Zhigang Li University of Hong Kong

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Zhigang LiUniversity of Hong Kong
Efficiency and Exchange
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Example 7.1.

• All community residents are neutral with respect
  to this proposal except for the following three

P1
P2
A rich resident (R), who favors the proposal
..and two poor residents (P1 and P2), who oppose
it.
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Example 7.1.

• Each of these three feels equally strongly about
  the issue.
• But because R is wealthy, he is willing to pay
  1000 to see the switch enacted, while P1 and P2
  are willing to pay only 100 each to prevent it.
• Should the switch be made?

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Example 7.1.

• Cost-benefit analysis says to make the switch,
  because the benefit (1000) exceeds the cost
  (200).
• Is willingness to pay (WTP) the right basis for
  making such decisions?
• Many social critics say no, that WTP gives unfair
  decision weight to the preferences of the wealthy.

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Example 7.1.

• In the US, recent Presidential executive orders,
  for example, have directed agencies to temper
  cost-benefit calculations with distributional
  concerns.
• These orders militate against making the format
  switch.
• Yet both rich and poor would benefit if we
  resolved all such cases on the basis of pure,
  unweighted willingness to pay, using the tax and
  transfer system to compensate those who would be
  hurt in the process.
• For instance, raise Rs taxes by 500, reduce
  those of P1 and P2 by 250 each.
• Compared to the status quo, R has net gain of
  500,while P1 and P2 each reap a net gain of 150.

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Decision based on unweighted WTP
Aggregate unweighted WTP 1000 100 100 800
gt0. Thus, based on pure unweighted WTP, the
station should switch to all talk.
Aggregate weighted WTP 0.011000 0.9100
0.09100 - 89 lt0. Thus, based on weighted WTP
(with this particular weight), the station should
not switch to all talk.
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A bigger pie
Using unweighted willingness to pay results in
the largest possible economic pie. When the pie
is bigger, everyone can have a larger slice.
Total surplus with weighted willingness to pay
Total surplus with unweighted willingness to pay
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Example 7.2
Illinois needs a new maximum security prison...
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Example 7.4.

• Two locations under consideration
• Dixon, average income 100,000/yr.
• Moline, average income 22,000/yr.
• Neither community wants the prison.

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Example 7.4.

• Two locations under consideration
• Dixon, average income 100,000/yr.
• Moline, average income 22,000/yr.
• Neither community wants the prison.
• Dixon residents are collectively willing to pay
  1 million to avoid it.
• Moline residents collectively willing to pay only
  100,000 to avoid it.
• Where should the prison be built?

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Example 7.4.

• Build the prison in Moline.
• Levy 200,000 in supplemental taxes on Dixon
  residents.
• Reduce taxes by 200,000 in Moline.

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Should redistribution of wealth be allowed?

• Recall Example 7.1. R is willing to pay 1000
  for the switch from all music to all talk.
• P1 and P2 are willing to pay only 100 each to
  prevent the switch.
• If redistribution is ruled out and we settle the
  issue democratically, the switch loses, two votes
  to one.

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Should redistribution of wealth be allowed?

• But a better outcome is to redistribute and make
  the switch.
• For example, raise Rs taxes by 500, reduce
  those of P1 and P2 by 250 each.
• Compared to the status quo, R has net gain of
  500,while P1 and P2 each reap a net gain of
  150.
• Refusal to redistribute makes the economic pie
  smaller.

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Calculating Total Economic Surplus

• Consumer surplus the difference between the most
  a buyer would have been willing to pay for a
  product and the amount it actually costs her.
• Producer surplus the difference between what a
  company gets paid for the goods it sells, and the
  smallest amount it would have been willing to
  accept for them.
• Total economic surplus the sum of consumer
  surplus and producer surplus for all buyers and
  sellers in a market. It is a measure of the
  total amount by which they benefit from their
  participation in that market.

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Example 7.7.
For the equilibrium price and quantity implied by
the demand and supply curves shown for the
gasoline market, compute consumer and producer
surplus.
Consumer surplus2250/day
Producer surplus 2250/day
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• Efficient does not mean the same thing as
  good.
• Still, efficiency should be our primary
  objective, because it enables us to pursue all
  other goals more effectively.
• When the economic pie is larger, everyone can
  have a larger slice.

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The Efficiency Criterion

• If resources are to be used efficiently, price
  must be equal to marginal cost.
• If price is not equal to marginal cost, resources
  will be used inefficiently.
• To say that resources are being used
  inefficiently is the same thing as saying that
  resources can be rearranged in a way that helps
  some people with out hurting others.

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Example 7.3

• Citizens of a small country use coal for home
  heating.
• The country imports all of its coal supplies from
  abroad.
• To keep coal affordable for the poor, the
  government purchases coal at the world price of
  100/ton and then sells it to citizens for only
  50/ton.
• Will coal use be efficient in this country?

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Example 7.3

• When P50/ton, people will continue to purchase
  coal until the benefit of the last ton of coal
  consumed is 50.
• Each ton consumed, however, costs the country
  100.
• If people used a ton less coal, they would lose
  benefits worth 50.
• But the country would save 100.

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Example 7.8.

• Concern for the well-being of the poor motivates
  most societies to try to alter market outcomes.
• The difficulty is that many of our direct
  interventions in markets produce unintended and
  often very harmful consequences.

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Example 7.9.

• In the preceding example, if Q 80 million
  tons/yr and Q 100 million tons/yr, how much
  economic surplus is lost as a result of pegging
  the price of coal at 50/ton?

Consumer surplus without subsidy
Price (/ton)
Consumer surplus with subsidy
Cost of subsidy
Total welfare CS -Subsidy
100
Welfare loss 500 million /yr
50
Quantity (millions of tons/yr)
80
100
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Example 7.9.

