Micro Lecture Ch06-08 TS Govt Intervention
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Transcript of Micro Lecture Ch06-08 TS Govt Intervention
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Measuring Well-Being ofConsumers and Producers
&
Government Intervention in the Market
Dr. Katherine Sauer
Principles of Microeconomics
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So far we have been looking atpositive questions.
- What are equilibrium price and quantity?
It is time to ask a normative question.
- Is market equilibrium price and quantity the best
solution to the resource allocation problem?
The tool well use to answer this question is welfare
economics.
-the study of how the allocation of resourcesaffects economic well-being
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I. Measuring the Economic Well-Being of Consumers
A. Willingness to Pay is the maximum amount that a
buyer is willing to pay for a good or service.
It is a way to measure the benefit a consumer
receives from an item.
(not a perfect measure happiness cant easilybe measured)
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Ex: Suppose you are willing to spend $95 to buy newsneakers.
When you go to buy them, you find that they only cost
$80.
Economists call this difference between what a
consumer is willing to pay and the actual price paid
consumer surplus.
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B. Consumer Surplus is used to measure the well-being of
consumers.
Willingness to pay is a way to measure the benefit
a consumer receives from an item.
The items price is the cost to the consumer.
So, thebenefit to the consumer minus the cost to
the consumeris a way of measuring their economicwell-being.
WTP price = CS
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C. We can use the Demand Curve to measure consumer
surplus
price
Quantity
S
D
Q*
p*
CS
Demand reflects the
total willingness to pay.
Graphically we can
show consumer surplus
as the area below the
demand curve andabove the price.
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A lower price raises consumer surplus in two ways:
price
Quantity
D
Q1
p1
When the price is P1:area A is consumer surplus
When the price is P2:
- existing customers paya lower price (area B)
- more people buy the
good (area C)
A
CB
p2
Q2
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II. Measuring the Economic Well-Being of Producers
A. Cost and the Willingness to Sell
Cost is the value ofeverything a seller must give up to
produce a good.
Usually a seller is not willing to sell unless the selling
price is greater than the cost to produce the good.
- including opportunity cost
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B. Producer Surplus is the difference between the price a
good is sold for and the price a seller is willing to accept
(cost)
- used to measure the well-being of producers
price production cost = PS
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Supply reflects
production costs.
Graphically show
producer surplus as
the area below the
price and above the
supply curve.
price
Quantity
S
D
Q*
p*
PS
C. We can use the supply curve to measure producer
surplus.
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A higher price raises producer surplus in two ways:
price
Quantity
S
Q1
p1
When the price is P1:area X is producer surplus
When the price is P2:
- higher price onexisting sales (area Y)
- gain from selling a
higher quantity (areaZ)
X
p2
Q2
YZ
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III. Market Efficiency
A. Total Surplus
The economic well-being ofeveryone in society can be
measured by total surplus.
Total Surplus = Consumer Surplus + Producer Surplus
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Total Surplus =
Value to Buyers Amount Paid by Buyers
+ Amount Received by Sellers
Cost to Sellers
But, the Amount Paid by Buyers equals the Amount
Received by Sellers so
Total Surplus =Value to Buyers
Cost to Sellers
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B. Efficiency and Equality
Efficiency means the resources are allocated in a way
that maximizes the total surplus.
Equality means distributing economic well-being
uniformly on the members of society.
Many government policies involve a trade-offbetweenefficiency and equity.
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C. Evaluating the Market Outcome
price
Quantity
S
D
Q*
p*
PS
CS
TS
Total Surplus is the
sum of Consumer
Surplus and Producer
Surplus.
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The free market:
1. allocates the supply of goods to the buyers who value
them most highly, as measured by willingness to pay.
2. allocates the demand for goods to the sellers who can
produce at the lowest cost
3. produces the quantity of a good that maximizes totalsurplus (is efficient)
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The market outcome in a competitive market is
efficient.
But, many markets are not competitive!- market power
- market failure
Even if the outcome is efficient, it may not be equitable.
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IV. Government Intervention in Markets
There are two common ways that governments choose to
intervene in markets:
- controlling prices- levying taxes on goods or services
Both types of interventions result in some unintended
consequences.
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What happens if prices arent allowed to equate Supply
and Demand?
- legally set a maximum or minimum price
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Extreme Case:
In the former Soviet Union, prices were set, raised, and
lowered by central planning. The government was
responsible for over 20 million prices.
The government decided to increase the price for
moleskins.
- hunters increased their hunting of moles
- state purchases of moleskins increased- the distribution centers were filled with pelts
- industry was unable to use all the pelts and they
rotted
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When a government tries to control all the prices, the
result is a surplus of some items and a shortage of
others.
In the US (and many other market economies), the
government doesnt try to control ALL the prices, but
does control some of them.
