Econ 120
Efficiency and Policy Chapter 4+5
Game Plan ● Review intuition from last class ● Efficiency of the market ● Event + Policy Analysis
○ Price Floors ○ Price Ceilings
Announcements: 1. Typo in Problem Set Question: Should say “Quantity Supplied” for Bangor Brownies 2. Short Quiz covering basics of Chapter 3 + Chapter 4→ practice quiz will be on blackboard on Thursday 3. Problem Set due Friday. Next one due next Friday→ to be posted Thursday 4. Discussion Session questions will be posted after class.
Consumer Surplus Consumer Surplus = Willingness to Pay - Price, if WTP > P → 0 otherwise
Willingness to Pay = Maximum one would pay for a good
If Willingness to Pay > Price → I buy the good. I would prefer to buy the good.
If Willingness to Pay < Price → I don’t buy the good.
WTP and Demand 1. Can construct Demand Curve using WTP 2. At each price, quantity = # of units where
The WTP >= that price 3. CS = Area below Demand and above Price
a. You get something like the graph on the right.
Person WTP
John 100
Paul 80
George 70
Ringo 50
WTP and Demand With lots of consumers --> Demand is more like a line Demand Curve at unit n shows the n-th highest WTP
Two ways to read Demand Curve:
1. At this price, how much will people buy?
The answer to question 1 is also the answer to the question:
2. For this quantity, what’s the highest price I could charge?
“Proof”: 1. Suppose At Qa, WTP = Pa. 2. If Price = Pa, I won’t buy less than Qa, because WTP decreases with quantity, and so at quantities less than Qa, WTP > Price 3. If Price = Pa, I won’t buy more than Pa, because WTP decreases with quantity, and so WTP < Price above Qa 4. Therefore, if at Qa WTP = Pa, I will therefore buy Qa if the price is set at Pa.
WTP and Demand With lots of consumers --> Demand is more like a line Demand Curve at unit n shows the n-th highest WTP
Two ways to read Demand Curve:
1. At this price, how much will people buy? a. Number of Units where:
i. the Price =< WTP for those units ii. Price > WTP for all other units iii. Thus Price = WTP
The answer to question 1 is also the answer to the question:
2. For this quantity, what’s the highest price I could charge? a. Price at which:
i. Price < WTP for those units ii. Price > WTP for all other units iii. Thus Price = WTP
Consumer Surplus CS = Area below Demand And above the price level
Taking WTP - Price for each Unit and adding them together
Why does increasing Q lead to A drop in WTP?
1. Lower WTP people willing To buy
2. As Q goes up, I value each Additional unit less
Producer Surplus PS = Price - Cost if Price >= Cost, 0 otherwise Cost = Lowest Price at which they’ll
sell the good Can construct supply curve using Costs: At each price, how much will be sold?
Unit Number Cost
1 10
2 20
3 35
Cost and Supply 1. You can construct the supply curve using
Costs. 2. Two ways to read supply:
a. At this price, how much will producers supply? b. At this quantity, what’s the lowest price producers
Are willing to sell at?
Suppose at Qa, the lowest price they’ll sell at is Pa. 1. If the price were Pa, every unit =< Qa is worth producing since the price is less than the cost. 2. Every unit > Qa is not worth producing, since Cost > Pa. 3. Therefore, if the price is Pa, they’ll sell at Qa.
Producer Surplus Price - Cost if Price > Cost, 0 otherwise PS = Area below Price and above the Supply curve
Supply curve at unit n shows additional cost of producing the “n-th” unit
Why is it upward sloping?
1. At higher prices, producers with Higher costs might be willing to Produce.
2. As you produce more, more inputs might be necessary to produce more
Find CS and PS before and after each of the shifts
*Assume Price = 7 at Q = 0 for D2
Find CS and PS before and after each of the shifts *Assume Price = 7 at Q = 0 for D2 Before: CS = (5-3)*30/2 = 30 PS = (3-1)*30/2 = 30
After: CS = (7-4)*40/2 = 60 PS = (4-1) *40/2 = 60
Find CS and PS before and after each of the shifts Before: CS = (5-3)*30/2 = $30 PS = (3-1)*30/2 = $30
After: CS = (5-4)*20/2 = $10 PS = (4-3)*20/2 = $10
How Shifts Affect Surplus 1. Demand Increases → CS and PS increase
For Consumers, Quantity is increasing (which is good). Price goes up, but the increase in WTP has a dominating effect. For Producers, Price and Quantity go up → Good!
