Chapter 2 Theoretical Tools of Public Finance PDF

2/19/2024 Chapter 2 Theoretical Tools of Public Finance Jonathan Gruber Public Finance and Public Policy Aaron S. Yelowitz - Copyright 2005 © Worth Publishers 1...

2/19/2024 Chapter 2 Theoretical Tools of Public Finance Jonathan Gruber Public Finance and Public Policy Aaron S. Yelowitz - Copyright 2005 © Worth Publishers 1 Introduction Theoretical Tools of Public Finance ◼ Theoretical tools are a set of tools used to understand economic decision making. They are primarily graphical and mathematical. ◼ Empirical tools allow you to examine the theory with data. 2 1  2/19/2024 CONSTRAINED UTILITY MAXIMIZATION ◼ Constrained utility maximization means that all decisions are made in order to maximize the well-being of the individual, subject to his available resources. ◼ Utility maximization involves preferences and a budget constraint. ◼ One of the key assumptions about preferences is non-satiation–that “more is preferred to less.” 3 Constrained Utility Maximization Preferences and indifference curves ◼ Figure 1 illustrates some preferences over movies (on the x-axis) and CDs (on the y-axis). ◼ Because of non-satiation, bundles A and B are both inferior to bundle C. 4 2  2/19/2024 QCD Bundle “C” gives (quantity of Bundle “A” gives 22 CDs higher utility andthan 2 CDs) CDs and 1 movieeither “A” or “B” movies Bundle “B” gives 1 A C CD and 2 movies 2 1 B 0 1 2 QM (quantity of movies) Figure 1 Different Bundles of Goods 5 Constrained Utility Maximization: Preferences and indifference curves ◼ A utility function is a mathematical representation U = f(X1, X2, X3, …) ◼ Where X1, X2, X3 and so on are the goods consumed by the individual, ◼ And f( ) is some mathematical function. 6 3  2/19/2024 Constrained Utility Maximization: Preferences and indifference curves ◼ One formulation of a utility function is U(QM,QC) = QMQC, where QM = quantity of movies and QC = quantity of CDs. ◼ The combinations {1, 2} (bundle A) and {2,1} (bundle B) both give 2 “utils.” ◼ The combination {2, 2} (bundle C) gives 4 “utils.” ◼ With these preferences, indifferent to A or B. ◼ Figure 2 illustrates this. 7 QCD “A” and “B” Bundle Bundle“C” both “C”gives gives4 Higher utility as (quantity of “utils” and and give 2 “utils”higher is than utility on a move toward CDs) either indifference higher lie on the same “A” or “B” northeast in the indifference curve curve quadrant. A C 2 B 1 IC2 IC1 0 1 2 QM (quantity of movies) Figure 2 Utility From Different Bundles 8 4  2/19/2024 Constrained Utility Maximization: Utility mapping of preferences ◼ How are indifference curves derived? ◼ Set utility equal to a constant level and figure out the bundles of goods that get that utility level. ◼ For U = QMQC, how would we find the bundles for the indifference curve associated with 25 utils? ◼ Set 25 = QMQC, ◼ Yields QC = 25/QM, ◼ Or bundles like {1,25}, {1.25,20}, {5,5}, etc. 9 Constrained Utility Maximization: Marginal utility ◼ Marginal utility is the additional increment to utility from consuming an additional unit of a good. ◼ Diminishing marginal utility means each additional unit makes the individual less happy than the previous unit. 10 5  2/19/2024 Constrained Utility Maximization: Marginal utility ◼ With the utility function given before, U = QMQC, the marginal utility is: U MU Q = = QC M Q M ◼ Take the partial derivative of the utility function with respect to QM to get the marginal utility of movies. 11 Constrained Utility Maximization: Marginal utility ◼ Evaluating the utility function U = (QMQC)1/2, at QC = 2 allows us to plot a relationship between marginal utility and movies consumed. ◼ Figure 3 illustrates this. 12 6  2/19/2024 Marginal utility of First movie gives movies 1.41 additional utils Second movie gives 0.59 1.41 Third movie gives additional utils Analysis holds CD 0.45 additional consumption utils constant at 2 CDs 0.59 0.45 MU (QCD=2) 0 1 2 3 QM (quantity of movies) Figure 3 Declining Marginal Utility From Movies 13 Constrained Utility Maximization: Marginal utility ◼ Why does diminishing marginal utility make sense? ◼ Most consumers order consumption of the goods with the highest utility first. 