Masaryk University Microeconomics 1 Dali Laxton Lecture 4 Government Policies and Efficiency © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png Last Lecture •What is elasticity? What kinds of issues can elasticity help us understand? •What is the price elasticity of demand? How is it related to the demand curve? How is it related to revenue & expenditure? •What is the price elasticity of supply? How is it related to the supply curve? •The concept of elasticity in illegal drugs market © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png Lecture Today •What are price ceilings and price floors? What are some examples of each? •How do price ceilings and price floors affect market outcomes? •How do taxes affect market outcomes? How do the effects depend on whether the tax is imposed on buyers or sellers? •What is the incidence of a tax? What determines the incidence? © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png Lecture Today Lecture Today •What is consumer surplus? How is it related to the demand curve? •What is producer surplus? How is it related to the supply curve? •Do markets produce a desirable allocation of resources? Or could the market outcome be improved upon? © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Government Policies That Alter the Private Market Outcome § Price controls §Price ceiling: a legal maximum on the price of a good or service Example: rent control §Price floor: a legal minimum on the price of a good or service Example: minimum wage § Taxes §The govt can make buyers or sellers pay a specific amount on each unit. We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and eq’m quantity). ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› EXAMPLE 1: The Market for Apartments §Eq’m w/o price controls P Q D S Rental price of apts 12,000 CZK 300 Quantity of apts ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› How Price Ceilings Affect Market Outcomes §A price ceiling above the eq’m price is not binding— has no effect on the market outcome. P Q D S 12,000 CZK 300 Price ceiling 15,000 CZK ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› How Price Ceilings Affect Market Outcomes §The eq’m price (12,000 CZK) is above the ceiling and therefore illegal. §The ceiling is a binding constraint on the price, causes a shortage. P Q D S 12,000 CZK Price ceiling 7,500 CZK 250 400 shortage ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› How Price Ceilings Affect Market Outcomes §In the long run, supply and demand are more price-elastic. §So, the shortage is larger. P Q D S 12,000 CZK 150 Price ceiling 7,500 CZK 450 shortage ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Shortages and Rationing §With a shortage, sellers must ration the goods among buyers. §Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers’ biases §These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly. §In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair). §Example: price ceiling on crude oil in 1973. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› EXAMPLE 2: The Market for Unskilled Labor §Eq’m w/o price controls W L D S Wage paid to unskilled workers per hour 100 CZK 500 Quantity of unskilled workers ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› How Price Floors Affect Market Outcomes W L D S 100 CZK 500 Price floor 80 CZK §A price floor below the eq’m price is not binding – has no effect on the market outcome. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› How Price Floors Affect Market Outcomes W L D S 100 CZK Price floor 120 CZK §The eq’m wage (100 CZK) is below the floor and therefore illegal. §The floor is a binding constraint on the wage, causes a surplus (i.e., unemployment). 400 550 labor surplus ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› §Min wage laws do not affect highly skilled workers. §They do affect teen workers. §Studies: A 10% increase in the min wage raises teen unemployment by 1–3%. The Minimum Wage W L D S 100 CZK Min. wage 120 CZK 400 550 unemp-loyment ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Evaluating Price Controls §Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. §Prices are the signals that guide the allocation of society’s resources. This allocation is altered when policymakers restrict prices. §Price controls often intended to help the poor, but often hurt more than help. