Principles of Microeconomics 9. Prices, Total Surplus, and Market Efficiency* Akos Lada August 1 st, 2014 * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

Contents 1.Review of previous lecture 2.Prices and producer surplus 3.Market efficiency 4.Price controls and economic welfare 5.Taxes and economic welfare

1. Review

The picture frames auction BuyerWTB Day 1Day 2Day 3 PQSQS PQSQS PQSQS Rosalia20$ units$ 50 units$ 7.51 unit Seeye18$ 176 units$ units$ 92 units Mehnaz16$ 166 units$ 103 units$ units Rachel14$ 145 units$ 124 units$ 145 units Monica12$ 124 units$ units$124 units Ellen10$ units$ units$103 units BuyerWTB Price floor $16Price ceiling $ 10Tax of $4 PQSQS PQSQS PQSQS Rosalia20$ 166 units$ 103 units$ 101 unit Seeye18$ units$ units$ units Mehnaz16$ 166 units$ 163 units$ 164 units Rachel14No bid0 units$ 133 units$ 143 units Monica12No bid0 units$ 123 units$123 units Ellen10No bid0 units$ 103 units$9.890 units

Q P WTP and D curve, Cost and S curve D S At any Q: the height of the Demand Curve is the WTP of the marginal buyer. …and the height of the Supply Curve is the cost of the marginal seller. At equilibrium WTP of marginal buyer and costs of marginal seller are the same

Q P CS and a change in Price Q* D S P* 1 P* 2 Consumer surplus is the area between the demand curve and the equilibrium price A higher price implies a loss in CS that comes from: Buyers that remain in the market paying more money per units. Buyers leaving the market.

P Q Calculating consumer surplus in a smooth demand curve D To calculate the area of the triangles: ½ (base x height) To calculate the area of the rectangles: base x height 1. Fall in CS due to buyers leaving market 2. Fall in CS due to remaining buyers paying higher P

2. Prices and Producer Surplus

Q P Students’ Turn: What is the Producer surplus at Price $13? Q* D S P*

Q P The PS at Price $13? Q* D S P* Kirk: = 7 Golib: = 5 Rebeca: 13 – 10 = 3 Chandrika: 13 – 12 = 1 Total PS = 16

P Q PS with Lots of Sellers & a Smooth S Curve The supply of shoes S 1000s of pairs of shoes Price per pair Suppose P = $40. At Q = 15(thousand), the marginal seller’s cost is $30, and her producer surplus is $10.

P Q PS with Lots of Sellers & a Smooth S Curve The supply of shoes S PS is the area b/w P and the S curve, from 0 to Q. The height of this triangle is $40 – 15 = $25. So, PS = ½ x b x h = ½ x 25 x $25 = $ h

Q P How a lower price reduces PS in our example Q* D S P* 1 P* 2 In the Price falls from $13 to $11, total PS decreases from $16 to $ 9. From the $7 loss in PS: $ 6 are because each of the 3 sellers remaining gets $2 less per frame. $ 1 is because one seller left the market

P Q How a Lower Price Reduces PS with a Smooth Supply Curve If P falls to $30, PS = ½ x 15 x $15 = $ 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

P Q supply curve A. Find marginal seller’s cost at Q = 10. B. Find total PS for P = $20. Suppose P rises to $30. Find the increase in PS due to… C. selling 5 additional units D. getting a higher price on the initial 10 units STUDENTS’ TURN: Producer surplus

Answers P Q supply curve A. At Q = 10, marginal cost = $20 B. PS = ½ x 10 x $20 = $100 P rises to $30. C. PS on additional units = ½ x 5 x $10 = $25 D. Increase in PS on initial 10 units = 10 x $10 = $100

3. Market Efficiency

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)

Q P Total surplus at Price $13 Q* D S P* CONSUMER SURPLUS (16) PRODUCER SURPLUS (16) TOTAL SURPLUS (32)

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 are focus here is on efficiency.)

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

Evaluating the Market Equilibrium Market equilibrium: P = $30 Q = 15,000 Total surplus = CS + PS Is the market equilibrium efficient? P Q S D CS PS

Which Buyers Consume the Good? P Q S D Every buyer whose WTP is ≥ $30 will buy. Every buyer whose WTP is < $30 will not. So, the buyers who value the good most highly are the ones who consume it.

