Download - 16 Market Welfare
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Lecture 16 Market Welfare
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Outline
1. Welfare1. Producer welfare
2. Consumer welfare
3. Competition and welfare
2. Policies
1. Sales tax2. Price ceiling
3. Free trade
4. Tariffs
5. Qoutas
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Perfect competition and welfare
Model of perfect competition is important for two reasons:
First, it is a pretty good approximation of many markets that have the
features that we discussed last time.
Second, we will show that perfect competition maximizes social welfare.
perfect competition is an useful benchmark.
How to measure social welfare? We know how to measure consumers welfare consumer surplus.
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Consumer Surplus
Consumer surplus (CS)
is the monetary
difference between the
maximum amount that
a consumer is willing to
pay for the quantity
purchased and what the
good actually costs.
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Consumer Surplus
Consumer surplus (CS)
is the area under the
inverse demand curve
and above the market
price up to the quantity
purchased by the
consumer.
Smooth inversedemand function
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Producer Welfare (in the short-run)
Producer surplus (PS) is
the difference between
the amount for which a
good sells (market price)
and the minimum amount
necessary for sellers to be
willing to produce it
(marginal cost).
Step function
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Producer Welfare (in the short-run)
Producer surplus (PS) is the
area above the inverse
supply curve and below the
market price up to the
quantity purchased by theconsumer.
Smooth inverse supply
function
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Producer Welfare (in the short-run)
Producer surplus is closely related to profit.
Profit:
Subtracting off fixed costs yields PS:
Producer surplus is useful for examining the effects of any
shock that doesnt affect a firms fixed costs.
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Total Welfare (in the short-run)
How should we measure societys welfare?
We will add the well-being of consumers and producers and
measure total welfare as W= CS + PS
In other words, we treat welfare of producers and consumers
equally. The idea is that producers ultimately are the same people as
consumers firms are owned by people and the owners are the
beneficiaries of producers welfare.
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How Competition Maximizes Welfare
Producing at price
higher and quantity
lower than the
competitive level of
output lowers totalwelfare
consumer surplus is
lower by area C+B
Producer surplus
increases by B andxlowers by C
Total welfare decreases
by C+E, which equals
DWL.
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How Competition Maximizes Welfare
Competitive equilibrium maximizes welfare because oftwo facts:
In equilibrium, price equals marginal costs, This comes from profit maximization ,
Consumers willingness to pay for the the last unit of outputis equal to the price This comes from the consumers problem
In sum, consumers value the last unit of output by exactlythe amount that it costs to produce it.
A market failure is inefficient production orconsumption, often because a prices exceeds marginalcost.
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Departures from competitive equilibrium and welfare
Departures from competitive equilibrium
Due to government policies
Due to actions of firms
Mergers lead to smaller number of firms on the market
Cartel agreements,
Advertisement may create false impression that products are not homgenuous
Due to consumers actions
Example: fair trade coffee
Example: buy local actions (Keep Austin Weird)
Because it is difficult to coordinate behavior of many consumers, this is the least
important source of thye departures from competitive equilibrium.
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Government Policies and Welfare
We will examine the impact of different types of governmentpolicies
Policies that create a wedge between supply and demandcurves Sales tax
Price floor Price ceiling
Policies that shift supply curve Restricting the number of firms
Raising entry and exit costs
Policies that affect trade Trade ban
Tariffs
quotas
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Policies That Create a Wedge Between Supply and
Demand Curves: Sales Tax
Sales Tax A new sales tax causes the price that consumers pay to rise and the
price that firms receive to fall.
The former results in lower CS
The latter results in lower PS New tax revenue is also generated by a sales tax and, assuming the
government does something useful with the tax revenue, it should
be counted in our measure of welfare:
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Policies That Create a Wedge Between Supply and
Demand Curves: Sales Tax
Constant sales tax of
11c per unit
Sales tax creates
wedge that generatestax revenue ofB+D
and DWL ofC+E.
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Policies That Create a Wedge Between Supply and
Demand Curves: Sales subsidy
Demand D(p)=900-3p
Supply S(p)=-200+2p
Equilibrium p*=220, q*=D(p*)=S(p*)=240
Consumer surplus CS=
Producers surplus
Total welfare
( ) [ ] ( ) KKKKKppdpp 6.96.72198135270|5.19003900 3002203/900
220
2 ===
( ) [ ] ( ) KKKKKppdpp 4.1410204.4844|2002200 220100
220
100
2 =++=+=+
KKKPSCS 244.146.9 =+=+
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Policies That Create a Wedge Between Supply and
Demand Curves: Sales subsidy
Sales subsidy s=100$ Producers receive price p for each unit product
Consumers pay p-s for each unit
New equlibrium D(p-s)=S(p)
Equlibrium price p=280
Equilibrium quantity q=D(p-s)=S(p)=360
Consumer surplus
Producer surplus
Governments expenditure
Total welfare
( ) [ ] ( ) KKKKKppdpp 6.216.48162135270|5.19003900 300180
3/900
180
2 ===
( ) [ ] ( ) KKKKKppdpp 4.3210204.7856|2002200 280100
280
100
2 =++=+=+K36360*100 =
KKKKGEPSCS 18364.326.21'' =+=+
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What to tax?
