Lecture 3 Welfare and Government PDF

Lecture 3: Economic Efficiency and Government Price Regulations Chapter 4 - Markets and Government Consumer Surplus Welfare Economics: The study of how the allocation of resources affects economic well-­‐being. o Remember the allocation of resources refers to:...

Lecture 3: Economic Efficiency and Government Price Regulations Chapter 4 - Markets and Government Consumer Surplus Welfare Economics: The study of how the allocation of resources affects economic well-­‐being. o Remember the allocation of resources refers to: -­‐ how much of each good is produced -­‐ which producers produce it -­‐ which consumers consume it Recall -­‐ Willingness to Pay (WTP): How much a buyer values a good. It is the maximum amount the buyer will pay for that good Example 3.1 The willingness to pay (or reservation price) for a textbook of 3 different buyers is listed below. If the price of a textbook is $151 who will buy it? Why won’t everyone buy the textbook? 1  Consumer Surplus (CS): 1. The amount a buyer values a good minus the amount she actually paid for it 2. The area between the demand curve and the price. 2  Example 3.2 Using the same information given in Ex. 3.2 calculate total consumer surplus when the price is $80. __________________________________________________________________________ Consumer surplus always increases (decreases) as prices go down (up). In particular: 1. Those already buying the product will receive more (less) surplus since the price fell (rose). 2. Some buyers will enter (exit) the market and receive some (no) consumer surplus. Consumer surplus is used to measure consumer's well-­‐being. In particular, it measures the benefit buyers receive from a good as the buyers themselves perceive it. 3 Producer Surplus Cost: 1. The value of everything a seller must give up in order to produce a good. 2. The seller's opportunity cost to produce a good. Willingness to Sell: 1. The amount for which a seller would be willing to sell a good. 2. The seller's cost Example 3.3 The table below lists the willingness to sell tutoring services for 3 individuals. If the market price of tutoring is $25, which sellers will choose to tutor? Producer Surplus: 1. The amount a seller is paid for a good minus the sellers cost of providing it. 2. The seller's profit from selling the good. 3. The area between the price and the supply curve. Calculate the PS when the market price is $25. 4  Producer surplus always increases (decrease) as prices go up (down). In particular: 1. Those already selling the product will receive a greater surplus since the price has increased. 2. Some new sellers will enter the market and receive some producer surplus Summary: 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 (TS) = sum of surplus’ of all individuals in society = CS + PS = total gains from trade in a market = (value to buyers) – (cost to sellers) 5 Example 3.4 Use the figure below to answer the following questions. If Q2 units of the good were sold at a price of P2, which areas represent the consumer surplus? The producer surplus? If Q1 units of the good were sold at a price of P1, which areas represent the consumer surplus? The producer surplus? If Q1 units of the good were sold at a price of P3, which areas represent the consumer surplus? The producer surplus? If Q3 units of the good were sold at a price of P1, which areas represent the consumer surplus? If Q3 units of the good were sold at a price of $P1, which areas represent producer surplus? 6 Market Efficiency 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. 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. Social Planner: A hypothetical character whose sole responsibility is to 1. maximize the economic well-being of a society. 2. maximize Total Surplus (Consumer Surplus + Producer Surplus). Efficiency is different from equity! Equity: The fairness of the distribution of surplus among the various buyers and sellers. If the economic gains from a market are viewed as a pie, Efficiency is concerned with maximizing the size of the pie. Equity is concerned with dividing the pie as fairly as possible. Equity and efficiency rarely "work together" The Free Market vs. Government Intervention The market equilibrium is efficient. No other outcome achieves higher total surplus. Government cannot raise total surplus by changing the market’s allocation of resources. Laissez faire (French for “allow them to do”): the notion that government should not interfere with the market. The Free Market vs. Central Planning Suppose resources were allocated not by the market, but by a social planner who cares about society’s well-being. To allocate resources efficiently and maximize total surplus, the planner would need to know every seller’s cost and every buyer’s WTP for every good in the entire economy. This is impossible, and why centrally-planned economies are never very efficient. 7 The Central Planner vs Free Market: Graphically Total Surplus Deadweight Loss (DWL) Using Welfare To Analyze Changes in Surplus Steps To Analyze Policy Decisions 1. Draw the existing supply/demand curves. 2. Decide whether the situation would shift the supply or demand curve (or perhaps both). Or neither: Price Floors/ceilings don’t shift curves, taxes are not usually graphed by shifting a curve but by putting a wedge between prices. 3. Decide in which direction the curve shifts. 4. Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity. 5. Determine whether the old or new equilibrium has a more welfare (i.e. more Total Surplus) 6. Any loss/reduction in surplus is called a Deadweight Loss 8 Social Planner vs The Free Market A Little History Passages from Adam Smith's The Wealth of Nations, 1776: " Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them…. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest…" "Every individual… neither intends to promote the public interest, nor knows how much he is promoting it… He intends only his own gain, and he is in this as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intend to promote it." The first passage conveys the sense that the economy is made up of a completely uncoordinated mass of individuals, each acting in his or her own self-interest. In the second passage Smith discusses the invisible hand in action. 9 Price Controls Price Floor: Price Ceiling: : Non-Binding Constraint: The Market for Unskilled Labor The demand for unskilled labor comes from firms. The supply comes from workers. We focus on unskilled labor because the minimum wage is not relevant for higher skilled, higher wage workers. Example 3.5 How will a minimum wage below the equilibrium affect the market outcome? Illustrate using S-D graphs. 10 How will a minimum wage above the equilibrium affect the market outcome? Illustrate using S-D graphs. The Market for Apartments Example 3.6 How will a price ceiling above the equilibrium affect the market outcome? Illustrate using S-D graphs. 11 How will a price ceiling below the equilibrium affect the market outcome? Illustrate using S-D graphs. Evaluating Price Controls Recall one of the Seven Principles of Microeconomics: Markets are usually a good way to organize economic activity. Prices are the signals that guide the allocation of society’s resources (the invisible hand). This allocation is altered when policymakers restrict prices. Price controls often intended to help the poor, but often hurt more than help. Key Concepts: Add extra pages at the end of your notes where you define and explain these terms. consumer surplus producer surplus total surplus deadweight loss price ceiling misallocation of resources price floor market failure 12