14 7  2/19/2024 Constrained Utility Maximization: Marginal rate of substitution ◼ Marginal rate of substitution—slope of the indifference curve is called the MRS, and is the rate at which consumer is willing to trade off the two goods. ◼ Returning to the (CDs, movies) example. ◼ Figure 4 illustrates this. 15 QCD (quantity of Marginal rate MRS of at bundle C CDs) substitutionappears at bundleto Abe larger than B but is its slope smaller than A. MRS at bundle B is A C smaller in absolute terms 2 than at A. B 1 IC2 IC1 0 1 2 QM (quantity of movies) Figure 4 Marginal Rate of Substitution At Different Bundles 16 8  2/19/2024 Constrained Utility Maximization: Marginal rate of substitution ◼ MRS is diminishing (in absolute terms) as we move along an indifference curve. ◼ This means that Andrea is willing to give up fewer CD’s to get more movies when she has more movies (bundle B) than when she has less movies (bundle A). ◼ Figure 5 illustrates this. 17 QCD (quantity of Willing to give up a lot of CDs) CDs for another movie … Not willing to give up A very many CDs for 2 Even less willing to give another movie up additional CDs B 1 D IC1 0 1 2 3 QM (quantity of movies) Figure 5 Marginal Rate of Substitution is Diminishing 18 9  2/19/2024 Constrained Utility Maximization Marginal rate of substitution ◼ Direct relationship between MRS and marginal utility. MU M MRS = − MU C ◼ MRS shows how the relative marginal utilities evolve over the indifference curve. ◼ Straightforward to derive this relationship graphically, as well. ◼ Consider the movement from bundle A to bundle B. Figure 6 illustrates this. 19 QCD (quantity of Moving from A to B does Must Simplyhave MU ΔQthe rearrange =MU MΔQM equation CDs) not change utilityC C Loss to Movement getinthe because utility we down fromonless relationship are isthebetween same Gain Movement inisin utility across from. more.is change CDs MRS andMU CDs, indifference CΔQ ΔQ marginalcurve. C Cutilities. change MUMΔQ moviesinismovies, ΔQ M. M. A 2 B 1 IC1 0 1 2 3 QM (quantity of movies) Figure 6 Relationship Between Marginal Utility and MRS 20 10  2/19/2024 Constrained Utility Maximization: Budget constraints ◼ The budget constraint is a mathematical representation of the combination of goods the consumer can afford to buy with a given income. ◼ Assume there is no saving or borrowing. ◼ In the example, denote: ◼ Y = Income level ◼ PM = Price of one movie ◼ PC = Price of one CD 21 Constrained Utility Maximization: Budget constraints ◼ The expenditure on movies is: PM QM ◼ While the expenditure on CDs is: PC QC 22 11  2/19/2024 Constrained Utility Maximization: Budget constraints ◼ Thus, the total amount spent is: PM QM + PC QC ◼ This must equal income, because of no saving or borrowing. Y = PM QM + PC QC 23 Constrained Utility Maximization: Budget constraints ◼ This budget constraint is illustrated in the next figure. ◼ Figure 7 illustrates this. 24 12  2/19/2024 QCD Her If Andrea budget spent constraint all her (quantity of consists income of allon combinations CDs, she CDs) could on the buyred thisline. amount. 3 Andrea would never choose the interior of the budget set 2 because of nonsatiation. If Andrea spent all her income on movies, she 1 could buy this amount. 0 1 2 3 QM (quantity of movies) Figure 7 The Budget Constraint 25 Constrained Utility Maximization: Budget constraints ◼ The slope of the budget constraint is: PM − PC ◼ It is thought that government actions can change a consumer’s budget constraint, but that a consumer’s preferences are fixed. 26 13  2/19/2024 Constrained Utility Maximization: Putting it together: Constrained choice ◼ What is the highest indifference curve that an individual can reach, given a budget constraint? ◼ Preferences tells us what a consumer wants, and the budget constraint tells us what a consumer can actually purchase. ◼ This leads to utility maximization, shown graphically, in Figure 8. 27 QCD (quantity of This bundle of goods Thisgives indifference the curve gives much CDs) highest utility, subject higher to the budget utility, but is not attainable. 3 constraint. This indifference curve is not utility- maximizing, because there are 2 bundles that give higher utility. 1 0 1 2 3 QM (quantity of movies) Figure 8 Utility Maximization 28 14  2/19/2024 Constrained Utility Maximization: Putting it together: Constrained choice ◼ In this figure, the utility maximizing choice occurs where the indifference curve is tangent to the budget constraint. ◼ This implies that the slope of the indifference curve equals the slope of the budget constraint. 