The government has various goals: It needs to collect money that it spends on itself, defense, firefighters, etc.
Social goals: social security, redistribution of income, unemployment benefits,
etc.
Political goals: it may want to grant money to influential political groups
(subsidies to farmers) National security goals: it may want to keep domestic production of some
goods (oil, tanks)
The goal of optimal tax (or subsidy) policies Minimize the loss of efficiency
Tax goods with steep demand (very low price elasticity of demand)
For example, cigarettes, alcohol, food.
Tax goods that are consumed proportionally more by people that are rich or
young
Subsidize (or dont tax too heavily) food and domestic oil
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Policies That Create a Wedge Between Supply and
Demand Curves: Price Ceilling
Price Ceiling
Aprice ceiling, or maximum price, is the highest price a firm can
legally charge.
Example: rent controlled apartments
Maximum price is only binding if it is below the competitiveequilibrium price.
Deadweight loss may underestimate true loss for two reasons:
1. Consumers spend additional time searching and this extra search is
wasteful and often unsuccessful.
2. Consumers who are lucky enough to buy may not be the
consumers who value it the most (allocative cost).
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Policies That Create a Wedge Between Supply and
Demand Curves: Price Ceilling
Price ceiling creates wedge that generates excess demand
ofQd Qs and DWL ofC+E.
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Policies That Create a Wedge Between Supply and
Demand Curves: Price Floor
Price Floor
Aprice floor, or minimum price, is the lowest price a consumer can legally
pay for a good.
The government promises to buy any excess supply necessary to sustain the price
Example: agricultural products
Minimum price is guaranteed by government, but is only binding if it is
above the competitive equilibrium price.
Deadweight loss generated by a price floor reflects two distortions in the
market:
1. Excess production: More output is produced than consumed
2. Inefficiency in consumption: Consumers willing to pay more for last unit
bought than it cost to produce
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Policies That Create a Wedge Between Supply and
Demand Curves: Price Floort
Price floor creates
wedge that
generates excess
production ofQs Qd
and DWL ofC+F+G.
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Policies That Shift Supply Curves:
Restricting the number of firms Restricting the
number of firms
causes supply to
shift left
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Policies That Shift Supply Curves: Entry
and Exit Barriers
Entry Barriers: raising entry costs A LR barrier to entryis an explicit restriction or a cost that applies
only to potential new firms (e.g. large sunk costs).
Indirectly restricts the number of firms entering
Costs of entry (e.g. fixed costs of building plants, buying
equipment, advertising a new product) are not barriers to entry
because all firms incur them.
Exit Barriers: raising exit costs
In SR, exit barriers keep the number of firms high
In LR, exit barriers limit the number of firms entering Example: job termination laws
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Comparing Both Types of Policies:
Trade
Finally, we use welfare analysis to examine government policies that areused to control international trade:
1. Free trade
2. Ban on imports (no trade)
3. Set a tariff
4. Set a quota
Welfare under free trade serves as the baseline for comparison to effects
of no trade, quotas and tariffs.
Assume zero transportation costs and horizontal supply curve for the
potentially imported good
Assumptions imply U.S. can import as much as it wants atp* per unit.
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Comparing Both Types of Policies:
Trading Crude Oil Daily domestic (U.S.) demand:
Daily domestic (U.S.) supply:
Foreign supply curve is horizontal at the prevailing world price of$14.70 per barrel.
Comparison offree trade and no trade (e.g. total ban on imports of
crude oil) demonstrates the welfare benefit to society of free trade.
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Free Trade vs. No Trade
With free trade, domestic
producers supply Q=8.2
and imports ofQ=4.9 fill
out our additional
demand for oil at the low
world price.
With no trade, we lose
surplus equal to area C.
This is the DWL of a
total ban on trade.
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Tariffs
A tariffis essentially a tax on imports and there are two commontypes:
Specific tariff is a per unit tax
Ad valorem tariff is a percent of the sales price
Assuming the U.S. government institutes a tariff on foreign crude
oil:
1. Tariffs protect American producers of crude oil from foreign
competition.
2. Tariffs also distort American consumers consumption by inflating
the price of crude oil.
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Tariffs
A $5 per unit (specific) tariffraises the world price,
which increases the
quantity supplied
domestically and decreases
the quantity imported.
Tariff revenue of area D is
generated by the U.S.
DWL is equal to C+E.
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Quotas
A quota is a restriction on the amount of a good that can be
imported.
When analyzed graphically, a quota looks very similar to a tariff.
A tariff is a restriction on price
A quota is a restriction on quantity
One can find a tariff and a quota that generate the sameequilibrium
The only difference is that quotas do not generate any additional
revenue for the domestic government.
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Quotas
An import quota of 2.8
millions of barrels of oil per
day increases the quantity
supplied domestically and
decreases the quantity
imported.
Equivalent to $5 per unit
tariff
DWL is equal to C+D+E
because no tariff revenue is
generated.
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Next lecture
As we have seen today, typically any intervention that moves the marketfrom its competitive equilibrium
Next time, we will prove it formally we will show that any otucome that
cannot be obtained in a competitive equilibrium, cannot be efficient.