2. PRODUCER AND CONSUMER SURPLUS Colander 8 th ed Ch. 8 (179 – 180) Colander 9 th ed Ch. 7 Baumol Ch. 5 (94-96) 1

3. Market Demand: Value consumers place on each unit purchased 2 The distance to the Demand curve tells us how much consumers are willing to pay for a given quantity of the good. 100th $10 $1 The distance to the Demand curve tells us how much the last unit is worth to the consumer 500th D 1st $11 Willing to pay $10 for the 100 th unit Willing to pay $1 for the 500 th unit When she buys 100 units: she is willing to pay $10 only for the last unit

4. 3 Willingness to Pay D 1 10 Willingness to pay 23 8 6 $10 for one unit $8 for the second unit $6 for the third unit 10 8 6 $24

5. © 2000 Claudia Garcia-Szekely 4 Consumer Surplus The difference between the price the consumer actually pays and the price s/he is willing to pay.

6. 5 Willingness to Pay D 60 20 60 15 5 If the price is $0.05 60*0.2=$12 60*0.15=$960*0.05=$3 $24 Consumer Actually pays $0.05 x 180 = $9 Long distance phone service Minutes $9 Consumer is willing to pay $24 for 180 minutes Consumer Surplus = 24 – 9= 15 $15 Cents per minute

7. 6 Willingness to Pay D 30 9 7 5 Consumer Surplus If the price is $0.05 10 8 6 Consumer Actually pays

8. 7 Consumer Surplus D Willingness to pay 1 Minute intervals 180 minutes What the consumer actually pays = 0.05*180 Consumer surplus If the price is $0.05

9. © 2000 Claudia Garcia-Szekely 8 Consumer Surplus The amount consumers are willing to pay MINUS amount they actually pay The area below the demand curve and above the price the consumer pays

10. 9 Consumer Surplus D Willingness to pay 1 Minute intervals 180 minutes What the consumer actually pays = Price x Quantity Consumer surplus = Area of triangle If the price is $0.05

11. 10 Consumer surplus in a Perfectly Competitive market D Supply = Cost Number of units purchased Consumer Surplus Price Consumer Pays What the consumer actually pays = Price x Quantity

12. Market Supply 11 The distance to the Supply curve tells us how much it costs to produce a given quantity of the good. $3 $1 The distance to the Supply curve tells us the cost of producing the last unit S 1st Cost $1 2nd Cost $3 Producer would be willing to produce this unit if and only if the price covers the cost Price Quantity Produced If the price is $3 per unit, this price covers the cost of producing the first and the second units $10 20th Cost $10 If the price is $10 per unit, this price covers the cost of producing 20 units

13. © 2000 Claudia Garcia-Szekely 12 Producer Surplus The difference between the per unit price the producer receives and his/her per unit cost.

14. 13 Producer Surplus S = Cost 2 4 6 123 If The market price is $6 Producer Surplus = 18 – 12 = 6 Cost=12 TR = $18 PS = 6 The area above the supply curve and below the price the producer receives

15. 14 Producer Surplus under Perfect Competition D Supply = Cost Quantity Sold PS 10 Price producer receives 2

16. 15 Consumer surplus in a Perfectly Competitive market: D Supply = Cost Equilibrium Quantity = 4000 CS = Triangle Area 10 Equilibrium Price = $5 2 Triangle Area = Base x Height x ½ Triangle Area = 4000 x (10-5) x 1/2

17. 16 Producer Surplus under Perfect Competition D Supply/Cost 4000 PS = Triangle Area 10 5 2 Triangle Area = Base x Height x ½ Triangle Area = 4000 x (5-2) x 1/2 Triangle Area = Base x Height x ½ Triangle Area = 4000 x (5-2) x 1/2

18. 17 Perfect Competition D Q Supply/Cost Qe=4000 C S P S 10 5 2

19. 100th1000th S (cost) Cost $10 $10 $1 Cost $1 Willing to pay $10 D (Value given by consumer) Willing to pay $1 Optimum Output Level

