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Producer and Consumer Surplus Consumer surplus is the value the consumer gets from buying a product, less its price It is the area below the demand curve and above the price Producer surplus is the value the producer sells a product for less the cost of producing it It is the area above the supply curve but below the price the producer receives 8-2

Producer and Consumer Surplus Consumer surplus = area of red triangle = ½($5)(5) = $12.5 $10 9 8 7 6 5 4 3 2 1 S Producer surplus = area of green triangle = ½($5)(5) = $12.5 CS PS The combination of producer and consumer surplus is maximized at market equilibrium D Q 0 1 2 3 4 5 6 7 8 8-3

The Burden of Taxation The costs of taxation include: Direct cost of the tax paid to the government by consumers and producers The deadweight loss which is the loss of consumer and producer surplus that is not gained by the government The administrative costs of compliance which are the resources used by the government to administer the tax and individuals and businesses to comply with it 8-4

Demand is relatively elastic Demand is relatively inelastic The Burden of Taxation Demand is relatively elastic Demand is relatively inelastic P P Consumers pay more S1 Producers pay more S1 S0 S0 t t P1 P1 P0 P0 P1-t P1-t D D Q Q Q1 Q0 Q1 Q0 8-5

Government Intervention as Implicit Taxation Government intervention in the form of price controls can be viewed as a combination tax and subsidy An effective price ceiling is a government set price below the market equilibrium price It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation An effective price floor is a government set price above the market equilibrium It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers 8-6

Application: The Effect of a Price Ceiling An effective price ceiling is set below market equilibrium price P A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity S P0 P1 Price ceiling Shortage D Q Q1 Q0 8-7

Application: The Effect of a Price Floor An effective price floor is set above market equilibrium price P Surplus S P1 Price floor P0 A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity D Q Q1 Q0 8-8

The Difference Between Taxes and Price Controls Price ceilings create shortages and taxes do not Taxes leave people free to choose how much to supply and consume as long as they pay the tax Shortages may also create black markets 8-9

Rent Seeking, Politics, and Elasticities Rent-seeking activities are activities designed to transfer surplus from one group to another Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public 8-10

Inelastic Demand and Incentives to Restrict Supply Revenue gained When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue S1 S0 P1 C P0 Revenue lost A B D Q Q1 Q0 8-11

Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic, consumers have incentives to restrict prices When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls Rent control in New York City is an example 8-12

Application: Price Floors and Elasticity The surplus created by a price floor is larger if demand and supply are elastic P P S Surplus Surplus S P1 P1 Price floor P0 P0 D D Q Q Q1 Q0 Q1 Q0 8-13

Long-Run and Short-Run Effects on Price Control Higher long-run elasticity of supply results in smaller price increases when demand increases Sshort-run PSR Slong-run PLR P0 D1 D0 Q Q0 QSR QLR 8-14