Transcript Macro Connections Seminar Subnational Productive

Principles of Microeconomics
9. Prices, Total Surplus, and Market
Efficiency*
Akos Lada
August 1st , 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
Contents
1. Review of previous lecture
2. Prices and producer surplus
3. Market efficiency
4. Price controls and economic welfare
5. Taxes and economic welfare
1. Review
The picture frames auction
Buyer
Day 1
WTB
Day 2
Day 3
P
QS
P
QS
P
QS
Rosalia
20
$ 3.50
0 units
$5
0 units
$ 7.5
1 unit
Seeye
18
$ 17
6 units
$ 10.25
3 units
$9
2 units
Mehnaz
16
$ 16
6 units
$ 10
3 units
$ 15.50
5 units
Rachel
14
$ 14
5 units
$ 12
4 units
$ 14
5 units
Monica
12
$ 12
4 units
$ 11.01
3 units
$12
4 units
Ellen
10
$ 4.50
0 units
$ 9.72
2 units
$10
3 units
Buyer
WTB
Price floor $16
P
Price ceiling $ 10
QS
P
Tax of $4
QS
P
QS
Rosalia
20
$ 16
6 units
$ 10
3 units
$ 10
1 unit
Seeye
18
$ 16.23
6 units
$ 8.99
2 units
$ 10.01
2 units
Mehnaz
16
$ 16
6 units
$ 16
3 units
$ 16
4 units
Rachel
14
No bid
0 units
$ 13
3 units
$ 14
3 units
Monica
12
No bid
0 units
$ 12
3 units
$12
3 units
Ellen
10
No bid
0 units
$ 10
3 units
$9.89
0 units
WTP and D curve, Cost and S curve
At any Q:
P
S
the height of the
Demand Curve is
the WTP of the
marginal buyer.
…and the height
of the Supply
Curve is the cost of
the marginal seller.
D
Q
At equilibrium
WTP of marginal
buyer and costs of
marginal seller are
the same
CS and a change in Price
P
S
P*2
P*1
Consumer surplus
is the area
between the
demand curve and
the equilibrium
price
A higher price
implies a loss in
CS that comes
from:
D
Q*
• Buyers that remain
in the market paying
more money per
units.
• Buyers leaving the
market.
Q
Calculating consumer surplus in a
smooth demand curve
P
To calculate the area
of the triangles:
½ (base x height)
60
1.
50
Fall in CS
due to buyers
leaving market
40
To calculate the area
of the rectangles:
30
base x height
10
20
2.
Fall in CS due
to remaining
buyers
paying higher P
D
0
0
5 10 15 20 25 30
Q
2. Prices and Producer
Surplus
Students’ Turn: What is the
Producer surplus at Price $13?
P
S
P*
D
Q*
Q
The PS at Price $13?
P
S
Kirk: 13 - 6 = 7
Golib: 13 - 8= 5
Rebeca: 13 – 10 = 3
Chandrika: 13 – 12 = 1
P*
Total PS = 16
D
Q*
Q
PS with Lots of Sellers & a Smooth S Curve
Price
per pair
P
60
Suppose P = $40.
50
At Q = 15(thousand),
the marginal seller’s
cost is $30,
40
and her producer
surplus is $10.
The supply of shoes
S
30
1000s of pairs
of shoes
20
10
Q
0
0
5 10 15 20 25 30
PS with Lots of Sellers & a Smooth S Curve
PS is the area b/w
P and the S curve,
from 0 to Q.
The height of this
triangle is
$40 – 15 = $25.
So,
PS = ½ x b x h
= ½ x 25 x $25
= $312.50
P
The supply of shoes
60
S
50
40
30
h
20
10
Q
0
0
5 10 15 20 25 30
How a lower price reduces PS
in our example
P
S
In the Price falls
from $13 to $11,
total PS decreases
from $16 to $ 9.
P*1
From the $7 loss
in PS:
P*2
• $ 6 are because
each of the 3 sellers
remaining gets $2
less per frame.