20. S (cost) Cost Willing to pay D (Value given by consumer) Willing to pay Optimum Output Level is the Equilibrium Quantity Equilibrium QThese units should be produced These units should NOT be produced Consumers are willing to pay the cost of bringing these units to market Consumers are not willing the pay the cost of bringing these units to market Equilibrium Quantity

21. 20 D S 27 16.5 8.5 30 11 3 43 24.5 Practice Calculate Consumer and Producer Surplus at equilibrium

22. THE EFFECT OF PRICE CONTROLS Colander 8 th ed. Ch. 8 (187-188) Colander 9 th ed. Ch. 7 Baumol Ch. 4 21

23. A Price Ceiling: Government prohibits any price above $3 D Q S P=$3 C S P S Qd =6000 Shortage Qs =2000 CS PS Consumer surplus when only 2000 units are purchased due to shortage 4000 Lost consumer and producer surplus when only 2000 units are purchased and sold at $3 Producer surplus when only 2000 units are sold Producer surplus when 4000 units are purchased at equilibrium Consumers purchase 2000 at $3 per unit Consumer surplus when 4000 units are purchased at equilibrium 10 5 2

24. 23 The Effect of a Price Ceiling D S 600 3,900 2,200 CS at equilibrium 300 CS with the ceiling Gain to consumer Loss to Consumer 7,300 1000 900 CS: Area below D Above Price CS: Area below D Above Price

25. 24 PS at equilibrium The Effect of a Price Ceiling D S PS Loss to Producer 3,900 2,200 600 300 1000 7,300 900 PS: Area below Price Above S PS: Area below Price Above S

26. 25 CS A Price Ceiling has the same effect of charging a Tax to Producers and giving that money as a subsidy to Consumers Loss to Producer D S 600 3,900 2,200 300 CS PS Gain to consumer D S 600 3,900 2,200 CS 300 Tax Subsidy

27. 26 Welfare Loss From Price Ceiling D Q $ S P=$2 4 C S P S $1 CS PS Welfare Loss

28. 27 Welfare Loss From Price Ceiling D Q S $6 40 C S P S $4 $8 $10 20 $2

29. 28 A Price Floor: Government prohibits any price below $8 D Q S P=$8 C S P S Qs =6000 Surplus Qd =2000 PS 4000 Consumers purchase 2000 at $8 per unit 10 5 2 Consumer surplus when only 2000 units are purchased due to price above equilibrium Producer surplus when only 2000 units are sold due to price above equilibrium Consumer surplus when 4000 units are purchased at equilibrium Producer surplus when 4000 units are purchased at equilibrium Lost consumer and producer surplus when only 2000 units are purchased and sold at $8

30. 29 The Effect of a Price Floor on Consumer Surplus D S 4 2 CS 2 3 Loss to Consumer 6 CS

31. 30 PS The Effect of a Price Floor on Producer Surplus D S 4 2 2 3 Loss to Producer PS Gain to Producer 6

32. 31 D S 4 2 CS at Equilibrium 2 3 CS D S 4 2 2 3 PS A Price Floor has the same effect as charging a Tax to Consumers and giving that money as a subsidy to Producers Loss to Consumer Gain to Producer Tax Subsidy

33. 32 D S 4 2 CS 2 3 PS D S 4 2 2 3 Loss of Surplus to Society Loss to Consumer Loss to Producer

34. Welfare Loss from Price Floor D Q $ S P=$2 4 $5 C S P S Welfare Loss C S

35. 34 Welfare Loss from Price Floor D Q S 50 $8 C S $4 $6 $10 30 $2

36. 35 Most governments around the world intervene actively in the operation of their agricultural markets.

37. Governments in poor Third World countries 36 Though numerous, farmers do not organize politically and therefore have much less political power than people in the cities To gain favor with their more politically powerful urban residents. Governments impose price controls to keep food prices artificially low. By artificially depressing the price of food, Third World governments reduce incentives for farmers to produce and reduce the availability of food from domestic sources By artificially depressing the price of food, Third World governments create a permanent shortage of food.