Which Sellers Produce the Good? P Q S D Every seller whose cost is ≤ $30 will produce the good. Every seller whose cost is > $30 will not. So, the sellers with the lowest cost produce the good.

Does Equilibrium Q Maximize Total Surplus? P Q S D At Q = 20, cost of producing the marginal unit is $35 value to consumers of the marginal unit is only $20 Hence, can increase total surplus by reducing Q. This is true at any Q greater than 15.

Does Equilibrium Q Maximize Total Surplus? P Q S D At Q = 10, cost of producing the marginal unit is $25 value to consumers of the marginal unit is $40 Hence, can increase total surplus by increasing Q. This is true at any Q less than 15.

Q P Same in our example: If Q is higher than the equilibrium Q… Q* D S

Q P If Q is lower than the equilibrium Q… Q* D S

Q P Conclusion: The Market Equilibrium is efficient Q* D S The market equilibrium quantity maximizes total surplus: At any other quantity, can increase total surplus by moving toward the market equilibrium quantity.

4. Price Controls and Economic Welfare

Q P A binding price floor and CS Q* D S P* Min P QSQS QDQD How does the CS change? In this example, consumer surplus is reduced Partly because buyers leave the market Partly because those buyers still in the market pay more per unit

Q P A binding price floor and PS Q* D S P* Min P QSQS QDQD How does the PS change? In this example, producer surplus is increased On the one hand, less units are sold (since buyers leave the market. But on the other hand, the sellers receive more per unit In this example, the first effect is smaller than the second.

Q P A binding price floor and total surplus Q* D S P* Min P QSQS QDQD But what happens to this surplus? Deadweight Loss! (DWL) The surplus that buyers who remain in the market loose because of higher prices …becomes producer surplus from the sellers’ point of view (doesn’t affect total surplus) The CS and the PS lost because of people leaving the market goes nowhere… just disappears! Economists call this a Deadweight Loss

A binding price ceiling and CS Q P Q* D S P* Max P QDQD QSQS How does the CS change? In this example, consumer surplus increases On the one hand, some surplus is lost because some buyers cannot find anybody to sell at the new price (shortage) But on the other hand, those buyers who stay in the market pay less per unit In our example, the first effect is smaller than the second

A binding price ceiling and PS Q P Q* D S P* Max P QDQD QSQS How does the PS change? In this example, producer surplus is reduced Partly because sellers leave the market Partly because those sellers still in the market receive less money per unit

Q P A binding price ceiling and total surplus Q* D S P* QDQD QSQS But what happens to this surplus? Deadweight Loss! (DWL) The surplus that sellers who remain in the market loose because of lower prices …becomes consumer surplus from the buyers’ point of view (doesn’t affect total surplus) The CS and the PS lost because of people leaving the market goes nowhere… just disappears! Economists call this a Deadweight Loss Max P

5. Taxation and Deadweight Loss

QTQT The Effects of a Tax P Q D S Equilibrium with no tax: Price = P E Quantity = Q E PSPS PBPB PEPE QEQE Equilibrium with tax = $T per unit: Sellers receive P S Quantity = Q T Buyers pay P B Size of tax = $T

Tax Revenue P Q D S Revenue from tax: $ T x Q T PSPS PBPB PEPE QEQE QTQT Size of tax = $T

Government Revenue and Total Surplus Next, we apply welfare economics to measure the gains and losses from a tax. We determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax. Tax revenue can fund beneficial services ( e.g., education, roads, police) so we include it in total surplus.

Before the Tax P Q D S PEPE QEQE QTQT A B C D E F CS = A + B + C PS = D + E + F Tax revenue = 0 Total surplus = CS + PS = A + B + C + D + E + F

After the Tax P Q D S PSPS PBPB QEQE QTQT A B C D E F CS = A PS = F Tax revenue = B + D Total surplus = A + B + D + F The tax reduces total surplus by C + E

The DWL of a tax P Q D S PSPS PBPB QEQE QTQT A B C D E F C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax.

About the Deadweight Loss P Q D S PSPS PBPB QEQE QTQT Because of the tax, the units between Q T and Q E are not sold. The value of these units to buyers is greater than the cost of producing them, so the tax prevents some mutually beneficial trades.

