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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…

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

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

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

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

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

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

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

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

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

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
  • 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

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

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

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

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

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?

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

$

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

$

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

$

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
  • 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?
  • 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.

P

S

Size of tax

D

Q

DWL and the Elasticity of Supply
dwl and the elasticity of supply1
P

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

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

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’ TURNElasticity 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
  • 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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