38. 37 Fair Trade Coffee Agricultural prices are low because there is overproduction. To solve overproduction, only the most efficient farmers should remain in business. The market mechanism ensures that only those with lower costs (the most efficient) remain in business. If prices are held artificially high, farmers will not have an incentive to leave this industry and find alternatives. Fair trade prices perpetuate the surplus…not so good for the farmers after all.

39. 38 Why Agricultural Price Supports? Rural districts have greater political power. Farmers are often viewed as disadvantaged. Farm prices are volatile from uncertain weather conditions. Floors

40. 39 Forms of Price Supports 1.Government buys any quantity of a product at the guaranteed "support price." For example In the U.S. the Commodity Credit Corporation buys to support the price of milk. The CCC disposes of the commodities in ways that will not depress the domestic market price. For example, dairy products are often given away to low-income people, in the school lunch program, and as foreign aid. A price floor

41. 40 D Q S $1.5 4020 $2 60 Effect of a Price Floor $0.5 $1 No transactions allowed below $2 Price paid by consumers increases Quantity decreases Use tax payer money to purchase Surplus 60-20 = 40 $2.5

42. 41 Other Forms of Price Supports 2.Limiting production. Each farmer is given a quota that stipulates how much he can sell in a given year. Example: peanuts in the United States and milk in Canada. Limiting supply can raise market prices as long as government inspectors monitor the market to ensure that no production above the quota is sold for a lower price. Leftward shift in supply

43. 42 Forms of Price Supports 3.Set-aside program: Requiring (or paying) farmers to take land out of production. Rarely effective because farmers set aside their least productive land and intensively produce in the more productive land thus increasing supply Leftward shift in supply

44. 43 D Q S0S0 $1.5 402060 Effect of a Leftward shift in Supply $0.5 $1 Price paid by consumers increases Quantity decreases S1S1 $2

45. 44 Forms of Price Supports 4. Purchase and Release: CCC buys grain at the support price, stores it, and releases it back into the market if the market price rises to a prescribed trigger level of, say, 140 percent of the support price. This policy protects growers against the risk of low prices but also protects consumers against unusually high prices.

46. 45 D0D0 Q S0S0 $1.5 4020 $2 60 Purchase and Release $0.5 $1 Government purchase the surplus at $2 D1D1 If the price in the market rises above $2 $2.5 S1S1 The government releases the surplus until the price is $2

47. 46 Forms of Price Supports 5.Loans: CCC gives farmers nine-month loans equal to their production times the support price. The CCC accepts the grain as collateral for the loan. If, during the term of the loan, the market price rises above the support price, farmers repay the loan with interest and sell the grain in the market. If the market price remains at or below the loan rate, farmers forfeit the grain to the CCC, keep the money, and have no further obligation.

48. 47 D0D0 Q S0S0 $1.5 4020 $2 60 Loans to Farmers $0.5 $1 D1D1 If the price in the market falls below $2, the farmer forfeits the grain and does not repay the loan $2.5 If the price in the market rises above $2, farmers sell their crop at the higher price and repay the loan. Government loan= Production(60) x $2(support price)

49. 48  Farmers compete against one another for limited amount of farmland, bidding up its price. Thus, it is the owners of farmland, and not farmers, who are the principal beneficiaries.  Price supports create a surplus.  The typical way for the price support agency to get rid of its inventories is to use export subsidies to make them cheaper for foreigners to buy. Is subsidizing foreign consumption a proper use of taxpayer money? The EC uses this approach for grains. From the mid seventies to early eighties, internal EC grain prices were 150 to 200 percent of the prices at which other countries were willing to buy their grain. Subsidies to agriculture account for over two-thirds of the total EC budget. Effect of Price Supports

