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.