Welfare Economics and the Gains from Trade Chapter 8 Welfare Economics and the Gains from Trade Steven Landsburg, University of Rochester Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Landsburg, Price Theory and Applications, 6th edition Introduction Choosing policies that are best for economy Normative criterion: way to balance benefits that accrue to some people against cost imposed on others Efficiency criterion Choosing a measurement for weighing costs and benefits Measure gains from trade Discuss Invisible Hand Theorem Landsburg, Price Theory and Applications, 6th edition

Measuring the Gains from Trade Consumer purchases good Consumer gains Consumer surplus Producer gains Producer surplus Develop measure for gauging extent of gain Landsburg, Price Theory and Applications, 6th edition

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 Good bought as long as marginal value exceeds price stops when equal Marginal value curve and demand curve convey similar information Landsburg, Price Theory and Applications, 6th edition

Landsburg, Price Theory and Applications, 6th edition Consumers’ Surplus Total value as an area Consumer’s purchases equal area under demand curve out of quantity demanded Consumer’s surplus Consumer’s gain from 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 Landsburg, Price Theory and Applications, 6th edition

Landsburg, Price Theory and Applications, 6th edition EXHIBIT 8.2 Total Value Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.3 The Consumer’s Surplus Landsburg, Price Theory and Applications, 6th edition

Landsburg, Price Theory and Applications, 6th edition Producers’ Surplus Producer’s surplus Producer’s gains from trade Amount by which producer’s revenue exceeds variable production costs Area above supply curve up to price received and out to quantity supplied Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.4 The Producer’s Surplus Landsburg, Price Theory and Applications, 6th edition

Landsburg, Price Theory and Applications, 6th edition Social Gain Sum of all gains from trade to all participants Social gains and markets Can calculate gains across consumers and producers Landsburg, Price Theory and Applications, 6th edition

Landsburg, Price Theory and Applications, 6th edition EXHIBIT 8.5 Welfare Gains Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.6 Consumers’ Surplus in the Market Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.7 Producers’ Surplus in the Market Landsburg, Price Theory and Applications, 6th edition

Landsburg, Price Theory and Applications, 6th edition Efficiency Criterion Weighing the interest of one group versus the interest of another group Normative criterion: general method for choosing amongst alternative policies Ex. Majority rule Efficiency criterion: normative criterion according to which your votes are weighted according to your willingness to pay for your preferred outcome Landsburg, Price Theory and Applications, 6th edition

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 Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.8 The Effect of a Sales Tax Landsburg, Price Theory and Applications, 6th edition

Understanding Deadweight Loss Imagine social gain as a pie Taxation changes way pie distributed Taxation changes size of pie Consumer and producer share of pie changes Recipients of tax revenue now get part of pie Add up pieces of pie Pie shrunk Shrinkage is deadweight loss If deadweight loss created, develop alternative policy where not true Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.9 Deadweight Loss Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.10 The Tax Collector versus Robin Hood Landsburg, Price Theory and Applications, 6th edition

Other Normative Criteria Pareto criterion One policy is better than another when it is preferred unanimously Advantage: recommendations noncontroversial Potential Pareto criterion Any proposal that can be unanimously defeated – even by a candidate not under consideration – should be rejected Potential Pareto criterion and efficiency criterion make same recommendation Landsburg, Price Theory and Applications, 6th edition

Examples and Applications Subsidies Price ceilings Tariffs Robbery Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.12 The Effect of a Subsidy Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.14 A Price Ceiling Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.15 A Tax on Imported Cameras Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.17 A Tariff When There Is a Domestic Industry Landsburg, Price Theory and Applications, 6th edition

Landsburg, Price Theory and Applications, 6th edition Theories of Value Diamond-water paradox Price reflects 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 Assertion that value of object determined by amount labor needed to produce it Value determined not by cost of inputs but by consumer’s willingness to pay for good Landsburg, Price Theory and Applications, 6th edition

General Equilibrium and the Invisible Hand Fundamental theorem of welfare economics Competitive equilibrium is Pareto-optimal Invisible hand Equilibrium point also maximum social gain point General equilibrium Way to model economy where take account of all markets at once and of all intersections among them Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.20 The Invisible Hand Landsburg, Price Theory and Applications, 6th edition

Landsburg, Price Theory and Applications, 6th edition Edgeworth Box Economy Edgeworth box Graph of an economy with two individuals, two goods, and no production Endowment point Point representing the initial holdings of an individual in a Edgeworth box Region of mutual advantage Set of points considered at least as good as the initial endowment derived from trades between consumers Contract curve Set of Pareto-optimal points created from indifference curve tangencies Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.21 Trade in an Edgeworth Box Economy Landsburg, Price Theory and Applications, 6th edition

Edgeworth Box Economy Continued Competitive equilibrium in the Edgeworth box Infinite variety of possible outcomes for bargaining process Bargain according to some set of prices Continue adjusting prices until reach equilibrium Competitive equilibrium point where everyone will choose to trade to Invisible hand in Edgeworth box Consumer’s indifference curves tangent at the competitive equilibrium Point on contract curve Pareto optimal Invisible hand theorem true Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.22 Competitive Equilibrium in an Edgeworth Box Economy Landsburg, Price Theory and Applications, 6th edition

General Equilibrium with Production Robinson Crusoe and production possibility curve Displays all baskets that can be produced Slope equal to relative price of good X in terms of good Y Bows outward from origin Consumer ultimately equates slope of production possibility curve to slope of indifference curve Open economy World economy Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.24 Production and Consumption with Foreign Trade Landsburg, Price Theory and Applications, 6th edition

General Equilibrium with Production Continued Open economy Trades with outsiders at prices determined in world economy Production occurs at point where production possibility curve tangent to line of slope equal to relative price of good X Line of tangency becomes budget line How much gain occurs for consumer due to trade? Autarkic price World relative price Determined by supply and demand If prices equal, no gain from trade More world price differs from autarkic price, more gains from trade World economy Process for determining world supply and demand of goods Landsburg, Price Theory and Applications, 6th edition

EXHIBIT 8.25 Autarkic versus World Relative Prices Landsburg, Price Theory and Applications, 6th edition