2 Recall: Consumer surplus is the difference between what the consumer has to pay for a good and the amount he/she is willing to pay.It is the area under the demand curve & above the price.PSP*DQ*Q
3 Producer surplus is the difference between what the producer receives for the good and the amount he/she must receive to be willing to provide the good.It is the area above the supply curve & below the price.PSP*DQ*Q
4 Social Welfare Social welfare = consumer surplus + producer surplus. In cases where there is tax revenue involved, that is added as well in the computation of social welfare.
5 Let’s look at the sizes of the consumer & producer surpluses at various output levels.
6 At quantity Q1 & price P1, consumer surplus is the purple area & producer surplus is the green area.
7 As we increase the quantity & reduce the price, the total area of the consumer & producer surpluses increases,PSP2DQQ2
9 until we reach the perfectly competitive equilibrium. SP*DQ*Q
10 We can not continue this process beyond that equilibrium however. Output levels greater than the equilibrium will only be purchased at prices below the equilibrium price, but they will only be produced at prices above the equilibrium price.So there is no price at which those output levels will be produced & sold.PSPSPDDQ4Q
11 We have found that social welfare, which equals total consumer & producer surplus, is maximized at the perfectly competitive equilibrium.
12 How do we compare the social welfare of two different situations? Calculate the welfare from situation 1 by summing its consumer surplus and producer surplus: W1 = CS1 + PS1.Calculate the welfare from situation 2 by summing its consumer surplus and producer surplus: W2 = CS2 + PS2.Calculate the difference, W2 – W1 = (CS2 + PS2) – (CS1 + PS1).This tells us the gain or loss of welfare of one situation relative to the other.When a policy results in a loss of welfare to society, that loss is often referred to as the deadweight loss.
13 Notice that we just calculated the social welfare gain or loss as the difference in combined consumer and producer surplus, W2 – W1 = (CS2 + PS2) – (CS1 + PS1).An alternative equivalent way is the following.Calculate the change in consumer surplus: ΔCS = CS2 – CS1 .Calculate the change in producer surplus: ΔPS = PS2 – PS1 .Add to get the total gain or loss in social welfare: ΔCS + ΔPS = (CS2 – CS1) + (PS2 – PS1)
14 Let’s explore the welfare effects of some government policies.
15 Price Ceilings P S P* D Q Q* Without the ceiling our consumer & producer surpluses are as shown by the purple & green areas.PSP*DQ*Q
16 With price ceiling, Pc , the consumer & producer surpluses are as shown. QQc
17 Consumers have lost area V but gained area U. PSVUPcDQQc
18 The consumers who gain are those who get the product at a lower price. The consumers who lose are those who are no longer able to buy the product because there is less supplied.PSVUPcDQQc
19 In the graph shown, area U is larger than area V, so consumers as a whole gain. However, if area U is smaller than area V, consumers lose.PSVPcUDQQc
21 So area U just moved from producers to consumers, but areas V and W were lost to everyone. PcUDQQc
22 Area V+W is the difference in the total consumer and producer surplus with and without the policy (CS2 + PS2) – (CS1 + PS1).PSVIt is the deadweight loss to society that results from the policy.WPcDQQc
23 Price Ceiling Example: Rent Controls Suppose in the absence of controls, equilibrium rent would be $8,000 per year and quantity would be 2 million apartments.Rent (thousands of dollars per year)S987DQuantity of apartments (millions)
24 Based on the graph, determine the effects on consumers, producers, & society as a whole. Rent (thousands of dollars per year)S987DQuantity of apartments (millions)
25 U = (1. 8 million) (8,000 – 7,000) = $1,800 million V = (1/2)(0 U = (1.8 million) (8,000 – 7,000) = $1,800 million V = (1/2)(0.2 million)(1,000) = $100 million W = (1/2)(0.2 million)(1,000) = $100 millionRent (thousands of dollars per year)S987VWUDQuantity of apartments (millions)
26 Consumers gain U – V = $1,800 million - $100 million = $1,700 million Consumers gain U – V = $1,800 million - $100 million = $1,700 million. Producers lose U + W = $1,800 million + $100 million = $1,900 millionRent (thousands of dollars per year)S987VWUDQuantity of apartments (millions)
27 Producers lose $200 million dollars more than consumers gain Producers lose $200 million dollars more than consumers gain. So there is a deadweight loss of $200 million per year.Rent (thousands of dollars per year)S987VWUDQuantity of apartments (millions)
28 Are the effects of price floors similar to those of price ceilings Are the effects of price floors similar to those of price ceilings? Let’s see.
