero
requires the development of major new
technologies such as electric cars—an enormously more costly
undertaking.
The marginal abatement curve reflects the cost to society of
reducing the quantity of pollution
by one unit.
If producers are unconstrained in the amount of pollution they
produce, they may produce more
than what we will show is the optimal amount – corresponding
to Q∗ . This amount is optimal in
the sense that at levels greater than Q∗ the damage exceeds the
cost of reducing the emissions.
However, reducing emissions by one unit below Q∗ would
mean incurring a cost per unit reduction
that exceeds the benefit of that reduction. Another way of
illustrating this is to observe that at a
level of pollution above Q∗ the cost of reducing it is less than
the damage it inflicts, and therefore
a net gain accrues to society as a result of the reduction. But to
reduce pollution below Q∗ would

involve an abatement cost greater than the reduction in
pollution damage and therefore no net gain
to society. This constitutes a first rule in optimal pollution
policy.
An optimal quantity of pollution occurs when the marginal cost
of abatement equals the marginal
damage.
A second guiding principle emerges by considering a situation
in which some firms are relative
‘clean’ and others are ‘dirty’. More specifically, a clean firm A
may have already invested in new
equipment that uses less energy per unit of output produced, or
emits fewer pollutants per unit
of output. In contrast the dirty firm B uses older dirtier
technology. Suppose furthermore that
these two firms form a particular sector of the economy and that
the government sets a limit on
total pollution from this sector, and that this limit is less than
what the two firms are currently
producing. What is the least costly method to meet the target?
The intuitive answer to this question goes as follows: in order
to reduce pollution at least cost to
the sector, calculate what it would cost each firm to reduce

pollution from its present level. Then
implement a system so that the firm with the least cost of
reduction is the first to act. In this case
the ‘dirty’ firm will likely have a lower cost of abatement since
it has not yet upgraded its physical
plant. This leads to a second rule in pollution policy:
With many polluters, the least cost policy to society requires
producers with the lowest abatement
costs to act first.
This principle implies that policies which impose the same
emission limits on firms may not be
the least costly manner of achieving a target level of pollution.
Let us now consider the use of
tradable permits and corrective/carbon taxes as policy
instruments. These are market-based
systems aimed at reducing GHGs.
Tradable permits and corrective/carbon taxes are market-based
systems aimed at reducing
GHGs.
Incentive mechanism I: tradable permits
A system of tradable permits is frequently called a ‘cap and
trade’ system, because it limits or caps

the total permissible emissions, while at the same time allows a
market to develop in permits. For
illustrative purposes, consider the hypothetical two-firm sector
we developed above, composed of
firms A and B. Firm A has invested in clean technology, firm B
has not. Thus it is less costly for
B to reduce emissions than A if further reductions are required.
Next suppose that each firm is
allocated by the government a specific number of ‘GHG
emission permits’; and that the total of
such permits is less than the amount of emissions at present,
and that each firm is emitting more
than its permits allow. How can these firms achieve the target
set for this sector of the economy?
The answer is that they should be able to engage in mutually
beneficial trade: If firm B has a lower
cost of reducing emissions than A, then it may be in A’s interest
to pay B to reduce B’s emissions
heavily. This would free up some of B’s emission permits. A in
essence is thus buying B’s emission
permits from B.

This solution may be efficient from a resource use perspective:
having A reduce emissions might
involve a heavy investment cost for A. But having B reduce
emissions might involve a more modest
cost – one that he can more than afford by selling his emission
permits to A.
The largest system of tradable permits currently operates in the
European Union. It covers more
than 10,000 large energy-using installations. Trading began in
2005. A detailed description of its
operation is contained in Wikipedia. California introduced a
similar scheme in November 2012.
See: Wikipedia – European Union Emission Trading Scheme
Incentive mechanism II: taxes
Corrective taxes are frequently called Pigovian taxes, after the
economist Arthur Pigou. He advo-
cated taxing activities that cause negative externalities. These
taxes have been examined above in
Section 5.4. Corrective taxes of this type can be implemented as
part of a tax package reform. For
example, taxpayers are frequently reluctant to see governments
take ‘yet more’ of their money, in
the form of new taxes. Such concerns can be addressed by
reducing taxes in other sectors of the

