Lecture 3 Notes

HE191 Principles of Economics Lecture 3 Chapters 7 and 8 Principles of Economics, Fourth Edition N. Gregory Mankiw

In this lecture, look for the answers to these questions: „ What is consumer surplus? How is it related to the demand curve? „ What is producer surplus? How is it related to the supply curve? „ Do markets produce a desirable allocation of resources? Or could the market outcome be improved upon? „ How does a tax affect consumer surplus, producer surplus, and total surplus? „ What is the deadweight loss of a tax? „ What factors determine the size of this deadweight loss? „ How does tax revenue depend on the size of the tax?

Welfare Economics „ Recall, the allocation of resources refers to: „ how much of each good is produced „ which producers produce it „ which consumers consume it

„ Welfare economics: the study of how the allocation of resources affects economic well-being „ First, we look at the well-being of consumers.

Willingness to Pay (WTP) „A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. „WTP measures how much the buyer values the good. Name WTP Example: 4 buyers’ WTP for an iPod

Anthony $250 Chad

$175

Flea

$300

John

$125

WTP and the Demand Curve Q: If price of iPod is $200, who will buy an iPod, and what is quantity demanded? name

WTP

Anthony $250 Chad

175

Flea

300

John

125

A: ______________________ _______________________

Hence, Qd = when P = $200.

WTP and the Demand Curve P (price

Derive the demand schedule:

of iPod)

$301 & up

WTP

251 – 300

Anthony $250

176 – 250

name Chad

175

Flea

300

John

125

126 – 175 0 – 125

who buys

Qd

WTP and the Demand Curve $350 $300

P

$250 $200 $150 $100 $50 $0

Q

0

1

2

3

4

P

Qd

$301 & up

0

251 – 300

1

176 – 250

2

126 – 175

3

0 – 125

4

About the Staircase Shape… This D curve looks like a staircase with 4 steps – one per buyer.

P

$350 $300

If there were a huge # of buyers, as in a competitive market,

$250 $200

there would be a huge # of very tiny steps,

$150 $100 $50

and it would look more like a smooth curve.

$0

Q

0

1

2

3

4

Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the buyer actually pays: CS = WTP – P name

WTP

Suppose P = $260.

Anthony $250

Flea’s CS = ____________.

Chad

175

Flea

300

The others get no CS because they do not buy an iPod at this price.

John

125

Total CS = ____.

CS and the Demand Curve $350 $300

P

Instead, suppose P = $220

Flea’s WTP Anthony’s WTP

$250 $200

Flea’s CS = $300 – 220 = $80 Anthony’s CS = $250 – 220 = $30

$150

Total CS = $110

$100 $50 $0 0

1

2

3

4

Q

The lesson: Total CS equals the area under the demand curve above the price, from 0 to Q.

CS with Lots of Buyers & a Smooth D Curve CS is the area b/w P P and the D curve, from $ 60 0 to Q. Recall: area of a triangle equals ½ x base x height Height of triangle is $60 – 30 = $30. So, CS = ½ x 15 x $30 = $225.

The demand for shoes

50

h

40 30 20 10

D Q

0 0

5 10 15 20 25 30

Cost and the Supply Curve „ Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost). „ Includes cost of all resources used to produce good, including value of the seller’s time. „ Example: Costs of 3 sellers in the lawn-cutting business.

Name

Cost

Angelo

$10

Hunter

20

Kitty

35

A seller will only produce and sell the good if the price exceeds his or her cost. Hence, cost is a measure of willingness to sell.

Cost and the Supply Curve

Derive the supply schedule from the cost data:

P $0 – 9

name

cost

Angelo

$10

Hunter

20

20 – 34

Kitty

35

35 & up

10 – 19

Qs

Cost and the Supply Curve P

$40

Kitty’s cost

$30 $20

Hunter’s cost

$10

Angelo’s cost

$0

Q

0

1

2

3

At each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower. Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost.

Producer Surplus and the S Curve P

PS = P – cost

$40

Kitty’s cost

$30 $20

Hunter’s cost

$10

Angelo’s cost

$0

Q

0

1

2

3

Suppose P = $25. Angelo’s PS = $15 Hunter’s PS = $5 Kitty’s PS = $0 Total PS = $20 Total PS equals the area above the supply curve under the price, from 0 to Q.

PS with Lots of Sellers & a Smooth S Curve 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 = $312.5

P 60

The supply of shoes

S

50 40 30 h 20 10

Q

0 0

5 10 15 20 25 30

What do CS, PS, and Total Surplus Measure? CS = (value to buyers) – (amount paid by buyers) CS measures the benefit buyers receive from participating in the market. PS = (amount received by sellers) – (cost to sellers) PS measures the benefit sellers receive from participating in the market. Total surplus = CS + PS TS measures the total gains from trade in a market.

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. „ Total surplus = CS + PS = (value to buyers) – (amount paid by buyers) + (amount received by sellers) – (cost to sellers) = (value to buyers) – (cost to sellers)

Efficiency Total = (value to buyers) – (cost to sellers) surplus An allocation of resources is efficient if it maximizes total surplus. Efficiency means: „ Raising or lowering the quantity of a good would not increase total surplus. „ The goods are being produced by the producers with lowest cost. „ The goods are being consumed by the buyers who value them most highly.