50. 49 D S 150 200 100 200 250 100 50 300 Figure 2 1.Equilibrium price is: ______ Equilibrium quantity is __________ 2.If the price is $100, there would be a (surplus/shortage)_________ of size__________ 3.Given your answer to #2 above, you expect the price to (increase/decrease/remain the same) to _________ 4.Draw a supply and demand diagram showing the effect of an increase in incomes. Be sure to label properly old and new values (P 0, Q 0, P 1,Q 1 ), show shortage/surplus and write your answer. Practice

51. 50 D S 10 20 25 5 90210650 6 Calculate CS, PS, WL and the equivalent “tax/subsidy” resulting from a price ceiling placed at $6. Practice

52. 51 D S 11 21.5 25 4 5 20 50 Calculate CS, PS, WL and the equivalent “tax/subsidy” resulting from a price floor placed at $20. 5.75 Practice

53. 52 D S 10 15 25 5 420200 650 20 1.Equilibrium price is: ______ Equilibrium quantity is __________ 2.A $10 ceiling, would cause a (surplus/shortage)_________ of size__________ 3.Calculate Consumer and Producer Surplus at equilibrium Practice

54. 53 D S 15 1000 10 20 25 500 5 1500 1.Equilibrium price is: ______ Equilibrium quantity is __________ 2.A $20 floor, would cause a (surplus/shortage)_________ of size__________ 3.Calculate Consumer and Producer Surplus at equilibrium Practice

55. ©2001,2002Claudia Garcia-Szekely54 Another Look at Supply and Demand 60 Producers are willing to bring 500 units for sale if and only if the price per unit is $60 500 Consumers are willing to buy 500 units if and only if the price per unit is $60

56. Elasticity and Price Controls When supply and demand are both elastic, a price floor will cause a larger surplus than when supply and demand are inelastic When supply and demand are both elastic, a price ceiling will cause a a larger shortage than when supply and demand are inelastic. 55

57. ©2001Claudia Garcia-Szekely56 The Effect of a Tax Consumers and producers share the burden of a tax

58. ©2001Claudia Garcia-Szekely57 The Effect of a Tax Levied on the Producer

59. ©2001,2002Claudia Garcia-Szekely58 The Effect of a $10 Tax Paid by Producers 60 500 If the price is $60 per unit, producer would produce 500 units After tax, producers receive only $50 At $50, producers would not bring 500 units for sale. 70 S0S0 For producers to be willing to produce 500 units, the consumer must pay $70 5050 Less than 500

60. ©2001,2002Claudia Garcia-Szekely59 The Effect of a $10 Tax Paid by Producers 10 S0S0 The same would be true for all quantities… 60 70 500 10 53 63 260 S plus tax The tax is equivalent to an increase in cost.

61. ©2001,2002Claudia Garcia-Szekely60 After Tax Equilibrium Price 60 500 70 S0S0 S1S1 After the shift in supply, the new equilibrium price is higher than $60 New Equilibrium Price New Equilibrium Quantity But is NOT $70!!

62. 61 After the tax… 60 500 S0S0 S with tax And pay a higher price: P c The government receives t (tax per unit) The producer receives P c - t P c - t Consumers purchase fewer units New Equilibrium Price PcPc New Equilibrium Quantity t t

63. ©2001,2002Claudia Garcia-Szekely62 A Producer Tax The tax drives a “wedge” between the price the buyer pays 60 500 P c - t PcPc Tax and the price the seller receives

64. ©2001,2002Claudia Garcia-Szekely63 P S Welfare Loss From a Tax D Q $ S P=$2 4 C S $1 PS CS Tax Revenue Welfare Loss 3 Tax = $2 per unit

65. 4 6 8 9 S0S0 2 3 5 7 10 4030205010607080 Impose a $2 tax on Producers 1. Shift Supply up by the amount of the tax

66. 4 6 8 9 S0S0 S tax 2 3 5 7 10 t=$2 403020501060 PCPC 2. Find the new equilibrium price: Pc the price the consumer pays after the tax