economy, in such a way that the package of tax changes
maintains a ‘revenue neutral’ impact.
Policy in practice – international
In an ideal world, permits would be traded internationally, and
such a system might be of benefit to
developing economies: if the cost of reducing pollution is
relatively low in developing economies
because they have few controls in place, then developed
economies, for whom the cost of GHG
reduction is high could induce firms in the developing world to
undertake cost reductions. Such a
trade would be mutually beneficial. For example, if a
developed-economy firm must expend $30 to
reduce GHGs by one tonne, and this can be achieved at a cost of
$10 in the developing economy,
then the firm in the developed world could pay up to $20 to the
firm in the developing world to
reduce GHGs by one tonne. Both would obviously gain from
such an arrangement. This gain
arises because of the common property nature of the gases – it
matters not where they originate.
This process is evidently just an extension of the domestic cap-
and-trade system described above

under ‘incentive mechanism I’ to the international market. The
advantage of internationalizing the
system is that the differences in the cost of reducing emissions
may be very large internationally,
and the scope for gains correspondingly larger.
Policy in practice – domestic large final emitters
Governments frequently focus upon quantities emitted by
individual firms, sometimes because
governments are reluctant to introduce carbon taxes or a system
of tradable permits. Specifically
the focus is upon firms called large final emitters (LFEs).
Frequently, a relatively small number of
producers are responsible for a disproportionate amount of an
economy’s total pollution, and limits
are placed on those firms in the belief that significant economy-
wide reductions can be achieved
in this manner. A further reason for concentrating on these
LFEs is that the monitoring costs are
relatively small compared to the costs associated with
monitoring all firms in the economy. It
must be kept in mind that pollution permits may be a legal

requirement in some jurisdictions, but
monitoring is still required, because firms could choose to risk
polluting without owning a permit.
Revenues from taxes and permits
Taxes and tradable permits differ in that taxes generate revenue
for the government from polluting
producers, whereas permits may not generate revenue, or may
generate less revenue. If the gov-
ernment simply allocates permits initially to all polluters, free
of charge, and allows a market to
develop, such a process generates no revenue to the
government. While economists may advocate
an auction of permits in the start-up phase of a tradable permits
market, such a mechanism may
run into political objections.
Setting taxes at the appropriate level requires knowledge of the
cost and damage functions associ-
ated with GHGs.
Despite the monitoring costs and the incomplete information
that governments typically have about
pollution activities, there exist a number of fruitful tools for
reducing pollutants and GHGs. Permits
and taxes are market based and are efficient when sufficient

information is available. In contrast,
direct controls may be fruitful in specific instances. In
formulating pollution policy it must be kept
in mind that governments rarely have every bit of the
information they require; pollution policy is
no exception.
5.8 Equity, justice, and efficiency
Our discussion of environmental challenges in the modern era
illustrates starkly the tradeoffs that
we face inter-generationally: disregarding the impacts of
today’s behaviour can impact future
5.8. Equity, justice, and efficiency 141
generations. Clearly there is a question here of equity.
Economists use several separate notions of equity in
formulating policy: horizontal equity, ver-
tical equity, and inter-generational equity. Horizontal equity
dictates, for example, that people
who have the same income should pay the same tax, while the
principle of vertical equity dic-
tates that people with more income should pay more tax, and
perhaps a higher rate of tax. Inter-

generational equity requires that the interests of different
cohorts of individuals—both those alive
today and those not yet born—should be balanced by ethical
principles.
Horizontal equity is the equal treatment of similar individuals.
Vertical equity is the different treatment of different people in
order to reduce the consequences
of these innate differences.
Intergenerational equity requires a balancing of the interests
and well-being of different gener-
ations and cohorts.
Horizontal equity rules out discrimination between people
whose economic characteristics and
performance are similar. Vertical equity is more strongly
normative. Most people agree that hor-
izontal equity is a good thing. In contrast, the extent to which
resources should be redistributed
from the “haves” to the “have-nots” to increase vertical equity
is an issue on which it would be
difficult to find a high degree of agreement.
People have different innate abilities, different capacities, and
different wealth. These differences
mean people earn different incomes in a market economy. They

