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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

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Principles of microeconomics 9 prices total surplus and market efficiency

Principles of Microeconomics9. Prices, Total Surplus, and Market Efficiency*

AkosLada

August 1st , 2014

* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint


Contents
Contents

  • Review of previous lecture

  • Prices and producer surplus

  • Market efficiency

  • Price controls and economic welfare

  • Taxes and economic welfare




Wtp and d curve cost and s curve
WTP and D curve, Cost and S curve

  • At 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

  • P

    S

    D

    Q


    Cs and a change in price
    CS and a change in Price

    P

    • 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.

    S

    P*2

    P*1

    D

    Q

    Q*


    Calculating consumer surplus in a smooth demand curve
    Calculating consumer surplus in a smooth demand curve

    To calculate the area of the triangles:

    ½ (base x height)

    To calculate the area of the rectangles:

    base x height

    P

    1. Fall in CS due to buyers leaving market

    2. Fall in CS due to remaining buyers paying higher P

    D

    Q




    The ps at price 13
    The PS at Price $13?

    P

    S

    Kirk: 13 - 6 = 7

    Golib: 13 - 8= 5

    Rebeca: 13 – 10 = 3

    Chandrika: 13 – 12 = 1

    Total PS = 16

    P*

    D

    Q

    Q*


    Ps with lots of sellers a smooth s curve
    PS with Lots of Sellers & a Smooth S Curve

    Suppose P = $40.

    At Q = 15(thousand), the marginal seller’s cost is $30,

    and her producer surplus is $10.

    Price per pair

    P

    S

    1000s of pairs of shoes

    Q

    The supply of shoes


    Ps with lots of sellers a smooth s curve1
    PS with Lots of Sellers & a Smooth S Curve

    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

    P

    S

    h

    Q

    The supply of shoes


    How a lower price reduces ps in our example
    How a lower price reduces PS in our example

    P

    S

    • 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

    P*1

    P*2

    D

    Q

    Q*


    How a lower price reduces ps with a smooth supply curve
    How a Lower Price Reduces PS with a Smooth Supply Curve

    If P falls to $30,

    PS = ½ x 15 x $15 = $112.50

    Two reasons for the fall in PS.

    P

    1. Fall in PS due to sellers leaving market

    S

    2. Fall in PS due to remaining sellersgetting lower P

    Q


    Students turn producer surplus
    STUDENTS’ TURN:Producer surplus

    supply curve

    P

    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

    Q


    Answers
    Answers

    supply curve

    P

    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

    Q



    Cs ps and total surplus
    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)


    Total surplus at price 13
    Total surplus at Price $13

    P

    S

    CONSUMER SURPLUS (16)

    PRODUCER SURPLUS (16)

    P*

    TOTAL SURPLUS (32)

    D

    Q

    Q*


    The market s allocation of resources
    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.

    Total surplus

    = (value to buyers) – (cost to sellers)

    Efficiency


    Evaluating the market equilibrium

    Market equilibrium:P = $30 Q = 15,000

    Total surplus = CS + PS

    Is the market equilibrium efficient?

    P

    S

    CS

    PS

    D

    Q

    Evaluating the Market Equilibrium


    Which buyers consume the good
    Which Buyers Consume the Good?

    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.

    P

    S

    D

    Q


    Which sellers produce the good
    Which Sellers Produce the Good?

    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.

    P

    S

    D

    Q


    Does equilibrium q maximize total surplus
    Does Equilibrium Q Maximize Total Surplus?

    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.

    P

    S

    D

    Q


    Does equilibrium q maximize total surplus1
    Does Equilibrium Q Maximize Total Surplus?

    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.

    P

    S

    D

    Q


    Same in our example if q is higher than the equilibrium q
    Same in our example: If Q is higher than the equilibrium Q…

    P

    S

    Cost of production of the marginal seller

    Value of the product for the marginal buyer

    D

    Q

    Q*


    If q is lower than the equilibrium q
    If Q is lower than the equilibrium Q… Q…

    P

    S

    Value of the product for the marginal buyer

    Cost of production of the marginal seller

    D

    Q

    Q*


    Conclusion the market equilibrium is efficient
    Conclusion: The Market Equilibrium is efficient Q…

    The market equilibrium quantity maximizes total surplus:At any other quantity, can increase total surplus by moving toward the market equilibrium quantity.

    P

    S

    D

    Q

    Q*



    A binding price floor and cs
    A binding price floor and CS Q…

    P

    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

    S

    SURPLUS

    Min P

    P*

    D

    Q

    Q*

    QS

    QD


    A binding price floor and ps
    A binding price floor and PS Q…

    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.

    P

    S

    SURPLUS

    Min P

    P*

    D

    Q

    Q*

    QS

    QD


    A binding price floor and total surplus
    A binding price floor and total surplus Q…

    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

    P

    S

    SURPLUS

    Min P

    But what happens to this surplus?