29 Once again without the floor, consumer & producer surpluses are as shown by the purple & green areas.SDPQP*Q*
30 If a price floor of Pf is imposed, consumer & producer surpluses are these purple & green areas. QQf
33 Again the deadweight loss is area V+W . PSPfVWDQQf
34 In the analysis that we just did, we assumed that producers cut their output so that it was just equal to Qf, the quantity demanded.PSPfDQQf
35 However, it doesn’t always work that way However, it doesn’t always work that way. In the case of agricultural price supports, producers grow as much as they want and the government buys the surplus.
36 At a price of Pf, producers will supply Qs. The resulting surplus is Qs – Qd, which is purchased by the government with taxpayer money at price Pf.This represents a cost to consumers of the gray rectangle T.PSPfP*TDQQd Qs
37 Consumer surplus also falls by area U + V. So consumers lose a total of T + U + V .PSPfP*UVTDQQd Qs
38 Remember that producer surplus is the area under the price and above the supply curve. So producer surplus increases from the orange areato the yellow area.PSPfP*DQQf
39 The increase in producer surplus is the pink area. PfP*DQQf
40 That gain to producers is much smaller than the loss to consumers (T + U + V). PfP*UTherefore, as a result of the price floor, total social welfare falls.VTDQQd Qs
42 Suppose a tax of $0.25 per unit is imposed on an item. From the consumer’s perspective, it is as if the supply curve has shifted up vertically by the tax amount of $0.25.S’PS$0.251.50DQ50
43 The equilibrium quantity falls & the equilibrium price rises. Although the price rises, it does not rise by the full amount of the tax.S’PS$0.251.50$0.25DQ
44 The buyer pays (in this example) 15 cents more than before The buyer pays (in this example) 15 cents more than before. The seller gets 25 cents less than the buyer pays. So the seller gets 10 cents less than before.S’PS$0.251.651.501.40DQ
45 Consumer surplus falls by area U + V. 1.651.501.40UVDQ
46 Producer surplus falls by area X + W. 1.651.501.40WXDQ
47 Tax revenues equal the tax per unit times the number of units sold Tax revenues equal the tax per unit times the number of units sold. The area U + X is the government tax revenue.S’PS1.651.501.40UXDQ
48 The total change in social welfare is the change in consumer surplus [-(U + V)] plus the change in producer surplus [-(X + W)] plus the government revenue (U + X), which equals [-U - V] + [-X - W] + (U + X) = – V – W or – (V + W) .S’PS1.651.501.40UVThe negative sign in front of the V + W indicates that it is a loss of V + W.WXDQ
49 So area V + W is deadweight loss. PS1.651.501.40VWDQ
50 Next, we’ll examine the effects of international trade and of tariffs & quotas.
51 Domestic Demand Curve (DD ): Demand for Cars by U.S. Consumers priceDDquantity
52 Domestic Supply Curve (SD ): Supply of Cars to U. S. Consumers by U. S Domestic Supply Curve (SD ): Supply of Cars to U.S. Consumers by U.S. ProducerspriceSDDDquantity
53 Without trade: price is P1 & quantity is Q1. SDP1ODDQ1quantity
54 Without trade: consumer surplus is area A ... priceSDP1OADDQ1quantity
55 ... and producer surplus is area B. priceSDP1OBDDQ1quantity
56 Total Supply Curve (ST ): Supply of Cars to U. S Total Supply Curve (ST ): Supply of Cars to U.S. Consumers by All ProducerspriceSDP1OSTDDQ1quantity
57 With trade: price is P2 and quantity purchased by U.S. consumers is Q2. SDSTDDQ1 Q2quantity
58 The quantity sold by U.S. producers is Q0 and the quantity of imports is Q2 – Q0. priceP1P2OSDSTDDQ0 Q1 Q2quantity
59 With trade: Consumer Surplus is area C priceP1P2OSDCSTDDQ0 Q1 Q2quantity
60 Recall: Without trade, consumer surplus was area A. Consumers have gained area C-A from trade.priceP1P2OSDASTC – ADDQ0 Q1 Q2quantity
61 Suppose we are viewing this issue from the perspective of the U. S Suppose we are viewing this issue from the perspective of the U.S. government.Our concern is the welfare of U.S. consumers and U.S. producers (not foreign producers).Domestic producer surplus is the area above the domestic supply curve and below the price.