also affect the pattern of consumer
demand. Brazil, with a very unequal distribution of income and
wealth, has a high demand for
luxuries such as domestic help. In more egalitarian Denmark,
few can afford servants. Different
endowments of ability, capital, and wealth thus imply different
demand curves and determine dif-
ferent equilibrium prices and quantities. In principle, by varying
the distribution of earnings, we
could influence the outcomes in many of the economy’s
markets.
This is an important observation, because it means that we can
have many different efficient out-
comes in each of the economy’s markets when considered in
isolation. The position of a demand
curve in any market may depend upon how incomes and
resources are distributed in the economy.
Accordingly, when it is proposed that the demand curve
represents the “value” placed on a good or
service, we should really think of this value as a measure of
willingness to pay, given the current
distribution of income.
For example, the demand curve for luxury autos would shift
downward if a higher tax rate were

imposed on those individuals at the top end of the income
distribution. Yet the auto market could
be efficient with either a low or high set of income taxes. Let us
pursue this example further in
order to understand more fully that the implementation of a
degree of redistribution from rich to
poor involves an equity–efficiency trade-off.
John Rawls, a Harvard philosopher who died recently, has been
one of the most influential
proponents of redistribution in modern times. He argued that
much of the income difference
we observe between individuals arises on account of their
inherited abilities, social status, or
good fortune. Only secondarily, he proposes, are income
differences due to similar individu-
als making different work choices.
If this view is accurate, he challenges us to think today of a set
of societal rules we would
adopt, not knowing our economic status or ability in a world
that would begin tomorrow! He

proposes that, in such an experiment, we could collectively
adopt a set of rules favouring the
less fortunate, in particular those at the very bottom of the
income heap.
Application Box 5.1: Equity, ability, luck, and taxes
Equity versus efficiency
Figure 5.8 describes the market for high-skill labour. With no
income taxes, the equilibrium labour
supply and wage rate are given by (L0,W0). If a tax is now
imposed that reduces the gross wage
W0 to Wt1, the consequence is that less labour is supplied and
there is a net loss in surplus equal to
the dollar amount E0E1A. This is the efficiency loss associated
with raising government revenue
equal to W0AE1Wt1. Depending on how this money is spent,
society may be willing to trade off
some efficiency losses in return for redistributive gains.
Wt2 Dt2
Wt1 Dt1
W0 D0
S
Wage

Labour
E2
L2
E1
L1
E0
L0
AB
Initial wage tax
Final
wage
tax
Figure 5.8: Equity versus efficiency in the labour market
Doubling the wage tax on labour from (W0 −Wt1) to (W0 −Wt2)
increases
the DWL from AE0E1 to BE0E2. The DWL more than doubles –
in this
case it quadruples when the tax doubles.
5.8. Equity, justice, and efficiency 143
Let us continue with the illustration: suppose the tax is
increased further so as to reduce the net

wage to Wt2. The DWL is now BE0E2, much larger than before.
Whether we should take this
extra step in sacrificing more efficiency for redistributive gains
is an ethical or normative issue.
The citizens of some economies, most notably in Scandinavia,
appear more willing than the citi-
zens of the United States to make efficiency sacrifices in return
for other objectives. Canada lies
between these extremes, and our major political parties can be
placed clearly on a spectrum of
willingness to trade equity and efficiency. A vital role for the
economist, therefore, is to clarify the
nature and extent of the trade-offs. The field of public
economics views this as a centrepiece in its
investigations.
144 Key Terms
KEY TERMS
Efficiency addresses the question of how well the economy’s
resources are used and allocated.
Equity deals with how society’s goods and rewards are, and
should be, distributed among its

different members, and how the associated costs should be
apportioned.
Consumer surplus is the excess of consumer willingness to pay
over the market price.
Supplier or producer surplus is the excess of market price over
the reservation price of the
supplier.
Efficient market: maximizes the sum of producer and consumer
surpluses.
Tax wedge is the difference between the consumer and producer
prices.
Revenue burden is the amount of tax revenue raised by a tax.
Excess burden of a tax is the component of consumer and
producer surpluses forming a net
loss to the whole economy.
Deadweight loss of a tax is the component of consumer and
producer surpluses forming a net
loss to the whole economy.
Distortion in resource allocation means that production is not at
an efficient output, or a given
output is not efficiently allocated.
Externality is a benefit or cost falling on people other than
those involved in the activity’s

