ECON 309 Northern Virgina Community College Economics Worksheet

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Module 2: Efficiency
ECON 3 0 9 D0 1 S U M M ER 2 0 2 2
I n st ru ctor: Ha i r uo Ta n
E – ma il : hta n 6@ gmu .edu
Week of May 30, 2022
MODULE 2
1
Efficiency and market
imperfections
Week of May 30, 2022
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2
Measurement problems
?Individual and societal well-being are both subject to measurement problems.
?On the individual level:
?there is likely to be a difference between the maximum a person is willing to pay in order to
receive a benefit (compensating variation) and the amount the person is willing to accept in
order to forego a benefit (equivalent variation)
?On the societal level:
?Individual utilities are only observable in terms of the ranking of different combinations of
goods. It is hard to evaluate the intensity of various individuals’ preferences.
?The total well-being of society depends on how much weight each person’s utility receives.
?But these measurements problems do not and should not preclude the
economic analysis of efficiency.
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3
Efficiency Concept: Pareto Optimality
?Definition: Pareto optimality*. A situation is Pareto optimal (or Pareto
efficient) if it is impossible to make any person better off without making at least
one person worse off. In other words, Pareto optimality requires that all
possible opportunities for efficient production and mutually beneficial trade
have been fulfilled.
?Definition: Pareto improvement. An action leads to a Pareto improvement if it
makes at least one person better off without making at least one person worse
off. A Pareto improvement can also be achieved if anybody who would
otherwise lose due to a policy is fully compensated for his or her losses.
?Relation: If a situation is Pareto optimal, no Pareto improvement is possible.
* named after Vilfredo Pareto (1878–1923)
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Conditions for a Pareto improvement
1) Total benefits must be greater than total costs.
2) Losers (if any) must be fully compensated for their net losses.
?Together, these conditions imply that nobody is made worse off (by condition
2), and that some net gains will remain after the losers are compensated (by
condition 1).
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5
Efficiency in a Pure Exchange Economy:
The Edgeworth Box
?The Edgeworth box represents an abstract world with two individuals and no
production.
?The Edgeworth box is often labeled a pure exchange model.
?This model has little direct use for policy analysis, but it is useful in the
identification of two important concepts that help explain the meaning of Pareto
optimality.
?Mutually beneficial exchange: informed individuals will not undertake a trade, purchase, or
task unless the action makes them better off
?Endowment point: the initial distribution of income or wealth from which exchange takes
place.
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Schwartz’s indifference curves
(turn this graph 180°, you will
see that Schwartz’s indifference
curves are normally shaped)
Efficiency in a Pure
Exchange Economy:
The Edgeworth Box
?The Edgeworth box model assumes
that there are two individuals, who
we will label Dottie and Schwartz,
and two goods, fruit and eggs.
?Each individual starts with fixed
quantities of the two goods. These
initial quantities represent the
endowment point.
Dottie’s utility increases from lower
left to upper right.
Schwartz’s utility increases from
upper right to lower left.
Week of May 30, 2022
Dottie’s indifference
curves
MODULE 2
?The core represents the space
within which a Pareto improvement
can take place. Any point in the core
will make at least one party better off
without making the other worse off.
7
Pareto Optimality (P.O.)
after Exchange: Any Point
of Tangency on the Black
Contract Curve is P.O.
?Schwartz gave up some fruit
and received eggs in trade,
while Dottie gave up some eggs
and received fruit. Both have
moved to higher indifference
curves after the exchange.
?The black square represents a
Pareto optimal outcome. From
this new allocation of goods, it
will be impossible to make one
person better off without
making the other person worse
off.
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8
Pareto Optimality (P.O.)
after Exchange: Any Point
of Tangency on the Black
Contract Curve is P.O.
?The dark black line,
commonly called a contract
curve, represents all possible
Pareto optimal points in this
Edgeworth box.
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Lessons of Pareto Optimality
?Individual utility maximization is a necessary condition for a Pareto optimal
outcome.
?Pareto optimality maximizes the well-being of both parties given any initial
distribution of goods.
?Pareto optimality and Pareto improvement vary with the initial allocation of
goods.
?An initial allocation of goods that leaves one person with everything and
another with nothing will be Pareto optimal since transferring goods from the
person with everything will cause him or her to be worse off.
