Welfare economics part 2 (producer surplus) Application of welfare economics: The Costs of Taxation & International Trade

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1 Welfare economics part 2 (producer surplus) Application of welfare economics: The Costs of Taxation & International Trade Dr. Anna Kowalska-Pyzalska Department of Operations Research Presentation is based on:

2 Cost Producer surplus Total surplus Deadweight loss Tax wedge World price Tariff

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4 It measures the benefit to sellers participating in a market. Producer surplus is the amount a seller is paid for a good minus the seller s cost.

5 Each painter is willing to do the work, if the price is right... The price must exceed the cost of doing the work. Copyright 2004 South-Western

6 Because a painter s cost is the lowest price he would accept for his work, Cost is a measure of his willingness to sell the services. Each painter would be: eager to sell the services at a price greater than the cost. would refuse to sell the services at a price less than the cost. indifferent about selling his services at a price exactly equal to the cost.

7 The job goes to the painter who can do the work at the lowest cost If the painters compete for the job, the price falls If Grandma bids $600, she receives the producer surplus of $100.

8 Producer surplus measures the benefits to sellers of participating in a market. Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve.

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10 marignal seller a seller who would leave the market if the price were any lower. At any quantity, the price given by the supply curve shows the cost of the marginal seller.

11 The area below the price and above the supply curve measures the producer surplus in a market. The height of the supply curve measures seller s cost, and the difference between the price and the cost is each seller s producer surplus. The total area is the sum of the producer surplus of all sellers.

12 (a) Price = $600 Price of House Painting Supply $ Grandma s producer surplus ($100) Quantity of Houses Painted Copyright 2003 Southwestern/Thomson Learning

13 Price of House Painting $ Total producer surplus ($500) (b) Price = $800 Supply Georgia s producer surplus ($200) Grandma s producer surplus ($300) Quantity of Houses Painted Copyright 2003 Southwestern/Thomson Learning

14 Copyright 2003 Southwestern/Thomson Learning (a) Producer Surplus at Price P Price Supply P 1 B Producer surplus C Sellers always want to get a higher price for the goods they sell. A 0 Q 1 Quantity

15 Copyright 2003 Southwestern/Thomson Learning (b) Producer Surplus at Price P Price Additional producer surplus to initial producers Supply P 2 D E F P 1 B Initial producer surplus C Producer surplus to new producers A 0 Q 1 Q 2 Quantity

16 Consumer surplus and producer surplus may be used to address the following question: Is the allocation of resources determined by free markets in any way desirable?

17 Consumer Surplus = Value to buyers Amount paid by buyers and Producer Surplus = Amount received by sellers Cost to sellers

18 Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers Cost to sellers

19 Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society. An allocation is inefficient if: a good is not being consumed by the buyers who value it most highly. is not being produced by the sellers who could produce it with the lowest cost.

20 In addition to market efficiency, a social planner might also care about: Equity the fairness of the distribution of well-being among the various buyers and sellers.

21 Copyright 2003 Southwestern/Thomson Learning Price A D Supply Equilibrium price Consumer surplus Producer surplus E Those buyers who value the good more than the price (AE) will buy it. Those sellers whose costs are less than the price will produce and sell the good (CE) B Demand C 0 Equilibrium Quantity quantity

22 Three Insights Concerning Market Outcomes: Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. Free markets allocate the demand for goods to the sellers who can produce them at least cost. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

23 Copyright 2003 Southwestern/Thomson Learning Price At quantities below equilibrium value to buyers exceeds the cost to sellers. In this region, increasing quantity raises total surplus, until the quantity reaches Eq. 0 Value to buyers Cost to sellers Equilibrium quantity Cost to sellers Value to buyers Supply Demand Quantity At quantities above the equilibrium the value to buyers is less than the cost to sellers it would lower total surplus Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers.

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25 How do taxes affect the economic well-being of market participants? It does not matter whether a tax on a good is levied on buyers or sellers of the good... the price paid by buyers rises, and the price received by sellers falls. We must compare the reduced welfare of buyers and sellers to the amount of revenue the government gets.

