Unit 4: Welfare, Efficiency, and Price Controls PDF

Unit 4: Welfare, Efficiency, and Price Controls Unit objectives: (1) Illustrate and explain the effect of a binding price ceiling using the model of demand and supply. (2) Illustrate and explain the effect of a binding price floor using the model of demand and supply. (3) Illustrate and exp...

Unit 4: Welfare, Efficiency, and Price Controls Unit objectives: (1) Illustrate and explain the effect of a binding price ceiling using the model of demand and supply. (2) Illustrate and explain the effect of a binding price floor using the model of demand and supply. (3) Illustrate and explain the efficiency of markets and the distribution of welfare using the concepts of consumer surplus, producer surplus, and deadweight loss. (Part 1) Consumer surplus - “welfare to consumers.” Marginal benefit: the incremental value of an additional unit of a good. (IOW) The maximum you are willing and able to pay for an additional unit. Recall: Quantity Marginal Total Price The Gatorade demanded Benefit Benefit Example from Unit 1 1 $1.40 $1.40 $1 2 $1.30 $2.70 $1 3 $1.20 $3.90 $1 4 $1.10 $5.00 $1 5 $1.00 $6.00 $1 6 $0.90 $6.90 $1 7 $0.80 $7.70 $1 Consumer surplus: Total benefit to consumers minus the amount they paid (for all units). Consumer Surplus = Total benefit – Total cost (IOW) To calculate CS: 1. For each quantity demanded, take the height of the demand curve minus the price. 2. Then add up the values for each quantity demanded. Consumer surplus: total benefit minus total cost. Quantity Marginal Total Price Consumer demanded Benefit Benefit Surplus 1 $1.40 $1.40 $1 $0.40 2 $1.30 $2.70 $1 $0.70 3 $1.20 $3.90 $1 $0.90 4 $1.10 $5.00 $1 $1.00 5 $1.00 $6.00 $1 $1.00 6 $0.90 $6.90 $1 $0.90 7 $0.80 $7.70 $1 $0.70 Consumer surplus If the market price is $1.00, what is the optimal quantity consumed? 5 bottles What would be the consumer surplus? $1.00 Price (P) Point QD Max. WTP – Price a a 1 $0.40 $1.40 b $1.30 b 2 $0.30 c $1.20 d $1.10 CS c 3 $0.20 e $1.00 (P = $1) d 4 $0.10 e 5 $0.00 D 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity (Q)  Graphically (if allowed to have fractional units) Consumer surplus is the area below the demand curve and above the price line. Price (P) What would be the value of CS in this picture? $1.50 Consumer Surplus $1.00 D 0 5 Quantity (Q) (Part 2) Producer surplus - “welfare to producers.” Marginal cost: The incremental opportunity cost of producing each additional unit of a good/service. Producer surplus: The difference between the price suppliers actually receive for a good and the minimum price they would be willing to accept. (IOW) To calculate PS: (1) For each quantity supplied, take the difference between the market price and the height of the supply curve. (2) For each quantity, add up the values. Producer surplus: Total revenue – Total opportunity costs Quantity Marginal Total Price Producer supplied Cost Opportunity Surplus (minimum WTA) Costs 1 $0.60 $0.60 $1 $0.40 2 $0.70 $1.30 $1 $0.70 3 $0.80 $2.10 $1 $0.90 4 $0.90 $3.00 $1 $1.00 5 $1.00 $4.00 $1 $1.00 6 $1.10 $5.10 $1 $0.90 7 $1.20 $6.30 $1 $0.70 Producer surplus If the market price is $1.00, what is the optimal quantity supplied? 5 bottles S What would be the producer surplus? $1.00 Price (P) Point QS Min. WTA – Price a 1 $0.40 b 2 $0.30 c 3 $0.20 d 4 $0.10 $1.00 (P = $1) e 5 $0.00 e $0.90 PS $0.80 d $0.70 c $0.60 b a 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity (Q)  Graphically (if allowed to have fractional units) Producer surplus is the area above the supply curve and below the price line. Price (P) What would be the value of PS in this picture? S $1.00 Producer Surplus $0.50 0 5 Quantity (Q) (Part 3) Economic efficiency  Market Equilibrium and Economic Efficiency In equilibrium, the marginal benefit to society equals the marginal cost of production. (economic efficiency) Price (P) $1.50 S = MSC Consumer Efficient outcomes Surplus maximize social surplus $1.00 Producer (the sum of CS and PS). Surplus $0.50 D = MSB 0 5 Quantity (Q)  Market Equilibrium and Economic Efficiency A price above the equilibrium level would reduce social surplus below the maximum level. Price (P) S = MSC CS Pactual = $1.10 $1.00 PS DW PS $0.90 D = MSB 0 4 5 Quantity (Q)  Market Equilibrium and Economic Efficiency A price below the equilibrium level also would reduce social surplus below the maximum level. Price (P) S = MSC CS $1.10 $1.00 DW Pactual = $0.90 PS D = MSB 0 4 5 Quantity (Q) Deadweight loss (DW): - A reduction in social surplus caused by an inefficient price. Shortages and surpluses result in deadweight loss.  Review questions Using the model of demand supply, can you illustrate (P*, Q*, QD, QS, QE, consumer surplus, producer surplus, and deadweight loss) for the following scenarios: - A labor market with a binding minimum wage. - A labor market with a minimum wage that is not binding. - A market for rental apartments with a binding rent control policy. - A market for rental apartments with a rent control policy that is not binding.