29 Constrained Utility Maximization: Putting it together: Constrained choice ◼ Thus, the marginal rate of substitution equals the ratio of prices: MU M P MRS = − =− M MU C PC ◼ At the optimum, the ratio of the marginal utilities equals the ratio of prices. But this is not the only condition for utility maximization. ◼ Figure 9 illustrates this. 30 15  2/19/2024 QCD The MRS equals the price ratio at (quantity of this bundle, but is unaffordable. CDs) 3 The MRS equals the price ratio at 2 this bundle, but it wastes resources. 1 0 1 2 3 QM (quantity of movies) Figure 9 MRS Equal to Price Ratio is Insufficient 31 Constrained Utility Maximization: Putting it together: Constrained choice ◼ Thus, the second condition is that all of the consumer’s money is spent: Y = PM QM + PC QC ◼ These two conditions are used for utility maximization. 32 16  2/19/2024 The Effects of Price Changes: Substitution and income effects ◼ Consider a typical price change in our framework: ◼ Increase the price of movies, PM. ◼ This rotates the budget constraint inward along the x-axis. ◼ Figure 10 illustrates this. 33 QCD (quantity of CDs) Andrea Increase is worse in PM rotates off, andthe consumes budget 3 constraint lessinward movies. on x-axis. 2 1 0 1 2 3 QM (quantity of movies) Figure 10 Increase in the Price of Movies 34 17  2/19/2024 The Effects of Price Changes: Substitution and income effects ◼ A change in price consists of two effects: ◼ Substitution effect–change in consumption due to change in relative prices, holding utility constant. ◼ Income effect–change in consumption due to feeling “poorer” after price increase. ◼ Figure 11 illustrates this. 35 QCD Movement from one indifference (quantity of curve to the other is the income effect. CDs) 3 Movement along the indifference curve is the substitution effect 2 1 Decline Decline in QMindue QMtodue income to substitution effect effect 0 1 2 3 QM (quantity of movies) Figure 11 Illustration of Income and Substitution Effects 36 18  2/19/2024 PUTTING THE TOOLS TO WORK TANF and labor supply among single mothers ◼ TANF is “Temporary Assistance for Needy Families.” ◼ Cash welfare for poor families, mainly single mothers. ◼ For example, in New Mexico, family of three receives $389 per month. ◼ Assume the two “goods” in utility maximization problem are leisure and food consumption. ◼ Whatever time is not devoted to leisure is spent working and earning money. 37 PUTTING THE TOOLS TO WORK Identifying the budget constraint ◼ What does the budget constraint look like? ◼ Assume the person can work up to 2000 hours per year, at a wage rate of $10 per hour, and that TANF is not yet in place. ◼ Price of food is $1 per unit. 38 19  2/19/2024 PUTTING THE TOOLS TO WORK Identifying the budget constraint ◼ The “price” of one hour of leisure is the hourly wage rate. ◼ Creates a direct tradeoff between leisure and food: each hour of work brings her 10 units of food. ◼ Figure 12 illustrates this. 39 Food consumption Food is a more “typical” good. 500 hours of leisure, 15,000 units of (QF) Thus, there are various food 20,000 combinations of (L,F) consumed … The This slope 1,000 leads hoursofto the ofthebudget kind of leisure, constraint budget 10,000 units constraint iswe–w/P have ofF,food or seen -10.previously. 15,000 Leisure 1,500 hours ofisleisure, a “good” justunits 5,000 as movies 10,000 were …ofmore food is preferred to less. 5,000 0 500 1000 1500 2000 Leisure (hours) Figure 12 Leisure is a “good” and labor is a “bad.” 40 20  2/19/2024 PUTTING THE TOOLS TO WORK The effect of TANF on the budget constraint ◼ Now, let’s introduce TANF into the framework. TANF has two key features: ◼ Benefit guarantee, G – amount that a recipient with $0 earnings gets. ◼ Benefit reduction rate, J – rate at which benefit guarantee falls as earnings increases. 41 PUTTING THE TOOLS TO WORK The effect of TANF on the budget constraint ◼ Assume that benefit guarantee, G, is $5,000 per year. ◼ Assume the benefit reduction rate, J, is 50%. ◼ Figure 13 illustrates this. 42 21  2/19/2024 Food consumption Slope on this section of the budget (QF) constraint is -10. 20,000 At 1,000 hours of work, TANF benefits The benefit reduction rate of 50% fall to zero. Slope onthe reduces thisguarantee section ofas theearnings budget increase. constraint is -5. $5000 guarantee means that a new Green area represents recipient 15,000 couldbundles from TANF. now consume (2000,5000). 