Welfare Economics: Market Efficiency & Trade

• The lecture discusses concepts in welfare economics, the efficiency of free market equilibrium, and the welfare effects of taxation and international trade.

Concepts in Welfare Economics

• Welfare economics studies how resource allocation affects economic wellbeing.
• Willingness to pay signifies the maximum amount a buyer will pay for a good and is illustrated by market demand.
• Consumer surplus measures the benefit to buyers and is the difference between what a buyer is willing to pay and what they actually pay in the market.
• Consumer surplus is represented as the area below the demand curve and above the market price, where a lower market price increases surplus and a higher price reduces it.
• Cost is the value a seller gives up to produce a good and is illustrated by the supply curve.
• Producer surplus equals the amount a seller is paid minus the cost of production and measures the benefits sellers receive from participating in a market.
• Producer surplus is the area above the supply curve and below the market price; a lower market price reduces producer surplus, and a higher market price increases it.

Economic Wellbeing of Society

• Total surplus is the sum of consumer and producer surplus, calculated as the value to buyers minus the costs to sellers.
• Efficiency occurs when resource allocation maximizes total surplus.

Total Surplus in Free Market Equilibrium

• In equilibrium, consumer surplus is the area below the demand curve and above the equilibrium price.
• Producer surplus is the area below the equilibrium price and above the supply curve.
• Total surplus is the sum of these two areas.
• A competitive market in equilibrium allocates goods to buyers who value them most, allocates demand to sellers who can produce at the lowest cost, and maximizes the sum of consumer and producer surplus.

The Welfare Effects of Taxation

• Taxes generate government revenue but result in lower consumer and producer surplus and cause a deadweight loss (DWL).
• Deadweight loss is the reduction in total surplus from a market distortion like a tax.
• The size of a tax's deadweight loss is affected by the quantities supplied and demanded which respond to the tax levy, and depends on the price elasticities of supply and demand and the tax rate.
• As taxes increase, deadweight loss greatly increases.
• Tax revenue first rises with the size of a tax, but as the tax gets larger, the market shrinks and tax revenue starts to fall.
• The Laffer Curve depicts the relationship between tax rates and tax revenue.

The Effects of a Subsidy

• Subsidies generates dead weight loss

International Trade and Tariffs

• Trade involves analyzing consumer and producer surplus in closed and open economies, under the assumption that actions of buyers and sellers have minimal impact on the world's economy.
• When the world price exceeds the domestic price, sellers export, creating comparative advantage and raising the domestic price to the world price.
• The increase in domestic price reduces consumer surplus yet increases producer surplus, with the gains originating from international trade.
• When the world price is less than the domestic price, buyers import and the domestic price falls to the world price.
• This fall increases consumer surplus and decreases producer surplus, with gains from trade.
• Exports benefit domestic producers, but harms domestic consumers, while imports benefit domestic consumers, but harms domestic producers.
• Despite the gains and loses, the gains of the winners exceed the losses of the losers.

Effects of Tariffs

• Tariffs are taxes on goods produced abroad and sold domestically, raising the price of imported goods above the world price.

Import Quotas

• Import quotas limit the quantity of imports, with total supply in the domestic market totaling domestic supply plus the quota.
• In equilibrium, the domestic price equates total supply with domestic demand.
• The deadweight loss from an import quota mirrors that of a tariff.

Arguments Against Trade

• One argument is that trade destroys domestic jobs; however, free trade creates jobs while destroying others.
• Workers move from importing industries to those with a comparative advantage.
• It is argued that a country should protect crucial industries for national security purposes.
• Protecting key industries has legitimate concerns for national security, but producers may exaggerate their role to gain protection.
• New industries need temporary trade restrictions to begin; governments need to 'pick winners'.
• If an industry is to be profitable, owners have to incur losses for profits.
• Trade is said to be unfair when firms are subject to different laws, the threat of trade restrictions is useful when bargaining with trading partners.