Some More Micro-Foundations for CBA

Consumer Surplus – The difference between what consumers would have been willing to pay and what they actually did pay. – Economic surplus gained by the buyers of a product. – Measured by the cumulative difference (adding up over all consumers) between their reservation price for each unit of the good, and the price they pay. Consumer Surplus © 2012 McGraw-Hill Ryerson Limited Ch7-2 LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

Producer Surplus – The difference between what producers do get for output and the minimum price they would have been willing to accept. – Economic surplus gained by the sellers of a product. – Measured by the cumulative difference (adding up over all producers) between the price they receive and their reservation price for each unit of the good. Producer Surplus © 2012 McGraw-Hill Ryerson Limited Ch7-3 LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

Consumer and Producer Surplus S D Consumer surplus Producer surplus © 2012 McGraw-Hill Ryerson Limited Ch7-4 LO3: Graphical representation of consumer surplus, producer surplus, and total economic surplus

: How Excess Demand Creates an Opportunity for a Surplus-Enhancing Transaction S D 1.25 © 2012 McGraw-Hill Ryerson Limited Ch7-5 $0.75 $0.25 At a market price of $1/litre, the most intensely dissatisfied buyer is willing to pay $2 for an additional litre, which a seller can produce at a cost of only $1. If this buyer pays the seller $1.25 for the extra litre, the buyer gains an economic surplus of $0.75 and the seller gains an economic surplus of $0.25.

How Excess Supply Creates an Opportunity for a Surplus-Enhancing Transaction S D 1.75 At a market price of $2/litre, dissatisfied sellers can produce an additional litre of milk at a cost of only $1, which is $1 less than a buyer would be willing to pay for it. If the buyer pays the seller $1.75 for an extra litre, the buyer gains an economic surplus of $0.25 and the seller gains an economic surplus of $0.75. © 2012 McGraw-Hill Ryerson Limited Ch7-6 Market Equilibrium and Mutually Beneficial Exchange $0.25 $0.75

Public vs. private goods Private goods – demand sums horizontally Public goods – demand sums vertically Consumer A demand falls to 0 MB is the marginal social benefit

Valuation in efficient markets – no effect on price. Increase in supply has no effect on price. Gross social benefits = net government revenue generated by the program + change in social surplus. Supply shift to the right (publicly provided good) increases benefits to consumers (S → S+q’). − The cost to the consumer of the new amount (q’) is offset by the benefits of consuming more − Only benefit is the increased revenue to supplier – government or (abq 1 q 0 ) Supply shifts due to cost reduction which increases benefits to producers. − Benefit is the increase in producer surplus (abde)

Valuation in efficient markets – supply reduces price Downward sloping demand Increase in supply cases price to fall and change in social surplus is abc. Three scenarios a.If goods are distributed free the increase in consumer surplus is cbq 1 q 0 and the total is area abc + cbq 1 q 0 b.If good goes to consumers without charge, some receive the product who would not have purchased at P 1. c.Assume q due to increase in supply arises from cost reduction − increase in consumer surplus is P 0 P 1 ab − change in producer surplus is P 0 ae-P 1 bd or ecbd-P 0 abP 1 Note that that the last scenario is the most realistic.

Valuation in inefficient markets – monopoly power reduces price Monopoly – market demand is the revenue schedule Marginal revenue is lower than the average revenue (MA<AR). Profit maximization at MC=MR Consumer surplus – P 0 P m a Producer surplus – P m abx The social surplus under monopoly is P 0 abx The social surplus under competition is P 0 cX. The deadweight loss is the reduction in social surplus due to monopoly. P0P0 X

Natural Monopoly Always defined by falling average cost over the region where demand exists for any price >0 Typical in capital intensive industries, or industries with high entry/exit barriers, and knowledge barriers Policies to deal with natural monopoly −Ignore and accept deadweight loss −Regulate (price so that price set at AC = AR) −Regulate (price so that MC=AR) −Allow free access (accept social cost that demand exceeds marginal cost) Natural monopolies usually erode due to technical change – high profits create incentives to innovate. Policy may create temporary monopolies to induce innovation (e.g., pharmaceuticals). Demand > 0, AC falling

Information asymmetry Present in every market Imbalance between information held by sellers and buyers −Buyers can have the edge in labour markets (they know what the job truly entails) −Sellers (job applicants) can have the edge if they fabricate experience. Where sellers have information, the presumption is that the demand would fall as addition product/service attributes become known to the buyer (D u → D i ). The information asymmetry transfers P u P i ca to the seller from the buyer, and the deadweight loss is acd. Policies −Caveat venditor and caveat emptor −Private market (Consumer Reports) −Public provision of information)

Negative Externality Externalities create a divergence of marginal private and marginal social costs. Negative externality MSC > MPC Positive externality MSC < MPC Negative externality reduces consumer and producer surplus S # - S* = social costs = WTP to avoid the costs. Market will under price good/service and too much is produced. Taxation is the standard policy with the level set “t”, price shifts to P # and quantity drops to Q #. Positive externalities work in reverse, subsidies to increase consumption. BenefitsCosts ConsumerA + B ProducerE + F Third PartiesB + C + F Gov. Rev.A + E Social BenefitC