Q P In our example: A 4 dollars tax Q* 1 D S1S1 Q* 2 S2S2 P* 1 P* 2 Equilibrium 1 Equilibrium 2 The tax was imposed on the sellers The Supply curve shifts left There is a new equilibrium quantity and a new equilibrium price range.

Q P What happens to the CS and the PS? Q* 1 D S1S1 P* 1 S2S2 PBPB PSPS CS lost by buyers PS lost by sellers Tax revenue collected by the government But what happens to this surplus? Deadweight Loss! (DWL) Q* 2

STUDENTS’ TURN: Analysis of tax A.Compute CS, PS, and total surplus without a tax. B.If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL. D S P Q $ The market for airplane tickets

A C T I V E L E A R N I N G 1 Answers to A D S CS = ½ x $200 x 100 = $10,000 P Q $ Total surplus = $10,000 + $10,000 = $20,000 PS = ½ x $200 x 100 = $10,000 P = The market for airplane tickets

A C T I V E L E A R N I N G 1 Answers to B D S CS = ½ x $150 x 75 = $5,625 P Q $ Total surplus = $18,750 PS = $5,625 Tax revenue = $100 x 75 = $7,500 DWL = $1,250 P S = P B = A $100 tax on airplane tickets

Discussion: the airline tax relief Refer to the article “A Bonanza for Airlines as Taxes End” on the recent impasse that led to a 2-weeks shutdown of the US Federal Aviation Administration How can we use the tools learned in the class to understand the airlines’ behavior?

Determinants of the Deadweight Loss

What Determines the Size of the DWL? Which goods or services should government tax to raise the revenue it needs? One answer: those with the smallest DWL. When is the DWL small vs. large? Turns out it depends on the price elasticities of supply and demand Recall: The price elasticity of demand (or supply) measures how much Q D (or Q S ) changes when P changes.

DWL and the Elasticity of Supply When supply is inelastic, it’s harder for firms to leave the market when the tax reduces P S. So, the tax only reduces Q a little, and DWL is small. When supply is inelastic, it’s harder for firms to leave the market when the tax reduces P S. So, the tax only reduces Q a little, and DWL is small. P Q D S Size of tax

DWL and the Elasticity of Supply P Q D S Size of tax The more elastic is supply, the easier for firms to leave the market when the tax reduces P S, the greater Q falls below the surplus- maximizing quantity, the greater the DWL. The more elastic is supply, the easier for firms to leave the market when the tax reduces P S, the greater Q falls below the surplus- maximizing quantity, the greater the DWL.

DWL and the Elasticity of Demand P Q D S Size of tax When demand is inelastic, it’s harder for consumers to leave the market when the tax raises P B. So, the tax only reduces Q a little, and DWL is small. When demand is inelastic, it’s harder for consumers to leave the market when the tax raises P B. So, the tax only reduces Q a little, and DWL is small.

DWL and the Elasticity of Demand P Q D S Size of tax The more elastic is demand, the easier for buyers to leave the market when the tax increases P B, the more Q falls below the surplus- maximizing quantity, and the greater the DWL. The more elastic is demand, the easier for buyers to leave the market when the tax increases P B, the more Q falls below the surplus- maximizing quantity, and the greater the DWL.

Would the DWL of a tax be larger if the tax were on: A. Breakfast cereal or sunscreen? B. Hotel rooms in the short run or hotel rooms in the long run? C. Groceries or meals at fancy restaurants? STUDENTS’ TURN Elasticity and the DWL of a tax

A.Breakfast cereal or sunscreen Breakfast cereal has more close substitutes than sunscreen, so demand for breakfast cereal is more price-elastic than demand for sunscreen. So, a tax on breakfast cereal would cause a larger DWL than a tax on sunscreen. B.Hotel rooms in the short run or long run The price elasticities of demand and supply for hotel rooms are larger in the long run than in the short run. So, a tax on hotel rooms would cause a larger DWL in the long run than in the short run. C.Groceries or meals at fancy restaurants Groceries are more of a necessity and therefore less price-elastic than meals at fancy restaurants. So, a tax on restaurant meals would cause a larger DWL than a tax on groceries. Answer