Chapter 7

Chapter 7

Welfare Economics Consumer Surplus and Producer Surplus Reading Material See the Consumer and Producer Surplus subsection of the Costs and Benefits of a Tariff section of Chapter 9 (The Instruments of Trade Policy) of International Economics: Theory and Policy, 10th edition, by Paul Krugman, Maurice Obstfeld, and Marc Melitz 2 Revisiting The Market Equilibrium The theory of supply and demand shows how markets allocate scarce resources among competing needs. But are the equilibrium price and the equilibrium quantity the right price and the right quantity from societys point of view? This question takes us into welfare economics. 3 Welfare Economics

Welfare economics is the study of how the allocation of resources affects economic well-being It shows that: Both buyers and sellers gain from all the buying and selling The equilibrium outcome in the theory of supply and demand maximizes the total welfare of buyers and sellers 4 Two main concepts When buyers and sellers trade willingly, it must be because they expect to benefit Consumer surplus measures what the buyers gain. Producer surplus measures what the sellers gain. 5 CONSUMER SURPLUS 6 Willingness to pay To define consumer surplus we first need to define willingness

to pay. Willingness to pay is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good. 7 Willingness to pay: background Assume there is a commodity such that every additional unit of it increases a consumers happiness by the same amount In other words, the consumption of additional units of this commodity induces neither boredom nor addiction Possible examples: Potato chips? Candy? Then the consumers willingness to pay for a product is a good measure of the happiness that he or she gets from it 8 Willingness to pay: background Suppose a bag of potato chips provides a fixed amount of happiness

If your willingness to pay is 4 bags of potato chips for a shirt, and 2 bags of potato chips for a cup of coffee, then one can safely say that the shirt makes you twice as happy as the cup of coffee So, your willingness to pay for a commodity is a good measure of how much you like it 9 Willingness to pay: background If the dollar price of a bag of potato chips is known, willingness to pay in the example above can also be expressed in dollars 10 Willingness to pay: background Another example: if you are willing to pay $15 for a shirt, and if a bag of potato chips always gives you 3 haps of happiness, and sells at the price of $0.50 each, then

the shirt gives you 90 haps of happiness. 11 Willingness to pay: background In other words, your willingness to pay for the shirt is a monetary measure of the happiness you get from the shirt, and it is proportional to the happiness you get from the shirt, as measured in haps 12 Table 1 Four Possible Buyers Willingness to Pay For a mint-condition recording of Elvis Presleys first album I will illustrate consumer surplus through this extended example. 13

Consumer Surplus Consumer surplus is the buyers willingness to pay for a good minus the amount the buyer actually pays for it. Example: If the Elvis albums price is $75 Buyer Willingness to Pay Consumer Surplus Buy? John 100 25 Yes

Paul George Ringo 80 70 50 5 0 0 Yes No No 14 Market Demand The market demand shows the total quantity demanded by all buyers at different prices. We can use the willingness-to-pay numbers to calculate the market demand

See the next slide 15 The Demand Schedule Buyer Willingness to Pay John 100 Paul 80 George 70 Ringo

50 16 Figure 1 The Demand Curve Price of Album Buyer Willingness to Pay John 100 Paul 80 George 70 Johns willingness to pay

$100 Ringo Pauls willingness to pay 80 Georges willingness to pay 70 Ringos willingness to pay 50 Demand 0 50

1 2 3 4 The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit. Quantity of Albums Copyright2003 Southwestern/Thomson Learning 17

Area of a Rectangle Area = Width Height Width Height 18 Figure 2 Measuring Consumer Surplus with the Demand Curve Buyer Willingness (b) Price = $70.01 Price of Album $100 to Pay Consumer

Surplus Buy? John 100 30 Yes Paul 80 10 Yes George

70 0 No Ringo 50 0 No 1. The area under the demand curve measures the total willingness to pay for the quantity demanded. 80 70

50 2. It is also the maximum willingness to pay that could be generated from that quantity. Demand 0 Johns willingness to pay 1 4 Quantity of Albums Pauls willingness to pay 2 3 19

Interpersonal comparability We just saw that the total area under the demand curve is $180, and that is also the total willingness to pay of John and Paul But can we say it is the total happiness of John and Paul? 20 Interpersonal comparability Yes, if there is a commoditysay, a bag of potato chipsthat provides an unchanging amount of happiness to the consumer, and if Johns happiness and Pauls happiness are comparable, and if both John and Paul get the same happiness from a bag of potato chips Thats a lot of ifs! But we will make these simplifying assumption anyway Not just for John and Paul, but for everybody 21

Utilitarianism The idea that the happiness of an individual can be measured numerically, the happiness of a group of people can be measured numerically, the happiness of a group of people is simply the sum of the numbers representing the happiness of the individual members of the group, and that social policy should seek to maximize the total happiness of society, is called utilitarianism Welfare analysis in this course takes utilitarianism as its guiding philosophy 22 The market and the planner Suppose the government has two copies of the Elvis album. The governments goal is to give them to two of the four guys so as to generate the maximum happiness. Who will get the governments copies? Obviously, John and Paul, same as in the market outcome we saw before. So, the market does the best that the government could have done