market. It can create a difference between private costs or
values and social costs or values.
Corrective tax seeks to direct the market towards a more
efficient output.
Greenhouse gases that accumulate excessively in the earth’s
atmosphere prevent heat from
escaping and lead to global warming.
Marginal damage curve reflects the cost to society of an
additional unit of pollution.
Marginal abatement curve reflects the cost to society of
reducing the quantity of pollution
by one unit.
Tradable permits and corrective/carbon taxes are market-based
systems aimed at reducing
GHGs.
Key Terms 145
Horizontal equity is the equal treatment of similar individuals.
Vertical equity is the different treatment of different people in
order to reduce the conse-
quences of these innate differences.

Intergenerational equity requires a balancing of the interests
and well-being of different
generations and cohorts.
146 Exercises
EXERCISES FOR CHAPTER 5
Exercise 5.1. Four teenagers live on your street. Each is willing
to shovel snow from one driveway
each day. Their “willingness to shovel” valuations (supply) are:
Jean, $10; Kevin, $9; Liam, $7;
Margaret, $5. Several households are interested in having their
driveways shoveled, and their
willingness to pay values (demand) are: Jones, $8; Kirpinsky,
$4; Lafleur, $7.50; Murray, $6.
(a) Draw the implied supply and demand curves as step
functions.
(b) How many driveways will be shoveled in equilibrium?
(c) Compute the maximum possible sum for the consumer and
supplier surpluses.
(d) If a new (wealthy) family arrives on the block, that is
willing to pay $12 to have their drive-
way cleared, recompute the answers to parts (a), (b), and (c).

Exercise 5.2. Consider a market where supply and demand are
given by P = 10 and P = 34−Q
respectively.
(a) Illustrate the market geometrically, and compute the
equilibrium quantity.
(b) Impose a tax of $2 per unit on the good so that the supply
curve is now P = 12. Calculate
the new equilibrium quantity, and illustrate it in your diagram.
(c) Calculate the tax revenue generated, and also the deadweight
loss.
Exercise 5.3. Redo Exercise 5.2 with the demand curve replaced
by P = 26− (2/3)Q.
(a) Is this new demand curve more or less elastic than the
original at the equilibrium?
(b) What do you note about the relative magnitudes of the DWL
and tax revenue estimates here,
relative to the previous question?
Exercise 5.4. Next, consider an example of DWL in the labour
market. Suppose the demand for
labour is given by the fixed gross wage W = $16. The supply is
given by W = 0.8L.
(a) Illustrate the market geometrically.
(b) Calculate the equilibrium amount of labour supplied, and the
supplier surplus.

(c) Suppose a wage tax that reduces the wage to W = $12 is
imposed. By how much is the
supplier’s surplus reduced at the new equilibrium?
Exercise 5.5. Governments are in the business of providing
information to potential buyers. The
first serious provision of information on the health
consequences of tobacco use appeared in the
United States Report of the Surgeon General in 1964.
Exercises 147
(a) How would you represent this intervention in a supply and
demand for tobacco diagram?
(b) Did this intervention “correct” the existing market demand?
Exercise 5.6. In deciding to drive a car in the rush hour, you
think about the cost of gas and the
time of the trip.
(a) Do you slow down other people by driving?
(b) Is this an externality, given that you yourself are suffering
from slow traffic?
Exercise 5.7. Suppose that our local power station burns coal to
generate electricity. The demand
and supply functions for electricity are given by P = 12− 0.5Q
and P = 2+ 0.5Q, respectively.

However, for each unit of electricity generated, there is an
externality. When we factor this into the
supply side of the market, the real social cost is increased, and
the supply curve is P = 3+0.5Q.
(a) Find the free market equilibrium and illustrate it
geometrically.
(b) Calculate the efficient (i.e. socially optimal) level of
production.
Exercise 5.8. Evan rides his mountain bike down Whistler each
summer weekend. The utility
value he places on each kilometre ridden is given by P = 4−
0.02Q, where Q is the number of
kilometres. He incurs a cost of $2 per kilometre in lift fees and
bike depreciation.
(a) How many kilometres will he ride each weekend? [Hint:
Think of this “value” equation as
demand, and this “cost” equation as a (horizontal) supply.]
(b) But Evan frequently ends up in the local hospital with pulled
muscles and broken bones. On
average, this cost to the Canadian taxpayer is $0.50 per
kilometre ridden. From a societal
viewpoint, what is the efficient number of kilometres that Evan
should ride each weekend?
Exercise 5.9. Your local dry cleaner, Bleached Brite, is willing
to launder shirts at its cost of $1.00

