Social Welfare and Government Intervention

Total Surplus and Government Intervention

We’ve presented a perfectly competitive market. Now want to ask, is a perfectly competitive market efficient?

What does it mean to be efficient?

• For a given supply and demand, there is no other price or quantity that will give a larger total surplus.

• Total surplus = Consumer surplus + Producer surplus. Need to define each.

Consumer surplus (CS)

Measure of consumer welfare. How much do consumers benefit from being able to consume some good?

CS = willingness to pay (WTP)- Amount Paid

"bonus to the consumer"

 Recall market experiment: If you were an apple consumer, you were told your value for the apples. You bargained for a price. The difference between your value and the price paid was your CS.

 Ex) sale

Apply definition of CS to graph. Demand curve shows how much individuals are WTP for each extra unit. But they only pay P* for each unit bought.

Graphically, CS= "area under demand and above P*, up to Q*"

Producer Surplus

Measure of producer welfare. How much do producers benefit from being able to sell some they have produced?

"bonus" to producer

PS= price –willingness to accept (MC of producing good)

Ex) In experiment, sellers were told cost of producing good

Supply curve shows minimum amount firms require in order to produce an extra unit. But, firms receive one price, P*, for all units sold.

Graphically, PS= "area under P* and above S, up to Q*".

Putting it together:

Total Surplus=

Think of total surplus as a pie that represents the well-being of producers and consumers in this market. This pie can be divided between CS and PS. Ideally, we would like society's well-being to be as large as possible. (Assume for the moment that we don't care about how the pie is divided between consumers and producers, only the total size of the pie.)

Conditions for market efficiency:

• MB=MC of last unit produced (marginal principle)

Suppose this wasn’t true. MB>MC – benefit of taking action is greater than cost. Can make someone better off for a lower cost. Should do it.

If MB<MC – doing too much of an action

Note that saying MB=MC is equivalent to saying that the total surplus is maximized.

Perfect competition maximizes total surplus-- thus, we say it is efficient. There is no P other than P* that would make CS+PS as large.

Ex)

Qd=12-P

Qs=P-4

Calculate total surplus. (Draw the graph!)

Now lets examine how government intervention can decrease social welfare.

Caveats:

• We are continuing to assume perfect competition and that markets are perfectly efficient. As we will discuss later in the class, perfect competition is rare and there are many markets that are not efficient. In these cases, government intervention can actually lead to efficiency.

• Equity vs. efficiency

Price ceilings

Def: maximum price at which good can be sold.

Exs) rent control

Gas prices in 1970s

Discussion during elections about pharmaceutical drugs

Price controls on energy in CA

Rent Control

What is it? Local government establishes maximum rental price

Why is it established? Concern that poor are being priced out of the market

Goal: Help poor get housing

Tend to see in expensive urban markets: SF, NY

Ex) Suppose city council imposes price ceiling of $800.

Results of rent control

How many apartments will be rented?

600

600<800 -- < efficient number rented

What happened to the 200 apartments that were in the market before?

Converted to condos

Not maintained

How many apartments do people want to rent at a price of $800?

1000 --- Qs<Qd (shortage)

What has happened to CS, PS, and total surplus?

PS decreased, CS ?, total surplus decreased, DWL b/c fewer apartments rented than is efficient

Rent control not efficient b/c does not maximize total surplus

Who benefits from rent control?

Anyone with a rent controlled apartment. Benefits rich and poor renters.

Might expect that poor renters would have a more difficult time getting apartments

Other effects

Key $, people move less

Rent control isn’t efficient and is an expensive way to trying to meet the goal of helping the poor find housing

Connection with elasticity

What might explain the increase in wait time?

Increase in income – increased D for apartments

Effective versus Ineffective price ceilings

Ex) reconsider previous example. Qd=12-P, Qs=P-4. Suppose price ceiling of $6 is imposed. There will be a _________________ of ________________.

How much did total surplus fall?

 Q: What happens if P ceiling set above market price?

No effect

Price Floor

Def: minimum price at which good can be sold

Ex) Agricultural subsidies, minimum wage

Goal: Help family farmers

Results:

 Q sold in market < Q* -- not efficient

Qd<Qs -- surplus

 CS decreases, PS ?, total surplus falls – not efficient

Doesn’t’ just benefit small family farmers

 Misallocates resources: increased value of producing corn compared to other goods that could be produces with same resources

Ineffective Example

Quantity Controls

Government controls quantity through licenses rather than prices.

Examples: taxicab medallions, liquor licenses

Issue license -- vertical S --creates limit on quantity supplied –

Results:

 CS decreases

Total surplus falls