Welfare Analysis

Transcript Welfare Analysis

Welfare Economics

Consumer Surplus and Producer Surplus

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 society’s point of view? • This question takes us into welfare economics.

Welfare Economics

•

Welfare economics

is the study of how the allocation of resources affects economic well being • It shows that: – Both buyers and sellers receive benefits from taking part in the market – The equilibrium outcome in the theory of supply and demand maximizes the total welfare of buyers and sellers 3

Two main concepts

• When buyers and sellers trade willingly, it must be because they expect to benefit • Consumer surplus of the buyers.

measures economic welfare • Producer surplus of the sellers.

measures economic welfare 4

CONSUMER SURPLUS

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.

Willingness to pay: background

• Assume there is a commodity such that every additional unit of it increases a consumer’s 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 consumer’s willingness to pay for a product is a good measure of the happiness that he or she gets from it 7

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 8

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 9

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.

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” 11

Table 1 Four Possible Buyers’ Willingness to Pay

For a mint-condition recording of Elvis Presley’s first album I will illustrate consumer surplus through this extended example.

Consumer Surplus

•

Consumer surplus

is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.

– Example: If the Elvis album’s price is $75…

Buyer Willingness to Pay Buy?

John Paul George Ringo 100 80 70 50

Consumer Surplus

25 5 -5 -25 Yes Yes No No 13

Market Demand

• The market demand shows the quantities demanded by buyers at different prices. • We can use the willingness-to-pay numbers to calculate the market demand – See the next slide 14

The Demand Schedule

Buyer

John Paul

Willingness to Pay

100 80 George 70 Ringo 50 15

Figure 1 The Demand Curve Price of Album

$100 John ’s willingness to pay

Buyer

John

Willingness to Pay

100 Paul 80 George 70 Ringo 50 80 70 Paul ’s willingness to pay George ’s willingness to pay 50 0 1 2 3 4 Ringo ’s willingness to pay Demand

The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit.

Quantity of Albums

Area of a Rectangle

Area = Width × Height Height Width

Figure 2 Measuring Consumer Surplus with the Demand Curve Buyer Willingness to Pay Price of Album

$100

(b) Price = $70.01

John Paul George Ringo 100 80 70 50

Consumer Surplus

30 10 0 -20

Buy?

Yes Yes No No 80 70

1. The area under the demand curve measures the total willingness to pay for the quantity demanded.

50 0

John’s willingness to pay 2. It is also the maximum willingness to pay that could be generated from that quantity.

Demand 1 2 3

Paul’s willingness to pay

Quantity of Albums

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?

Interpersonal comparability

• Yes, – if there is a commodity—say, a bag of potato chips—that provides an unchanging amount of happiness to the consumer, and – if John’s happiness and Paul’s happiness are comparable, and – if both John and Paul get the same happiness from a bag of potato chips • That’s a lot of if’s! • But we will make these simplifying assumption anyway – Not just for John and Paul, but for everybody 22

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 23

The market and the planner

• Suppose the government has two copies of the Elvis album. The government’s goal is to give them to two of the four guys so as to generate the maximum happiness.

• Who will get the government’s 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 Paul 100 80 George Ringo 70 50 24

Willingness to Pay from the Demand Curve

Price

1 B C

The area under the demand curve measures the total willingness to pay of the consumers who bought Q 1 units. It also measures the maximum willingness to pay that could be obtained from Q 1 units

1 Demand

Quantity

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.

Figure 3 How the Price Affects Consumer Surplus (a) Consumer Surplus at Price P Price

A Consumer Surplus (ABC) + Total Payment (OBCQ 1 ) = Willingness to Pay (OACQ 1 ) Consumer surplus

1 B C Total Payment Demand 0

Quantity

Using the Demand Curve to Measure Consumer Surplus

• In general, the area below the demand curve and above the price measures the consumer surplus .

Figure 3 How the Price Affects Consumer Surplus (b) Consumer Surplus at Price P Price

A Initial consumer surplus

1 B C

2 0 D Additional consumer surplus to initial consumers E

2 Consumer surplus to new consumers F Demand

Quantity

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?

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.

PRODUCER SURPLUS

Producer Surplus

•

Producer surplus

is the amount a seller is paid for a good minus the seller’s

cost

. • It measures the net benefit to sellers • It is almost but not quite the same as

profit

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.

Table 2 The Cost of Painting a House for Four Possible Sellers 38

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 39

Seller

Mary Frida

Cost ($)

900 800 Georgia 600 Grandma 500

Costs → Supply

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

Mary

Cost ($)

900 Frida Georgia 800 600 Grandma 500 41

Producer Surplus

•

Producer surplus

is the amount a seller is paid minus the seller’s cost – Example: If the going price for getting a house painted is $700 we get the following table.

Seller Cost ($) Producer Surplus

Mary Frida 900 800 Georgia 600 Grandma 500 -200 -100 100 200

Sell?

No No Yes Yes 42

Using the Supply Curve to Measure Producer Surplus

• The area below the price and above the supply curve measures the producer surplus.

Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $799.99

1. The area under Price of House Painting

Supply

the supply curve is the cost of the quantity supplied

$900

2. It is also the lowest cost for that quantity

800 600 500

Seller

Mary Frida Georgia Grandma

Cost ($) Producer Surplus

900 800 -100 0 600 500 200 300

Sell?

No No Yes Yes

Grandma’s cost

0 1

Georgia’s cost

2 3 4

Quantity of Houses Painted

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, that’s exactly what happens in the market outcome.

• So, the market achieves the best

that the government could have achieved Seller Cost ($)

Mary Frida 900 800 Georgia 600 Grandma 500 49

Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $800 1. The rectangular area under the price Price of and up to the House Painting

Supply

quantity supplied is the Total Revenue.

Total producer

2. The area under the

$900 surplus ($500)

price and above the

supply is the

800

Producer Surplus.

600 500 Grandma ’s producer surplus ($300) Georgia

Seller

surplus ($200) Mary Frida Georgia Grandma

Cost ($) Producer Surplus

900 800 -100 0 600 500 200 300

Sell?

No No Yes Yes 0 1 2 3 4

Quantity of Houses Painted

Figure 6 How the Price Affects Producer Surplus (a) Producer Surplus at Price P Price

Supply

1 B Producer surplus 0 A C Production Cost

1 Total Revenue (OBCQ 1 ) = Production Cost (OACQ 1 ) + Producer Surplus (ABC)

Quantity

Figure 6 How the Price Affects Producer Surplus (b) Producer Surplus at Price P Price

2 D Additional producer surplus to initial producers E F Supply

1 B Initial producer surplus C Producer surplus to new producers 0 A

Quantity

Figure 7 Consumer and Producer Surplus in the Market Equilibrium Price

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

Quantity