10,000 5,000 0 500 1,000 1,500 2,000 Leisure (hours) Figure 13 Introduce Temporary Assistance to Needy Families 43 PUTTING THE TOOLS TO WORK The effect of changes in the benefit guarantee ◼ One possible “policy experiment” is reducing the benefit guarantee level G. ◼ What happens when G falls from $5,000 to $3,000, holding all other parameters constant? ◼ Figure 14 illustrates this. 44 22  2/19/2024 Food consumption (QF) 20,000 The earnings level where 15,000 TANF ends falls from $10,000 Lowering the guarantee to $6,000. reduces the initial non-working 10,000 bundle to (2000,3000). 6,000 5,000 3,000 0 500 1,000 1,400 1,500 2,000 Leisure (hours) Figure 14 Lower the Benefit Guarantee 45 PUTTING THE TOOLS TO WORK How large will the labor supply response be? ◼ What is the expected labor supply response to such a policy change? ◼ It depends on where the single mother initially was on the budget constraint. ◼ If she initially earned less than $6,000 per year, the policy change involves only an income effect, not a substitution effect. ◼ Figure 15 illustrates this. 46 23  2/19/2024 Food consumption (QF) 20,000 The effective If leisurewage rate does is a normal good, the 15,000 not change foreffect this person. income would reduce leisure (increase work). 10,000 6,000 5,000 3,000 0 500 1,000 1,400 2,000 Leisure (hours) Figure 15 Policy Change Generates Income Effect Only 47 PUTTING THE TOOLS TO WORK How large will the labor supply response be? ◼ If she initially earned between $6,000 and $10,000 per year, the policy change involves both an income and substitution effect. ◼ The substitution and income effects go in the same direction. ◼ Figure 16 illustrates this. 48 24  2/19/2024 Food consumption (QF) 20,000 The change The effectiveinwage laborrate supply changes involvesfor boththisincome person. and 15,000 substitution effects. 10,000 6,000 5,000 3,000 0 500 1,000 1,400 2,000 Leisure (hours) Figure 16 Both Income and Substitution Effects From Policy 49 PUTTING THE TOOLS TO WORK How large will the labor supply response be? ◼ Economic theory clearly suggests that such a benefit reduction will increase labor supply, but does not speak to the magnitude of the response. ◼ For example, some welfare recipients who were not initially working continue to choose not to work. ◼ Figure 17 illustrates this. 50 25  2/19/2024 Food consumption (QF) 20,000 15,000 This person was initially out of the labortoforce. She continues stay out of the labor force, even with the 10,000 benefits reduction. 6,000 5,000 3,000 0 500 1,000 1,400 2,000 Leisure (hours) Figure 17 No Labor Supply Response To Policy Change 51 PUTTING THE TOOLS TO WORK How large will the labor supply response be? ◼ The actual magnitude of the labor supply response therefore depends on the preferences of various welfare recipients. ◼ To the extent the preferences are more like the first two cases, the larger the labor supply response. ◼ Thus, theory alone cannot say whether this policy change will increase labor supply, or by how much. ◼ Must analyze available data on single mothers to figure out the magnitude. 52 26  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE ◼ Welfare economics is the study of the determinants of well-being, or welfare, in society. It depends on: ◼ Determinants of social efficiency, or size of the economic “pie.” ◼ Redistribution. 53 EQUILIBRIUM AND SOCIAL WELFARE Demand curves ◼ Demand curve is the relationship between the price of a good and the quantity demanded. ◼ Derive demand curve from utility maximization problem, as shown in Figure 18. 54 27  2/19/2024 QCD (quantity of CDs) Raising P M even more gives another Initial utility-maximizing point gives (PM,QM)Raising combination P one (P withanother M gives even less (PM,QM) M,QM) combination. movies with combination demanded. fewer movies demanded. QM,3 QM,2 QM,1 QM (quantity of movies) Figure 18 Increase in the Price of Movies 55 EQUILIBRIUM AND SOCIAL WELFARE Demand curves ◼ This gives various (PM,QM) combinations that can be mapped into price/quantity space. ◼ This gives us the demand curve for movies. ◼ Figure 19 illustrates this. 56 28  2/19/2024 PM Various At a high combinations price for of pointsdemanded movies, like these create QM,3 the demand curve. At a somewhat lower price for movies, demanded QM,2 PM,3 At an even lower price for PM,2 movies, demanded QM,1 PM,1 Demand curve for movies QM,3 QM,2 QM,1 QM Figure 19 Deriving the Demand Curve for Movies 57 EQUILIBRIUM AND SOCIAL WELFARE Elasticity of demand ◼ A key feature of demand analysis is the elasticity of demand. It is defined as: QD QD D = P P ◼ That is, the percent change in quantity demanded divided by the percent change in price. 