16 Market Welfare

8/4/2019 16 Market Welfare

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Lecture 16 Market Welfare


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Outline

1. Welfare1. Producer welfare

2. Consumer welfare

3. Competition and welfare

2. Policies

1. Sales tax2. Price ceiling

3. Free trade

4. Tariffs

5. Qoutas


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Perfect competition and welfare

Model of perfect competition is important for two reasons:

First, it is a pretty good approximation of many markets that have the

features that we discussed last time.

Second, we will show that perfect competition maximizes social welfare.

perfect competition is an useful benchmark.

How to measure social welfare? We know how to measure consumers welfare consumer surplus.


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Consumer Surplus

Consumer surplus (CS)

is the monetary

difference between the

maximum amount that

a consumer is willing to

pay for the quantity

purchased and what the

good actually costs.


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Consumer Surplus

Consumer surplus (CS)

is the area under the

inverse demand curve

and above the market

price up to the quantity

purchased by the

consumer.

Smooth inversedemand function


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Producer Welfare (in the short-run)

Producer surplus (PS) is

the difference between

the amount for which a

good sells (market price)

and the minimum amount

necessary for sellers to be

willing to produce it

(marginal cost).

Step function


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Producer surplus (PS) is the

area above the inverse

supply curve and below the

market price up to the

quantity purchased by theconsumer.

Smooth inverse supply

function


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Producer surplus is closely related to profit.

Profit:

Subtracting off fixed costs yields PS:

Producer surplus is useful for examining the effects of any

shock that doesnt affect a firms fixed costs.


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Total Welfare (in the short-run)

How should we measure societys welfare?

We will add the well-being of consumers and producers and

measure total welfare as W= CS + PS

In other words, we treat welfare of producers and consumers

equally. The idea is that producers ultimately are the same people as

consumers firms are owned by people and the owners are the

beneficiaries of producers welfare.


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How Competition Maximizes Welfare

Producing at price

higher and quantity

lower than the

competitive level of

output lowers totalwelfare

consumer surplus is

lower by area C+B

Producer surplus

increases by B andxlowers by C

Total welfare decreases

by C+E, which equals

DWL.


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How Competition Maximizes Welfare

Competitive equilibrium maximizes welfare because oftwo facts:

In equilibrium, price equals marginal costs, This comes from profit maximization ,

Consumers willingness to pay for the the last unit of outputis equal to the price This comes from the consumers problem

In sum, consumers value the last unit of output by exactlythe amount that it costs to produce it.

A market failure is inefficient production orconsumption, often because a prices exceeds marginalcost.


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Departures from competitive equilibrium and welfare

Departures from competitive equilibrium

Due to government policies

Due to actions of firms

Mergers lead to smaller number of firms on the market

Cartel agreements,

Advertisement may create false impression that products are not homgenuous

Due to consumers actions

Example: fair trade coffee

Example: buy local actions (Keep Austin Weird)

Because it is difficult to coordinate behavior of many consumers, this is the least

important source of thye departures from competitive equilibrium.


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Government Policies and Welfare

We will examine the impact of different types of governmentpolicies

Policies that create a wedge between supply and demandcurves Sales tax

Price floor Price ceiling

Policies that shift supply curve Restricting the number of firms

Raising entry and exit costs

Policies that affect trade Trade ban

Tariffs

quotas


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Policies That Create a Wedge Between Supply and

Demand Curves: Sales Tax

Sales Tax A new sales tax causes the price that consumers pay to rise and the

price that firms receive to fall.

The former results in lower CS

The latter results in lower PS New tax revenue is also generated by a sales tax and, assuming the

government does something useful with the tax revenue, it should

be counted in our measure of welfare:


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Demand Curves: Sales Tax

Constant sales tax of

11c per unit

Sales tax creates

wedge that generatestax revenue ofB+D

and DWL ofC+E.


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Demand Curves: Sales subsidy

Demand D(p)=900-3p

Supply S(p)=-200+2p

Equilibrium p*=220, q*=D(p*)=S(p*)=240

Consumer surplus CS=

Producers surplus

Total welfare

( ) [ ] ( ) KKKKKppdpp 6.96.72198135270|5.19003900 3002203/900

220

2 ===

( ) [ ] ( ) KKKKKppdpp 4.1410204.4844|2002200 220100

220

100

2 =++=+=+

KKKPSCS 244.146.9 =+=+


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Demand Curves: Sales subsidy

Sales subsidy s=100$ Producers receive price p for each unit product

Consumers pay p-s for each unit

New equlibrium D(p-s)=S(p)

Equlibrium price p=280

Equilibrium quantity q=D(p-s)=S(p)=360

Consumer surplus

Producer surplus

Governments expenditure

Total welfare

( ) [ ] ( ) KKKKKppdpp 6.216.48162135270|5.19003900 300180

3/900

180

2 ===

( ) [ ] ( ) KKKKKppdpp 4.3210204.7856|2002200 280100

280

100

2 =++=+=+K36360*100 =

KKKKGEPSCS 18364.326.21'' =+=+


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What to tax?