• $ 1 is because one
seller left the market
D
Q*
Q
How a Lower Price Reduces PS
with a Smooth Supply Curve
P
If P falls to $30,
PS = ½ x 15 x $15
= $112.50
60
50
1. Fall in PS
due to sellers
leaving market
S
Two reasons for the 40
fall in PS.
30
2. Fall in PS due to
remaining sellers
getting lower P
20
10
Q
0
0
5 10 15 20 25 30
STUDENTS’ TURN:
Producer surplus
supply curve
P
50
45
A. Find marginal
seller’s cost
40
at Q = 10.
35
B. Find total PS for
30
P = $20.
25
Suppose P rises to $30.
20
Find the increase
15
in PS due to…
10
C. selling 5
additional units
5
D. getting a higher price on 0
the initial 10 units
0
5
10
15
20
Q
25
Answers
A. At Q = 10,
marginal cost = $20
B. PS = ½ x 10 x $20
= $100
P rises to $30.
C. PS on
additional units
= ½ x 5 x $10 = $25
D. Increase in PS
on initial 10 units
= 10 x $10 = $100
supply curve
P
50
45
40
35
30
25
20
15
10
5
0
0
5
10
15
20
Q
25
3. Market Efficiency
CS, PS, and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
Total surplus at Price $13
P
S
CONSUMER
SURPLUS (16)
PRODUCER
SURPLUS (16)
P*
TOTAL
SURPLUS (32)
D
Q*
Q
The Market’s Allocation of
Resources
• In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.
• Is the market’s allocation of resources desirable? Or
would a different allocation of resources make society
better off ?
• To answer this, we use total surplus as a measure of
society’s well-being, and we consider whether the
market’s allocation is efficient.
(Policymakers also care about equality, though are
focus here is on efficiency.)
Efficiency
Total
= (value to buyers) – (cost to sellers)
surplus
An allocation of resources is efficient if it maximizes
total surplus. Efficiency means:
• The goods are consumed by the buyers who value them most
highly.
• The goods are produced by the producers with the lowest costs.
• Raising or lowering the quantity of a good
would not increase total surplus.
Evaluating the Market
Equilibrium
Market equilibrium:
P = $30
Q = 15,000
Total surplus
= CS + PS
Is the market
equilibrium efficient?
P
60
S
50
40
CS
30
PS
20
10
D
0
0
5 10 15 20 25 30
Q
Which Buyers Consume the Good?
Every buyer
whose WTP is
≥ $30 will buy.
P
60
S
50
Every buyer
whose WTP is
< $30 will not.
40
So, the buyers who
value the good most
highly are the ones
who consume it.
20
30
10
D
0
0
5 10 15 20 25 30
Q
Which Sellers Produce the Good?
P
Every seller whose
cost is ≤ $30 will
produce the good.
Every seller whose
cost is > $30 will not.
So, the sellers with the
lowest cost produce the
good.
60
S
50
40
30
20
10
D
0
0
5 10 15 20 25 30
Q
Does Equilibrium Q Maximize Total Surplus?
At Q = 20,
cost of producing
the marginal unit
is $35
value to consumers
of the marginal unit
is only $20
Hence, can increase
total surplus
by reducing Q.
This is true at any Q
greater than 15.
P
60
S
50
40
30
20
10
D
0
0
5 10 15 20 25 30
Q
Does Equilibrium Q Maximize Total Surplus?
At Q = 10,
cost of producing
the marginal unit
is $25
value to consumers
of the marginal unit
is $40
Hence, can increase
total surplus
by increasing Q.
This is true at any Q less
than 15.
P
60
S
50
40
30
20
10
D
0
0
5 10 15 20 25 30
Q
Same in our example: If Q is
higher than the equilibrium Q…
P
S
D
Q*
Q
If Q is lower than the
equilibrium Q…
P
S
D
Q*
Q
Conclusion: The Market
Equilibrium is efficient
P
S
D
Q*
Q
The market
equilibrium
quantity
maximizes
total surplus:
At any other
quantity,
can increase
total surplus by
moving toward
the market
equilibrium
quantity.
4. Price Controls and
Economic Welfare
A binding price floor and CS
P
How does the CS
change?
