Economics 100B Microeconomics

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Economics 100BMicroeconomics
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Announcements

• Solution of problem set 1 is available on the
  course website

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Course Outline
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Todays plan

• Social Surplus
• Economic Efficiency (Chapter 11)
• Applied Welfare Analysis (Chapter 11)

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I. Social Surplus

• Definition
• Social surplus is the total additional value
  obtained by market participants by being able to
  make market transactions
• Formally
• Social Surplus Consumer Surplus Producer
  Surplus

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A. Consumer Surplus

• Definition
• Consumer surplus is the monetary difference
  between what consumers would be willing to pay
  for the quantity of the good purchased and what
  they actually pay.
• Formally

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Why?

• Utility
• Budget
• FOC
• Consumer surplus

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A. Consumer Surplus
px
Consumer surplus is the area above price and
below demand
P
Quantity of x
Q
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A. Consumer Surplus
px
Consumer surplus decreases when price increases
from P to P
P
P
P(q)
Quantity of x
Q
Q
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Example effect of a 10 increase in price on
consumer surplus
Source Blanciforti (1982)
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B. Producer Surplus

• Definition
• Producer surplus is the monetary difference
  between what producers would be willing to
  receive for the quantity of the good produced and
  what they actually receive.
• Formally

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B. Producer Surplus
px
MC(q)
Firms surplus is the area below price and above
firm supply
P
Quantity of x
Q
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B. Producer Surplus
px
MC(q)
P
Firms surplus increases when price increases
from P to P
P
Quantity of x
Q
Q
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C. Putting Things Together
px
S
P
D
Quantity of x
Q
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Example

• Demand qD 2000 10p
• Supply qS p/2
• If Q1 units are sold, what is the
• Consumer surplus?
• Producer surplus?
• Social surplus?

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II. Economic Efficiency

• Key Concept Pareto efficiency
• An allocation of resources is Pareto efficient if
  no one can be made (strictly) better-off without
  making someone else (strictly) worse-off
• Key Result
• The competitive market equilibrium maximizes
  social surplus

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Graphically
px
S
Total surplus would be smaller at output Q1
P
Deadweight loss (DWL)
D
Quantity of x
Q
Q1
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Mathematically

• By definition, the social surplus is equal to

• It is maximum at Q such that
• P(Q) MC(Q)

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III. Applied Welfare Analysis

• Objective
• Compute the decrease in social surplus, or
  deadweight loss, caused by restrictions on
  voluntary transactions
• Examples
• Price controls
• Taxes
• Tariffs

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A. Price Controls and Shortages
Price
Initially, the market is in equilibrium at (P1,Q1)
S
P2
P1
D
Quantity
Q2
Q1
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A. Price Controls and Shortages
Price
Social surplus in the competitive equilibrium
S
P2
P1
D
D
Quantity
Q2
Q1
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A. Price Controls and Shortages
Price
Suppose that the government imposes a price
ceiling at P1
S
P2
Shortage Q3 - Q1
P1
D
D
Quantity
Q2
Q1
Q3
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A. Price Controls and Shortages
Price
Under price control, there is less social surplus
S
P2
P1
D
D
Quantity
Q2
Q1
Q3
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A. Price Controls and Shortages
The shaded rectangle represents a pure transfer
from producers to consumers
Price
S
P2
P1
D
D
Quantity
Q2
Q1
Q3
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A. Price Controls and Shortages
Price
S
P2
P1
D
D
Quantity
Q2
Q1
Q3
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A. Price Controls and Shortages
Price
This shaded triangle represents lost producer
surplus
S
P2
P1
D
D
Quantity
Q2
Q1
Q3
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A. Price Controls and Shortages
Price
S
P2
P1
D
D
Quantity
Q2
Q1
Q3
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B. Tax Incidence

• Suppose that the government introduces a per-unit
  tax t
• Let us call
• PD the price paid by consumers
• PS the price received by producers
• Then
• PD PS t

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B. Tax Incidence
Price
S
A per-unit tax creates a wedge between the
price that consumers pay (PD) and the price that
producers receive (PS)
PD
P
PS
DP(Q)
DP(Q)-t
Quantity
Q
Q
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B. Tax Incidence
Price
S
Buyers incur a welfare loss equal to the shaded
area
PD
P
Some of this loss goes to the government in
the form of tax revenue
PS
D
Quantity
Q
Q
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B. Tax Incidence
Price
S
Sellers incur a welfare loss equal to the shaded
area
PD
Some of this loss goes to the government in
the form of tax revenue
P
PS
D
Quantity
Q
Q
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B. Tax Incidence
Price
S
PD
The shaded area represents the deadweight loss
from the tax
P
PS
D
Quantity
Q
Q
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B. Tax Incidence

• Formally, one can check that

• The actor with the least elastic response
  experiences most of the price change

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B. Tax Incidence

• General Insight
• All nonlump-sum taxes involve deadweight losses
• The size of the losses depend on the elasticities
  of supply and demand
• A linear approximation to the deadweight loss
  caused by a small tax, dt, is given by
• DW -0.5(dt)(dQ)

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C. International Trade and Tariffs
Price
In the absence of international trade, the
domestic equilibrium price would be P and the
domestic equilibrium quantity would be Q
S
P
D
Quantity
Q
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C. International Trade and Tariffs
Price
S
Assume the world price (PW) is less than the
domestic price
P
Imports Q2 Q1
PW
D
Quantity
Q
Q2
Q1
imports
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C. International Trade and Tariffs
Pure transfer from producers to consumers
Price
S
Triangle represents the gains from trade
P
PW
D
Quantity
Q
Q2
Q1
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C. International Trade and Tariffs
Price
S
Suppose that the government creates a tariff t
that raises the price to PR
PR
Imports are now Q4 Q3
PW
D
Quantity
Q2
Q1
Q3
Q4
imports
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C. International Trade and Tariffs
Price
S
The two pink triangles represent the deadweight
loss from tariffs
PR
PW
D
Quantity
Q2
Q1
Q3
Q4
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Welfare Costs of Trade Barriers(millions of 2002
dollars)
Source Lopez and Pagoulatos (1994)
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Assignments

• Finish reading Nicholson Chapter 11