Principles of Microeconomics 9. Prices, Total Surplus, and Market Efficiency*

1. Principles of Microeconomics9. Prices, Total Surplus, and Market Efficiency* AkosLada August 1st , 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

2. Contents • Review of previous lecture • Prices and producer surplus • Market efficiency • Price controls and economic welfare • Taxes and economic welfare

3. 1. Review

4. The picture frames auction

5. WTP and D curve, Cost and S curve • At any Q: • the height of the Demand Curve is the WTP of the marginal buyer. • …and the height of the Supply Curve is the cost of the marginal seller. • At equilibrium WTP of marginal buyer and costs of marginal seller are the same P S D Q

6. CS and a change in Price P • Consumer surplus is the area between the demand curve and the equilibrium price • A higher price implies a loss in CS that comes from: • Buyers that remain in the market paying more money per units. • Buyers leaving the market. S P*2 P*1 D Q Q*

7. Calculating consumer surplus in a smooth demand curve To calculate the area of the triangles: ½ (base x height) To calculate the area of the rectangles: base x height P 1. Fall in CS due to buyers leaving market 2. Fall in CS due to remaining buyers paying higher P D Q

8. 2. Prices and Producer Surplus

9. Students’ Turn: What is the Producer surplus at Price $13? P S P* D Q Q*

10. The PS at Price $13? P S Kirk: 13 - 6 = 7 Golib: 13 - 8= 5 Rebeca: 13 – 10 = 3 Chandrika: 13 – 12 = 1 Total PS = 16 P* D Q Q*

11. PS with Lots of Sellers & a Smooth S Curve Suppose P = $40. At Q = 15(thousand), the marginal seller’s cost is $30, and her producer surplus is $10. Price per pair P S 1000s of pairs of shoes Q The supply of shoes

12. PS with Lots of Sellers & a Smooth S Curve PS is the area b/w P and the S curve, from 0 to Q. The height of this triangle is $40 – 15 = $25. So, PS = ½ x b x h = ½ x 25 x $25 = $312.50 P S h Q The supply of shoes

13. How a lower price reduces PS in our example P S • In the Price falls from $13 to $11, total PS decreases from $16 to $ 9. • From the $7 loss in PS: • $ 6 are because each of the 3 sellers remaining gets $2 less per frame. • $ 1 is because one seller left the market P*1 P*2 D Q Q*

14. How a Lower Price Reduces PS with a Smooth Supply Curve If P falls to $30, PS = ½ x 15 x $15 = $112.50 Two reasons for the fall in PS. P 1. Fall in PS due to sellers leaving market S 2. Fall in PS due to remaining sellersgetting lower P Q

15. STUDENTS’ TURN:Producer surplus supply curve P A. Find marginal seller’s cost at Q = 10. B.Find total PS for P = $20. Suppose P rises to $30.Find the increase in PS due to… C. selling 5 additional units D. getting a higher price on the initial 10 units Q

16. Answers supply curve P A. At Q = 10, marginal cost = $20 B.PS = ½ x 10 x $20 = $100 P rises to $30. C. PS on additional units= ½ x 5 x $10 = $25 D. Increase in PS on initial 10 units= 10 x $10 = $100 Q

17. 3. Market Efficiency

18. CS, PS, and Total Surplus CS = (value to buyers) – (amount paid by buyers) = buyers’ gains from participating in the market PS = (amount received by sellers) – (cost to sellers) = sellers’ gains from participating in the market Total surplus = CS + PS = total gains from trade in a market = (value to buyers) – (cost to sellers)

19. Total surplus at Price $13 P S CONSUMER SURPLUS (16) PRODUCER SURPLUS (16) P* TOTAL SURPLUS (32) D Q Q*

20. The Market’s Allocation of Resources • In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers. • Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off? • To answer this, we use total surplus as a measure of society’s well-being, and we consider whether the market’s allocation is efficient. (Policymakers also care about equality, though are focus here is on efficiency.)

21. An allocation of resources is efficient if it maximizes total surplus. Efficiency means: The goods are consumed by the buyers who value them most highly. The goods are produced by the producers with the lowest costs. Raising or lowering the quantity of a good would not increase total surplus. Total surplus = (value to buyers) – (cost to sellers) Efficiency

22. Market equilibrium:P = $30 Q = 15,000 Total surplus = CS + PS Is the market equilibrium efficient? P S CS PS D Q Evaluating the Market Equilibrium

23. Which Buyers Consume the Good? Every buyer whose WTP is ≥ $30 will buy. Every buyer whose WTP is < $30 will not. So, the buyers who value the good most highly are the ones who consume it. P S D Q

24. Which Sellers Produce the Good? Every seller whose cost is ≤ $30 will produce the good. Every seller whose cost is > $30 will not. So, the sellers with the lowest cost produce the good. P S D Q

25. Does Equilibrium Q Maximize Total Surplus? At Q = 20, cost of producing the marginal unit is $35 value to consumers of the marginal unit is only $20 Hence, can increase total surplus by reducing Q. This is true at any Q greater than 15. P S D Q