?Therefore, it is often important to include ethical considerations as well as efficiency
when analyzing the social impact of a public policy.
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10
Limits to Pareto Optimality
?The Pareto improvement principle is an impractical efficiency standard for
many public policy decisions.
?Public programs are often funded by taxation. Since taxes by definition lower the spendable
incomes and well-being of taxpayers, programs that allocate tax revenues from the general
public to specific groups violate the Pareto improvement principle.
?Identifying and compensating all individuals who suffer losses from a government program is
likely to be impractical.
?Those with strong libertarian tendencies tend to approve of Pareto
improvement as a standard.
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11
The Kaldor-Hicks Principle
?Kaldor-Hicks Principle is a standard that is less restrictive than Pareto
optimality.
?Definition: The Kaldor-Hicks Principle (also known as the Fundamental Rule
of Policy Analysis) states that a policy should be adopted if the winners could IN
PRINCIPLE compensate the losers. This principle requires that the total benefits
outweigh the total costs but does not require that the losers actually be
compensated.
?The One Condition for Meeting the Kaldor Hicks Principle: Total benefits
must be greater than total costs.
?This rule based on the Kaldor-Hicks principle provides the basis for benefit-cost
analysis.
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12
The Competitive Market and Pareto
Optimality
?The perfectly competitive market requires: (1) many buyers and sellers; (2)
perfect mobility; (3) perfect information; (4) a homogeneous product; and (5) no
collusion among buyers or sellers.
?Another assumption that is required for a fully efficient competitive market is
fully defined property rights. Without this added condition, markets may
produce externalities.
?If a competitive market produces no externalities, the resultant competitive
equilibrium will be Pareto optimal and will maximize the total net gains from
trade.
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13
The First Welfare Theorem: A Competitive
Equilibrium is Pareto optimal
?Recall: In a private market (with only buyers and
sellers), net gains equal the sum of consumer and
producer surplus (areas A and B in Figure 4-3).
?The first welfare theorem states that a competitive
equilibrium is Pareto optimal.
?If the price rises consumer surplus falls.
?If price falls producer surplus falls.
?If the quantity decreases from 10, one or both of the
surpluses must also fall.
?This is also known as the invisible hand theorem, and
suggests that for competitive markets, only minimal
government intervention is needed for efficient
outcomes.
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14
Questions Arising from The First Welfare
Theorem
1) Is a given market perfectly competitive, or nearly so?
2) If a market is not perfectly competitive, how serious are the efficiency losses
and which parties experience them?
3) If the market is competitive, is the equilibrium undesirable even if it is
efficient?
The second question is usually the most fundamental for policy analysis of
specific markets and policies. Measuring efficiency losses is often a complex task,
but identifying the likely sources of such losses is much more reasonable for this
level of analysis.
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Markets May Not Be Perfect
?There may not be many buyers and sellers.
?A market with a single seller is called a monopoly.
?A market with a few sellers is called an oligopoly.
?A market with one buyer is called a monopsony.
?Information may be incomplete and unequally distributed.
?Markets may not be complete, creating what are called externalities.
?Mobility (entry and exit) may be costly, and other costs of buying and selling
may exist.
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Demand for Competitive
Firm vs. Monopoly (A
single seller)
Figure 4-7: Individual and Market Demands
Competitive Market
Competitive Firm
Monopoly
Supply
Firm’s
Demand
Price
Market Demand =
Firm’s Demand
Market
Demand
Quantity
Week of May 30, 2022
Quantity
Quantity
MODULE 2
?The competitive firm’s
demand curve is flat at the
market price because it has
no individual power over the
price it charges.
?The basic monopoly model
assumes that the monopolist
faces a downward-sloping
demand curve for its
product.
17
Monopoly Profit Maximization
Steps for Monopoly Profit Maximization:
(1) Find the Quantity where Marginal Revenue =
Marginal Cost (Qm in Figure 4-8)
(2) Go up to the Demand Curve to find the highest
price consumers are willing to pay for that quantity
(Pm in Figure 4-8)
Effects of Monopoly:
(1) Quantity falls and price rises
(2) Consumer surplus falls
(3) Producer surplus generally rises
(4) Total net gains falls, leaving a
“deadweight loss”
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Deadweight Loss
?Concept: Deadweight Loss equals the lost net gains due to a market
inefficiency or government policy. It equals the total net gains under a perfectly
competitive equilibrium MINUS the total net gains under any other market
situation.
