principles of microeconomics 9. prices, total surplus, and market efficiency*
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Principles of Microeconomics 9. Prices, Total Surplus, and Market Efficiency*. Akos Lada August 1 st , 2014. * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint. Contents. Review of previous lecture Prices and producer surplus - PowerPoint PPT PresentationTRANSCRIPT
Principles of Microeconomics
9. Prices, Total Surplus, and Market Efficiency*
Akos LadaAugust 1st , 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
Contents
1. Review of previous lecture
2. Prices and producer surplus
3. Market efficiency
4. Price controls and economic welfare
5. Taxes and economic welfare
1. Review
The picture frames auction
Buyer WTBDay 1 Day 2 Day 3
P QS P QS P QS
Rosalia 20 $ 3.50 0 units $ 5 0 units $ 7.5 1 unit
Seeye 18 $ 17 6 units $ 10.25 3 units $ 9 2 units
Mehnaz 16 $ 16 6 units $ 10 3 units $ 15.50 5 units
Rachel 14 $ 14 5 units $ 12 4 units $ 14 5 units
Monica 12 $ 12 4 units $ 11.01 3 units $12 4 units
Ellen 10 $ 4.50 0 units $ 9.72 2 units $10 3 units
Buyer WTBPrice floor $16 Price ceiling $ 10 Tax of $4
P QS P QS P QS
Rosalia 20 $ 16 6 units $ 10 3 units $ 10 1 unit
Seeye 18 $ 16.23 6 units $ 8.99 2 units $ 10.01 2 units
Mehnaz 16 $ 16 6 units $ 16 3 units $ 16 4 units
Rachel 14 No bid 0 units $ 13 3 units $ 14 3 units
Monica 12 No bid 0 units $ 12 3 units $12 3 units
Ellen 10 No bid 0 units $ 10 3 units $9.89 0 units
Q
P
WTP and D curve, Cost and S curve
D
SAt any Q:
the height of the Demand Curve is the WTP of the marginal buyer.
…and the height of the Supply Curve is the cost of the marginal seller.
At equilibrium WTP of marginal buyer and costs of marginal seller are the same
Q
P
CS and a change in Price
Q*
D
S
P*1
P*2
Consumer surplus is the area between the demand curve and the equilibrium price
A higher price implies a loss in CS that comes from:• Buyers that remain in the market paying more money per units.• Buyers leaving the market.
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
Calculating consumer surplus in a smooth demand curve
D
To calculate the area of the triangles:
½ (base x height)
To calculate the area of the rectangles:
base x height
1. Fall in CS due to buyers leaving market
2. Fall in CS due to remaining buyers paying higher P
2. Prices and Producer Surplus
Q
P
Students’ Turn: What is the Producer surplus at Price
$13?
Q*
D
S
P*
Q
P
The PS at Price $13?
Q*
D
S
P*
Kirk: 13 - 6 = 7Golib: 13 - 8= 5Rebeca: 13 – 10 = 3Chandrika: 13 – 12 = 1
Total PS = 16
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
PS with Lots of Sellers & a Smooth S Curve
The supply of shoes
S
1000s of pairs of shoes
Price per pair
Suppose P = $40.
At Q = 15(thousand), the marginal seller’s cost is $30,
and her producer surplus is $10.
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
PS with Lots of Sellers & a Smooth S Curve
The supply of shoes
S
PS is the area b/w P and the S curve, from 0 to Q.
The height of this triangle is $40 – 15 = $25.
So, PS = ½ x b x h = ½ x 25 x $25 = $312.50
h
Q
P
How a lower price reduces PS in our
example
Q*
D
S
P*1
P*2
In the Price falls from $13 to $11, total PS decreases from $16 to $ 9.
From the $7 loss in PS:• $ 6 are because each of the 3 sellers remaining gets $2 less per frame.• $ 1 is because one seller left the market
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
How a Lower Price Reduces PS with a Smooth Supply
CurveIf P falls to $30,
PS = ½ x 15 x $15 = $112.50
Two reasons for the fall in PS.
S
1. Fall in PS due to sellers leaving market
2. Fall in PS due to remaining sellersgetting lower P
0
5
1015
20
25
30
3540
45
50
0 5 10 15 20 25
P
Q
supply curve
A. Find marginal seller’s cost at Q = 10.
B. Find total PS for P = $20.
Suppose P rises to $30.Find the increase in PS due to… C. selling 5
additional units
D. getting a higher price on the initial 10 units
STUDENTS’ TURN:STUDENTS’ TURN:
Producer surplusProducer surplus
AnswersAnswers
0
5
1015
20
25
30
3540
45
50
0 5 10 15 20 25
P
Q
supply curve
A. At Q = 10, marginal cost = $20
B. PS = ½ x 10 x $20 = $100
P rises to $30.