26. Does Equilibrium Q Maximize Total Surplus? At Q = 10, cost of producing the marginal unit is $25 value to consumers of the marginal unit is $40 Hence, can increase total surplus by increasing Q. This is true at any Q less than 15. P S D Q

27. Same in our example: If Q is higher than the equilibrium Q… P S Cost of production of the marginal seller Value of the product for the marginal buyer D Q Q*

28. If Q is lower than the equilibrium Q… P S Value of the product for the marginal buyer Cost of production of the marginal seller D Q Q*

29. Conclusion: The Market Equilibrium is efficient The market equilibrium quantity maximizes total surplus:At any other quantity, can increase total surplus by moving toward the market equilibrium quantity. P S D Q Q*

30. 4. Price Controls and Economic Welfare

31. A binding price floor and CS P How does the CS change? In this example, consumer surplus is reduced Partly because buyers leave the market Partly because those buyers still in the market pay more per unit S SURPLUS Min P P* D Q Q* QS QD

32. A binding price floor and PS How does the PS change? In this example, producer surplus is increased On the one hand, less units are sold (since buyers leave the market. But on the other hand, the sellers receive more per unit In this example, the first effect is smaller than the second. P S SURPLUS Min P P* D Q Q* QS QD

33. A binding price floor and total surplus The surplus that buyers who remain in the market loose because of higher prices …becomes producer surplus from the sellers’ point of view (doesn’t affect total surplus) The CS and the PS lost because of people leaving the market goes nowhere… just disappears! Economists call this a Deadweight Loss P S SURPLUS Min P But what happens to this surplus? P* Deadweight Loss! (DWL) D Q Q* QS QD

34. A binding price ceiling and CS How does the CS change? In this example, consumer surplus increases On the one hand, some surplus is lost because some buyers cannot find anybody to sell at the new price (shortage) But on the other hand, those buyers who stay in the market pay less per unit In our example, the first effect is smaller than the second P S P* Max P SHORTAGE D Q Q* QD QS

35. A binding price ceiling and PS P How does the PS change? In this example, producer surplus is reduced Partly because sellers leave the market Partly because those sellers still in the market receive less money per unit S P* Max P SHORTAGE D Q Q* QD QS

36. A binding price ceiling and total surplus The surplus that sellers who remain in the market loose because of lower prices …becomes consumer surplus from the buyers’ point of view (doesn’t affect total surplus) The CS and the PS lost because of people leaving the market goes nowhere… just disappears! Economists call this a Deadweight Loss P S But what happens to this surplus? P* Deadweight Loss! (DWL) Max P SHORTAGE D Q Q* QS QD

37. 5. Taxation and Deadweight Loss

38. P Size of tax = $T S PB PE PS D Q QT QE The Effects of a Tax Equilibrium with no tax: Price = PE Quantity = QE Equilibrium with tax = $T per unit: Buyers pay PB Sellers receive PS Quantity = QT

39. P Size of tax = $T PB PS Q Tax Revenue Revenue from tax: $T x QT S PE D QT QE

40. Government Revenue and Total Surplus • Next, we apply welfare economics to measure the gains and losses from a tax. • We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax. • Tax revenue can fund beneficial services (e.g., education, roads, police) so we include it in total surplus.

41. P S PE D Q QE Before the Tax CS = A + B + C PS = D + E + F A Tax revenue = 0 B C Total surplus= CS + PS = A + B + C + D + E + F E D F QT

42. P PB PS Q After the Tax CS = A PS = F A Tax revenue = B + D S B C Total surplus= A + B + D + F E D D F The tax reduces total surplus by C + E QT QE

43. P PB PS Q The DWL of a tax C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax. A S B C E D D F QT QE

44. P PB PS Q About the Deadweight Loss Because of the tax, the units between QT and QE are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax prevents some mutually beneficial trades. S D QT QE

45. In our example: A 4 dollars tax P S1 S2 The tax was imposed on the sellers The Supply curve shifts left There is a new equilibrium quantity and a new equilibrium price range. Equilibrium 2 P*1 P*2 Equilibrium 1 D Q Q*1 Q*2

46. What happens to the CS and the PS? P S1 S2 CS lost by buyers But what happens to this surplus? Tax revenue collected by the government P*1 PB PS Deadweight Loss! (DWL) PS lost by sellers D Q Q*1 Q*2

47. P $ S D Q STUDENTS’ TURN:Analysis of tax The market for airplane tickets A. Compute CS, PS, and total surplus without a tax. B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL.

48. P $ S P = D Q A C T I V E L E A R N I N G 1Answers to A The market for airplane tickets CS = ½ x $200 x 100 = $10,000 PS = ½ x $200 x 100 = $10,000 Total surplus = $10,000 + $10,000 = $20,000

49. P $ S PB = PS = D Q A C T I V E L E A R N I N G 1Answers to B A $100 tax on airplane tickets CS = ½ x $150 x 75 = $5,625 PS = $5,625 Tax revenue = $100 x 75 = $7,500 Total surplus = $18,750 DWL = $1,250

50. Discussion: the airline tax relief • Refer to the article “A Bonanza for Airlines as Taxes End” on the recent impasse that led to a 2-weeks shutdown of the US Federal Aviation Administration • How can we use the tools learned in the class to understand the airlines’ behavior?