Lecture 3

1. Lecture 3 Markets and Welfare

2. What will we discuss? • What is consumer surplus? • What is producer surplus? • Why is free market equilibrium efficient? • Use the concepts of consumer surplus and producer surplus to study the welfare effects of • Taxation • International trade and tariffs

3. Consumer surplus • The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. • Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.

4. Measuring consumer surplus Price of album $100 John’s consumer surplus ($30) 80 Paul’s consumer surplus ($10) 70 Total consumer surplus ($40) 50 Demand 0 1 2 3 4 Quantity of albums

5. Consumer surplus and price • Consumer surplus is the area below the demand curve and above the market price. • A lower market price will increase consumer surplus. • A higher market price will reduce consumer surplus.

6. How the price affects consumer surplus Price A Initial consumer surplus C P1 B F P2 D E Demand 0 Q1 Q2 Quantity

7. Producer surplus • Market supply: • depicts the various quantities that suppliers would be willing and able to sell at different prices • may be viewed as a measure of the costs of supplying various quantities of the good. • Producer surplus is the amount a seller is paid minus the cost of production.

8. Measuring producer surplus Price of house painting Supply Total producer surplus ($500) $900 800 Georgia’s producer surplus ($200) 600 500 Grandma’s producer surplus ($300) 0 1 2 3 Quantity of houses painted

9. Producer surplus and price • Producer surplus is the area above the supply curve and below the market price. • A lower market price will reduce producer surplus. • A higher market price will increase producer surplus.

10. How price affects producer surplus Price Supply E D P2 F B P1 C Initial producer surplus A 0 Q1 Q2 Quantity

11. Why is free market equilibrium efficient? • The invisible hand • Individuals motivated by self-interest are guided (as if by an invisible hand) to promote general welfare. • Adam Smith (1776, An inquiry into the Nature and Causes of the Wealth of Nations) “Every individual…intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. … By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

12. Why is free market equilibrium efficient? • Free markets • allocate the supply of goods to the buyers who value them most highly. • allocate the demand for goods to the sellers who can produce them at least cost. • As a result, the sum of consumer and producer surplus is maximised.

13. Free market equilibrium Price Consumer surplus Supply Equilibrium price Demand Producer surplus 0 Quantity Equilibrium quantity

14. Why is the total surplus maximized in equilibrium? Price Supply Value to buyers Cost to sellers Cost to sellers Value to buyers Demand 0 Quantity Equilibrium quantity Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers.

15. The welfare effects of taxation

16. Price Supply Size of tax (T) Price buyers pay Tax revenue (T X Q) Price sellers receive Demand Quantity sold (Q) 0 Quantity with tax Quantity without tax Quantity The costs of taxation

17. Price buyers pay A = PB B C Price without tax = P1 E D Price sellers receive = PS F How a tax affects welfare Price Supply Demand Q2 Q1 0 Quantity

18. How a tax affects welfare

19. The welfare effects of taxation • Taxes • Form government revenue • Lower consumer’s surplus • Lower producer’s surplus • Result in a deadweight loss (DWL) • Are there other costs of taxation apart from the DWL?

20. Determinants of the DWL of taxation • The size of the deadweight loss depends on • how much the quantities supplied and demanded respond to the tax levy. • That, in turn, depends on • the price elasticitiesof supply and demand. • the tax rate

21. DWL and elasticity of supply

22. DWL and elasticity of demand

23. DWL and the tax rate

24. Tax rate, DWL and tax revenue • As the size of a tax increases, its deadweight loss quickly gets larger. • By contrast, • tax revenue first rises with the size of a tax, but then, • as the tax gets larger, the market shrinks so much that tax revenue starts to fall. • The Laffer curve depicts the relationship between tax rates and tax revenue.

25. Tax rate, DWL and tax revenue

26. Question • If tax rate increases, what happens to DWL and tax revenue?

27. International trade and tariffs

28. Comparative advantage and the world price

29. Free trade for an exporting country

30. Welfare effects of free trade

31. Free trade for an importing country

32. An importing economy

33. The effects of a tariff • A tariff is a tax on goods produced abroad and sold domestically. • Tariffs raise the price of imported goods above the world price by the amount of the tariff.

34. The effects of a tariff

35. The effects of a tariff

36. Question • What does the domestic price (without international trade) tell us about a nation’s comparative advantage?

37. References • J. Gans, S. King. R. Stonecash and N. Mankiw, Principles of Economics (Fifth Edition), Gengage Learning, 2012. Chapters 7, 8, 9. • Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. Chicago: University of Chicago Press.