C. PS on additional units= ½ x 5 x $10 = $25
D. Increase in PS on initial 10 units= 10 x $10 = $100
3. Market Efficiency
CS, PS, and Total Surplus
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 = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
Q
P
Total surplus at Price $13
Q*
D
S
P*
CONSUMER SURPLUS
(16)
PRODUCER SURPLUS
(16)
TOTAL SURPLUS
(32)
The Market’s Allocation of Resources
• 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. (Policymakers also care about equality, though are focus here is on efficiency.)
Efficiency
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.
= (value to buyers) – (cost to sellers)
Total surplus
Evaluating the Market Equilibrium
Market equilibrium: P = $30 Q = 15,000
Total surplus = CS + PS
Is the market equilibrium efficient? 0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
S
D
CS
PS
Which Buyers Consume the Good?
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
S
D
Every buyer whose WTP is ≥ $30 will buy.
Every buyer whose WTP is < $30 will not.
So, the buyers who value the good most highly are the ones who consume it.
Which Sellers Produce the Good?
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
S
D
Every seller whose cost is ≤ $30 will produce the good.
Every seller whose cost is > $30 will not.
So, the sellers with the lowest cost produce the good.
Does Equilibrium Q Maximize Total Surplus?
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
S
D
At Q = 20, cost of producing the marginal unit is $35
value to consumers of the marginal unit is only $20
Hence, can increase total surplus by reducing Q.
This is true at any Q greater than 15.
Does Equilibrium Q Maximize Total Surplus?
0
10
20
30
40
50
60
0 5 10 15 20 25 30
P
Q
S
D
At Q = 10, cost of producing the marginal unit is $25
value to consumers of the marginal unit is $40
Hence, can increase total surplus by increasing Q.
This is true at any Q less than 15.
Q
P
Same in our example: If Q is higher than the equilibrium
Q…
Q*
D
S
Q
P
If Q is lower than the equilibrium Q…
Q*
D
S
Q
P
Conclusion: The Market Equilibrium is efficient
Q*
D
SThe market equilibrium quantity maximizes total surplus:At any other quantity, can increase total surplus by moving toward the market equilibrium quantity.
4. Price Controls and Economic Welfare
Q
P
A binding price floor and CS
Q*
D
S
P*
Min P
QSQD
How does the CS change?
In this example, consumer surplus is reduced
Partly because buyers leave the market
Partly because those buyers still in the market pay more per unit
Q
P
A binding price floor and PS
Q*
D
S
P*
Min P
QSQD
How does the PS change?
In this example, producer surplus is increased
On the one hand, less units are sold (since buyers leave the market.
But on the other hand, the sellers receive more per unit
In this example, the first effect is smaller than the second.
Q
P
A binding price floor and total surplus
Q*
D
S
P*
Min P
QSQD
But what happens to
this surplus?
Deadweight Loss! (DWL)
The surplus that buyers who remain in the market loose because of higher prices
…becomes producer surplus from the sellers’ point of view (doesn’t affect total surplus)
The CS and the PS lost because of people leaving the market goes nowhere… just disappears!
Economists call this a Deadweight Loss
A binding price ceiling and CS
Q
P
Q*
D
S
P*
Max P
QDQS
How does the CS change?
In this example, consumer surplus increases
On the one hand, some surplus is lost because some buyers cannot find anybody to sell at the new price (shortage)
But on the other hand, those buyers who stay in the market pay less per unit
In our example, the first effect is smaller than the second
A binding price ceiling and PS
Q
P
Q*
D
S
P*
Max P
QDQS
How does the PS change?
In this example, producer surplus is reduced
Partly because sellers leave the market
Partly because those sellers still in the market receive less money per unit
Q
P
A binding price ceiling and total surplus
Q*
D
S
P*
QDQS
But what happens to
this surplus?
Deadweight Loss! (DWL)
The surplus that sellers who remain in the market loose because of lower prices
…becomes consumer surplus from the buyers’ point of view (doesn’t affect total surplus)
The CS and the PS lost because of people leaving the market goes nowhere… just disappears!
Economists call this a Deadweight Loss
Max P
5. Taxation and Deadweight Loss
QT
The Effects of a TaxP
Q
D
S
Equilibrium with no tax: Price = PE
Quantity = QE
PS
PB
PE
QE
Equilibrium with tax = $T per unit:
Sellers receive PS
Quantity = QT
Buyers pay PB
Size of tax = $T
Tax RevenueP
Q
D
S
Revenue from tax: $T x QT
PS
PB
PE
QEQT
Size of tax = $T
Government Revenue and Total Surplus
• Next, we apply welfare economics to measure the gains and losses from a tax.
• We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax.
• Tax revenue can fund beneficial services (e.g., education, roads, police) so we include it in total surplus.
