LECTURE February Thursday, February 21, 13

Transcription

1 LECTURE February

2 ANNOUNCEMENTS HW 4 due Friday at 11:45 PM Midterm 1 next Monday February 25th 7:30 PM - 8:30 PM in Anderson 270 (not this room) 2 old midterms are on Moodle; they are very similar to what this midterm will be like 2

3 MIDTERM 1: CONTENT Midterm will cover: Lectures 1-10 (through the end of this week) - my 1 through 10 (on Moodle this is 1 through 5) The three readings: i) UK electricity auction, ii) global gas prices, iii) supply management in Canada The format is all multiple choice (just like the practice midterms) To the midterm bring number 2 pencils and your U identification Do not bring scratch paper, calculator 3

4 SUPPLY CONTROLS Real impact of sugar quotas on US sugar prices 4

5 SUPPLY CONTROLS Remember President Ive s disastrous subsidy plan, which increased the surplus to producers There are alternatives that achieve similar policy goals Suppose a government wanted to ensure farmers received a high price (higher than in competitive equilibrium) for their products We could implement a subsidy; typically the way Americans boost producer welfare In Canada, supply management policies are used instead 5

6 CANADIAN DAIRY MARKET We will deal with the Canadian dairy market from the reading How does the Canadian government control supply? Each farmer must own a quota, which is a right to sell milk created by the government and in limited quantity More production requires the purchase of more quotas One quota corresponds approximately to the right to sell the milk of one cow per day By limiting the number of quotas, the Canadian government can limit the amount of milk in the market 6

7 QUOTA EXCHANGE After collecting quotas from the government, farmers can buy and sell them on a quota exchange (in which the price of one quota is now about $25,000) This cost is much larger than the cost of milking a cow or the cow itself A farm described in the reading had a total value of $5.8 million $2.8 million (or about half) was in costs of the quota 7

8 MODELING A QUOTA Return to our simple 10 unit model with everyone producing and consuming one unit, and suppose the total quota is 3 units of milk We know what quantity will be in equilibrium (3), what will be prices? Requires finding the price of the quota, which requires several steps Dairy Market Price 10 Supply Demand Quantity Quota 8

9 MODELING A QUOTA Step 1: If the total quota is higher than the competitive market quantity, price of the quota is 0 Here this is not the case Step 2: The price of the milk is given by demand curve That is, for quantity demanded to be the total quota, what must price be? If quantity demanded is 3, then the price must be 7 P Milk Price Dairy Market Supply Demand Quantity Quota 9

10 MODELING A QUOTA Suppose each farmer runs two businesses: a milk business and quota business The farmer cares about total profit: using a quota for the milk business ensures that he cannot use sell it in his quota business So there is a loss (opportunity cost) to the farmer from using the quota to produce milk So the total cost for a farmer deciding to produce is: Total Cost = Production Cost + Cost of Quota 10

11 MODELING A QUOTA Step 3: The price of the quota is the price so that the marginal producer (last producer) breaks even when considering the opportunity cost of holding the quota To produce the last (third) milk, we need S3, who has a cost of production of $3 Alternatively, recall that the supply curve is simply the marginal cost curve so marginal cost at Q = 3 is $3 This producer gets paid $7 for milk and produces at a cost of $3, so what must be the price of the quota The quota must be $4 since $7 - $3 = $4, i.e. the producer breaks even (has zero profit including the opportunity cost of the quota) P Milk Cost of Last Producer Price Dairy Market Quota Supply Demand Quantity 11

12 QUOTA PRICES Board Work: Why this pricing scheme makes sense What do incentives change if the quota price is greater than $4 (think of S3) S3 could make milk for a profit of $4, but would rather sell the quota and get more than $4? Who would buy it S3 s quota if S1 and S2 are already making milk? No one so lack of demand ensures price of the quota falls If the quota price is less than $4? Demand for the quota will be too high There will be more than three suppliers willing to buy the quota rent (check this) 12

13 WELFARE EFFECTS What is consumer surplus for the original market? Area of the red triangle (standard condition) CS =.5*3*3 = 4.5 What is the producer surplus? Recall we consider the profit of the producer is now: price received - cost - quota price So net price received for every producer is $7 - $4 = $3, and use this to calculate the normal producer surplus So producer surplus = 4.5 (blue triangle) P Milk Cost of Last Producer Price CS PS Dairy Market Quota Price Quota Supply Demand Quantity Is anything missing? 13

14 WELFARE EFFECTS Need to also calculate value generated from quota exchange Producers selling their quotas on the quota market receive a profit as well Total producer profit is then PS 1 + PS 2 = 16.5 Notice the similarities to the consumer resale market P Milk Cost of Last Producer Price CS Quota Rent = PS 2 PS 1 Dairy Market Quota Price Deadweight Loss Quota Supply Demand Quantity 14

15 WELFARE EFFECTS So, as expected, total welfare decreases under a quota. Why? We have a failure of general principle 3 Output is too low How would this change if there was no exchange market? The result would be similar to the effect we found in the consumer resale market Production allocation would not be efficient Notice also how similar this structure is to a tax. What is the difference? There is no government revenue Quota rents go to those who own the quota rights No Quota 3 Un. Quota Change Q P Milk P Quota CS PS PS TS

16 PRESENT VALUE OF QUOTA In reality what is the value of holding a quota? For one day it is valued at $4 in our economy, but quotas can be used for today and every day in the future The value of the quota as an asset that can be sold (or sold each day for $4) must take into account these potential future payments Normally, we would calculate the present value - value of the quota in the future in terms of today Can simplify by assuming every firm operates for a year Value today is the same as value tomorrow What is the value of a quota over a year? $4 * 365 days = $1,460 16

17 SUMMARY The government can use price ceilings and floors to set a maximum and minimum price in a market, and can use supply controls to restrict the quantity traded In general controls cause a failure of principle 3, efficient production quantity; as a result total welfare will be lower than under a competitive equilibrium (though some may win and some may lose from the policy) Because of rationing under price and supply controls, we may also face a failure of principle 1 or 2 (efficient allocation) Resale markets or quota markets can ensure the supply that does exist is sold to the highest value consumer or produced by the lowest cost producers so efficient allocations are achieved 17

18 GOVERNMENT POLICIES 18

19 SUMMARY OF GOVERNMENT POLICIES We have essentially covered all the basic ways the government can impact our competitive equilibrium Price Market Supply They are all very similar in their source of inefficiency by causing output to fall below the efficient quantity (Except for a subsidy, which pushes output too high) CS Deadweight Loss Graph to the right depicts a very general case Red triangle always goes to consumers Blue triangle always goes to producers PS Demand Purple triangle is deadweight loss Q Low Q Eff Quantity Green triangle? 19

20 SUMMARY OF GOVERNMENT POLICIES To whom does the green box go? Policy Tax Green box owner Government Quota Quota Owners We can summarize it based on the type of policy implemented Price Ceiling (efficient) Price Ceiling Price Floor (efficient) Price Floor Consumers Partly destroyed by inefficient allocation Producers Partly destroyed by inefficient allocation 20