26 Copyright 2004 South-Western Price Supply Price buyers pay Size of tax Price without tax Price sellers receive Demand 0 Quantity with tax Quantity without tax Quantity

27 A tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. The size of the market for that good shrinks.

28 Tax Revenue T = the size of the tax Q = the quantity of the good sold T Q = = the government s tax revenue

29 Copyright 2004 South-Western Price Tax revenue is spent on public services: e.g. roads, public education, transfer payments, etc. Supply Price buyers pay Price sellers receive Tax revenue (T Q) Size of tax (T) Quantity sold (Q) Demand 0 Quantity with tax Quantity without tax Quantity

30 Copyright 2004 South-Western Price A tax on a good reduces consumer surplus (by the area B+C) and producer surplus (by the area D+E). Price buyers pay Price without tax Price sellers receive = PB = P1 = PS A B D F C E Supply The tax is said to impose a deadweight loss (area C + E). Demand 0 Q2 Because the fall in producer and consumer surplus exceeds tax revenue Quantity Q1 (area B + D), the tax is said to impose a deadweight loss (area C + E).

31 The change in total welfare includes: The change in consumer surplus, The change in producer surplus, and The change in tax revenue. The losses to buyers and sellers exceed the revenue raised by the government. This fall in total surplus is called the deadweight loss.

32 Changes in Welfare A deadweight loss is the fall in total surplus that results from a market distortion, such as a tax. A tax is an incentive to buyers and sellers Taxes distort incentives. They cause markets to allocate resources inefficiently.

33 PETER: OC = $80 PS = $100-$80=$20 Peter cleans Jane s house for $100 Total surplus: $20+$20=$40 JANE: WTP = $120 CS = $120-$100=$20

34 PETER: OC = $80 PS = $100-$80=$20 PETER: OC = $80 PS = $120-$50=$70<$80 Peter cleans Jane s house for $100 Total surplus: $20+$20=$40 If the tax $50 is levied on supplier of the service, then JANE: WTP = $120 CS = $120-$100=$20 JANE: WTP = $120 She cannot pay more than $120. She would need to pay at least $130.

35 Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade.

36 What determines whether the deadweight loss from a tax is large or small? The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. That, in turn, depends on the price elasticities of supply and demand.

37 Copyright 2004 South-Western (a) Inelastic Supply Price Supply Size of tax When supply is relatively inelastic, the deadweight loss of a tax is small. Demand 0 Quantity

38 Copyright 2004 South-Western (b) Elastic Supply Price When supply is relatively elastic, the deadweight loss of a tax is large. Size of tax Supply Demand 0 Quantity

39 Copyright 2004 South-Western (c) Inelastic Demand Price Supply Size of tax When demand is relatively inelastic, the deadweight loss of a tax is small. Demand 0 Quantity

40 Copyright 2004 South-Western (d) Elastic Demand Price Supply Size of tax Demand When demand is relatively elastic, the deadweight loss of a tax is large. 0 Quantity

41 The greater the elasticities of demand and supply: the larger will be the decline in equilibrium quantity and, the greater the deadweight loss of a tax.

42 With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax.

43 Copyright 2004 South-Western Price (a) Small Tax Deadweight loss Supply P B Tax revenue P S Demand 0 Q 2 Q 1 Quantity

44 Copyright 2004 South-Western Price (b) Medium Tax P B Deadweight loss Supply Tax revenue P S Demand 0 Q 2 Q 1 Quantity

45 Tax revenue Copyright 2004 South-Western (c) Large Tax Price P B Deadweight loss Supply Demand P S 0 Q 2 Q 1 Quantity

46 Copyright 2004 South-Western (a) Deadweight Loss Deadweight Loss As the size of a tax increases, its deadweight loss quickly gets larger. 0 Tax Size

47 For the small tax, tax revenue is small. As the size of the tax rises, tax revenue grows. But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market.

48 Copyright 2004 South-Western (b) Revenue (the Laffer curve) Tax Revenue Tax revenue first rises with the size of a tax, but then, as the tax gets larger, the market shrinks so much that tax revenue starts to fall. 0 Tax Size

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50 What determines whether a country imports or exports a good? Who gains and who loses from free trade among countries? What are the arguments that people use to advocate trade restrictions?

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52 Equilibrium Without Trade Assume: A country is isolated from rest of the world and produces steel. The market for steel consists of the buyers and sellers in the country. No one in the country is allowed to import or export steel.

53 Copyright 2004 South-Western Price of Steel Domestic supply Equilibrium price Consumer surplus Producer surplus Domestic demand 0 Equilibrium Quantity quantity of Steel

54 Equilibrium Without Trade Results: Domestic price adjusts to balance demand and supply. The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive.

55 If the country decides to engage in international trade, will it be an importer or exporter of steel?

56 The effects of free trade can be shown by comparing the domestic price of a good without trade and the world price of the good. The world price refers to the price that prevails in the world market for that good.

57 If a country has a comparative advantage, then the domestic price will be below the world price, and the country will be an exporter of the good. If the country does not have a comparative advantage, then the domestic price will be higher than the world price, and the country will be an importer of the good.

