Introduction to Economic Institutions

Transcription

1 Introduction to Economic Institutions ECON 1500 Week 3 Lecture 2 13 September 1 / 35

2 Recap 2 / 35

3 LAW OF SUPPLY AND DEMAND the price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance shifts in supply and demand curves and the effects on prices and quantities of goods demanded and supplied On Tuesday during the game you also probably realized that buyers always want to pay less, sellers want to be paid more today we ask a question: is there a right price to pay? from a point of view of society is the equilibrium quantity of ice cream produced too large? too small? just right? 3 / 35

4 Topics covered Consumer Surplus Producer Surplus Welfare analysis Application: taxation Reading: Mankiw, Chapter 7 & 8 4 / 35

5 Willingness to pay Suppose that it s a very hot day and you want to eat ice cream the maximum price you want to pay for a cone of ice cream is: $2 this maximum is called willingness to pay you d purchase the cone at a price lower than willingness to pay suppose that the cone of ice cream is $1.50 it s a bargain; your benefit from buying that cone is $2-$1.50=$0.50 we say that $0.50 is a consumer surplus 5 / 35

6 Willingness to pay Now suppose that one ice cream cone doesn t fill you up you want to eat another one, but now you don t want to pay as much for it, you re somewhat full the maximum price you want to pay for a second cone of ice cream is: $1.60 this maximum is called willingness to pay suppose that the cone of ice cream is $1.50 your benefit from buying that cone is $1.60-$1.50=$0.10 we say that $0.10 is a consumer surplus if you consume both ice cream cones, the total surplus is $ / 35

7 Consumer Surplus Definition: the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it the benefit buyers receive from participating in the market we can use the demand curve to measure consumer surplus how? at any quantity the price given by the demand curve shows willingness to pay for marginal buyer i.e. the height of demand curve represents the value buyers place on the good, measured by their willingness to pay for it the marginal buyer is the person who would leave the market if the price was any higher 7 / 35

8 Consumer Surplus 8 / 35

9 Consumer Surplus the area above the price and below the demand curve measure the consumer surplus in a market the difference between willingness to pay and the market price is consumer surplus 9 / 35

10 10 / 35

11 The effect of price change on consumer surplus D E F ABC: initial CS; BCDE: additional CS to initial consumers; CEF: CS to new consumers 11 / 35

12 Consumer Surplus consumer surplus measures the amount that buyers are willing to pay for a good minus the amount they actually pay for it this is the benefit that buyers receive from a good as they perceive it themselves Hence, it s a good measure of economic well-being If policy makers want to satisfy the preferences of buyers in some markets not a good measure: Example? 12 / 35

13 Willingness to sell Suppose that Aggie Ice cream produces a cone for a cost of $1 Cost is the lowest price that they would accept for the ice cream cone cost measures their willingness to sell Aggies Ice Cream would want to sell a cone at a price higher than their willingness to sell suppose they sell it for $2 it s a great deal for them since they earn $2- $1=$1 we say that $1 is a producer surplus 13 / 35

14 Producer Surplus Definition: the amount a seller is paid for a good minus the seller s cost of providing it The benefit sellers receive from participating in the market we can use supply curve to measure producers surplus how? at any quantity the price given by the supply curve shows the cost of the marginal seller i.e. the height of supply curve measures seller s cost the marginal seller is the person who would leave the market if the price was any lower 14 / 35

15 Producer Surplus 15 / 35

16 Producer Surplus the area below the price and above the supply curve measures the producers surplus in a market the difference between the price and the cost of production is each seller s producers surplus 16 / 35

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18 The effect of price change on Producer surplus D E F ABC: initial PS; BCDE: additional PS to initial producers; CEF: PS to new producers 18 / 35

19 Equilibrium 19 / 35

20 Market efficiency using CS and PS can help us understand whether the allocation of resources determined by free market is desirable what does a social planner want to maximise? The total surplus! total surplus=consumer surplus+producer surplus total surplus=value to buyers - cost to sellers the allocation of resources that maximises total surplus is called efficient we may also want to care about equality is the well being equally distributed amongst buyers and sellers? 20 / 35

21 Market equilibrium Is the equilibrium allocation efficient? Yes! Why? demand curve: value to buyers, free market allocates supply of goods to buyers who value them most highly supply curve: cost to sellers, free market allocates demands for goods to sellers who can produce them at lowest cost social planner cannot increase well being by changing allocation, but can they change the quantity of good produced? NO: free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus 21 / 35

22 B E D A Q2 Q3 22 / 35

23 Market equilibrium Is the equilibrium price of a good right? it s the best one, because it maximizes the total welfare of consumers and producers invisible - hand guides them to make these welfare - maximizing choices laissez faire principles: leave the market alone or let the people do as they will 23 / 35

24 Note of caution To conclude that markets are efficient we make few assumptions what if no perfect competition? what if market doesn t only matter to buyers and sellers? externalities Both of above are example of market failure: inability of an unregulated market to allocated resources efficiently this is where public policy can help 24 / 35

25 Application: Taxation taxes raise the price buyers have to pay for a good and lower the price sellers receive the quantity of good sold is lower than without taxes both buyers and sellers are worse off 25 / 35

26 Application: Taxation consider how taxes affect welfare how does that reduced welfare compare to the tax revenue that government receives? here the consumer and producer surplus we have just learned will come in handy 26 / 35

27 Application: Taxation 27 / 35

28 Application: Taxation R 28 / 35

29 Application: Taxation A B C D E F 29 / 35

30 Effect of taxes on welfare Consumer surplus without tax with tax change producer surplus tax revenue total surplus 30 / 35

31 Deadweight loss Definition: the fall in total surplus that results from a market distortion why do taxes create a deadweight loss? taxes distort incentives markets allocate resources inefficiently the size of the market is smaller than it would have been in the absence of taxes at every quantity between quantity with and without tax the potential gains from trade among buyers and sellers are not realized they create the deadweight loss 31 / 35

32 Determinants of deadweight loss the more responsive buyers and sellers are to changes in the price (the larger the elasticities) the greater the deadweight loss of tax 32 / 35

33 Tax cut? What is the effect of the tax cut on consumer and producers surplus and on total welfare? what effect does it have on tax revenue? what does this effect depend on? 33 / 35

34 Is there an optimal tax? as the size of tax increases, deadweight loss increases tax revenues increase with the size of tax initially BUT! for very large taxes the tax revenue starts falling again Laffer curve: the relationship between size of taxes and tax revenues 34 / 35

35 Is there an optimal tax? as the size of tax increases, deadweight loss increases tax revenues increase with the size of tax initially BUT! for very large taxes the tax revenue starts falling again Laffer curve: the relationship between size of taxes and tax revenues 34 / 35

36 Why is this relevant? Tax policy matters - we disagree about it, relevant in research in economics we discuss the size of optimal taxes we disagree on who bears the burden of taxes? consumers producers? how much falls on who? Tax policy matters in politics the recently passed package of tax cuts Tax Foundation Analysis 35 / 35