67. 4 6 8 9 S0S0 S tax 2 3 5 7 10 t=$2 403020501060 PC=PC= PP=PP= 3. Drop a line to the OLD supply curve: this represents subtracting the tax from the price the consumer pays, to get the price the producer receives

68. 4 6 8 9 S0S0 S tax 2 3 5 7 10 403020501060 PC=PC= PP=PP= 3. Ignore the Supply +tax line to determine CS, PS and Tax Revenue. CS PS Tax Revenue

69. 4 6 8 9 S0S0 2 3 5 7 10 403020501060 PC=PC= PP=PP= 4. At equilibrium (before the tax) 40 units are produced. CS PS Tax Revenue WL After the tax, only 30 units are produced: Tax creates a Welfare Loss

70. 4 6 8 9 S0S0 2 3 5 7 10 403020501060 PC=PC= PP=PP= CS =3*30*1/2 3*30*1/2 = PS Tax Rev =2*30 WL= 2*10*1/2

71. ©2001Claudia Garcia-Szekely70 The Effect of a Tax Levied on the Consumer

72. 71 10 S0S0 The same would be true for all quantities… P c =60 P p =50 500 10 45 55 600 D0D0 10 D Tax If the price is $60 consumers buy 500 units With a $10 tax, the actual Price consumers pay to be willing to buy 500 units is $10 lower than before The Effect of a $10 Tax Paid by Consumers

73. 4 6 8 9 S0S0 2 3 5 7 10 4030205010607080 Impose a $2 tax on Consumers 1. Shift Demand down by the amount of the tax

74. 4 6 8 9 S0S0 2 3 5 7 10 4030205010607080 2. Find the new equilibrium price: Pp Price the producer receives after the tax 3. Draw a line up to the OLD demand curve: this represents adding the tax from the price the producer receives, to get the price the consumer pays

75. 4 6 8 9 S0S0 S tax 2 3 5 7 10 403020501060 PC=PC= PP=PP= CS PS Tax Revenue Tax WL

76. 4 6 8 9 D0D0 D tax 2 3 5 7 10 403020501060 S0S0 $2 tax on Producer $2 tax on consumer PCPC P S tax

77. 4 6 8 9 D0D0 D tax 2 3 5 7 10 403020501060 S0S0 $2 tax on Producer $2 tax on consumer PCPC P $4 tax on consumer $4 tax on Producer PCPC P

78. 4 6 8 9 D0D0 D tax 2 3 5 7 10 403020501060 S0S0 $2 tax on Producer $2 tax on consumer PCPC P S tax

79. ©2001,2002Claudia Garcia-Szekely78 Regardless of Who Pays the Tax Pe Qe Tax Price Consumer Pays Price Producer Receives As price Increases quantity demanded falls As price drops quantity supplied falls The Consumer The Producer

80. ©2001,2002Claudia Garcia-Szekely79 Determining the Burden of The Tax Regardless on who the tax is levied on, consumers and producers end up “sharing” the burden of the tax… 60 500 P c -t PcPc Consumers now pay $t c more per unit. Producers now receive $t p less per unit sold tctc tptp

81. 80 The more Inelastic Demand is relative to Supply: Larger the price increase to consumer The smaller the price drop to producer P Q PpPp PcPc tctc tptp PcPc PcPc tctc tctc

82. ©2001,2002Claudia Garcia-Szekely81 60 500 57 67 490 If Demand is more inelastic than Supply The price the consumer pays after tax is $7 higher The price the producer receives after tax is $3 lower Clearly, the consumer bears a larger burden of the tax than the producer… Extra cost to consumer Cost to producer 7 x 490 3 x 490 10

83. 82 The more Inelastic Supply is relative to Demand: Smaller the price increase to consumer The larger the price drop to producer P Q P 0 -t P0P0 tctc tptp