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A. Price Controls
There are 2 basic types of price controls:
price ceilings prevent the price from going too high
price floors prevent the price from falling too low
- making sure the price is fair
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Price
Quantity
Supply
Demand
Q*
P*
Pc
Qs Qd
shortage
Price ceiling
1. Price Ceilings are legally binding maximum prices.
To be effective, they must beplaced below the
equilibrium price. (binding) Price ceilings areimplemented in order to
help out buyers of a
good or service.
They cause shortages.
They often cause a
reduction in quality.
They sometimes lead to
black markets.
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Ex: Rent control
Proponents of rent control often argue that rents need to
be controlled so that people who begin renting an
apartment cannot be forced to move out of the apartment
as a result of increases in rent (e.g. fixed income retirees).
Rent control is considered abig success politically.
In the short run, the shortage is smallbecause the supply
of housing is fixed.
In the long run, the shortage grows larger.
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New York City is a famous example.
some results:
- low turnover of rent-controlled housing
- abandoned buildings (1,000s taken over by the
government)
San Francisco (2001 study): 75% of rent controlled
housing was at least 50 years old.
Santa Monica 1979: building permits for apartments fell
to one tenth of previous.
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Price
Quantity
Supply
Demand
Q*
P*
Pf
Qd Qs
surplus
Price floor
2. Price Floors are legally binding minimum prices.
To be effective, they must beplaced above the
equilibrium price. (binding)
Price floors are
implemented in order
to help out sellers of a
good or service.
They cause surpluses.
They often lead toadditional government
actions.
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Ex: agricultural goods
During the Great Depression there were price floorsmany agricultural goods.
The higher price caused a surplus of food.
But hunger was a problem for many Americans.
1933 the US government bought 6 million hogs and
destroyed them.
Farmers poured milk into the sewers to keep prices up.
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http://emsnews.wordpress.com/2009/10/16/crying-over-spilt-milk-in-world-trade/
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3. Evaluating Price Controls
Economists say that markets are usually a good way toorganize economic activity.
- prices balance supply and demand
- prices coordinate economic activity
A government will implement price controls because the
market outcome is unfair.
consequences:
- price no longer balances supply and demand(shortage/surplus is created)
- setting price by legal decree obscures the signals
that would normally guide resource allocation
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4. Algebraic Example
Market for movie tickets: P=25 - Qd P = 1 + Qs
Suppose the local government decides to win favor with the
college crowd and puts a price ceiling of $5 on movie tickets.
Illustrate graphically and algebraically what happens in thismarket.
1) solve for market equilibrium
25-2Q = 1+Q
24 = 3Q
8=Q*
P=1+8
P*=9 so the ceiling is binding
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Price
Quantity
Supply
Demand
8
9
Graphically:
25
1
5 priceceiling
P=25-Qd P = 1 + Qs
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2) solve for the Qd and Qs with the price ceiling5=25-2Qd
2Qd=20
Qd=10
5=1+Qs4=Qs
Qd>Qs so there is a shortage
The amount of the shortage is 10 - 4 = 6
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Price
Quantity
Supply
Demand
8
9
Graphically:
25
1
5price
ceiling
4 10
shortage
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B. Taxes on Goods or Services
Taxes on goods and services are typically levied onsellers.
- ease of collection
Just because the seller is the one responsible forsending in the tax money doesnt mean they are the one
paying the tax.
- passed on to consumers
Tax incidence = how the tax burden is distributed
between the buyer and seller.
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1. How a Tax on a Good Works (levied on seller)
Price
Quantity
Supply
Demand
Q
P
Because the seller isresponsible for
payment of the tax, a
tax on a good
shifts the supplycurve to the left.
Consumers pay a
higher price andpurchase a lower
quantity.
Supply + tax
tax
Pt
Qt
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Price
Quantity
Supply
Demand
Q
P
But sellers dont get to
keep all of that higher
price.
They get to keep
Pt tax = Pp
Buyers pay a higher
price per item, sellers
keep a lower price, the
government collectsthe difference (the
tax).
Supply + tax
tax
Pt
Qt
Pp
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37
Price
Quantity
Supply
Demand
Q
P
The total amount of
tax revenue that the
government collectsis:
(tax)(Qt)
The burden that fallson consumers is
(Qt)(Pt P)
The burden that fallson producers is
(Qt)(P Pp)
Supply + tax
tax
Pt
Qt
Pp
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2. Elasticity will determine how the tax incidence is split
between buyers and sellers.
quantity
price
quantity
price
D
D
demand more inelastic supply more inelasticthan supply than demand
Pt
P
Pt
P
Qt Q QQt
S
S + tax
S + tax
Pp Pp
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When demand is more inelastic than supply, consumers
pay more of the tax.- not as responsive to price
- easier for producers to pass on the tax
When supply is more inelastic than demand,producerspay more of the tax.
