POE_Week10.pdf

8/19/2019 POE_Week10.pdf

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Objective : examine effects of policy

Consider a perfectly competitive market equilibrium

Consumer Surplus = difference between what a consumer is

willing to pay for a good and the amount actually paid


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Consumer surplus

S

D

P

Q

P*

Q*

It is the area under the demand curve & above the price.


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For some producers, equilibrium price is

higher than the minimum price at whichthey are willing to produce

For all the producers, this is called

producer surplus


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Producer surplus

difference between what the producer receives for the good

and the amount the producer is willing to receive to provide

the good.

S

D

P

Q

P*

Q*

It is the area above the supply curve & below the price.


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Social Welfare

Social welfare = consumer surplus + producer surplus.


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D

P

Q

P1

Q1

S


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As we increase the quantity & reduce the price,the total area CS+PS increases

S

D

P

Q

P2

Q2


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S

D

P

Q

P3

Q3

and increases,


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CS + PS is maximum when we reach the perfectly

competitive equilibrium.

S

D

P

Q

P*

Q*


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Implication:social welfare (i.e. total surplus) = CS+ PS

is maximized at the perfectly competitive

equilibrium.


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How to compare the social welfare of

two different situations?

1.

Calculate the welfare from situation 1 by summing itsconsumer surplus and producer surplus:

W1 = CS1 + PS1.

2. Calculate the welfare from situation 2 by summing its

consumer surplus and producer surplus:

W2 = CS2 + PS2.

3. Calculate the difference,

W2 – W1 = (CS2 + PS2) – (CS1 + PS1).This tells us the gain or loss of welfare of one situation

relative to the other.

When a policy results in a loss of welfare to society,

that loss is often referred to as the deadweight loss.


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Change in welfare

W2 – W1 = (CS2 + PS2) – (CS1 + PS1)

• An alternative equivalent way is the following.

1.

Calculate the change in consumer surplus:

!CS = CS2 – CS1 .

2. Calculate the change in producer surplus:

!PS = PS2 – PS1 .

3. Add to get the total gain or loss in social welfare:

!CS + !PS = (CS2 – CS1) + (PS2 – PS1)


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Why useful?

Examine the welfare effects of some government

policies.

Calculate the benefits and costs of variouseconomic policies


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Price Ceiling

S

D

P

Q

P*

Q*

Without the ceiling what is CS+PS ?

Suppose the Govt. considers the price P* to be too high


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With price ceiling, Pc , the consumer & producer

surpluses are as shown.

S

D

P

Q

Pc

Qc


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Consumers have lost area V but gained area U.

S

D

P

Q

Pc

Qc

U

V


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The consumers who gain are those who get the product

at a lower price.

S

D

P

Q

Pc

Qc

U

V

The consumers who lose are those who are no longer

able to buy the product because there is less supplied.


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In the graph, area U > area V, so consumers as a whole gain.

However, if area U < area V, consumers would lose.

S

D

P

Q

Pc

Qc

U

V


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Producers have lost areas U and W.

S

D

P

Q

Pc

Qc

U W


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Observe: area U moved from producers to consumers,

But areas V and W are lost by society (consumers + producers)

S

D

P

Q

Pc

Qc

W

V

U


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Area V+W is the difference in the total consumer and

producer surplus with and without the policy

(CS2 + PS2) – (CS1 + PS1).

S

D

P

Q

Pc

Qc

W

V V+ W= deadweight

loss to society that

results from the policy.


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Price Ceiling Example:Suppose in the absence of controls, equilibrium price = 8K

& equilibrium quantity = 2 million

S

D

8K

0 2


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Next suppose that a price ceiling =7 is imposed. As a result the quantity supplied drops to 1.8 million.

S

D

8K

7K

0 1.8 2


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Based on the graph, determine the effectson consumers, producers, & society as a whole.

S

D

9K8K

7K

0 1.8 2.0


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S

D

9K8K

7K

0 1.8 2.0

W

V

U

U = (1.8 million) (8,000 – 7,000) = 1,800 millionV = (1/2)(0.2 million)(1,000) = 100 million

W = (1/2)(0.2 million)(1,000) = 100 million


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S

D

98

7

0 1.8 2.0

W

V

U

Consumers gain

U – V = 1,800 million - 100 million = 1,700 million.

Producers lose

U + W = 1,800 million + 100 million = 1,900 million


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S

D

98

7

0 1.8 2.0

W

V

U

Producers lose 200 million more than consumers gain.So there is a deadweight loss of 200 million per year.


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Price Floor

Without the floor, market clears at P*

S

D

P

Q

P*

Q*


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Suppose a price floor of Pf is imposed

S

D

P

Q

Pf

Qf


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Consumers lose areas U & V.

S

D

P

Q

Pf

Qf

VU


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Producers gain area U & lose area W.

S

D

P

Q

Pf

Qf

U

W


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Again the deadweight loss is area V+W .

S

D

P

Q

Pf

Qf

W

V

POE_Week10.pdf

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