Welfare Analysis Consumers buy and producer sells. Both benefit from the trade. You do a hair cut for $80. Your gross benefit in term of money should be larger or at least equal to $80. What is you benefit net of the cost? I offer the haircut to you for $80. It costs me $80 or less. What is my benefit net of the cost?

Welfare Analysis Concepts of these gain (or loss): -Consumer surplus: consumer’s net benefit from transactions. -Producer surplus: producer’s net benefit from transactions. In economics, these are called welfare analysis. Why welfare analysis? Only after we know the net benefit of some market situations can we decide: Do we need to implement some policies to change the current situation? Is the current institutional arrangement ideal? Reading: 4.4

Consumer Surplus The simplest way to evaluate consumers’ benefit from market exchange is to use demand curve. The idea: People’s valuation of a good is different. The keenest person is willing to pay more. The least enthusiastic person is willing is pay less. However, in most situations (in a competitive market), price charged for the good is the same for all different people. → Those who voluntarily buy is expected to gain from the purchase.

Demand Back to the small town, the 4 long hairs’ maximum money that they are willing to pay for a haircut are: -Amy: $120 -Benny: $80 -Calvin: $50 -Dora: $30

Demand If market price is $50, Amy, Benny, Calvin will do the deal. The value of the haircut to Amy is $120. She indeed has a net gain of $70. Benny’s net gain: $30. Calvin’s net gain: $0. Total net gain: $100 = consumer surplus Amy: $120 Benny: $80 Calvin: $50 Dora: $30

Consumer Surplus Consumer surplus: -Adding up the blue charts. -Adding up the consumer value above the market price. -The part of demand charts (curve) that is above market price.

Another example: Each one may not buy just one unit of a good. Apple. Amy and Benny. If market price is $4, Amy’s net gain is $6 (buy one apple). Benny’s net gain is $6+$1 (buy 2 apples).

Consumer Surplus A Quantity Price If the good is highly divisible (not haircut), we have a demand curve, not charts. Consumer surplus is the triangle area above price.

Producer Surplus Producer surplus: In a competitive market, homogeneous products are sold at one price. But producers produces products at different costs. Even though price is as low as $2, I may be willing to sell. But you won’t, you require at least $3. If I can sell it at $3, I won’t sell it at $2, even though I will if I can only sell it at $2. My surplus is $1 if price is $3.

Supply Again, in our small town, four barbers. Kim Robertson requires at least $160 for a haircut. Mr Chan requires at least $110 for a haircut. X-man requires at least $80. Regina requires at least $60. Note that the lowest price required should reflect the barber’s cost of providing the service. The X-man doesn’t want to do the job because doing some other thing (e.g. sleeping) should give him a value of $80. The value of the next best alternative to X-man is $80. The opportunity cost of the haircut job is $80.

Supply Suppose the market price is $100. Only X-man and Regina do. X-man’s net gain is $20. Regina’s net gain is $40. Total net gain is $60 = producer surplus. Kim: $160 Mr Chan: $110 X-man: $80 Regina: $60

Producer Surplus Producer surplus: -Adding up the yellow charts -Adding up the value in excess of cost by suppliers -The area between price and supply charts.

Producer Surplus S Quantity Price ($ per unit) Similarly, if quantity is highly divisible, we’ll get a smooth supply curve. Producer surplus is the triangle below the price and above the supply curve.

Welfare in Market Equilibrium Surely, price is not arbitrarily determined. In equilibrium, there is only one price sustaining. Equilibrium price is $80. Consumer surplus: $40. Producer surplus: $20. Total surplus: $60.

Welfare in Market Equilibrium Total welfare in this market situation is? Why P 0 Q 0 is not the welfare? D S P0P0 Q0Q0 Quantity Price ($ per unit)