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The Efficiency Effects of
Monopoly vs. Competition
Figure 4.5 Monopoly
CS under monopoly
PS under monopoly
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Table 4-2:
Market
Condition
Consumer
Surplus
Producer
Surplus
Net Gain
Deadweight
Loss
Competition
A+B+C
D+E
A+B+C+D+E
None
Monopoly
A
B+D
A+B+D
C+E
Difference
-B-C
B-E
-C-E
C+E
MODULE 2
20
Unequal Information: When consumers
receive lower benefits than they expect
In Figure 4.7, the consumer thinks she is receiving the value associated with D2,
but after buying the product will actually receive the benefits under demand curve D1.
Consumer Surplus in Figure 4.7
Market
Condition
Competition
Unequal
Information
Total
Value
Total
Spending
B+C+F+G+I+J F+G+I+J
B+C+F+G+I+ C+D+F+G+I
J+H+K
+J+E+H+K
Consumer
Surplus
(Value-Spending)
B+C
B-D-E
(The dotted areas)
Figure 4.7 Unequal information
The Efficiency Effects of Unequal Information
Market
Consumer Producer Net Gain Deadweight
Condition
Surplus
Surplus
Loss
Competition
B+C
F+I
B+C+F+I
None
Unequal Information
B-D-E
C+D+F+I B+C+F+I-E
E
Difference
-C-D-E
C+D
-E
E
The consumer thinks that he or she is receiving the marginal value of
demand curve D2, which leads to an equilibrium at price P2 and quantity Q2.
But the actual total value he or she receives is equal to the area under the
Week of May 30, 2022
MODULE 2
true demand
curve D1 up to quantity Q2, not the area under
D 2.
21
Unequal Information: When consumers
receive lower benefits than they expect
?In a market where the consumer is being misled,
the producer surplus grows while the consumer
surplus shrinks.
Figure 4.7 Unequal information
?Misleading the consumer is inefficient as well as
unethical.
?The difference between the net gains with perfect
information and imperfect information equals the
negative of area E, which is the deadweight loss
caused by imperfect information.
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22
Externality
?An externality is a cost or benefit to a party not involved in the production or
consumption of the good.
?An example of negative externality:
?Pollution flowing from an auto factory can harm people who have nothing to do with the
production or consumption of cars.
?Examples of positive externality:
?The beauty of a well-designed building can provide pleasure to passersby who neither work
nor shop in the building.
?A beekeeper’s insects will provide great benefits to an orchard located next door through the
pollination of its trees. This will happen whether or not the orchard owner pays for this
benefit.
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23
Externalities: Effects of a market on those
not participating in that market
?Private cost = the cost of production to the firm. This generally does not include external costs to
outsiders from pollution or other effects. The usual market supply curve is based on the marginal
costs of producers.
?External cost = the negative effect of production of a good on parties who are not involved with the
production or consumption of the good. Positive externalities can be thought of as negative external
costs.
?Social cost = private cost of production to the firm + external cost to others.
For goods whose production or consumption leads to external harms, the good’s social cost will be
higher than its private cost. However, a good which offers external benefits, such as the beekeeper’s
honey bees or a beautiful building, will have a social cost which is lower than its private cost.