58 29  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Elasticity of demand ◼ For example, an increase in the price of movies from $8 to $12 is a 50% rise in price. ◼ If the number of movies purchased fell from 6 to 4, there is an associated 33% reduction in quantity demanded. ◼ The demand elasticity is therefore -0.67. ◼ Demand elasticities features: ◼ Typically negative number. ◼ Not constant along the demand curve (for a linear demand curve). 59 EQUILIBRIUM AND SOCIAL WELFARE Elasticity of demand ◼ For a vertical demand curve ◼ Elasticity of demand is zero—quantity does not change as price goes up or down. ◼Perfectly inelastic ◼ For a horizontal demand curve ◼ Elasticity of demand is negative infinity—quantity changes infinitely for even a small change in price. ◼Perfectly elastic ◼ Figure 20 illustrates this. 60 30  2/19/2024 PM With this inelastic demand Inelastic demand curve, choose QM,2 curve for With movies this elastic demand of the price. regardless curve, choose any quantity PM,3 at price PM,2. PM,2 Elastic demand curve for movies PM,1 QM,3 QM,2 QM,1 QM Figure 20 Perfectly Elastic and Perfectly Inelastic Demand 61 EQUILIBRIUM AND SOCIAL WELFARE Elasticity of demand ◼ More generally, an elasticity divides the percent change in a dependent variable by the percent change in an independent variable: Y = Y X X ◼ For example, Y is often the quantity demanded or supplied, while X might be own-price, cross-price, or income. 62 31  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Supply curves ◼ Supply curve is the relationship between the price of a good and the quantity supplied. ◼ Derive supply curve from profit maximization problem. ◼ The firm’s production function measures the impact of a firm’s input use on output levels. 63 EQUILIBRIUM AND SOCIAL WELFARE Supply curves ◼ Assume two inputs, labor (L) and capital (K). Firm’s production function for movies is, in general: QM = f ( LM , K M ) ◼ That is, the quantity of movies produced is related to the amount of labor and capital devoted to movie production. ◼ Similarly, there would be a production function for CDs. 64 32  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Supply curves ◼ One specific production function is: QM = LM K M ◼ From a production function like this, we can figure out the marginal productivity of an input by taking the derivative with respect to it. 65 Equilibrium and Social Welfare: Supply curves ◼ For example, the marginal productivity of labor is: Q M 1 K M = 0 L M 2 L M ◼ This is the partial derivative of Q with respect to L. The marginal product is positive. 66 33  2/19/2024 Equilibrium and Social Welfare: Supply curves ◼ Taking the second derivative yields:  2QM 1 KM =− 0 L M 2 4 L3M ◼ This second derivative is negative, meaning that the production function features diminishing marginal productivity. 67 EQUILIBRIUM AND SOCIAL WELFARE Supply curves ◼ Diminishing marginal productivity means that holding all other inputs constant, increasing the level of one input (such as labor) yields less and less additional output. 68 34  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Supply curves ◼ The total costs of production are given by: TC = rK + wL ◼ In this case, r and w are the input prices of capital and labor, respectively. 69 EQUILIBRIUM AND SOCIAL WELFARE Supply curves ◼ If we assume capital is fixed in the short-run, the cost function becomes: TC = rK + wL ◼ Thus, only labor can be varied in the short run. The marginal cost is the incremental cost of producing one more unit of Q, or the product of the wage rate and amount of labor used to produce that unit. 70 35  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Supply curves ◼ Diminishing marginal productivity implies rising marginal costs. ◼ Since each additional unit, Q, means calling forth less and less productive labor at the same wage rate, costs of production rise. 71 EQUILIBRIUM AND SOCIAL WELFARE Supply curves ◼ Profit maximization means maximizing the difference between total revenue and total costs. ◼ This occurs at the quantity where marginal revenue equals marginal costs. 72 36  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Equilibrium ◼ In a perfectly competitive market, the marginal revenue is the market price. Thus, the firm produces until: ◼ P = MC. ◼ Thus, the MC curve is the supply curve. 