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Policy Analysis

Policy Analysis. Outline. Welfare Analysis Consumer surplus Producer surplus Welfare consequences of minimum wage Wage subsidy as alternative to minimum wage Tortillas as a Cautionary Tale. Economic Efficiency.

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Policy Analysis

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  1. Policy Analysis

  2. Outline • Welfare Analysis • Consumer surplus • Producer surplus • Welfare consequences of minimum wage • Wage subsidy as alternative to minimum wage • Tortillas as a Cautionary Tale

  3. Economic Efficiency • A situation is economically inefficient if there is some way to change it so that so that someone gains while no one else loses. • A change is a Pareto improvement if at least one person gains and no one loses • A change is economically efficient if the winners could compensate the losers by enough to make the change a Pareto improvement.

  4. Assessing Benefits • Consumer Sovereignty • “Willingness to Pay” = Consumer Benefit • Consumer Surplus • “Willingness to Sell” =Opportunity Cost • Producer Surplus

  5. Price P0 Demand Quantity Consumer Surplus -- Difference between Willingness to Pay and Price Paid by Buyer r1 r2 r3 r4 3 5 1 2 4

  6. Consumer Surplus Is Triangle Below Demand, Above Market Price. Price Consumer Surplus P0 Demand Quantity 5 Total Expenditure

  7. P0=t5 1 3 5 2 4 Producer Surplus- Difference Between Opportunity Cost and Selling Price Price t5 t4 t3 t2 t1 Quantity

  8. Producer Surplus Price Supply P0=t5 Producer Surplus Quantity

  9. Consumer and Producer Surplus - Market Equilibrium Price Consumer Surplus Supply P0 Demand Producer Surplus Q0 Quantity

  10. Impact of Price Floor on Efficiency A -- New CS A+B+E -- Old CS B+C+D -- New PS C+F+D -- Old PS Supply A Price Floor B E Market clearing price C F D Demand Q1 Q0 E+F is deadweight loss associated with the price floor.

  11. Impact of Price Ceiling on Efficiency A+B+C -- New CS A+B+E -- Old CS D -- New PS C+D+F -- Old PS Demand A Supply B E Market Clearing Price C F Price Ceiling D E+F is the Deadweight Loss Associated with Price Ceiling

  12. Market Equilibrium is Efficient. No Deadweight Loss. Price controls create a deadweight loss Also, there are costs associated with rationing mechanisms, black markets etc. SUMMARY

  13. Impact of $12 Minimum Wage

  14. $2 Wage Subsidy

  15. If demand is elastic, minimum wage reduces employment Benefits accrue to workers who stay employed Costs borne by employers and consumers Wage subsidy increases employment Benefits shared by employers and workers Subsidy funded from general government revenues Comparison

  16. Subsidy Benefits Employers and Workers

  17. Impact of Subsidy on Efficiency A+B+F+E = CS after Subsidy A+B = CS before Subsidy B+C+F+G = PS after Subsidy F+G= PS before Subsidy B+C+D+E+F = Subsidy D=Deadweight Loss from Subsidy A Price Sellers receive B C D Pre Subsidy Price F E Price buyers pay G Pre Subsidy Q Post Subsidy Q

  18. Tortillas On New Year’s Day 1999, Mexico ended price controls on tortillas. The price stood at 3 pesos per kilo (31 cents for 2.2 pound stack). Some shops immediately raised their prices by 50%. In 1998, the government phased out subsidies to the tortilla industry that helped keep prices down. The tortilla subsidy was replaced with programs such as one that gives the 1.2 million poorest Mexicans free tortillas each day. Source: Smith, James, Los Angeles Times, Jan 7, 1999

  19. Questions • What does the price increase suggest about the elasticity of demand for tortillas? • How does the impact of a subsidy to consumers differ from the impact of a subsidy to producers? • What are the advantages of price controls as compared with subsidies?

  20. Elasticity of Demand for Tortillas? P Supply PA Price ceiling PB Demand A Demand B Kilos of tortillas

  21. Subsidy to Producers

  22. Subsidy to Consumers

  23. Another Approach

  24. If All Consumers Received Subsidy: • If all consumers receive the subsidy, output is same • Price producers receive is same in two cases • Price consumers pay is same in two cases

  25. Disadvantages of Subsidies • Control of subsidies by local bureaucrats created opportunties to exploit subsidies for political ends. Price controls anonymous. • Consumers not eligible for subsidies, but still relatively poor will pay a higher price for tortillas.

  26. Key Concepts • Impact of price controls and of subsidies depends on elasticity of demand (and supply). • Price floors lead to surpluses. Price ceilings to shortages. • Price controls lead to a deadweight loss.

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