Ch 8 Welfare Economics and the Gains from Trade

1. Ch 8 Welfare Economics and the Gains from Trade • P229-265 of 6th edition • P219-251 of 7th edition

2. Introduction • Choosing policies that are best for economy • Normative criterion: way to balance benefits that accrue to some people against cost imposed on others • Majority Rule • Efficiency criterion: a policy should be enacted if the benefits outweigh the costs. • Choosing a measurement for weighing costs and benefits • Measure gains from trade

3. Measuring the Gains from Trade • Consumer purchases good • Consumer gains • Consumer surplus • Producer gains • Producer surplus • Develop measure for gauging extent of gain

4. Consumers’ Surplus • Total value as an area • Consumer’s purchases equal area under demand curve out of quantity demanded • Consumer’s surplus • Gain from consumer trade • Amount by which value of consumer’s purchases exceeds what actually pays for goods • Area under demand curve down to price paid and out to quantity demanded

5. Marginal Value and Demand • Maximum amount consumer willing to pay for a good • Additional goods have less value than the first unit of the good consumed • Application of equimarginal principle • Buy good as long as marginal value exceeds price • Stops when equal • Marginal value curve and demand curve convey similar information

6. Marginal value (MRS) and demand curve

7. Marginal value (MRS) and demand curve

8. Marginal value (MRS) and demand curve • Since the MRS tells us how much they are willing to pay, it also tells us the height of the demand curve for each unit consumed. • In other words, the demand curve measures the MRS at every point along an indifference curve.

9. Producers’ Surplus • Producer’s surplus • Gain from producer trade • Amount by which producer’s revenue exceeds variable production costs • Area above supply curve up to price received and out to quantity supplied • How much better of the firm is compared to shut down • PS = TR-VC, OR, PS = profit + FC

10. EXHIBIT 8.4 The Producer’s Surplus

11. Efficiency Criterion • Weighing the interest of one group versus the interest of another group • Normative criterion: general method for choosing amongst alternative policies • Efficiency criterion: normative criterion according to which your votes are weighted according to your willingness to pay for your preferred outcome • Pareto criterion: any policy that makes one or more person better off and makes no one worse off should be adopted.

12. Consumers’ Surplus and the Efficiency Criterion • Effect of sales tax • Calculate consumer surplus • Calculate producer surplus • Calculate tax revenue • Calculate social gain • If reduction in social gain, called deadweight loss • Note hidden assumptions

13. We have assumed: • Market is competitive (no market power, e.g. monopoly) • No positive or negative externalities (including public goods or tragedy of the commons). • Tax revenue is transferred to others so that the taxpayer loss is exactly the same as the benefit to those that receive the revenue.

14. EXHIBIT 8.8 The Effect of a Sales Tax

15. Other Normative Criteria • Pareto criterion • One policy is better than another when it is preferred unanimously • any policy that makes one or more person better off and makes no one worse off should be adopted. • Advantage: recommendations noncontroversial

16. Examples and Applications • Taxes • Subsidies • Price ceilings • Tariffs

17. EXHIBIT 8.12 The Effect of a Subsidy

18. EXHIBIT 8.14 A Price Ceiling

19. EXHIBIT 8.17 A Tariff When There Is a Domestic Industry

20. Theories of Value • Diamond-water paradox • Reflects price as the marginal value of last item consumed not total value • Marginal value of first gallon of water higher than marginal value of first diamond • Explains why water cheap relative to diamond • Labor theory of value • Asserts that value of object determined by amount labor needed to produce it • Determine value not by cost of inputs but by consumer’s willingness to pay for good

21. the Invisible Hand • Fundamental theorem of welfare economics • Shows that competitive equilibrium is Pareto-optimal • Invisible hand • Provides information that equilibrium point also maximum social gain point

22. EXHIBIT 8.20 The Invisible Hand Landsburg, Price Theory and Applications, 7th edition

23. Ch8 Numerical Example • Tax Example [QS=(1/3)P-(4/3) & QD=12-P] • CS & PS ? • TS After $1 Tax? • Tax Burden • International Trade Example [PS=1+0.1Q & PD=12-(1/12)Q] • CS & PS before free trade? • Perfectly Elastic World Supply at P=$9 • CS & PS after free trade? • CS & PS after $1 tariff