1. Copyright © 2002 by Thomson Learning, Inc. to accompany Exploring Economics 3rd Edition by Robert L. Sexton Copyright © 2005 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, 3 rd Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-324-26086-5 A Lecture Presentation

2. Copyright © 2002 by Thomson Learning, Inc. Market Efficiency and Welfare Chapter 7

3. Copyright © 2002 by Thomson Learning, Inc. 7.1 Consumer Surplus and Producer Surplus Using the tools of consumer and producer surplus, we can demonstrate the efficiency of a competitive market. Using the tools of consumer and producer surplus, we can demonstrate the efficiency of a competitive market. We can also use the tools of consumer and producer surplus to study the welfare effects of government policy—rent controls, taxes, and agricultural support prices. We can also use the tools of consumer and producer surplus to study the welfare effects of government policy—rent controls, taxes, and agricultural support prices.

4. Copyright © 2002 by Thomson Learning, Inc. Welfare to economists does not mean a government payment to the poor; rather, it is a way we measure the impact of a policy on a particular group—like consumers or producers. Welfare to economists does not mean a government payment to the poor; rather, it is a way we measure the impact of a policy on a particular group—like consumers or producers.

5. Copyright © 2002 by Thomson Learning, Inc. What a consumer actually pays for a good is usually less than what she is willing to pay. What a consumer actually pays for a good is usually less than what she is willing to pay. The monetary difference between what the consumer is willing and able to pay and the price the consumer actually pays is called consumer surplus. The monetary difference between what the consumer is willing and able to pay and the price the consumer actually pays is called consumer surplus. Consumer Surplus

6. Copyright © 2002 by Thomson Learning, Inc. If the consumer is a buyer of several units of a good, the earlier units will have greater marginal value and therefore create more consumer surplus because marginal willingness to pay falls as greater quantities are consumed in any period. If the consumer is a buyer of several units of a good, the earlier units will have greater marginal value and therefore create more consumer surplus because marginal willingness to pay falls as greater quantities are consumed in any period. Marginal Willingness to Pay Falls as More is Consumed

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8. Consumer surplus is shown graphically as the area under the demand curve (willingness to pay for the units consumed) and above the market price (what must be paid for those units). Consumer surplus is shown graphically as the area under the demand curve (willingness to pay for the units consumed) and above the market price (what must be paid for those units).

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10. Price Changes and Changes in Consumer Surplus Exhibit 3 shows the gain the consumer surplus associated with say a technological advance that shifts the supply curve to the right. Exhibit 3 shows the gain the consumer surplus associated with say a technological advance that shifts the supply curve to the right. As a result, equilibrium price falls and quantity rises. As a result, equilibrium price falls and quantity rises.

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12. Producer surplus is the difference between what a producer is paid for a good and the seller's cost for producing each unit of the good. Producer surplus is the difference between what a producer is paid for a good and the seller's cost for producing each unit of the good. Because some units can be produced at a cost that is lower than the market price, the seller receives a surplus, or net benefit, from producing those units. Because some units can be produced at a cost that is lower than the market price, the seller receives a surplus, or net benefit, from producing those units. Producer Surplus

13. Copyright © 2002 by Thomson Learning, Inc. Producer surplus for a particular unit is the difference between the market price and the seller's cost of producing that unit. Producer surplus for a particular unit is the difference between the market price and the seller's cost of producing that unit. Total producer surplus is shown graphically as the area under the market price (what was paid for those units) and above the supply curve (the total cost, or sum of marginal costs, of producing those units). Total producer surplus is shown graphically as the area under the market price (what was paid for those units) and above the supply curve (the total cost, or sum of marginal costs, of producing those units).

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15. A higher market price due to an increase in demand will increase total producer surplus. A higher market price due to an increase in demand will increase total producer surplus. Part of the added surplus is due to a higher price for the quantity already being produced. Part of the added surplus is due to a higher price for the quantity already being produced. Part is due to the expansion of output made profitable by the higher price. Part is due to the expansion of output made profitable by the higher price.

