University of Papua New Guinea Principles of Microeconomics Lecture 5: Markets in action

The University of Papua New Guinea Slide 1 Lecture 5: Markets in action Michael Cornish Overview Consumer and producer surplus Price floors and price ceilings Taxes Subsidies

The University of Papua New Guinea Slide 2 Lecture 5: Markets in action Michael Cornish Consumer and producer surplus The demand and supply model can also be used to illustrate the value created through markets Consumer surplus measures the additional benefit that accrues to consumers, beyond the cost of the products they purchase (the net benefit) –I.e. the difference between the price they pay for a product, and the maximum price they were willing to pay

The University of Papua New Guinea Slide 3 Lecture 5: Markets in action Michael Cornish Consumer and producer surplus Similarly, producer surplus measures the benefit that accrues to the suppliers beyond the cost of the products they produce (the net benefit) –I.e. the difference between price they sell a product for, and the minimum price they were willing to produce the product for Note: Producer surplus is different to economic profit! Economic Profit = Total Revenue – Total Cost Producer Surplus = Total Revenue – Total Variable Cost So the difference is Total Fixed Cost… But more on this later!

The University of Papua New Guinea Slide 4 Lecture 5: Markets in action Michael Cornish Consumer and producer surplus Price Quantity 0 D Q* P* S Producer surplus Consumer surplus Note: We can calculate CS and PS by using the formula for a triangle: (Base x Height) / 2

The University of Papua New Guinea Slide 5 Lecture 5: Markets in action Michael Cornish Price floors and price ceilings There are many ways in which governments can intervene in markets, and the simplest method is to fix the price in the market This will either be a: –Price ceiling: the government makes it illegal to sell at a price higher than the price they fix –Price floor: the government makes it illegal to sell at a price lower than the price they fix

The University of Papua New Guinea Slide 6 Lecture 5: Markets in action Michael Cornish Price Ceiling 0 S D PCPC Price P* QSQS Shortage P Ceiling Q*Q* QDQD Quantity

The University of Papua New Guinea Slide 7 Lecture 5: Markets in action Michael Cornish Price Floor 0 S D PFPF Price P* QDQD Surplus P Floor Q*Q* QSQS Quantity

The University of Papua New Guinea Slide 8 Lecture 5: Markets in action Michael Cornish Price floors and price ceilings But what is the purpose of these policies? –A price ceiling is intended to protect consumers; e.g. rent controls, food prices in low income countries –A price floor is intended to protect producers; e.g. Australian wool prices until the 1980s, the minimum wage (workers are ‘producers’ of labour) –But do they work??

The University of Papua New Guinea Slide 9 Lecture 5: Markets in action Michael Cornish B C A 0 S D $1,000 Price ($ / month) $1,500 1,900,0002,000,0002,100,000 Deadweight loss = B + C Producer surplus transferred from landlords to renters Shortage of apartments Rent control price ceiling Apartments An example: Rent Controls Max. black market price

The University of Papua New Guinea Slide 10 Lecture 5: Markets in action Michael Cornish Taxes The government raises revenues through taxes The government can apply the tax to the supplier or the consumer –However, it makes no difference to who bears the burden of the tax, only to who actually hands the money to the government! When a good or service is taxed, it leads to a loss of efficiency in that market –I.e. it leads to deadweight loss

The University of Papua New Guinea Slide 11 Lecture 5: Markets in action Michael Cornish Taxes So why levy a tax then? –To discourage consumption or production of a particular product –To spend the revenues in a way that creates a larger social benefit than the loss in efficiency in that market –For political purposes + other reasons

The University of Papua New Guinea Slide 12 Lecture 5: Markets in action Michael Cornish Price (kina per pack) Quantity of cigarettes (billions of packets per year) S0S0 D K1.00 per pack tax on cigarettes shifts the supply curve up by K1.00 K S1S1 Deadweight loss (via an excess burden) from tax Price the consumers pay after the K1.00 tax is imposed Tax revenue A C B Price received by producers after paying the tax An example: A tax on cigarette producers

The University of Papua New Guinea Slide 13 Lecture 5: Markets in action Michael Cornish Price (kina per pack) Quantity of cigarettes (billions of packets per year) S0S0 D0D0 K1.00 per pack tax on cigarettes shifts the demand curve down by K1.00 K S1S1 Deadweight loss (via an excess burden) from tax Tax revenue A C B Price consumers pay (price received by producers plus K1.00 tax to govt) Price received by producers An example: A tax on cigarette consumers D1D1

The University of Papua New Guinea Slide 14 Lecture 5: Markets in action Michael Cornish Taxes Conclusions: The more inelastic party bears the greater burden of the tax –The actual division of the burden is called the tax incidence

The University of Papua New Guinea Slide 15 Lecture 5: Markets in action Michael Cornish Taxes Conclusions (cont.): Again, which party ‘hands over the money’ to the government makes no difference to who bears the burden of the tax –I.e. who suffers the most from a tax is NOT DEPENDENT on who you choose to tax!!

The University of Papua New Guinea Slide 16 Lecture 5: Markets in action Michael Cornish Subsidies Subsidies are payments made by the government to consumers or producers in a market to encourage consumption or production Graphically? –Subsidies work in exactly the same way as taxes, simply in reverse! –Still creates dead weight loss

The University of Papua New Guinea Slide 17 Lecture 5: Markets in action Michael Cornish Price (kina per vacc’n) Quantity of vaccinations (thousands of per year) S1S1 D K S0S0 Deadweight loss from subsidy – government pays for this, but no-one gets it! Price the producers receive after they get the K1.00 subsidy C B A K1.00 per subsidy per vaccination shifts the supply curve out by K1.00 Additional consumer surplus Price paid by consumers An example: A subsidy for vaccination suppliers Additional producer surplus

The University of Papua New Guinea Slide 18 Lecture 5: Markets in action Michael Cornish An example: A subsidy for vaccination consumers Price (kina per vacc’n) Quantity of vaccinations (thousands of per year) S1S1 K S0S0 Deadweight loss from subsidy – government pays for this, but no-one gets it! Price the producers receive C B A K1.00 per subsidy per vaccination shifts the demand curve out by K1.00 Additional producer surplus Price paid by consumers after they get the K1.00 subsidy Additional consumer surplus D0D0 D1D1

The University of Papua New Guinea Slide 19 Lecture 5: Markets in action Michael Cornish Subsidies Conclusions: The more elastic party gets the greater benefit of the subsidy –The actual division of the benefit is called the subsidy incidence

The University of Papua New Guinea Slide 20 Lecture 5: Markets in action Michael Cornish Subsidies Conclusions (cont.): Again, which party ‘receives the money’ to the government makes no difference to who gets the benefit from the subsidy! –I.e. who benefits the most from a subsidy is NOT DEPENDENT on who you choose to subsidise!!