84. ©2001,2002Claudia Garcia-Szekely83 The more Inelastic Supply is relative to Demand: A 70 unit decrease in quantity demanded, requires a “smaller” increase in price A 70 unit decrease in quantity supplied, requires a “larger” decrease in price 500430 60 S0S0 53 63

85. ©2001,2002Claudia Garcia-Szekely84 The more Inelastic Supply is relative to Demand: The price the consumer pays after tax is $3 higher The price the producer receives after tax is $7 lower Clearly, the producer bears a larger burden of the tax than the consumer… 500430 60 S0S0 53 63

86. 85 e p d = %  Q d /%  P 60 500 S0S0 65 450 At new equilibrium: quantity demanded and quantity supplied must both drop by the same amount: say 10% Since the elasticity of demand is equal to the elasticity of supply say: 1.2 e p s = %  Q s /%  P 8.3% increase 8.3% decrease 55 10% decrease -10% -1.2 When Demand and Supply have the Same Elasticity The % change in price must also be the same.

87. ©2001,2002Claudia Garcia-Szekely86 When Demand and Supply have the Same Elasticity The price the consumer pays after tax is $5 higher The price the producer receives after tax is $5 lower The tax burden is equally shared… 60 S0S0 65 55

88. ©2001Claudia Garcia-Szekely87 Regardless of Who Pays the Tax The Burden of the tax falls more heavily on the group with the lowest elasticity

89. TAX ON INSURANCE “If the government imposes a tax on insurance companies, the tax will be entirely passed on to consumers and insurance premiums will increase” Is this true? When is this true? We need to know first if demand for health insurance is more or less inelastic than supply If Demand is more inelastic is this true? 88 Would it help if the government offers more alternatives for consumers to purchase insurance?

90. ©2001,2002Claudia Garcia-Szekely89 If Demand is More Inelastic Than Supply… 60 500 S0S0 57 480 DD tax 67 The price the consumer pays after tax is $7 higher The price the producer receives after tax is $3 lower Clearly, the consumer bears a larger burden of the tax than the producer…

91. ©2001,2002Claudia Garcia-Szekely90 The More Elastic Demand Is Relative to Supply Pe Qe Price Consumer Pays D0D0 D1D1 D2D2 The smaller the increase in price necessary to reduce the quantity demanded The smaller the burden of the tax shared by the consumer

92. 91 Percentage of the tax burden on Producer Producer’s tax Share Price Elasticity of Demand Price elasticity of Supply + Price elasticity of Demand X100= e p d = 0.7 e p s = 0.1 0.7 0.1 + 0.7 = 0.8 87.5%

93. ©2001,2002Claudia Garcia-Szekely92 The More Elastic Demand is Relative to Supply Pe Qe D0D0 D1D1 D2D2 Price Producer Receives The larger the drop in price necessary to reduce the quantity supplied The larger the burden of the tax shared by the producer

94. ©2001,2002Claudia Garcia-Szekely93 Pe Qe Smaller the drop in quantity after the tax is imposed The smaller the welfare loss Same size tax Inelastic supply and demand Elastic Larger the drop in quantity after the tax is imposed The larger the welfare loss The larger the elasticity of demand and supply, the larger the welfare loss

95. ©2001,2002Claudia Garcia-Szekely94 Pe Qe The larger the tax revenue Inelastic supply and demand Elastic The larger the elasticity of demand and supply, the smaller the amount of tax revenue collected. Tax Revenue Same size tax Tax Revenue The smaller the tax revenue Larger the drop in quantity after the tax is imposed Smaller the drop in quantity after the tax is imposed

96. ©2001,2002Claudia Garcia-Szekely95 Percentage of the tax burden on Consumer Consumer’s tax Share Price Elasticity of Supply Price elasticity of Supply + Price elasticity of Demand X100= e p d = 0.7 e p s = 0.1 0.1 0.1 + 0.7 = 0.8 12.5%

97. ©2001,2002Claudia Garcia-Szekely96 Perfect Competition D Q $ MC Pe=$2 Qe=4000 C S P S