62 With trade: (Domestic) Producer Surplus is area D. priceP1P2OSDSTDDDQ0 Q1 Q2quantity
63 Recall: Without trade, producer surplus was area B. priceP1P2OSDSTBDDQ0 Q1 Q2quantity
64 Producers have lost area B – D from trade. priceP1P2OSDSTB - DDDQ0 Q1 Q2quantity
65 So consumers have gained area C – A ... priceP1P2OSDSTC – ADDQ0 Q1 Q2quantity
66 ... and producers have lost area B – D. priceP1P2OSDSTB - DDDQ0 Q1 Q2quantity
67 So for U.S. citizens, there is a net gain from trade of area G. priceP1P2OSDSTGDDQ0 Q1 Q2quantity
68 Putting it all together: Relative to the no-trade situation, when there is free trade, the price paid by U.S. consumers is lower.the quantity purchased by U.S. consumers is higher.there is a gain in consumer surplus.there is a loss of producer surplus.there is a net gain to U.S. citizens or a gain in total social welfare.
69 The net gain we just found was the gain from free trade, that is, trade without tariffs or quotas. Let’s look now at the effect that quotas & tariffs have on consumer & producer surplus.In the analysis that follows, we assume that a single country’s production of a good is small relative to total world production. Therefore, the equilibrium price of the good in the world as a whole is not changed by the policy of a single country.Suppose a tariff of t dollars is imposed on cars imported to the U.S.
70 SD price P2+ t ST P2 O DD quantity Suppose a tariff of t dollars is imposed on cars imported to the U.S.The price of domestic cars in the U.S. will rise so that the new price equals the pre-tariff price + the tariff t.SDpricetP2+ tSTP2ODDQ Q Q2quantity
71 SD price P2+ t P2 ST O DD quantity The total number of cars purchased by U.S. consumers will fall to Q2’, the number of domestic cars purchased will rise to Q0’, and the number of imported cars will fall to Q2’ – Q0’.SDpriceP2+ tP2OSTDDQ0 Q0’ Q Q2’ Q2quantity
72 How will consumer & domestic producer surplus change?
73 Consumer surplus will fall from this area SDpriceP2+ tP2OSTtDDQ0 Q0’ Q Q2’ Q2quantity
74 to this areaSDpriceP2+ tP2OSTDDQ0 Q0’ Q Q2’ Q2quantity
75 which is a loss of consumer surplus of this area. SDpriceP2+ tP2OSTtDDQ0 Q0’ Q Q2’ Q2quantity
76 Domestic producer surplus rises from this area SDpriceP2+ tP2OSTDDQ0 Q0’ Q Q2’ Q2quantity
77 to this areaSDpriceP2+ tP2OSTDDQ0 Q0’ Q Q2’ Q2quantity
78 which is an increase in domestic producer surplus of this area. SDpriceP2+ tP2OSTDDQ0 Q0’ Q Q2’ Q2quantity
79 SD price P2+ t P2 ST O DD quantity Government revenues from the tariff are the number of imports times the tariff per import, which is this area.SDpriceP2+ tP2OSTtDDQ0 Q0’ Q Q2’ Q2quantity
80 SD price P2+ t P2 ST O DD quantity The deadweight loss from the tariff is the change in consumer surplus + the change in domestic producer surplus + the government tariff revenue.SDSo the deadweight loss is the area of these two triangles.priceP2+ tP2OSTDDQ0 Q0’ Q Q2’ Q2quantity
81 What is the effect of an import quota instead of a tariff? Suppose the government establishes a quota of q .Then the price of cars will rise until the quantity supplied by domestic producers + the import quota = the quantity demanded by U.S. consumers.
82 Suppose the quota is q = Q2’ – Q0’. The new price will be P3.SDpriceP3P2OSTDDQ0 Q0’ Q Q2’ Q2quantity
83 Again consumer surplus falls by this area. SDpriceP3P2OSTtDDQ0 Q0’ Q Q2’ Q2quantity
84 Domestic producer surplus increases by this area. SDpriceP3P2OSTDDQ0 Q0’ Q Q2’ Q2quantity
85 SD price P3 P2 ST O DD quantity However there is no additional government revenue. So the deadweight loss from a quota is this area which is greater than the deadweight loss from a comparable tariff.SDpriceP3P2OSTDDQ0 Q0’ Q Q2’ Q2quantity
86 We have shown that a perfectly competitive economy maximizes the total net gain of consumers & producers.We saw that deadweight losses (reductions in economic efficiency) resulted if the government imposes a price ceiling, price floor, import tariff or quota, or sales tax.The general theme seems to be that the economy would be better off if the government quit meddling & let competitive markets alone.This is frequently sound advice but not always.There are often other objectives besides economic efficiency to be considered (for example, equity or fairness).Also, there may be externalities involved.In addition, sometimes markets are not competitive.