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Taxes §The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. §The govt can make buyers or sellers pay the tax. §The tax can be a % of the good’s price, or a specific amount for each unit sold. §For simplicity, we analyze per-unit taxes only. §Directions to think: a)Which curve is affected? b)Which way is it shifted? c)Effects on price and quantity § ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› S1 EXAMPLE 3: The Market for Pizza §Eq’m w/o tax P Q D1 200 CZK 500 ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› S1 D1 200 CZK 500 A Tax on Buyers §The price buyers pay is now 30 CZK higher than the market price P. §P would have to fall by 30 CZK to make buyers willing to buy same Q as before. §E.g., if P falls from 200 CZK to 170 CZK, buyers still willing to purchase 500 pizzas. P Q D2 Effects of a 30 CZK per unit tax on buyers 170 CZK Hence, a tax on buyers shifts the D curve down by the amount of the tax. Tax ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› S1 D1 200 CZK 500 A Tax on Buyers P Q D2 210 CZK PB = 180 CZK PS = Tax Effects of a 30 CZK per unit tax on buyers New eq’m: Q = 450 Sellers receive PS = 180 CZK Buyers pay PB = 210 CZK Difference between them = 30 CZK= tax 450 ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› 450 S1 The Incidence of a Tax: §how the burden of a tax is shared among market participants P Q D1 200 CZK 500 D2 210 CZK PB = 180 CZK PS = Tax In our example, buyers pay 10 CZK more, sellers get 20 CZK less. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› S1 A Tax on Sellers P Q D1 500 S2 Effects of a 30 CZK per unit tax on sellers The tax effectively raises sellers’ costs by 30 CZK per pizza. Sellers will supply 500 pizzas only if P rises to 230 CZK, to compensate for this cost increase. 230 CZK Hence, a tax on sellers shifts the S curve up by the amount of the tax. Tax ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› S1 A Tax on Sellers P Q D1 200 CZK 500 S2 450 210 CZK PB = 180 CZK PS = Tax Effects of a 30CZK per unit tax on sellers New eq’m: Q = 450 Buyers pay PB = 210 CZK Sellers receive PS = 180 CZK Difference between them = 30 CZK= tax ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› S1 The Outcome Is the Same in Both Cases! §What matters is this: §A tax drives a wedge between the price buyers pay and the price sellers receive. P Q D1 200CZK 500 450 180 CZK 210 CZK PB = PS = Tax The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Elasticity and Tax Incidence §CASE 1: Supply is elastic and demand inelastic P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax PB PS It’s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Elasticity and Tax Incidence §CASE 2: Demand is elastic and supply inelastic P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden Price if no tax PB PS It’s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› CASE STUDY: Who Pays the Luxury Tax? §1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. §Goal: raise revenue from those who could most easily afford to pay—wealthy consumers. §But who really pays this tax? ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› CASE STUDY: Who Pays the Luxury Tax? §The market for yachts P Q D S Tax Buyers’ share of tax burden Sellers’ share of tax burden PB PS Demand is price-elastic. In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› CONCLUSION: Government Policies and the Allocation of Resources §Each of the policies in this chapter affects the allocation of society’s resources. §Example 1: A tax on pizza reduces eq’m Q. § With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. §Example 2: A binding minimum wage causes a surplus of workers, a waste of resources. §So, it’s important for policymakers to apply such policies very carefully. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Welfare Economics §Recall, the allocation of resources refers to: §how much of each good is produced §which producers produce it §which consumers consume it §Welfare economics studies how the allocation of resources affects economic well-being. §First, we look at the well-being of consumers. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Willingness to Pay (WTP) §A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. §WTP measures how much the buyer values the good. name WTP CZK Akram 250 Yana 175 Hannah 300 Martin 125 Example: 4 buyers’ WTP for a pizza ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› WTP and the Demand Curve §Q: If price of the pizza is 200 CZK, who will buy it, and what is quantity demanded? A: Akram & Hannah will buy a pizza, Yana & Martin will not. Hence, Qd = 2 when P = 200. name WTP CZK Akram 250 Yana 175 Hanna 300 Martin 125 ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› WTP and the Demand Curve §Derive the demand schedule: 4 Hannah, Akram, Yana, Martin 0 – 125 3 Hannah, Akram, Yana 126 – 175 2 Hannah, Akram 176 – 250 1 Hannah 251 – 300 0 nobody 301 & up Qd who buys P (price of pizza) CZK name WTP CZK Akram 250 Yana 175 Hannah 300 Martin 125 ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› WTP and the Demand Curve P CZK Qd 301 & up 0 251 – 300 1 176 – 250 2 126 – 175 3 0 – 125 4 P Q ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› About the Staircase Shape… §This D curve looks like a staircase with 4 steps – one per buyer. P Q If there were a huge # of buyers, as in a competitive market, there would be a huge # of very tiny steps, and it would look more like a smooth curve. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› WTP and the Demand Curve §At any Q, the height of the D curve is the WTP of the marginal buyer, the buyer who would leave the market if P were any higher. P Q Hannah’s WTP Akram’s WTP Yana’s WTP Martin’s WTP ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Consumer Surplus (CS) §Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays: § CS = WTP – P name WTP CZK Akram 250 Yana 175 Hannah 300 Martin 125 Suppose P = 260CZK. Hannah’s CS = 300CZK – 260CZK = 40CZK. The others get no CS because they do not buy pizza at this price. Total CS = 40 CZK. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› CS and the Demand Curve P Q Hannah’s WTP P = 260 CZK Hannah’s CS = 300 CZK – 260 CZK = 40CZK Total CS = 40CZK ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› CS and the Demand Curve P Q Hannah’s WTP Akram’s WTP Instead, suppose P = 220 CZK Hannah’s CS = 300CZK – 220CZK = 80CZK Akram’s CS = 250CZK – 220CZK = 30CZK Total CS = 110CZK ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› CS and the Demand Curve P Q The lesson: Total CS equals the area under the demand curve above the price, from 0 to Q. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› P Q CS with Lots of Buyers & a Smooth D Curve The demand for bread D 1000s loaves of bread Price per pair §At Q = 5(thousand), the marginal buyer is willing to pay 50 CZK for a loaf of bread. §Suppose P = 30CZK. §Then his consumer surplus = 20CZK. § ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› P Q CS with Lots of Buyers & a Smooth D Curve The demand for bread D §CS is the area b/w P and the D curve, from 0 to Q. §Recall: area of a triangle equals ½ x base x height §Height = 60CZK – 30CZK = 30CZK. §So, CS = ½ x 15 x 30CZK = 225CZK. h ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› P Q How a Higher Price Reduces CS D §If P rises to 40CZK, §CS = ½ x 10 x 20CZK = 100CZK. §Two reasons for the fall in CS. 1. Fall in CS due to buyers leaving market 2. Fall in CS due to remaining buyers paying higher P ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Cost and the Supply Curve § §Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost). §Includes cost of all resources used to produce good, including value of the seller’s time. §Amount a seller is paid for a good minus the seller’s cost of providing it §Price received minus willingness to sell § ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› P Q PS with Lots of Sellers & a Smooth S Curve The supply of bread S 1000s loaves of bread Price per pair §Suppose P = 40CZK. §At Q = 15(thousand), the marginal seller’s cost is 30CZK, §and her producer surplus is 10CZK. § ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› P Q PS with Lots of Sellers & a Smooth S Curve The supply of bread S §PS is the area b/w P and the S curve, from 0 to Q. §The height of this triangle is 40CZK – 15CZK = 25CZK. §So, PS = ½ x b x h = ½ x 25 x 25CZK = 312.50CZK § h ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› P Q How a Lower Price Reduces PS §If P falls to 30CZK, §PS = ½ x 15 x 15CZK = 112.50CZK §Two reasons for the fall in PS. S 1. Fall in PS due to sellers leaving market 2. Fall in PS due to remaining sellers getting lower P ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 our focus here is on efficiency.) ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Efficiency §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. = (value to buyers) – (cost to sellers) Total surplus ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Evaluating the Market Equilibrium §Market eq’m: P = 30 CZK Q = 15,000 §Total surplus = CS + PS §Is the market eq’m efficient? § P Q S D CS PS ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Which Buyers Consume the Good? P Q S D §Every buyer whose WTP is ≥ 30 CZK will buy. §Every buyer whose WTP is < 30 CZK will not. §So, the buyers who value the good most highly are the ones who consume it. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Which Sellers Produce the Good? P Q S D §Every seller whose cost is ≤ 30 CZK will produce the good. §Every seller whose cost is > 30 CZK will not. §So, the sellers with the lowest cost produce the good. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Does Eq’m Q Maximize Total Surplus? P Q S D §At Q = 20, cost of producing the marginal unit is 35CZK §value to consumers of the marginal unit is only 20CZK §Hence, can increase total surplus by reducing Q. §This is true at any Q greater than 15. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Does Eq’m Q Maximize Total Surplus? P Q S D §At Q = 10, cost of producing the marginal unit is 25CZK §value to consumers of the marginal unit is 40CZK §Hence, can increase total surplus by increasing Q. §This is true at any Q less than 15. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Does Eq’m Q Maximize Total Surplus? P Q S D §The market eq’m quantity maximizes total surplus: At any other quantity, can increase total surplus by moving toward the market eq’m quantity. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Adam Smith and the Invisible Hand §“Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only. Adam Smith, 1723-1790 Passages from The Wealth of Nations, 1776 He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them… It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest…. ©Georgios Kollidas/Shutterstock.com ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ‹#› Adam Smith and the Invisible Hand §“Every individual…neither intends to promote the public interest, nor knows how much he is promoting it…. Adam Smith, 1723-1790 Passages from The Wealth of Nations, 1776 He 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. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” an invisible hand ©Georgios Kollidas/Shutterstock.com ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Free Market vs. Govt Intervention §The market equilibrium is efficient. No other outcome achieves higher total surplus. §Govt cannot raise total surplus by changing the market’s allocation of resources. §Laissez faire (French for “allow them to do”): the notion that govt should not interfere with the market. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Free Market vs. Central Planning §Suppose resources were allocated not by the market, but by a central planner who cares about society’s well-being. §To allocate resources efficiently and maximize total surplus, the planner would need to know every seller’s cost and every buyer’s WTP for every good in the entire economy. §This is impossible, and why centrally-planned economies are never very efficient. ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION §This chapter used welfare economics to demonstrate one of the Ten Principles: Markets are usually a good way to organize economic activity. §Important note: We derived these lessons assuming perfectly competitive markets. §In other conditions we will study in later chapters, the market may fail to allocate resources efficiently… ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CONCLUSION §Such market failures occur when: §a buyer or seller has market power—the ability to affect the market price. §transactions have side effects, called externalities, that affect bystanders. (example: pollution) §We’ll use welfare economics to see how public policy may improve on the market outcome in such cases. §Despite the possibility of market failure, the analysis in this chapter applies in many markets, and the invisible hand remains extremely important. Summary •A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the eq’m price, it is binding and causes a shortage. •A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq’m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png Summary •A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq’m quantity to fall, whether the tax is imposed on buyers or sellers. •The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers. •The incidence of the tax depends on the price elasticities of supply and demand. •Chapter 8: home reading (but not in quiz). © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary •The height of the D curve reflects the value of the good to buyers—their willingness to pay for it. •Consumer surplus is the difference between what buyers are willing to pay for a good and what they actually pay. •On the graph, consumer surplus is the area between P and the D curve. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary •The height of the S curve is sellers’ cost of producing the good. Sellers are willing to sell if the price they get is at least as high as their cost. •Producer surplus is the difference between what sellers receive for a good and their cost of producing it. •On the graph, producer surplus is the area between P and the S curve. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png ‹#› © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary •To measure society’s well-being, we use total surplus, the sum of consumer and producer surplus. •Efficiency means that total surplus is maximized, that the goods are produced by sellers with lowest cost, and that they are consumed by buyers who most value them. •Under perfect competition, the market outcome is efficient. Altering it would reduce total surplus. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Screen Shot 2013-09-29 at 9.52.07 AM.png