73 EQUILIBRIUM AND SOCIAL WELFARE Equilibrium ◼ In equilibrium, we horizontally sum individual demand curves to get aggregate demand. ◼ We also horizontally sum individual supply curves to get aggregate supply. ◼ Competitive equilibrium represents the point at which both consumers and suppliers are satisfied with the price/quantity combination. ◼ Figure 21 illustrates this. 74 37  2/19/2024 PM Supply Intersection of supply and curve of demand is equilibrium. movies PM,3 PM,2 PM,1 Demand curve for movies QM,3 QM,2 QM,1 QM Figure 21 Equilibrium with Supply and Demand 75 EQUILIBRIUM AND SOCIAL WELFARE Social efficiency ◼ Measuring social efficiency is computing the potential size of the economic pie. It represents the net gain from trade to consumers and producers. 76 38  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Social efficiency ◼ Consumer surplus is the benefit that consumers derive from a good, beyond what they paid for it. ◼ Each point on the demand curve represents a “willingness-to-pay” for that quantity. ◼ Figure 22 illustrates this. 77 PM The Yet consumer’s The the actual“surplus” willingness-to-pay price paidfromfor is Supply the first the first unit much unit is this is lower. very trapezoid. high. curve of The There willingness is stilltosurplus, pay for the The consumer’s “surplus” from movies because second unitthe is pricea bitislower. lower. the next unit is this trapezoid. The The consumer total consumer surplus at Q* is surplus is the area this between triangle. the demand curve and market price. P* Demand curve for movies 0 1 2 Q* QM Figure 22 Deriving Consumer Surplus 78 39  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Social efficiency ◼ Consumer surplus is determined by market price and the elasticity of demand: ◼ With inelastic demand, demand curve is more vertical, so surplus is higher. ◼ With elastic demand, surplus is lower. ◼ Figure 23 illustrates this. 79 PM Supply curve of movies Consumer surplus is larger when demand curve is more inelastic. P* Demand curve for movies 0 1 2 Q* QM Figure 23 Consumer Surplus and Inelastic Demand 80 40  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Social efficiency ◼ Producer surplus is the benefit derived by producers from the sale of a unit above and beyond their cost of producing it. ◼ Each point on the supply curve represents the marginal cost of producing it. ◼ Figure 24 illustrates this. 81 PM Supply curve of movies total producer’s The producers surplus surplus at Q* is the area this between triangle. the demand curve and market price. P* TheThere producer’s The marginal “surplus” is producer for from costsurplus, the thebecause second next unitunit the is is price a bit this ishigher. higher. trapezoid. The producer’s TheYetmarginal “surplus” the actual forfrom costprice the the first received first unitunit isisthis is much very trapezoid. higher. low. Demand curve for movies 0 1 2 Q* QM Figure 24 Producer Surplus 82 41  2/19/2024 EQUILIBRIUM AND SOCIAL WELFARE Social efficiency ◼ Similar to consumer surplus, producer surplus is determined by market price and the elasticity of supply: ◼ With inelastic supply, supply curve is more vertical, so producer surplus is higher. ◼ With elastic supply, producer surplus is lower. 83 EQUILIBRIUM AND SOCIAL WELFARE Social efficiency ◼ The total social surplus, also known as “social efficiency,” is the sum of the consumer’s and producer’s surplus. ◼ Figure 25 illustrates this. 84 42  2/19/2024 PM The Providing surplus thefrom first theunit next Supply gives unit isathe great difference deal of curve of surplus between to demand the “society.”and movies supply curves. Social The area efficiency between is maximized the supplyat and Q *, and iscurves demand the sumfrom of the zero to consumer Q* represents and producer the surplus. surplus. P* This area represents the social surplus from producing the first unit. Demand curve for movies 0 1 Q* QM Figure 25 Social Surplus 85 EQUILIBRIUM AND SOCIAL WELFARE Competitive equilibrium maximizes social efficiency ◼ The First Fundamental Theorem of Welfare Economics states that the competitive equilibrium, where supply equals demand, maximizes social efficiency. ◼ Any quantity other than Q* reduces social efficiency, or the size of the “economic pie.” ◼ Consider restricting the price of the good to P´