S
In this example,
consumer
surplus is
reduced
Min P
P*
Partly because
buyers leave the
market
D
QD
Q*
QS
Q
Partly because
those buyers still
in the market pay
more per unit
A binding price floor and PS
How does the PS
change?
P
S
In this example,
producer surplus is
increased
Min P
On the one hand, less
units are sold (since
buyers leave the
market.
P*
But on the other hand,
the sellers receive more
per unit
D
QD
Q*
QS
Q
In this example, the
first effect is smaller
than the second.
A binding price floor and total
surplus
The surplus that buyers
who remain in the market
loose because of higher
prices
P
S
Min P
…becomes producer
surplus from the sellers’
point of view (doesn’t
affect total surplus)
But what
happens to this
surplus?
P*
Deadweight
Loss! (DWL)
The CS and the PS lost
because of people leaving
the market goes
nowhere… just
disappears!
D
Economists call this a
Deadweight Loss
QD
Q*
QS
Q
A binding price ceiling and CS
How does the CS change?
P
S
In this example, consumer
surplus increases
On the one hand, some
surplus is lost because
some buyers cannot find
anybody to sell at the new
price (shortage)
P*
Max P
But on the other hand,
those buyers who stay in
the market pay less per
unit
D
QS
Q*
QD
In our example, the first
effect is smaller than the
Q second
A binding price ceiling and PS
P
How does the PS
change?
S
In this example,
producer surplus
is reduced
P*
Partly because
sellers leave the
market
Max P
D
QS
Q*
QD
Q
Partly because
those sellers still
in the market
receive less
money per unit
A binding price ceiling and
total surplus
The surplus that
sellers who remain in
the market loose
because of lower
prices
P
S
…becomes consumer
surplus from the
buyers’ point of view
(doesn’t affect total
surplus)
But what
happens to this
surplus?
Deadweight
Loss! (DWL)
P*
Max P
The CS and the PS
lost because of people
leaving the market
goes nowhere… just
disappears!
D
QS
Q*
QD
Q
Economists call this a
Deadweight Loss
5. Taxation and
Deadweight Loss
The Effects of a Tax
Equilibrium with no
tax:
Price = PE
Quantity = QE
Equilibrium with
tax = $T per unit:
Buyers pay PB
P
Size of tax = $T
S
PB
PE
PS
D
Sellers receive PS
Quantity = QT
QT
QE
Q
Tax Revenue
P
Revenue from tax:
$T x QT
Size of tax = $T
S
PB
PE
PS
D
QT
QE
Q
Government Revenue and
Total Surplus
• Next, we apply welfare
economics to measure the gains
and losses from a tax.
• We determine consumer surplus
(CS), producer surplus (PS), tax
revenue, and total surplus with
and without the tax.
• Tax revenue can fund beneficial
services (e.g., education, roads,
police) so we include it in total
surplus.
Before the Tax
P
CS = A + B + C
PS = D + E + F
Tax revenue = 0
Total surplus
= CS + PS
=A+B+C
+D+E+F
A
S
B
PE
D
C
E
D
F
QT
QE
Q
After the Tax
P
CS = A
PS = F
Tax revenue
=B+D
Total surplus
=A+B
+D+F
The tax reduces
total surplus by
C+E
A
PB
S
B
D
C
E
PS
D
F
QT
QE
Q
The DWL of a tax
P
C + E is called the
deadweight loss
(DWL) of the tax,
the fall in total
surplus that
results from a
market distortion,
such as a tax.
A
PB
S
B
D
C
E
PS
D
F
QT
QE
Q
About the Deadweight Loss
P
Because of the tax,
the units between
QT and QE are not
sold.
The value of these
units to buyers is
greater than the cost
of producing them,
PB
S
PS
D
so the tax prevents
some mutually
beneficial trades.
QT
QE
Q
In our example: A 4 dollars
tax
S2
P
S1
The tax was
imposed on the
sellers
Equilibrium 2
P*2
Equilibrium 1
P*1
D
Q*2
Q*1
The Supply
curve shifts left
There is a new
equilibrium
quantity and a
new equilibrium
price range.