Before the TaxP
Q
D
S
PE
QEQT
A
B C
D E
F
CS = A + B + C
PS = D + E + F
Tax revenue = 0
Total surplus= CS + PS= A + B + C + D + E + F
After the TaxP
Q
D
S
PS
PB
QEQT
A
B C
D E
F
CS = A
PS = F
Tax revenue = B + D
Total surplus= A + B + D + F
The tax reduces total surplus by C + E
The DWL of a taxP
Q
D
S
PS
PB
QEQT
A
B C
D E
F
C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax.
About the Deadweight Loss
P
Q
D
S
PS
PB
QEQT
Because of the tax, the units between QT and QE are not
sold.
The value of these units to buyers is greater than the cost of producing them,
so the tax prevents some mutually beneficial trades.
Q
P
In our example: A 4 dollars tax
Q*1
D
S1
Q*2
S2
P*1
P*2
Equilibrium 1
Equilibrium 2 The tax was imposed on the sellers
The Supply curve shifts left
There is a new equilibrium quantity and a new equilibrium price range.
Q
P
What happens to the CS and the PS?
Q*1
D
S1
P*1
S2
PB
PS
CS lost by buyers
PS lost by sellers
Tax revenue collected by
the government
But what happens to this
surplus?
Deadweight Loss! (DWL)
Q*2
STUDENTS’ TURN:STUDENTS’ TURN:
Analysis of taxAnalysis of tax
A. Compute CS, PS, and total surplus without a tax.
B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL.
D
S
0
50
100
150
200
250
300
350
400
0 25 50 75 100 125
P
Q
$
The market for airplane tickets
A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11
Answers to AAnswers to A
D
S
CS = ½ x $200 x 100= $10,000
0
50
100
150
200
250
300
350
400
0 25 50 75 100 125
P
Q
$
Total surplus= $10,000 + $10,000= $20,000
PS = ½ x $200 x 100= $10,000
P =
The market for airplane tickets
A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11
Answers to BAnswers to B
D
S
CS = ½ x $150 x 75= $5,625
0
50
100
150
200
250
300
350
400
0 25 50 75 100 125
P
Q
$
Total surplus = $18,750
PS = $5,625
Tax revenue= $100 x 75= $7,500
DWL = $1,250
PS =
PB =
A $100 tax on airplane tickets
Discussion: the airline tax relief
• Refer to the article “A Bonanza for Airlines as Taxes End” on the recent impasse that led to a 2-weeks shutdown of the US Federal Aviation Administration
• How can we use the tools learned in the class to understand the airlines’ behavior?
Determinants of the Deadweight Loss
What Determines the Size of the DWL?
• Which goods or services should government tax to raise the revenue it needs?
• One answer: those with the smallest DWL.
• When is the DWL small vs. large?
Turns out it depends on the price elasticities of supply and demand
• Recall: The price elasticity of demand (or supply) measures how much QD (or QS) changes when P changes.
DWL and the Elasticity of Supply
When supply is inelastic,
it’s harder for firms to leave the market when the tax reduces PS.
So, the tax only reduces Q a little,
and DWL is small.
When supply is inelastic,
it’s harder for firms to leave the market when the tax reduces PS.
So, the tax only reduces Q a little,
and DWL is small.
P
Q
D
S
Size of tax
DWL and the Elasticity of Supply
P
Q
D
S
Size of tax
The more elastic is supply,
the easier for firms to leave the market when the tax reduces PS,
the greater Q falls below the surplus-maximizing quantity,
the greater the DWL.
The more elastic is supply,
the easier for firms to leave the market when the tax reduces PS,
the greater Q falls below the surplus-maximizing quantity,
the greater the DWL.
DWL and the Elasticity of Demand
P
Q
D
S
Size of tax
When demand is inelastic,
it’s harder for consumers to leave the market when the tax raises PB.
So, the tax only reduces Q a little,
and DWL is small.
When demand is inelastic,
it’s harder for consumers to leave the market when the tax raises PB.
So, the tax only reduces Q a little,
and DWL is small.
DWL and the Elasticity of Demand
P
Q
D
S
Size of tax
The more elastic is demand,
the easier for buyers to leave the market when the tax increases PB,
the more Q falls below the surplus-maximizing quantity,
and the greater the DWL.
The more elastic is demand,
the easier for buyers to leave the market when the tax increases PB,
the more Q falls below the surplus-maximizing quantity,
and the greater the DWL.
Would the DWL of a tax be larger if the tax were on:
A. Breakfast cereal or sunscreen?
B. Hotel rooms in the short run or hotel rooms in the long run?
C. Groceries or meals at fancy restaurants?
STUDENTS’ TURNSTUDENTS’ TURN
Elasticity and the DWL of a taxElasticity and the DWL of a tax
A. Breakfast cereal or sunscreen
Breakfast cereal has more close substitutes than sunscreen, so demand for breakfast cereal is more price-elastic than demand for sunscreen. So, a tax on breakfast cereal would cause a larger DWL than a tax on sunscreen.
B. Hotel rooms in the short run or long run
The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run.
C. Groceries or meals at fancy restaurants
Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries.
AnswerAnswer