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17. With the tools of consumer and producer surplus, we can better analyze the total gains from exchange. With the tools of consumer and producer surplus, we can better analyze the total gains from exchange. The demand curve represents a collection of maximum prices that consumers are willing and able to pay for additional quantities of a good or service. The demand curve represents a collection of maximum prices that consumers are willing and able to pay for additional quantities of a good or service. Market Efficiency and Producer and Consumer Surplus

18. Copyright © 2002 by Thomson Learning, Inc. The supply curve represents a collection of minimum prices that suppliers require to be willing to supply additional quantities of that good or service. The supply curve represents a collection of minimum prices that suppliers require to be willing to supply additional quantities of that good or service. At the market equilibrium, consumers receive consumer surplus and producers receive producer surplus. At the market equilibrium, consumers receive consumer surplus and producers receive producer surplus. Both benefit from trading every unit up to the market equilibrium output. Both benefit from trading every unit up to the market equilibrium output.

19. Copyright © 2002 by Thomson Learning, Inc. Buyers purchase each good, except for the very last unit, for less than the maximum amount that they would have been willing to pay. Buyers purchase each good, except for the very last unit, for less than the maximum amount that they would have been willing to pay. Sellers receive more than the minimum amount they would have been willing to accept to supply the good. Sellers receive more than the minimum amount they would have been willing to accept to supply the good.

20. Copyright © 2002 by Thomson Learning, Inc. Once the equilibrium output is reached at the equilibrium price, all of the mutually beneficial trade opportunities between the suppliers and the demanders will have taken place. Once the equilibrium output is reached at the equilibrium price, all of the mutually beneficial trade opportunities between the suppliers and the demanders will have taken place. The sum of consumer and producer surplus is maximized. The sum of consumer and producer surplus is maximized.

21. Copyright © 2002 by Thomson Learning, Inc. The total welfare gains to the economy from trade in a good is the sum of the consumer and producer surplus created. The total welfare gains to the economy from trade in a good is the sum of the consumer and producer surplus created. Consumers benefit from additional amounts of consumer surplus and producers benefit from additional amounts of producer surplus. Consumers benefit from additional amounts of consumer surplus and producers benefit from additional amounts of producer surplus.

22. Copyright © 2002 by Thomson Learning, Inc. Improvements in welfare come from additions to both consumer and producer surplus. Improvements in welfare come from additions to both consumer and producer surplus. In competitive markets, where there are large numbers of buyers and sellers at the market equilibrium price and quantity, the net gains to society are as large as possible. In competitive markets, where there are large numbers of buyers and sellers at the market equilibrium price and quantity, the net gains to society are as large as possible.

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24. Not producing the efficient level of output, in this case 4 million units, leads to what economists call a deadweight loss. Not producing the efficient level of output, in this case 4 million units, leads to what economists call a deadweight loss. A deadweight loss will often result in a reduction of both consumer and producer surpluses—it is the net loss of total surplus that results from the misallocation of resources. A deadweight loss will often result in a reduction of both consumer and producer surpluses—it is the net loss of total surplus that results from the misallocation of resources.

25. Copyright © 2002 by Thomson Learning, Inc. 7.2 The Welfare Effects of Taxes, Subsidies, and Price Controls We can use consumer and producer surplus to measure the welfare effects of various government programs—taxes and price controls. We can use consumer and producer surplus to measure the welfare effects of various government programs—taxes and price controls. When economists use the term welfare effects of a government policy, they are referring to the gains and losses associated with government intervention. When economists use the term welfare effects of a government policy, they are referring to the gains and losses associated with government intervention.

26. Copyright © 2002 by Thomson Learning, Inc. Using Consumer and Producer Surplus to Find the Welfare Effects of a Tax The tax is illustrated by the vertical distance between the supply and demand curve at the new after-tax output—shown as the bold vertical line in Exhibit 1. The tax is illustrated by the vertical distance between the supply and demand curve at the new after-tax output—shown as the bold vertical line in Exhibit 1.