    P*

    Deadweight Loss! (DWL)

    D

    Q

    Q*

    QS

    QD


    A binding price ceiling and cs
    A binding price ceiling and CS Q…

    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

    P

    S

    P*

    Max P

    SHORTAGE

    D

    Q

    Q*

    QD

    QS


    A binding price ceiling and ps
    A binding price ceiling and PS Q…

    P

    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

    S

    P*

    Max P

    SHORTAGE

    D

    Q

    Q*

    QD

    QS


    A binding price ceiling and total surplus
    A binding price ceiling and total surplus Q…

    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

    P

    S

    But what happens to this surplus?

    P*

    Deadweight Loss! (DWL)

    Max P

    SHORTAGE

    D

    Q

    Q*

    QS

    QD



    The effects of a tax

    P Q…

    Size of tax = $T

    S

    PB

    PE

    PS

    D

    Q

    QT

    QE

    The Effects of a Tax

    Equilibrium with no tax: Price = PE Quantity = QE

    Equilibrium with tax = $T per unit:

    Buyers pay PB

    Sellers receive PS

    Quantity = QT


    Tax revenue

    P Q…

    Size of tax = $T

    PB

    PS

    Q

    Tax Revenue

    Revenue from tax: $T x QT

    S

    PE

    D

    QT

    QE


    Government revenue and total surplus
    Government Revenue and Total Surplus Q…

    • 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 tax

    P Q…

    S

    PE

    D

    Q

    QE

    Before the Tax

    CS = A + B + C

    PS = D + E + F

    A

    Tax revenue = 0

    B

    C

    Total surplus= CS + PS

    = A + B + C + D + E + F

    E

    D

    F

    QT


    After the tax

    P Q…

    PB

    PS

    Q

    After the Tax

    CS = A

    PS = F

    A

    Tax revenue = B + D

    S

    B

    C

    Total surplus= A + B + D + F

    E

    D

    D

    F

    The tax reduces total surplus by C + E

    QT

    QE


    The dwl of a tax

    P Q…

    PB

    PS

    Q

    The DWL of a tax

    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.

    A

    S

    B

    C

    E

    D

    D

    F

    QT

    QE


    About the deadweight loss

    P Q…

    PB

    PS

    Q

    About the Deadweight Loss

    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.

    S

    D

    QT

    QE


    In our example a 4 dollars tax
    In our example: A 4 dollars tax Q…

    P

    S1

    S2

    The tax was imposed on the sellers

    The Supply curve shifts left

    There is a new equilibrium quantity and a new equilibrium price range.

    Equilibrium 2

    P*1

    P*2

    Equilibrium 1

    D

    Q

    Q*1

    Q*2


    What happens to the cs and the ps
    What happens to the CS and the PS? Q…

    P

    S1

    S2

    CS lost by buyers

    But what happens to this surplus?

    Tax revenue collected by the government

    P*1

    PB

    PS

    Deadweight Loss! (DWL)

    PS lost by sellers

    D

    Q

    Q*1

    Q*2


    Students turn analysis of tax

    P Q…

    $

    S

    D

    Q

    STUDENTS’ TURN:Analysis of tax

    The market for airplane tickets

    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.


    A c t i v e l e a r n i n g 1 answers to a

    P Q…

    $

    S

    P =

    D

    Q

    A C T I V E L E A R N I N G 1Answers to A

    The market for airplane tickets

    CS

    = ½ x $200 x 100

    = $10,000

    PS

    = ½ x $200 x 100

    = $10,000

    Total surplus

    = $10,000 + $10,000

    = $20,000


    A c t i v e l e a r n i n g 1 answers to b

    P Q…

    $

    S

    PB =

    PS =

    D

    Q

    A C T I V E L E A R N I N G 1Answers to B

    A $100 tax on airplane tickets

    CS

    = ½ x $150 x 75

    = $5,625

    PS = $5,625

    Tax revenue

    = $100 x 75

    = $7,500

    Total surplus = $18,750

    DWL = $1,250


    Discussion the airline tax relief
    Discussion: the airline tax relief Q…

    • 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?



    What determines the size of the dwl
    What Determines the Size of the DWL? Q…

    • 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 Q…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

    S

    Size of tax

    D

    Q

    DWL and the Elasticity of Supply


    Dwl and the elasticity of supply1

    P Q…

    S

    Size of tax

    D

    Q

    DWL and the Elasticity of Supply

    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…

    S

    Size of tax

    D

    Q

    DWL and the Elasticity of Demand

    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 demand1

    P Q…

    S

    Size of tax

    D

    Q

    DWL and the Elasticity of Demand

    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.


    Students turn elasticity and the dwl of a tax
    STUDENTS’ TURN Q…Elasticity and the DWL of a tax

    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?


    Answer
    Answer Q…

    • 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.

    • 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.

    • 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.


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