?Marginal social cost = the change in society’s total cost for a given change in output. It also equals
marginal private cost + marginal external cost. In this case the two costs are added vertically
Week of May 30, 2022
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social MC > private MC
external cost
social < social MC external benefit (negative external cost ) Social Versus Private Cost ?Assume that a factory on a river produces shoes and also water pollution that harms fishermen downstream. The production of these shoes will produce two types of costs, private production costs for the shoe company and external costs to the fishermen. Society’s total costs include both the private and external costs. ?The firm’s production will lead to two different cost curves, one representing marginal private costs, and the other curve representing marginal social costs. The difference in height between the two curves will equal the marginal external cost or benefit for that unit of production. Week of May 30, 2022 MODULE 2 25 Private vs Social Equilibrium ?A private equilibrium occurs where demand equals the private marginal costs of production. ?A social equilibrium exists where demand equals the social marginal cost of production. ?In a market with external costs, the private equilibrium will lead to overproduction and deadweight loss, while the social equilibrium will be Pareto optimal. Week of May 30, 2022 MODULE 2 26 External surplus at social equilibrium External surplus at private equilibrium Inefficiency in a Market with Negative Externalities ?External surplus: External benefits minus external costs, or the net benefits experienced by persons or firms not directly involved in production of a particular good. ?Social net benefits (Net Gain) in a market with externalities (but no government) equal consumer surplus (CS) + producer surplus (PS) + external surplus (ES). Week of May 30, 2022 MODULE 2 27 Efficiency: Private Versus Social Equilibrium External surplus is negative, because there is external cost not external benefit. Table 4-6: The Efficiency Effects of Negative Externalities Market Condition Consumer Surplus Producer Surplus External Surplus Net Gain Deadweight Loss Private Equilibrium A+B+C+D E+F+G -C-F-H-D-G A+B+E-H H Social Equilibrium A B+C+E+F -C-F A+B+E None Difference -B-C-D B+C-G H+G+D H H producer surplus at social equilibrium condition Note: When determining the social equilibrium condition, we find the intersection between social marginal cost curve and demand curve. But when determining the producer surplus at social equilibrium condition, we need to find the area bounded by private marginal cost curve (which is also the supply curve), the horizontal line at the social equilibrium price, and the vertical line at the social equilibrium quantity. Week of May 30, 2022 MODULE 2 28 Public Goods ?Public goods are goods for which consumption is entirely external to the individual. ?Those purchasing a purely public good will consume no more of it than a neighbor who pays nothing for the same good. ?A public good has no rivalry in consumption. This means that a public good can be consumed or enjoyed by more than one person simultaneously. ?The second characteristic of public goods is non-excludability. Nonexcludability means that one cannot prevent someone from consuming a public good if they have not paid. Week of May 30, 2022 MODULE 2 29 Numerical Examples Week of May 30, 2022 MODULE 2 30 The Effects of Monopoly by the Numbers: The Competitive Result Demand: P=30-2Q Marginal Revenue: MR=30-4Q Supply or Marginal Cost: P=0+Q Find the competitive equilibrium where Demand = Supply 30 – 2Q = Q Qc=10 Pc = $10 from either demand or supply. Competitive Consumer Surplus = ½ * (30-10)*10 = 100 Competitive Producer Surplus = ½*10*10 = 50 Net Gains = 100+50 = 150 10 10 Week of May 30, 2022 MODULE 2 31 The Effects of Monopoly by the Numbers: The Monopoly Result Demand: P=30-2Q Marginal Revenue: MR=30-4Q Supply or Marginal Cost: P=0+Q ? Step 1: Set MR = MC to find the monopoly Quantity 30-4Q = Q Qm = 6 ? Step 2: Plug this quantity into the Demand Equation to find the price Pm = 18 ? Step 3: to find producer surplus, you also need to find the marginal cost at Q=6, MCm=6 ? Step 4: Find the Surplus and Gains areas • Consumer Surplus = ½*(30-18)*6 = 36 • Producer Surplus = ½*6*(18+(18-6))= 90 • Net Gains = 36 + 90 = 126 • Deadweight Loss = 150 - 126 = 24 (the difference between the competitive and monopoly net gains). Week of May 30, 2022 MODULE 2 18 6 6 32 Imperfect Information with numbers The Perfect Information Case True demand (D1): P = 90 - Q Perceived demand (D2): P = 110 - Q Supply: P = 10 + Q. Find the price, quantity, and the dollar values of the consumer and producer surplus and total net gains (CS + PS) in a market with perfect information (use true demand only). Week of May 30, 2022 MODULE 2 33 Imperfect Information with numbers The Perfect Information Case True demand (D1): P = 90 - Q Perceived demand (D2): P = 110 - Q Supply: P = 10 + Q. Set Demand = Supply FindTrue the price, quantity, and the dollar values of the consumer and producer surplus and total net gains 50 (CS in a+ market with perfect information (use 90 –+QPS) = 10 Q true demand only). Q = 40 P = 50 Consumer Surplus = (1/2)($90 - $50)(40) = $800 Producer Surplus = (1/2)($40)(40) = $800 Net Gains = $1600 Week of May 30, 2022 MODULE 2 40 34 Imperfect Information with numbers The Consumer is Fooled True demand (D1): P = 90 - Q Perceived demand (D2): P = 110 - Q Supply: P = 10 + Q. Find the price,Demand quantity,=and the dollar values of the Set Perceived Supply consumer and producer surplus and total net gains Find new Price and Quantity, (CS + PS) a market perfect information (use Then findinthe surpluswith values true only). Hint:demand Consumer Surplus is not a single triangle Week of May 30, 2022 MODULE 2 35 Imperfect Information with numbers The Consumer is Fooled True demand (D1): P = 90 - Q Perceived demand (D2): P = 110 - Q Supply: P = 10 + Q. 110 – Q = 10 + Q Q 50 Find the price,Demand quantity,=and the dollar values of the 60 Set= Perceived Supply consumer and producer surplus and total net gains 50 P = 60new Price Find and Quantity, (CS + PS) a market perfect information (use 40 Then findinthe surpluswith values true demand only). •Hint: Consumer Surplus = B-D-I - $60)(30) – Consumer Surplus is not=a(1/2)($90 single triangle (1/2)($60 – $40)($50-$30) = $450 - $200 = $250 • Producer Surplus = (1/2)($60 - $10)(50) = $1250 • Deadweight Loss = $1600 – ($250+$1250) = $100 Week of May 30, 2022 MODULE 2 30 40 50 36 External Costs with Numbers: Private Equilibrium marginal private cost: MCp = 10 + Q marginal external cost MCx = ½ Q marginal social cost MCs = 10 + 1.5 Q demand: P = 100 - Q Week of May 30, 2022 MODULE 2 37 External Costs with Numbers: Private Equilibrium marginal private cost: MCp = 10 + Q marginal external cost MCx = ½ Q marginal social cost MCs = 10 + 1.5 Q demand: P = 100 - Q A. private equilibrium price and quantity: 100-Q = 10 + Q 90 = 2Q Q = 45 P = $55 B. Surplus Values: CS = ½ x 45 x ($100-55) = $1,012.5 PS = ½ x 45 x ($55-10) = $1,012.5 Ex. S. = -($77.5-$55) x 45 x ½=- $506.25. Net Gains = 1012.5 + 1012.5 – 506.25 = $1,518.75 Week of May 30, 2022 MODULE 2 38 External Costs with Numbers: Social Equilibrium marginal private cost: MCp = 10 + Q marginal external cost MCx = ½ Q marginal social cost MCs = 10 + 1.5 Q demand: P = 100 - Q To find social equilibrium quantity and price, set MCs equal to demand. 100 – Q = 10 + 1.5 Q 90 = 2.5 Q Q = 36 P = $64 Total Social Surplus is the area between Demand and Social Cost = ½•36 •(100-10) = $1,620. Week of May 30, 2022 MODULE 2 36 39 Efficiency and the role of government Week of May 30, 2022 MODULE 2 40 The Minimum Role of Government (Laissez Faire) According to Adam Smith, the fundamental roles of government include 1) national defense, 2) an impartial system of laws, 3) a set of public works and institutions which can’t be maintained by individuals, such as roads “According to the system of natural liberty, the sovereign has only three duties to attend to ... first, the duty of protecting the society from the violence and invasion of other independent societies; secondly, the duty of protecting, so far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice, and thirdly, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain” Adam Smith Week of May 30, 2022 MODULE 2 41 Government in Perfect Competition Any change from a Pareto optimal situation is likely to produce a loss of efficiency, including the actions of government. Week of May 30, 2022 MODULE 2 42 Efficiency Concepts in an Economy with Government ?A perfectly competitive market maximizes net gains from exchange and is Pareto optimal. Any divergence from the perfectly competitive outcome causes reduced gains from trade, or deadweight efficiency losses. Government involvement in perfectly competitive markets through taxes, subsidies, or various types of regulation can create similar losses. ?Government Surplus (GS) = the net benefits of the market to government = government tax revenue - government spending. ?Government surplus (GS) will tend to be either entirely positive in the case of taxes or entirely negative in the case of government spending. ?For other types of government policies