Price = $70 Buyer Willingness to Pay John 100 Paul 80 Georg e 70 Ringo

50 23 Willingness to Pay from the Demand Curve Price P1 A B C The area under the demand curve measures the total willingness to pay of the consumers who bought Q1 units. It also measures the maximum willingness to pay that could be obtained from Q1 units

Demand 0 Q1 Quantity 24 Using the demand curve to measure willingness to pay In general, the area under the demand curve up to the quantity demanded is a graphical measure of the total willingness to pay of the buyers. It is also the maximum willingness to pay that can be obtained from that quantity That is, the government could not give away that quantity in a way that generates higher willingness to pay. 25 Figure 3 How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P Price A Consumer Surplus (ABC) + Total Payment (OBCQ1) = Willingness to Pay (OACQ1) Consumer surplus P1 B C Total Payment 0 Demand

Q1 Quantity 26 Using the Demand Curve to Measure Consumer Surplus In general, the area below the demand curve and above the price measures the consumer surplus. 27 Figure 3 How the Price Affects Consumer Surplus (b) Consumer Surplus at Price P Price A Initial consumer surplus P1

P2 0 C B Consumer surplus to new consumers F D E Additional consumer surplus to initial consumers Q1 Demand Q2

Quantity 28 Shifts in Demand We know that the demand curve can shift, for reasons such as a change in tastes, and a change in the prices of related goods Given that the demand for a product can shift as a result of a change in the price of a related good, does it make sense to say that the area under the demand curve measures the happiness consumers get from the product? 29 Shifts in Demand Continued from the previous slide Yes! Keep in mind that the area under the demand curve is a monetary measure of the happiness obtained by buyers The objective or psychological happiness obtained from a shirt may be unchanged even if the

monetary willingness to pay for the shirt changes, perhaps because of a change in the price of a related good In an earlier slide, a bag of potato chips was assumed to always provide 3 haps of happiness, and sold at a price of $0.50. Consequently, consumers were wiling to pay $15 for a shirt that provided 90 haps of happiness. It follows that if the price of a bag of potato chips rises to $1, consumers would then be willing to pay $30 for the same shirt, leading to an upward shift in the demand curve for shirts. 30 PRODUCER SURPLUS 31 Producer Surplus Producer surplus is the amount a seller is paid for a good minus the sellers cost. It measures the net benefit to sellers It is almost but not quite the same as profit. 32

Cost of production The cost of production is the market value of all resources used in production By all, I do mean all. Even if some resources used in production were obtained for free, their market value must be included in cost. 33 Table 2 The Cost of Painting a House for Four Possible Sellers 34 Costs Supply The supply of house painting services shows the quantity of house painting services supplied at all possible prices The cost numbers in the previous slide can be used to calculate supply of house painting services 35

Costs Supply Seller Cost ($) Mary 900 Frida 800 Georgia 600 Grandma 500 36

Figure 4 The Supply Schedule and the Supply Curve The height of the supply curve at any quantity shows the production cost to whoever produces the last unit. Seller Cost ($) Mary 900 Frida 800 Georgia 600

Grandma 500 37 Producer Surplus Producer surplus is the amount a seller is paid minus the sellers cost Example: If the going price for getting a house painted is $700 we get the following table. Seller Cost ($) Producer Surplus Sell? Mary 900 0

No Frida Georgia Grandma 800 600 500 0 100 200 No Yes Yes 38 Using the Supply Curve to Measure Producer Surplus The area below the price and above the supply curve measures

the producer surplus. 39 Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $799.99 Price of House Painting Supply 1. The area under the supply curve is the cost of the quantity supplied 2. It is also the lowest cost for that quantity $900 800

600 500 0 1 Grandmas cost Georgias cost 2 3 Seller Cost ($) Producer Surplus Mary

900 0 No Frida 800 0 No Georgia 600 200 Yes

Grandma 500 300 Yes 4 Quantity of Houses Painted Sell? 40 Is there a better alternative to the market system? If the government had to get two houses painted, who would get the job? Grandma and Georgia, of course. And, as we just saw, thats exactly what happens in the

market outcome. So, the market achieves the best that the government could have achieved Seller Cost ($) Mary 900 Frida 800 Georgia 600 Grandma 500

41 Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $800 Price of House Painting $900 Supply Total producer surplus ($500) 2. The area under the price and above the supply is the Producer Surplus. 800 Seller

Cost ($) Georgia s producer surplus ($200) Mary 900 600 500 Grandma s producer surplus ($300) 0 1. The rectangular area under the price and up to the quantity supplied is the Total Revenue. 1 2

3 Producer Surplus Sell? 0 No Frida 800 0 No Georgia

600 200 Yes Grandma 500 300 Yes 4 Quantity of Houses Painted 42 Figure 6 How the Price Affects Producer Surplus (a) Producer Surplus at Price P

Price Supply P1 B Producer surplus A 0 C Total Revenue (OBCQ1) = Production Cost (OACQ1) + Producer Surplus (ABC) Production Cost Q1

Quantity 43 Figure 6 How the Price Affects Producer Surplus (b) Producer Surplus at Price P Price Supply Additional producer surplus to initial producers P2 P1 D E F B Initial

producer surplus C Producer surplus to new producers A 0 Q1 Q2 Quantity 44 Figure 7 Consumer and Producer Surplus in the Market Equilibrium Price A

D Supply Consumer surplus Equilibrium price E Producer surplus B Demand C 0 Equilibrium quantity

Quantity 45

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