Chapter 8 Welfare Economics and The Gains From Trade

1. Chapter 8 Welfare Economics and The Gains From Trade

2. review 1) Competitive markets operate where S = D. 2) Firms and individuals are price takers in competitive markets. 3) Individuals and firms seek to make themselves as well off as possible: individuals maximize utility by getting to the highest indifference curve as they can; firms maximize profit

3. what’s next We want to see how economists measure the gains from trade. We will focus on the concepts consumers’ and producers’ surplus. The efficiency criterion is a normative criterion that basically says that you can vote for a policy and you can vote 1 time for each dollar that you are willing to pay for the policy. Normative means what should be. Who knows what should be? I should be taller, right? In economics many look to the efficiency criterion to argue for or against a social policy.

4. consumers’ surplus consumers’ surplus = the maximum amount consumers are willing to pay for units of a good minus what they have to pay for those units. Interpretation: one unit will be demanded when the price is P1. If the price is any higher no units are demanded. Thus P1 is the maximum someone is willing to pay for 1 unit of the good. P a d P1 P2 b c e D Q

5. consumers’ surplus P2 is the maximum someone is willing to pay for the 2nd unit. At any higher price the second unit was not demanded. P2 is less than P1 because of the concept that additional units give us less and less additional satisfaction and thus additional units will only be demanded at lower prices. area b + c = (P1)(1) = P1 area e = (P2)(2 - 1) = P2. Area b + c + e is the major area under the demand curve out to quantity 2. If we only had to look at a couple, or three or so units, we would look at these areas as willingness to pay.

6. consumers’ surplus Areas a and d are a small part of the area under the demand curve and in fact these areas have no economic interpretation. But to make our life easier we assume areas a and d can be treated like b, c, and e, particularly when we have a boat load of units to consider. Thus the area under the demand curve out to the quantity in question is the maximum amount consumers are willing to pay for those units. In other words this area is the total value of the units to the consumer.

7. consumers’ surplus How much do consumers have to pay in the market? At this stage of our study we have assumed if the price of the product is x amount for one consumer then it is this amount for all consumers. P Thus if the price is P1 consumers have to pay P1Q1 for the Q1 units. P1 D Q Q1

8. consumers’ surplus Consumers’ surplus in a graph. area a + b = maximum consumers would willingly pay for Q1 units. area b = amount consumers have to pay for the Q1 units. area a = consumers’ surplus. P a b P1 D Q Q1

9. producers’ surplus producers’ surplus = amount producers actually receive for their output minus the minimum they would have willingly accepted for those units. s = mc P Recall that for a competitive firm the supply curve is the marginal cost curve. P2 P1 c d a e b Q Q1 Q2

10. producers’s surplus If the price is P1 the producer will only produce 1 unit. Here MR = MC and thus is the best the producer can do. Now if the price was higher more would be produced, but at a lower price the first unit would not be produced. P2 is the lowest price at which the producer would be willing to sell the second unit for. area a + b = P1 = minimum amount to sell the first unit, area c + d + e = P2 = minimum amount to sell the second unit. Note that a and c are above the supply curve and use this method if only a few units are considered.

11. producers’s surplus a and c are really part of the minimum payments suppliers need to make them want to sell. But to make life easier for us we will ignore a and c and only concentrate on the area under the supply curve up to a Q as the minimum amount producers need to supply that Q.

12. producers’s surplus What do producers actually receive in the market? P s Producers actually get P1(Q1) if the price is P1. In terms of areas it is a + b. P1 a b Q Q1

13. producers’s surplus a + b = what producers receive, b = what producers would have accepted and still supplied Q, a = producers’ surplus. P s P1 a b Q Q1

14. Gains in the market a = consumers’ surplus b = producers’ surplus a + b = social gain or welfare from trade in markets. In the market for a product producers and consumers 1) make transactions to meet their own objectives, 2) both receive surplus value from the market transaction. P s a P1 b D Q Q1

15. applying the concepts - a sales tax b Sbt Pat + tax a c d e Pbt f g h i Pat Dbt Dat Qat Qbt

16. applying the concepts - a sales tax before tax after tax consumers’ surplus a + b + c + d + e a + b producers’ surplus f + g + h + i i social gain = a + b + c + d e + f + g + h + i a + b + i.

17. applying the concepts - a sales tax The change in social welfare from the tax is the welfare after the tax minus the welfare before the tax: change in social welfare = a + b + i - a + b + c + d +e + f + g + h + i - c - d - e - f -g - h It looks like the sales tax is really a bad idea for producers and consumers of the product. It is, but the government collects the tax and this can be put to good use in the world. The tax amount is c + d + f + h.

18. applying the concepts - a sales tax If you add the tax revenue to the change in social welfare amount you are left with the true change in social welfare as - e - h. You will notice that areas e and h occur in the area above the reduction in output. What the area represents is the loss in output to producers and consumers that is not made up by something else in the form of what the tax revenue could buy. We call this a deadweight or efficiency loss due to the tax.