such as price regulation or quotas, we will ignore the costs of enforcement and assume that government surplus is zero. ?The net benefits in a market with externalities and government = consumer surplus (CS) + producer surplus (PS) + external surplus (ES) + government surplus (GS). Week of May 30, 2022 MODULE 2 43 A Tax on Producers Cuts Supply by Increasing Cost ? In the private market before imposing the tax, the equilibrium would be at price Pc and quantity Qc. ? After a constant per-unit tax is imposed, the supply curve shifts vertically upward (a supply decrease) by the amount of the tax, forcing the quantity down to Q2 and the price up to P2. ? Consumer surplus after tax: A ? Producer surplus after tax: H+I tax ? Government surplus (tax revenue): B+C+E+F ? Net gains fall because D and G are lost. Table 5-1: The Efficiency Effects of a Constant Per-Unit Tax Market Condition No Tax Consumer Surplus A+B+C+D With Tax A H+I B+C+E+F Difference -B-C-D -E-F-G B+C+E+F Week of May 30, 2022 Producer Government Surplus Surplus E+F+G+H+I None Net Gain A+B+C+D+E +F+G+H+I A+B+C+E+F+ H+I -D-G MODULE 2 the price increase is less than the amount of the tax Deadweight Loss None D+G D+G Use the new quantity Q2 and the original supply curve to determine the producer surplus after tax. 44 A tax on Consumers has very similar effects • A tax on consumers will have the effect of shifting the aftertax demand curve downward by the amount of the tax. • The original demand curve represents the maximum willingness to pay for the good. • The price-quantity relationship shifts down because the consumer has to directly pay the tax in addition to the price. • With this lower demand curve, the equilibrium price and quantity move downward to P2 and Q2. Producers receive P2 per unit, but the consumer pays a total of P2 plus tax for each unit. • Consumer Surplus falls to A+L . Producer Surplus Falls to H. • Govt. Surplus is B+C+E+F. • Net gains fall by D and G. D and G are the deadweight loss. Week of May 30, 2022 MODULE 2 Use the new quantity Q2 and the original demand curve to determine the consumer surplus after tax. 45 Producer vs. Consumer tax ?Given identical demand and supply curves, the net gains to all parties and the deadweight loss to society are identical whether the tax is placed on producers or consumers. ?The market will redistribute some of the harms from those paying the tax to the other party through changes in price and quantity. ?In either case, consumer surplus and producer surplus are reduced, while a positive government surplus is created from the tax revenue. Week of May 30, 2022 MODULE 2 46 Elasticity and the effect of taxes ?The inefficiency created by the tax will be smaller if the elasticities of demand and/or supply are low. ?If elasticity of demand is zero, the consumer bears all of the burden of the tax in the form of a higher price. There is no deadweight loss when the price elasticity of demand (or supply) is zero. ?If elasticity of demand is infinity, all the burden of tax is shifted to the producer in the form of lower aftertax revenue. Week of May 30, 2022 MODULE 2 47 The Effects of a Fixed per-unit Subsidy A subsidy is the opposite of a tax in several ways 1) Government loses money and will have a negative government surplus. 2) Consumers and producers are both likely to gain from a subsidy compared to the competitive market. 3) If applied to a perfectly competitive market, subsidies encourage overproduction rather than underproduction. 4) Subsidies are likely to be politically popular among those groups who receive them, unlike taxes. Week of May 30, 2022 MODULE 2 48 The Effects of a Fixed per-unit Production Subsidy • Because producers receive revenue from the government and also from consumers, consumers will pay less than producers receive in revenue. • Subsidy will shift the supply curve outward to Supply with subsidy, and move the equilibrium price and quantity to P2 and Q2. For each of the Q2 units produced, consumers will pay the price P2 and producers will receive P2 plus the subsidy. Week of May 30, 2022 MODULE 2 49 The Effects of a Fixed per-unit Production Subsidy Consumer surplus after subsidy • Consumer Surplus grows due to the lower price and higher quantity. • Producer Surplus grows because of the higher revenue per unit they receive and the higher quantity. • Government Surplus (GS) is negative because it is subsidizing the private sector. • Area I is the deadweight loss because it is the only part of the government subsidy that doesn’t benefit producers or consumers Note: the after-subsidy producer and consumer surplus triangles overlap Table 5-2: The Efficiency Effects of a Constant Per-Unit Subsidy Market Condition No Subsidy Subsidy Difference Week of May 30, 2022 Consumer Surplus A+B A+B+C+D+E C+D+E Producer Surplus C+F B+H+C+F B+G Government Net Gain Surplus None A+B+C+F -B-H-I-C-D-E A+B+C+F-I -B-H-I-C-D-E -I MODULE 2 Deadweight Loss None I I Use the new quantity Q2 and the original supply curve to determine the producer surplus after subsidy. 