Q
What happens to the CS and
the PS?
S2
P
S1
CS lost by
buyers
PB
Tax revenue
collected by
the
government
But what
happens to this
surplus?
Deadweight
Loss! (DWL)
P*1
PS
PS lost by
sellers
D
Q*2
Q*1
Q
STUDENTS’ TURN:
Analysis of tax
P
The market for
airplane tickets
$ 400
A. Compute
CS, PS, and
total surplus
without a tax.
350
B. If $100 tax
per ticket,
compute
CS, PS,
tax revenue,
total surplus, and
DWL.
200
300
S
250
150
D
100
50
Q
0
0
25
50
75 100 125
ACTIVE LEARNING 1
Answers to A
P
The market for
airplane tickets
$ 400
CS
= ½ x $200 x 100
= $10,000
350
300
S
250
PS
= ½ x $200 x 100
= $10,000
P = 200
Total surplus
= $10,000 + $10,000
= $20,000
150
D
100
50
Q
0
0
25
50
75 100 125
ACTIVE LEARNING 1
Answers to B
CS
= ½ x $150 x 75
= $5,625
P
$ 400
350
300
PS = $5,625
PB = 250
Tax revenue
= $100 x 75
= $7,500
200
Total surplus
= $18,750
DWL = $1,250
A $100 tax on
airplane tickets
S
PS = 150
D
100
50
Q
0
0
25
50
75 100 125
Discussion: the airline tax
relief
• Refer to the article “A Bonanza for Airlines as Taxes End”
on the recent impasse that led to a 2-weeks shutdown of the
US Federal Aviation Administration
• How can we use the tools learned in the class to understand
the airlines’ behavior?
Determinants of the
Deadweight Loss
What Determines the Size of the
DWL?
• Which goods or services should
government tax to raise the revenue it
needs?
• One answer: those with the smallest
DWL.
• When is the DWL small vs. large?
Turns out it depends on the price
elasticities of supply and demand 
• Recall:
The price elasticity of demand (or supply)
measures how much QD (or QS) changes
when P changes.
DWL and the Elasticity of
Supply
When supply
is inelastic,
it’s harder for firms
to leave the market
when the tax
reduces PS.
So, the tax only
reduces Q a little,
and DWL is small.
P
S
Size
of tax
D
Q
DWL and the Elasticity of
Supply
The more elastic is
supply,
the easier for firms
to leave the market
when the tax reduces
PS,
the greater Q falls
below the surplusmaximizing quantity,
the greater the DWL.
P
S
Size
of tax
D
Q
DWL and the Elasticity of
Demand
When demand
is inelastic,
P
S
it’s harder for
consumers to
leave the market
when the tax
raises PB.
Size
of tax
So, the tax only
reduces Q a little,
D
Q
and DWL is small.
DWL and the Elasticity of
Demand
P
The more elastic is
demand,
S
the easier for buyers
to leave the market
when the tax
increases PB,
Size
of tax
D
the more Q falls
below the surplusmaximizing quantity,
Q
and the greater the
DWL.
STUDENTS’ TURN
Elasticity and the DWL of a tax
Would the DWL of a tax be larger if
the
tax were on:
A. Breakfast cereal or
sunscreen?
B. Hotel rooms in the short
run or hotel rooms in the
long run?
C. Groceries or meals at fancy
restaurants?
Answer
A. Breakfast cereal or sunscreen
Breakfast cereal has more close substitutes than sunscreen, so demand for
breakfast cereal is more price-elastic than demand for sunscreen. So, a tax
on breakfast cereal would cause a larger DWL than a tax on sunscreen.
B. Hotel rooms in the short run or long run
The price elasticities of demand and supply for hotel rooms are larger in the
long run than in the short run. So, a tax on hotel rooms would cause a
larger DWL in the long run than in the short run.
C. Groceries or meals at fancy restaurants
Groceries are more of a necessity and therefore less price-elastic than meals
at fancy restaurants. So, a tax on restaurant meals would cause a larger
DWL than a tax on groceries.