- demand more elastic
- consumers are responsive to price changes
- harder for producers to pass on the tax
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Price
Quantity
Supply
Demand
Q
P
After a tax:
consumer surplus falls- some goes to govt
- some is just lost
producer surplus falls- some goes to govt
- some is just lost
government revenue
Total Surplus is lower.
deadweight loss
Supply + tax
Pt
Qt
Pp
CS
PS
3. Taxes cause dead weight loss
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4. Algebraic Example
Market for movie tickets: P=25-Qd P = 1 + Qs
Suppose the local government decides to promote reading
by taxing movie tickets by $3 each.
Illustrate graphically and algebraically how the market isaffected.
1) solve for market equilibrium
25-2Q = 1+Q24 = 3Q
8=Q*
P = 1 + 8
P* = 9
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Price
Quantity
Supply
Demand
8
9
25
1
2) a tax of $3 will shift
the supply left by a
vertical distance of $3
Add 3 to the p-intercept
in the supply equation to
get the new supplyequation
P=(1+3) + Qs
P = 4 + Qs
Supply + tax
4
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Price
Quantity
Supply
Demand
8
9
25
1
3) Set the new supply
equation equal to the
original demandequation and solve for
the after-tax quantity
25-2Q =4
+Q21 = 3Q
7 = Qt
Supply + tax
4
7
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Price
Quantity
Supply
Demand
8
9
25
1
4) Plug Qt into Demand
to find price consumers
pay:
Pt=25-2(7)=11
5) Plug Qt into originalSupply to find price
producers receive:
Pp=1+7=8
Or simply take Pt tax
Pp = 11 3 = 8
Supply + tax
4
7
11
8
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Price
Quantity
Supply
Demand
8
9
25
1
(tax)(Qt) =
= (3)(7)= 21
Supply + tax
4
7
11
8
How much tax revenue does the government collect?
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Price
Quantity
Supply
Demand
8
9
25
1
Consumers pay:
11 9 = 2 per unit
(2)(7) = 14 total
Producers pay:
9 8 = 1 per unit(1)(7) = 7 total
14
+ 7 = 21 makes sense
Demand for movies
must be more inelastic
than supply.
Supply + tax
4
7
11
8
How is the tax burden split between consumers and
producers?
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Price
Quantity
Supply
Demand
8
9
25
1
DWL = (0.5)(Q* - Qt)(Pt Pp)
= (0.5)(8 7)(11 8)
= 1.5Supply + tax
4
7
11
8
What is the dead weight loss?
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5. Determinants of dead weight loss
a. The size of the Dead weight Loss depends on elasticity
Given a stable demand curve, the deadweight loss is
larger when supply is relatively elastic.
Given a stable supply curve, the deadweight loss is larger
when demand is relatively elastic.
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A higher elasticity means people are changing their
behavior more in response to the higher price (from the
tax).
- fewer goods are produced and sold
- goods that arent produced/sold or taxed do not
benefit anyone
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quantity
price
quantity
price
D
D
Inelastic Demand Elastic Demand
Pt
P1
PtP1
Qt Q1 Q1Qt
S
S + tax
S + tax
Pp Pp
The DWL is larger when demand is more elastic.
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quantity
price
quantity
price
D
D
Inelastic Supply Elastic Supply
PtP1
PtP1
Qt Q1 Q1Qt
S
S + tax
S + tax
Pp
Pp
The DWL is larger when supply is more elastic.
S
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b. As the size of a tax increases, the deadweight loss from
the tax increases.
In fact, as taxes increase, the deadweight loss rises more
quickly than the size of the tax.
StaxStax
Stax
S S S
D D D
P P P
QQQ
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Mathematical reason:
Deadweight loss is always a triangle.The area of a triangle is always (1/2)(base)(height).
The height of the DWL triangle is the tax amount.
The base of the DWL triangle is the reduction inquantity sold.
When a tax is increased, both the base and height of the
DWL triangle increase.
So, when a tax is increased, DWL loss rises more than
the amount of the tax.
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Chapters 6, 7, 8 Summary:
A price ceiling is a legal maximum on the price of a
good or service.If the price ceiling is binding:
- helps some buyers
- shortage
- dead weight loss
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A price floor is a legal minimum on the price of a good
or service.
If the price floor is binding:
- helps some suppliers- surplus
- dead weight loss
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A tax on a good places a wedge between the price
paid by buyers and the price received by sellers.
- buyers pay more $- sellers keep less $
Buyers and sellers share the tax burden.
- according to relative elasticities
Taxes cause dead weight loss.
Dead weight loss varies with elasticity and with thesize of the tax.