Efficiency Total = (value to buyers) – (cost to sellers) surplus „ Efficiency means making the pie as big as possible. „ In contrast, equity refers to whether the pie is divided fairly. „ What’s “fair” is subjective, harder to evaluate. „ Hence, we focus on efficiency as the goal, even though policymakers in the real world usually care about equity, too.

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

60

S

50 40

CS

30

PS

20 10

D Q

0 0

5 10 15 20 25 30

Evaluating the Market Equilibrium : Summary The market equilibrium is efficient: „ The equilibrium Q maximizes total surplus. „ The goods are produced by the producers with lowest cost, „ and consumed by the buyers who value them most highly. The government cannot improve on the market outcome. Laissez faire (French for “allow them to do”): the government should not interfere with the market.

Why Non-Market Allocations Are Usually Bad ? „ Suppose the allocation of resources were instead determined by a central planner (e.g., the Communist leaders of the former Soviet Union.) „ To choose an efficient allocation, the planner would need to know every seller’s cost and every buyer’s WTP, for each of the thousands of goods produced in the economy. „ This is practically impossible, so centrally planned economies are never very efficient.

Review from Lecture 2: „ A tax is a wedge between the price buyers pay and the price sellers receive. „ A tax raises the price buyers pay and lowers the price sellers receive. „ A tax reduces the quantity bought & sold. „ These effects are the same whether the tax is imposed on buyers or sellers, so we do not make this distinction in this chapter.

The Effects of a Tax P

With no tax, eq’m price is PE and quantity is QE . Govt imposes a tax of $T per unit. The price buyers pay is PB , the price that sellers receive is PS and quantity is QT .

Size of tax = $T S

PB PE PS

D

QT

QE

Q

The Effects of a Tax P „ The tax generates revenue equal to T x QT . „ Next, we will determine consumer surplus (CS), producer surplus (PS), PB tax revenue, and total surplus with and without P E the tax. „ Tax revenue is included PS in total surplus, because tax revenue can be used to provide services such as roads, police, public education, etc.

Size of tax = $T S

D

QT

QE

Q

The Effects of a Tax P

Without a tax, CS = A + B + C, PS = D + E + F Tax revenue = 0 Total surplus = CS + PS =A+B+C +D+E+F

A

S B

C

D

E

PE

D F

QT

QE

Q

The Effects of a Tax P „With the tax, CS = A, PS = F „Tax revenue =B+D „Total surplus P =A+B+D+F „The tax causes total surplus B to fall by C + E P „C + E is called the deadweight loss (DWL) of S the tax, the fall in total surplus that results from a market distortion, such as a tax.

A

S B

C

D

E D

F

Q

Q

T

E

Q

About the Deadweight Loss Because of the tax, the units between QT and QE are not sold.

P

S

PB

The value of these units to buyers is greater than the cost PS of producing them, so the tax has prevented some mutually beneficial trades.

D

QT

QE

Q

What Determines the Size of the DWL? „ The govt needs tax revenue to finance roads, schools, police, etc., so it must tax some goods and services. „ Which ones? One answer is that govt should tax the goods or services with the smallest DWL. „ So when is the DWL small vs. large? Turns out it depends on the elasticities of supply and demand. „ Recall: The price elasticity of demand (or supply) measures how much quantity demanded (or supplied) changes when the price changes.

DWL and the Elasticity of Demand P

P S

S

Size of tax

Size of tax D

D Q The more elastic the demand, the higher the DWL from a tax

Q

DWL and the Elasticity of Supply P

P S S

Size of tax

Size of tax D

D Q

The more elastic the supply, the greater the DWL from a tax

Q

Why Elasticity Affects the Size of DWL „ A tax distorts the market outcome: consumers buy less and producers sell less, so eq’m Q is below the surplus-maximizing quantity. „ Elasticity measures how much buyers and sellers respond to changes in price, and therefore determines how much the tax distorts the market outcome.

How Big Should the Government Be? „ A bigger government provides more services, but requires higher taxes, which cause DWL. „ The larger the DWL from taxation, the greater the argument for smaller government. „ The tax on labor income is especially important; it’s the biggest source of govt revenue. „ For many workers in the US, the marginal tax rate (the tax on the last dollar of earnings) is almost 50%. „ How big is the DWL from this tax? It depends on elasticity…. „ If labor supply is inelastic, then this DWL is small. „ Some economists believe labor supply is inelastic, arguing that most workers work full time regardless of the wage.

How Big Should the Government Be? Other economists believe labor taxes are highly distorting because some groups of workers have elastic supply and can respond to incentives: „ Many workers can adjust their hours, e.g. by working overtime. „ Many families have a 2nd earner with discretion over whether and how much to work. „ Many elderly choose when to retire based on the wage they earn. „ Some people work in the “underground economy” to evade high taxes.

What happens to DWL and tax revenue when taxes change? P

new DWL

Initially, the tax is T per unit. Doubling the tax causes the DWL to more than double.

S

2T

T D

initial DWL Q2

Q1

Q