Transcript Document

Chapter 8
Welfare Economics and the Gains
from Trade
Steven Landsburg,
University of Rochester
Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.
Introduction
• Choosing policies that are best for economy
– Normative criterion: way to balance benefits that
accrue to some people against cost imposed on
others
– Efficiency criterion
• Choosing a measurement for weighing costs
and benefits
– Measure gains from trade
• Discuss Invisible Hand Theorem
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Measuring the Gains from Trade
• Consumer purchases good
• Consumer gains
– Consumer surplus
• Producer gains
– Producer surplus
• Develop measure for gauging extent of
gain
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Marginal Value and Demand
• Maximum amount consumer willing to pay for a
good
• Additional goods have less value than the first
unit of the good consumed
• Application of equimarginal principle
– Good bought as long as marginal value exceeds price
– stops when equal
• Marginal value curve and demand curve convey
similar information
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Consumers’ Surplus
• Total value as an area
– Consumer’s purchases equal area under
demand curve out of quantity demanded
• Consumer’s surplus
– Consumer’s gain from trade
– Amount by which value of consumer’s
purchases exceeds what actually pays for
goods
– Area under demand curve down to price paid
and out to quantity demanded
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EXHIBIT 8.2
Total Value
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EXHIBIT 8.3 The Consumer’s Surplus
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Producers’ Surplus
• Producer’s surplus
– Producer’s gains from trade
– Amount by which producer’s revenue exceeds
variable production costs
– Area above supply curve up to price received
and out to quantity supplied
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EXHIBIT 8.4 The Producer’s Surplus
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Social Gain
• Sum of all gains from trade to all
participants
• Social gains and markets
– Can calculate gains across consumers and
producers
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EXHIBIT 8.5 Welfare Gains
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EXHIBIT 8.6 Consumers’ Surplus in the Market
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EXHIBIT 8.7 Producers’ Surplus in the Market
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Efficiency Criterion
• Weighing the interest of one group versus
the interest of another group
– Normative criterion: general method for
choosing amongst alternative policies
• Ex. Majority rule
– Efficiency criterion: normative criterion
according to which your votes are weighted
according to your willingness to pay for your
preferred outcome
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Consumers’ Surplus and the
Efficiency Criterion
• Effect of sales tax
– Calculate consumer surplus
– Calculate producer surplus
– Calculate tax revenue
– Calculate social gain
• If reduction in social gain, called
deadweight loss
• Note hidden assumptions
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EXHIBIT 8.8 The Effect of a Sales Tax
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Understanding Deadweight Loss
• Imagine social gain as a pie
–
–
–
–
Taxation changes way pie distributed
Taxation changes size of pie
Consumer and producer share of pie changes
Recipients of tax revenue now get part of pie
• Add up pieces of pie
– Pie shrunk
– Shrinkage is deadweight loss
• If deadweight loss created, develop alternative
policy where not true
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EXHIBIT 8.9 Deadweight Loss
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EXHIBIT 8.10 The Tax Collector versus
Robin Hood
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Other Normative Criteria
• Pareto criterion
– One policy is better than another when it is preferred
unanimously
– Advantage: recommendations noncontroversial
• Potential Pareto criterion
– Any proposal that can be unanimously defeated –
even by a candidate not under consideration – should
be rejected
– Potential Pareto criterion and efficiency criterion make
same recommendation
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Examples and Applications
•
•
•
•
Subsidies
Price ceilings
Tariffs
Robbery
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EXHIBIT 8.12 The Effect of a Subsidy
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EXHIBIT 8.14 A Price Ceiling
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EXHIBIT 8.15 A Tax on Imported Cameras
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EXHIBIT 8.17 A Tariff When There Is a Domestic
Industry
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Theories of Value
• Diamond-water paradox
– Price reflects marginal value of last item consumed
not total value
– Marginal value of first gallon of water higher than
marginal value of first diamond
– Explains why water cheap relative to diamond
• Labor theory of value
– Assertion that value of object determined by amount
labor needed to produce it
– Value determined not by cost of inputs but by
consumer’s willingness to pay for good
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General Equilibrium and the
Invisible Hand
• Fundamental theorem of welfare
economics
– Competitive equilibrium is Pareto-optimal
– Invisible hand
• Equilibrium point also maximum social gain point
• General equilibrium
– Way to model economy where take account of
all markets at once and of all intersections
among them
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EXHIBIT 8.20 The Invisible Hand
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Edgeworth Box Economy
• Edgeworth box
– Graph of an economy with two individuals, two goods,
and no production
• Endowment point
– Point representing the initial holdings of an individual
in a Edgeworth box
• Region of mutual advantage
– Set of points considered at least as good as the initial
endowment derived from trades between consumers
• Contract curve
– Set of Pareto-optimal points created from indifference
curve tangencies
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EXHIBIT 8.21
Trade in an
Edgeworth Box
Economy
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Edgeworth Box Economy
Continued
• Competitive equilibrium in the Edgeworth box
– Infinite variety of possible outcomes for bargaining
process
– Bargain according to some set of prices
• Continue adjusting prices until reach equilibrium
• Competitive equilibrium point where everyone will choose to
trade to
• Invisible hand in Edgeworth box
– Consumer’s indifference curves tangent at the
competitive equilibrium
– Point on contract curve
– Pareto optimal
– Invisible hand theorem true
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EXHIBIT 8.22 Competitive Equilibrium in an
Edgeworth Box Economy
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General Equilibrium with
Production
• Robinson Crusoe and production possibility
curve
– Displays all baskets that can be produced
– Slope equal to relative price of good X in terms of
good Y
– Bows outward from origin
– Consumer ultimately equates slope of production
possibility curve to slope of indifference curve
• Open economy
• World economy
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EXHIBIT 8.24 Production and Consumption with
Foreign Trade
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General Equilibrium with
Production Continued
• Open economy
– Trades with outsiders at prices determined in world economy
– Production occurs at point where production possibility curve
tangent to line of slope equal to relative price of good X
• Line of tangency becomes budget line
– How much gain occurs for consumer due to trade?
• Autarkic price
• World relative price
– Determined by supply and demand
• If prices equal, no gain from trade
• More world price differs from autarkic price, more gains from trade
• World economy
– Process for determining world supply and demand of goods
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EXHIBIT 8.25 Autarkic versus World Relative
Prices
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