Policy Analysis

Policy Analysis

Outline

• Welfare Analysis– Consumer surplus– Producer surplus

• Welfare consequences of minimum wage

• Wage subsidy as alternative to minimum wage

• Tortillas as a Cautionary Tale

Economic Efficiency

• A situation is economically inefficient if there is some way to change it so that so that someone gains while no one else loses.

• A change is a Pareto improvement if at least one person gains and no one loses

• A change is economically efficient if the winners could compensate the losers by enough to make the change a Pareto improvement.

Assessing Benefits

• Consumer Sovereignty

• “Willingness to Pay” = Consumer Benefit

• Consumer Surplus

• “Willingness to Sell” =Opportunity Cost

• Producer Surplus

Consumer Surplus -- Difference between Willingness to Pay and Price

Paid by Buyer

1 2 3

Price

Quantity

P0

Demand

1

2

3

4 5

4

Price

Quantity

P0

Demand

5

Consumer Surplus

Total Expenditure

Consumer Surplus Is Triangle Below Demand, Above Market Price.

Producer Surplus- Difference Between Opportunity Cost and Selling Price

1

2

3

4

5

1 2 3 4 5

P0=5

Price

Quantity

Producer Surplus

P0=5

Quantity

Price

Supply

Producer Surplus

Consumer and Producer Surplus - Market Equilibrium

Quantity

Price

Demand

Supply

P0

Consumer Surplus

Producer SurplusQ0

Impact of Price Floor on Efficiency

A

B

C

D

EF

Price Floor

Market clearing price

Q1 Q0

Supply

Demand

A -- New CSA+B+E -- Old CSB+C+D -- New PSC+F+D -- Old PS

E+F is deadweight loss associated with the price floor.

Impact of Price Ceiling on Efficiency

D

A

B

C

E

FMarket Clearing Price

Price Ceiling

Supply

Demand

A+B+C -- New CSA+B+E -- Old CSD -- New PSC+D+F -- Old PS

E+F is the Deadweight Loss Associated with Price Ceiling

SUMMARY

• Market Equilibrium is Efficient. No Deadweight Loss.

• Price controls create a deadweight loss

• Also, there are costs associated with rationing mechanisms, black markets etc.

Impact of $12 Minimum Wage

0

5

10

15

20

25

0 10 20 30 40 50 60 70 80

Labor Units

Minimum Wage

$2 Wage Subsidy

0

5

10

15

20

25

30

0 10 20 30 40 50 60 70 80

Labor Units

Demand, no subsidy

Demand with Subsidy

SUPPLY

W before Subsidy

W after Subsidy

Comparison

• If demand is elastic, minimum wage reduces employment

• Benefits accrue to workers who stay employed

• Costs borne by employers and consumers

• Wage subsidy increases employment

• Benefits shared by employers and workers

• Subsidy funded from general government revenues

Subsidy Benefits Employers and Workers

0

5

10

15

20

25

30

0 10 20 30 40 50 60 70 80

Labor Units

Demand After Subsidy

Demand Before Subsidy

Supply

Wage with subsidy

Wage paid by employers

Impact of Subsidy on Efficiency

Price buyers pay

Price Sellers receive

Pre Subsidy Price

Pre Subsidy Q Post SubsidyQ

A

B C

F E

G

D

A+B+F+E = CS after SubsidyA+B = CS before SubsidyB+C+F+G = PS after SubsidyF+G= PS before SubsidyB+C+D+E+F = SubsidyD=Deadweight Loss from Subsidy

TortillasOn New Year’s Day 1999, Mexico ended price controls on tortillas. The price stood at 3 pesos per kilo (31 cents for 2.2 pound stack). Some

shops immediately raised their prices by 50%. In 1998, the government phased out subsidies to the

tortilla industry that helped keep prices down. The tortilla subsidy was replaced with programs

such as one that gives the 1.2 million poorest Mexicans free tortillas each day.

Source: Smith, James, Los Angeles Times, Jan 7, 1999

Questions• What does the price increase suggest about

the elasticity of demand for tortillas?

• How does the impact of a subsidy to consumers differ from the impact of a

subsidy to producers?

• What are the advantages of price controls as compared with subsidies?

Elasticity of Demand for Tortillas?

Price ceiling

Supply

Demand ADemand B

Kilos of tortillas

P

PA

PB

Subsidy to Producers

0

2

4

6

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10

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16

18

0 10 20 30 40 50 60 70 80

Quantity

Demand

SUPPLY

Supply after subsidy

Price Suppliers Receive

Price Buyers Pay

Subsidy to Consumers

-1

1

3

5

7

9

11

13

15

17

19

21

23

25

0 10 20 30 40 50 60 70 80

Kilos of tortillas

Price producers receive

Price consumers pay after subsidy

Demand After Subsidy

Demand Before Subsidy

Another Approach

0

2

4

6

8

10

12

14

16

18

20

0 10 20 30 40 50 60 70 80

Quantity

Price suppliers receive after subsidy

Price buyers pay after subsidy

If All Consumers Received Subsidy:

• If all consumers receive the subsidy, output is same

• Price producers receive is same in two cases

• Price consumers pay is same in two cases

Disadvantages of Subsidies

• Control of subsidies by local bureaucrats created opportunties to exploit subsidies for political ends. Price controls anonymous.

• Consumers not eligible for subsidies, but still relatively poor will pay a higher price for tortillas.

Key Concepts

• Impact of price controls and of subsidies depends on elasticity of demand (and supply).

• Price floors lead to surpluses. Price ceilings to shortages.

• Price controls lead to a deadweight loss.