• At world price of 100/ton, what is the producer
  surplus of the local supplier?

Producer surplus the difference between what a
company gets paid for the goods it sells, and the
smallest amount it would have been willing to
accept for them. Price 100, MC 100. PS 0.
Price (/ton)
S
100
50
Quantity (millions of tons/yr)
80
100
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Example 7.4

• In the preceding example, describe a change in
  policy that would make all citizens better off.

Price (/ton)
100
Welfare (surplus) loss 500 million /yr
50
Quantity (millions of tons/yr)
80
100
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Example 7.4

• First the cost of subsidy.

Price (/ton)
100
Cost of subsidy (100-50)100 5 billions
50
Quantity (millions of tons/yr)
80
100
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Example 7.4
Suppose the government were to eliminate the
subsidy and return the 5 billion to citizens in
the form of lower taxes.
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Example 7.4

• Confronted with the market price of 100/ton,
  citizens would respond by consuming 20 tons/yr
  less than before.

Price (/ton)
Loss in consumer surplus (100-50)80
(100-50)(100-80)/2 4.5 billions
100
50
Quantity (millions of tons/yr)
80
100
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Example 7.4
Thus families would be better off in the
aggregate by 5 billion - 4.5
billion (tax refund) (lost CS from
coal) 500 million each year.
Price (/ton)
100
Welfare (surplus) loss 500 million /yr
50
Quantity (millions of tons/yr)
80
100
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Example 7.5
What will be the effect on total economic surplus
in this rental market of setting a rent control
price of 200/month?
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Example 7.5
In an unregulated market, equilibrium rent
600/apt equilibrium quantity 3000 apts/mo.
Total economic surplus
0.5(1200/apt)(3000 apts/mo) 1,800,000/mo
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Example 7.5
With rents controlled at 200/apt, landlords will
offer only 1000 apartments per month.
Loss in economic surplus
0.5(800/apt)(2000 apt/mo) 800,000 /mo
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Example 7.6
Anticipating a high proportion of no-shows, a
hair salon manager routinely books five people
for each appointment time, even though only three
slots are available during each appointment
time. One day, all five people show up for 6
p.m. appointments.
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Example 7.12.
Their respective arrival times and the most each
would be willing to pay to avoid postponing his
or her appointment
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Example 7.12.
Suppose the salon manager accommodates the
customers on a first-come-first-served basis. By
how much will total economic surplus be smaller
than if she had offered cash compensation to
induce two volunteers to reschedule?
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Example 7.12.
First-come-first-served means that Ann, Bill, and
Carrie get to keep their appointments, which
results in a surplus of 611421.
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Example 7.12.
Suppose instead that the three willing to pay
most (Dana, Bill, and Ann) had been permitted to
keep their appointments. Total surplus would
then have been 1211629, or 8 more than
before.
The salon owner can achieve this result by
offering a cash payment of at least 5 to those
willing to volunteer to postpone their
appointments, which will induce Earl and Carrie
to volunteer.
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Example 7.12.
The cash payments to the volunteers have no other
net effect on total economic surplus (or
welfare). Thus, the owner loses 10 of
economic surplus (the 5 payments she makes to
Earl and Carrie), while Earl and Carrie each
experience a gain in surplus of 5a net change
in surplus of 0 for these three as a group.
However, the distribution of the total economic
surplus is different.
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In-class exercise

• The market for massages is perfectly competitive
  with an equilibrium price of 20 per massage.

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In-class exercise

• Terrys personal demand for massages is P 60
  Q, where P is the price per massage in dollars
  and Q is the number of massages per year.

Price (/massage)
60
20
Massages / yr
40
60
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In-class exercise

• Before marrying Susan, a masseuse, Terry
  purchased his massages from her at the market
  price.
• Now, however, he receives massages from her free
  of charge.
• Price apart, Terry is indifferent between
  receiving massages from Susan or from some other
  masseuse and Susan is indifferent between giving
  massages to Terry or to some other client.
• By how much does the new arrangement alter
• total economic surplus?

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In-class exercise

• By how much does the new arrangement alter
• total economic surplus?
• a. The new arrangement results in an increase in
  total economic surplus of 800.
• b. The new arrangement results in an increase in
  total economic surplus of 1000.
• c. The new arrangement results in a decline in
  total economic surplus of 200.
• d. The new arrangement results in a decline in
  total economic surplus of 1000.
• e. None of the above.

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In-class exercise

• The opportunity cost of each massage that Terry
  receives from Susan is 20, the amount that she
  could have earned by providing a massage for a
  paying client.

Price (/massage)

• If Terry treats Susans massages as if they were
  free, he will consume 60 of them per year,
  instead of the 40 he would have consumed if he
  had to pay 20 per massage.

60
20
Massages / yr
40
60
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In-class exercise

• The opportunity cost of each massage that Terry
  receives from Susan is 20, the amount that she
  could have earned by providing a massage for a
  paying client.

Price (/massage)
Consumer surplus if Terry buys the massage
service at market price.
60
Consumer surplus if Terry gets the massages for
free from his wife.
Susans opportunity cost of supplying the
messages to Terry without charge.
Total welfare CS -OC
20
Welfare loss 200 / yr
Massages / yr
40
60
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In-class exercise

• By how much does the new arrangement alter
• total economic surplus?
• a. The new arrangement results in an increase in
  total economic surplus of 800.
• b. The new arrangement results in an increase in
  total economic surplus of 1000.
• c. The new arrangement results in a decline in
  total economic surplus of 200.
• d. The new arrangement results in a decline in
  total economic surplus of 1000.
• e. None of the above.

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End