per shirt. The neighbourhood demand for this service is P =
5−0.005Q.
(a) Illustrate and compute the market equilibrium.
(b) Suppose that, for each shirt, Bleached Brite emits chemicals
into the local environment that
cause $0.25 damage per shirt. This means the full cost of each
shirt is $1.25. Calculate the
socially optimal number of shirts to be cleaned.
Exercise 5.10. The supply curve for agricultural labour is given
by W = 6+0.1L, where W is the
wage (price per unit) and L the quantity traded. Employers are
willing to pay a wage of $12 to all
workers who are willing to work at that wage; hence the demand
curve is W = 12.
(a) Illustrate the market equilibrium, and compute the
equilibrium wage (price) and quantity of
labour employed.
148 Exercises
(b) Compute the supplier surplus at this equilibrium.
Exercise 5.11. The demand for ice cream is given by P = 24−Q
and the supply curve by P = 4.

(a) Illustrate the market equilibrium, and compute the
equilibrium price and quantity.
(b) Calculate the consumer surplus at the equilibrium.
(c) As a result of higher milk prices to dairy farmers the supply
conditions change to P = 6.
Compute the new quantity traded, and calculate the loss in
consumer surplus.
Exercise 5.12. Two firms A and B, making up a sector of the
economy, emit pollution (pol) and
have marginal abatement costs: MAA = 24− pol and MAB =
24−(1/2)pol. So the total abatement
curve for this sector is given by MA = 24− (1/3)pol. The
marginal damage function is constant
at a value of $12 per unit of pollution emitted: MD = $12.
(a) Draw the MD and market-level MA curves and establish the
efficient level of pollution for
this economy.
Exercise 5.13. In Exercise 5.12, if each firm is permitted to emit
half of the efficient level of
pollution, illustrate your answer in a diagram which contains
the MAA and MAB curves.
(a) With each firm producing this amount of pollution, how
much would it cost each one to
reduce pollution by one unit?
(b) If these two firms can freely trade the right to pollute, how

many units will they (profitably)
trade?
Exercise 5.14. Once again, in Exercise 5.13, suppose that the
government’s policy is to allow
firms to pollute provided that they purchase a permit valued at
$10 per unit emitted (rather than
allocating a pollution quota to each firm).
(a) How many units of pollution rights would be purchased and
by the two participants in this
market?
Exercise 5.15. The market demand for vaccine XYZ is given by
P = 36−Q and the supply con-
ditions are P = 20. There is a positive externality associated
with being vaccinated, and the real
societal value is known and given by P = 36− (1/2)Q.
(a) What is the market solution to this supply and demand
problem?
(b) What is the socially optimal number of vaccinations?
(c) If we decide to give the supplier a given dollar amount per
vaccination supplied in order to
reduce price and therefore increase the number of vaccinations
to the social optimum, what
would be the dollar value of that per-unit subsidy?

Exercises 149
Exercise 5.16. In Exercise 5.15, suppose that we give buyers the
subsidy instead of giving it to the
suppliers. By how much would the demand curve have to shift
upward in order that the socially
optimal quantity is realized?
Exercise 5.17. The demand and supply curves in a regular
market (no externalities) are given by
P = 42−Q and P = 0.2Q.
(a) Solve for the equilibrium price and quantity.
(b) A percentage tax of 100% is now levied on each unit
supplied. Hence the form of the new
supply curve P = 0.4Q. Find the new market price and quantity.
(c) How much per unit is the supplier paid?
(d) Compute the producer and consumer surpluses after the
imposition of the tax and also the
DWL.

Chapter 4 Measure of Response Elasticities from Microeconomi.docx

Chapter 4 Measure of Response Elasticities from Microeconomi.docx

More Related Content

Similar to Chapter 4 Measure of Response Elasticities from Microeconomi.docx (20)

More from robertad6 (20)

Recently uploaded (20)

Chapter 4 Measure of Response Elasticities from Microeconomi.docx