58 Copyright 2004 South-Western Price of Steel Price after trade Price before trade 0 Domestic quantity demanded Exports Domestic quantity supplied Domestic supply Domestic demand World price Quantity of Steel

59 Copyright 2004 South-Western Price of Steel Price after trade Price before trade A C B Consumer surplus before trade Exports D Domestic supply World price Producer surplus before trade Domestic demand 0 Quantity of Steel

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61 The analysis of an exporting country yields two conclusions: Domestic producers of the good are better off, and domestic consumers of the good are worse off. Trade raises the economic well-being of the nation as a whole.

62 International Trade in an importing Country If the world price of steel is lower than the domestic price, the country will be an importer of steel when trade is permitted. Domestic consumers will want to buy steel at the lower world price. Domestic producers of steel will have to lower their output because the domestic price moves to the world price.

63 Price of Steel Price before trade Domestic supply Price after trade Imports Domestic demand World price 0 Domestic Domestic Quantity quantity quantity of Steel supplied demanded Copyright 2004 South-Western

64 Price of Steel Consumer surplus after trade Domestic supply A Price before trade Price after trade C B D Imports World price Producer surplus after trade Domestic demand 0 Quantity of Steel Copyright 2004 South-Western

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66 The analysis of an importing country yields two conclusions: Domestic producers of the good are worse off, and domestic consumers of the good are better off. Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers.

67 The gains of the winners exceed the losses of the losers. The winners could compensate the losers. The net change in total surplus is positive. But will trade make EVERYONE better off? In practice, compensation for the losers from international trade is rare Without such compensation, opening up to international trade is a policy that expands the size of the economic pie, while perhaps leaving some participants in the economy with a smaller slice...

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69 Tariffs raise the price of imported goods above the world price by the amount of the tariff. A tariff is a tax on goods produced abroad and sold domestically.

70 Price of Steel Domestic supply Equilibrium without trade Price with tariff Price without tariff Imports with tariff Domestic demand Tariff World price 0 Q S Q S Q D Q D Quantity of Steel Imports without tariff Copyright 2004 South-Western

71 Price of Steel Consumer surplus before tariff Domestic supply Producer surplus before tariff Equilibrium without trade Price without tariff Domestic demand World price 0 Q S Q D Quantity of Steel Imports without tariff Copyright 2004 South-Western

72 Price of Steel Consumer surplus with tariff Domestic supply A Equilibrium without trade Price with tariff B Tariff Price without tariff Imports with tariff Domestic demand World price 0 Q S Q S Q D Q D Quantity of Steel Imports without tariff Copyright 2004 South-Western

73 Price of Steel Domestic supply Producer surplus after tariff Equilibrium without trade Price with tariff Price without tariff G C Imports with tariff Domestic demand Tariff World price 0 Q S Q S Q D Q D Quantity of Steel Imports without tariff Copyright 2004 South-Western

74 Price of Steel Domestic supply Tariff Revenue Price with tariff Price without tariff E Imports with tariff Domestic demand Tariff World price 0 Q S Q S Q D Q D Quantity of Steel Imports without tariff Copyright 2004 South-Western

75 Price of Steel Domestic supply A Deadweight Loss Price with tariff Price without tariff G C D B E Imports with tariff F Domestic demand Tariff World price 0 Q S Q S Q D Q D Quantity of Steel Imports without tariff Copyright 2004 South-Western

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77 A tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade. With a tariff, total surplus in the market decreases by an amount referred to as a deadweight loss.

78 An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. The equilibrium of demand and supply maximizes the sum of consumer and producer surplus. This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. Markets do not allocate resources efficiently in the presence of market failures.

79 A tax on a good reduces the welfare of buyers and sellers of the good, and the reduction in consumer and producer surplus usually exceeds the revenues raised by the government. The fall in total surplus the sum of consumer surplus, producer surplus, and tax revenue is called the deadweight loss of the tax.

80 The effects of free trade can be determined by comparing the domestic price without trade to the world price. A low domestic price indicates that the country has a comparative advantage in producing the good and that the country will become an exporter. A high domestic price indicates that the rest of the world has a comparative advantage in producing the good and that the country will become an importer.

81 When a country allows trade and becomes an exporter of a good, producers of the good are better off, and consumers of the good are worse off. When a country allows trade and becomes an importer of a good, consumers of the good are better off, and producers are worse off. A tariff a tax on imports moves a market closer to the equilibrium than would exist without trade, and therefore reduces the gains from trade.