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28. Copyright © 2002 by Thomson Learning, Inc. In Exhibit 2, we can now use consumer and producer surplus to measure the amount of welfare loss associated with a tax. In Exhibit 2, we can now use consumer and producer surplus to measure the amount of welfare loss associated with a tax.

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30. The size of the deadweight loss from a tax, as well as how the burdens are shared between buyers and sellers, depends on the price elasticities of supply and demand. The size of the deadweight loss from a tax, as well as how the burdens are shared between buyers and sellers, depends on the price elasticities of supply and demand. That is, the more elastic the curves are, the greater the change in output and the larger the deadweight loss. That is, the more elastic the curves are, the greater the change in output and the larger the deadweight loss. Elasticity and the Size of the Deadweight Loss

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32. Copyright © 2002 by Thomson Learning, Inc. Elasticity differences can help us understand tax policy. Elasticity differences can help us understand tax policy. Those goods that are heavily taxed often have a relatively inelastic demand curve in the short run. Those goods that are heavily taxed often have a relatively inelastic demand curve in the short run. This means that the burden falls mainly on the buyer. This means that the burden falls mainly on the buyer. It also means that the deadweight loss to society is smaller than if the demand curve was more elastic. It also means that the deadweight loss to society is smaller than if the demand curve was more elastic.

33. Copyright © 2002 by Thomson Learning, Inc. The Welfare Effects of Subsidies If taxes cause deadweight or welfare losses, do subsidies create welfare gains? If taxes cause deadweight or welfare losses, do subsidies create welfare gains? Think of a subsidy as a negative tax. Think of a subsidy as a negative tax. In Exhibit 4, we see that the subsidy lowers the price to the buyer and increases the quantity exchanged. In Exhibit 4, we see that the subsidy lowers the price to the buyer and increases the quantity exchanged.

34. Copyright © 2002 by Thomson Learning, Inc. Producers lose producer surplus from the lower imposed ceiling price. Producers lose producer surplus from the lower imposed ceiling price. The net loss is the resulting deadweight loss triangle, just as with a tax. The net loss is the resulting deadweight loss triangle, just as with a tax.

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36. We can see the welfare effects of a price ceiling by observing the change in consumer and producer surplus from the implementation of the price ceiling. We can see the welfare effects of a price ceiling by observing the change in consumer and producer surplus from the implementation of the price ceiling. Consumers can now buy at a lower price, but cannot buy as much as before (since suppliers will not supply as much). Consumers can now buy at a lower price, but cannot buy as much as before (since suppliers will not supply as much). Price Ceilings and Welfare Effects

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38. We can also use consumer and producer surplus to see the welfare effects of a price floor, where the government buys up the surplus. We can also use consumer and producer surplus to see the welfare effects of a price floor, where the government buys up the surplus. Consumers lose consumer surplus due to the higher price floor, and must also pay taxes to pay for the buying and storing of the unsold (to consumers) output. Consumers lose consumer surplus due to the higher price floor, and must also pay taxes to pay for the buying and storing of the unsold (to consumers) output. Price Floors

39. Copyright © 2002 by Thomson Learning, Inc. Producers gain producer surplus from the higher prices and greater output (since the government buys up what is not sold on the market). Producers gain producer surplus from the higher prices and greater output (since the government buys up what is not sold on the market). On net, there is a deadweight loss from the price floor, illustrated in Exhibit 6. On net, there is a deadweight loss from the price floor, illustrated in Exhibit 6.

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41. Copyright © 2002 by Thomson Learning, Inc. Welfare Effects of a Price Floor When the Government Buys the Surplus Who gains and who loses under price support programs when the government buys the surplus? Who gains and who loses under price support programs when the government buys the surplus? In Exhibit 7, the equilibrium price and quantity without the price floor are at P 1 and Q 1, respectively. In Exhibit 7, the equilibrium price and quantity without the price floor are at P 1 and Q 1, respectively.

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43. In Exhibit 8, if the government sets the target price at P 2, producers will supply Q 2 and sell all they can at the market price, P M. In Exhibit 8, if the government sets the target price at P 2, producers will supply Q 2 and sell all they can at the market price, P M.

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