Consumer and Producer Surplus

• Study notes on the topics of consumer and producer surplus and government interventions in markets

Consumer Surplus

• Consumer surplus refers to the difference between the price a consumer is willing to pay for a product versus the actual market price.
• Consumer surplus decreases as price increases, because fewer people are willing to pay the higher prices.
• Consumer surplus increases as price decreases, as more people are able to and willing to buy at lower prices.
• The impact of price changes on consumer surplus is affected by the size of the price change and price elasticity of demand (PED)
• More inelastic PED causes less change in consumer surplus while more elastic PED causes greater change in consumer surplus

Producer Surplus

• Producer surplus refers to the difference between the price a producer is willing to accept for a product and what they are actually paid.
• As price increases, producer surplus increases, because producers are willing to accept and produce more.
• As price decreases, producer surplus decreases, as more producers are not willing to produce goods at certain lower prices.
• The extent of the price change and price elasticity of supply (PES) affect the impact of price changes on the producer surplus.
• More elastic PES causes a greater change in producer surplus, and more inelastic PES causes less change in consumer surplus.

Market Failure Review

• Market failure stems from the inefficient allocation of goods and services in the market
• Market failure has a number of causes
• Lack of public goods
• Overconsumption of demerit goods
• Underproduction of merit goods
• Information failure.

Reasons for Government Intervention

• Governments intervene to address non-provision of public goods, overconsumption of demerit goods, and underconsumption of merit goods.
• Intervention can include controlling prices in markets.

Public Goods

• Public goods are consumed collectively, and one person's use does not make them less available to others
• A free rider is someone who consumes a product without contributing towards its cost.
• Public goods tend to be undersupplied because the private sector is not interested in providing goods/services that don't provide profit.
• Possible solutions include direct provision/funding by the government out of tax revenue
• Challenges include an opportunity cost, as funding public goods compete with other types of government spending.

Demerit Goods

• Demerit goods are goods with undesirable effects; they are overprovided and overconsumed because consumers lack proper information about the negative effects
• Reasons for regulation include reducing negative spillover effects and savings for the government

Merit Goods

• Merit goods provide beneficial effects but are underprovided and underconsumed because consumers lack full information about the positive effects of the product
• Reasons for government intervention:
• Supply from the private sector is usually less than required
• Suppliers tend to price merit goods at a premium due to profit motive
• Solutions for underconsumption of merit goods:
  • Direct provision solely by the government
  • Direct provision by the government with a partnership from the private sector

Reasons for Government Price Controls

• Protect low-income earners
• Ensure affordability of necessities
• Encourage labor migration

How do Governments Address Market Failure?

• Regulations like price controls (maximum and minimum prices)
• Financial Interventions (taxation, subsidies, transfer payments)
• Government Provisions (direct provision of goods and services, nationalization, and privatization)

Government Regulation

• Regulation and equity create a trade-off between freedom for firms and individuals in unregulated markets, and greater social equality and equity through government regulation

Maximum Price (Price Ceiling)

• A price ceiling is when the government sets prices below market equilibrium
• The aim is to make goods more affordable and encourage consumption
• Governments protect consumers from soaring prices, such as rents, food, utilities, and transport fares
• Maximum prices may distort market forces and cause inefficient allocation
• At the price ceiling, production is less than demand, which leads to a shortage
• As price cannot rise, the available supply will be allocated on some other basis, such as queuing or rationing; this could lead to an informal or underground market with high prices

Minimum Price (Price Floor)

• A government sets prices above market equilibrium to encourage supply of certain goods and services while protecting farmers and other types of labor
• Minimum prices can sometimes cause unemployment if unskillfully applied to labor
• One of the most common forms of price floors is a national minimum wage
• Results of a minimum price include supply being greater than demand and restricted supply because this is the price affordable to consumers
• A lower quantity is traded than if it were in equilibrium
• Producers with high costs can stay in operation because the high minimum price will protect them from lower-cost competitors
• An informal market may develop with dealers selling in demand products for less than the regulated minimum price
• Minimum government price enforcement applies to demerit goods, wages in certain low-skilled occupations, and some imported goods

Taxation

• Taxes are charges imposed by governments on people and businesses to raise funds for government spending
• A good tax is:
• Equitable, with those who can afford to paying more
• Economic, with revenue higher than the costs of collection
• Transparent, so taxpayers know exactly what they are paying
• Convenient, and easy to pay

Direct Taxes

• Direct taxes charge income of people and firms and cannot be avoided
• The tax is paid directly by taxpayers to the government

Indirect Taxes

• Indirect taxes are levied on goods and services
• Indirect taxes are collected for the government by retailers and local government bodies
• They lower demand for demerit goods, such as alcohol and cigarettes
• Types of indirect taxes include
  • Ad Valorem Tax which refers to taxes levied as a percentage of the price charged by the retailer and are added to the price after the final stage of the transaction
  • Specific Tax – A form of fixed amount of tax levied per unit of purchased good.
• Indirect tax Advantages: reduces demand for demerit goods and increased source of revenue for the government
• Disadvantages: most demerit goods have inelastic PED which results in higher prices without lowering demand, and they are regressive causing greater impact on low-income earners

Subsidies

• Governments often provide subsidies to encourage consumption of certain goods and services
• Subsidies can be used to keep down market prices, encourage consumption of merit goods, achieve a more equitable income distribution, and provide services in a free market, as well as raise income for producers and provide opportunities for exporters and domestic producers

Incidence of Subsidies

• Subsidy payments usually come out of tax revenue, which can lead to conflicting demands for funding

Rules and Regulations

• Governments impose rules and regulations in an attempt to solve market failure.
• Advantages include reduced comsumption and an increased awareness of the negative aspects of demerit goods and the positive aspects of merit goods
• Disadvantages include the creation of underground markets, no controls on the quality of goods, and can require fines and punishments for those who break regulations

Provision of Information

• Governments provides information to address market failure
• They can list nutrition facts on Food Items, support school integration, add health warnings on Demerit Goods, add Posters and signages, and create Public Health Announcements and Campaigns.

Buffer Stock Schemes

• The intention of a buffer stock scheme is to smooth price rises and falls
• Buying and selling products adjusts the stocks depending on market conditions
• It combines the concepts of minimum and maximum price controls

Income vs. Wealth

• Income consists of factors of production (labor, and capital), with returns to factors of production as variable
• Wealth is a stock of assets built up over time

Gini Coefficient

• A numerical measure of income inequality, where 1 = income accrues to only 1 person and 0 = income is distributed equally to everyone

Causes of Income and Wealth Inequality

• Lack of formal employment
• Poor vocational training
• Difficulty obtaining credit
• Lack of education and healthcare investments
• Low savings rates
• Poor infrastructure

Policies to Redistribute Income and Wealth

• Minimum wage
• Transfer payments
• Progressive, inheritance and capital taxes
• Direct provision of education and healthcare