The government has various goals: It needs to collect money that it spends on itself, defense, firefighters, etc.

Social goals: social security, redistribution of income, unemployment benefits,

etc.

Political goals: it may want to grant money to influential political groups

(subsidies to farmers) National security goals: it may want to keep domestic production of some

goods (oil, tanks)

The goal of optimal tax (or subsidy) policies Minimize the loss of efficiency

Tax goods with steep demand (very low price elasticity of demand)

For example, cigarettes, alcohol, food.

Tax goods that are consumed proportionally more by people that are rich or

young

Subsidize (or dont tax too heavily) food and domestic oil


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Demand Curves: Price Ceilling

Price Ceiling

Aprice ceiling, or maximum price, is the highest price a firm can

legally charge.

Example: rent controlled apartments

Maximum price is only binding if it is below the competitiveequilibrium price.

Deadweight loss may underestimate true loss for two reasons:

1. Consumers spend additional time searching and this extra search is

wasteful and often unsuccessful.

2. Consumers who are lucky enough to buy may not be the

consumers who value it the most (allocative cost).


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Demand Curves: Price Ceilling

Price ceiling creates wedge that generates excess demand

ofQd Qs and DWL ofC+E.


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Demand Curves: Price Floor

Price Floor

Aprice floor, or minimum price, is the lowest price a consumer can legally

pay for a good.

The government promises to buy any excess supply necessary to sustain the price

Example: agricultural products

Minimum price is guaranteed by government, but is only binding if it is

above the competitive equilibrium price.

Deadweight loss generated by a price floor reflects two distortions in the

market:

1. Excess production: More output is produced than consumed

2. Inefficiency in consumption: Consumers willing to pay more for last unit

bought than it cost to produce


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Demand Curves: Price Floort

Price floor creates

wedge that

generates excess

production ofQs Qd

and DWL ofC+F+G.


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Policies That Shift Supply Curves:

Restricting the number of firms Restricting the

number of firms

causes supply to

shift left


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Policies That Shift Supply Curves: Entry

and Exit Barriers

Entry Barriers: raising entry costs A LR barrier to entryis an explicit restriction or a cost that applies

only to potential new firms (e.g. large sunk costs).

Indirectly restricts the number of firms entering

Costs of entry (e.g. fixed costs of building plants, buying

equipment, advertising a new product) are not barriers to entry

because all firms incur them.

Exit Barriers: raising exit costs

In SR, exit barriers keep the number of firms high

In LR, exit barriers limit the number of firms entering Example: job termination laws


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Comparing Both Types of Policies:

Trade

Finally, we use welfare analysis to examine government policies that areused to control international trade:

1. Free trade

2. Ban on imports (no trade)

3. Set a tariff

4. Set a quota

Welfare under free trade serves as the baseline for comparison to effects

of no trade, quotas and tariffs.

Assume zero transportation costs and horizontal supply curve for the

potentially imported good

Assumptions imply U.S. can import as much as it wants atp* per unit.


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Comparing Both Types of Policies:

Trading Crude Oil Daily domestic (U.S.) demand:

Daily domestic (U.S.) supply:

Foreign supply curve is horizontal at the prevailing world price of$14.70 per barrel.

Comparison offree trade and no trade (e.g. total ban on imports of

crude oil) demonstrates the welfare benefit to society of free trade.


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Free Trade vs. No Trade

With free trade, domestic

producers supply Q=8.2

and imports ofQ=4.9 fill

out our additional

demand for oil at the low

world price.

With no trade, we lose

surplus equal to area C.

This is the DWL of a

total ban on trade.


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Tariffs

A tariffis essentially a tax on imports and there are two commontypes:

Specific tariff is a per unit tax

Ad valorem tariff is a percent of the sales price

Assuming the U.S. government institutes a tariff on foreign crude

oil:

1. Tariffs protect American producers of crude oil from foreign

competition.

2. Tariffs also distort American consumers consumption by inflating

the price of crude oil.


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Tariffs

A $5 per unit (specific) tariffraises the world price,

which increases the

quantity supplied

domestically and decreases

the quantity imported.

Tariff revenue of area D is

generated by the U.S.

DWL is equal to C+E.


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Quotas

A quota is a restriction on the amount of a good that can be

imported.

When analyzed graphically, a quota looks very similar to a tariff.

A tariff is a restriction on price

A quota is a restriction on quantity

One can find a tariff and a quota that generate the sameequilibrium

The only difference is that quotas do not generate any additional

revenue for the domestic government.


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Quotas

An import quota of 2.8

millions of barrels of oil per

day increases the quantity

supplied domestically and

decreases the quantity

imported.

Equivalent to $5 per unit

tariff

DWL is equal to C+D+E

because no tariff revenue is

generated.


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Next lecture

As we have seen today, typically any intervention that moves the marketfrom its competitive equilibrium

Next time, we will prove it formally we will show that any otucome that

cannot be obtained in a competitive equilibrium, cannot be efficient.

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16 Market Welfare