50 The Effects of a Quota (a limit on quantity bought and sold) ?A quota is a maximum allowable quantity of output. ?Quotas are most commonly used to restrict imported goods or to limit agricultural production in order to raise prices. ? Graphically, a quota appears as a vertical line that defines the maximum quantity Week of May 30, 2022 MODULE 2 51 The Effects of a Quota (a limit on quantity bought and sold) A quota has effects similar to a monopoly • Higher price • Lower quantity • Price is greater than the marginal cost of production. • A deadweight loss due to underproduction. Table 5-3: Effects of a Quota Market Consumer Producer Condition Surplus Surplus Government Surplus Net Gain Deadweight Loss No Quota A+B+C D+E None A+B+C+D+E None Quota Difference A -(B+C) B+D B-E None None A+B+D -(C + E) C+E C+E Week of May 30, 2022 MODULE 2 52 The Effects of Price Floors and Ceilings ?A price ceiling sets a maximum legal price in a market. Examples of price ceilings include rent controls and the regulation of prices charged by electric and other utilities. ?In the case of a relatively competitive market such as residential housing, price ceilings are generally criticized by economists. ?In some types of less competitive markets, such as public utilities, a well-designed price ceiling can improve efficiency as well as lower the price paid by consumers. ?A price floor sets a minimum legal price in a market. Price floor examples include the minimum wage. Week of May 30, 2022 MODULE 2 53 The Effects of Price Floors and Ceilings • If effective, price floors and ceilings produce disequilibria (production shortages or surpluses). • With a price ceiling, producers are clearly worse off. • With a price floor, consumers are clearly worse off. • Both policies produce an under-production deadweight loss of C+E. surplus shortage Table 5-4: Price Floors and Ceilings Market Condition Competition Price Ceiling Price Floor Week of May 30, 2022 Consumer Surplus A+B+C A+B+D A Producer Surplus D+E+F F B+D+F Government Surplus None None None MODULE 2 Net Gain Deadweight Loss A+B+C+D+E+F None A+B+D+F C+E A+B+D+F C+E 54 Agricultural Policy: Alternative Strategies ?Agriculture is in many respects a competitive industry. There are many buyers and sellers, raw agricultural products are relatively homogeneous, prices for grain and other commodities are highly flexible, and information about product quality and market conditions is widespread and accurate. ?The cost of exiting the agriculture industry, a violation of the assumption of perfect mobility, is the primary market imperfection that might justify a modest degree of government intervention in the farming sector. ?Another market imperfection that provided an important justification for early federal government intervention in the U.S. agriculture market is monopsony (a market with a single buyer). ?A third argument, generally associated with developing countries, is that small farmers may suffer from a lack of accurate information regarding loans or contracts for harvest labor (Binswanger and Deininger 1997) Week of May 30, 2022 MODULE 2 55 Agricultural Policy: Price Floor Policies ?The government sets a price P2, which is above the equilibrium price. Thus, a quantity surplus exists. The government can either supplement consumer demand by buying the surplus, paying up to P2 multiplied by Q2 – Q1 for that purchase, or pay farmers not to grow more than Q1. ?A policy that includes buying surplus grain is much less efficient than paying farmers not to grow because the cost of growing the grain is wasted. ?Paying farmers not to grow more than Q1 produces far less deadweight loss because there is no production cost for the area between Q1 and Q2 as would be the case if farmers grew the surplus grain. In this case, the entire government payment becomes part of producer surplus. Week of May 30, 2022 MODULE 2 56 Government buying the surplus ?Producers produce Q2 and sell Q1 to consumers and (Q2-Q1) to the government at P2. Producer surplus: B+C+D+G+F ?Government spending produces a negative government surplus, which equals the rectangle defined by its grain purchase, P2*(Q2-Q1), which is represented by C+D+E+F+I. Policy Competitive Market Price Floor: Govt. buys the surplus Week of May 30, 2022 C