2. Demand Decreases → CS and PS decrease Argument in 1 → but the exact opposite.
3. Supply Increases → CS and PS increase For consumers, price is going down and quantity is increasing→ Good! For Producers, Quantity is Increasing and while price drops, the reduction in cost for each unit has a dominating effect.
4. Supply Decrease → CS and PS increases 3→ but the exact opposite.
Total Surplus (TS) Find Consumer Surplus, Producer Surplus, And Total Surplus.
Total Surplus (TS) TS = PS + CS
(Price - Cost) + (WTP - Price)= WTP-Cost
Here… CS = (100-75)*100/2 = (25)*50 = $1250 PS = (75-20)*100/2 = (55)*50 = $2750 TS = $1250 + $2750 = $4000
Similarly… TS = (100-20)*100/2 = (80)*50= $4000
The efficiency of the market 1. Markets approach equilibrium.
a. If there’s a surplus → prices will lower b. If there’s a shortage → prices will rise
2. New claim: a. At equilibrium, the market is efficient. b. No one can be made better off without
making someone else worse off. c. Similarly, we’re not “missing out” on
Beneficial transactions. No additional Surplus is possible.
Next, we’ll discuss why changing the price of quantity Leads to problems.
TS = Sum of “Willingness to Pay”s - Sum of Costs TS = PS + CS = (Price - Cost) + (WTP - Price) = WTP-Cost
Suppose 3 transactions occur: Total Surplus is… (WTP - C for transaction 1) + (WTP - C for transaction 2) + (WTP - C for transaction 3)
Or…
WTP1+ WTP2 + WTP3 - Cost1 - Cost2 - Cost3
Less transactions than equilibrium → Inefficient
1. At the current quantity, all buyers value the good more than all sellers.
2. All transactions create surplus. Willingess to Pay > Cost for all transactions
3. Therefore, Less transactions→ less “good” trades
More transactions than equilibrium → Inefficient There are no potential sellers who value the good less than any potential buyers.
More transactions → only adding “bad trades”
Increasing quantity adds people whose willingness to pay < cost → “negative surplus”
Changing anything can only reduce surplus *Read the end of Chapter 4 for a more thorough discussion of this.
Changing the Consumers At Equilibrium:
1. All buying consumers value the good more than producers. 2. All non-buying consumers value the good less than current consumers.
● The Consumers who value the good the most currently get it. ● Changing the Consumers results in reallocating the good away from those who value it most
towards those who value it less.
● If we change the consumers, we’re necessarily reducing surplus.
Total Surplus = WTP - Cost → lowering WTP lowers TS
Changing the Producers The Producers with the lowest costs are currently producing the goods.
Changing the producers results in reallocating sales away from those with lower costs and towards those with higher costs.
This also reduces surplus.
Total Surplus = WTP - Cost → Increasing Cost lowers TS
Markets lead to efficiency 1. Evidence that a free market might be efficient
a. Markets do seem to have some appealing characteristics. b. If the market is operating well, a non-market economy can’t be more efficient
2. But, make note: Markets often fail 3. Market Failure → when markets don’t result in efficiency
a. Assuming many producers and consumers→ market is competitive b. Assuming people have all the relevant information for making transactions c. Assuming transactions don’t affect third parties in ways unaccounted for in costs d. People are generally “rational” e. Efficiency doesn’t clearly imply equity
i. Poor people have low “willingness to pay” because they can’t afford goods ii. The poor not having goods is efficient → NOT clearly an equitable situation
Chapter 5: Price Controls Price Controls: legal restrictions on how high or low a market price may go Price Ceiling: Maximum price a sellers can charge
Example: Rent Control, prescription drugs, Maximum food prices Price Floor: A minimum price buyers have to pay
Example: A minimum wage
Why do it?
Usually for normative reasons-- varies by context.
1. Minimum Wage → People can’t afford to get by 2. Rent Control → Helps poor people not get displaced by gentrifiers 3. Food Prices → Foods too expensive
Is the rent “too high”?
Modeling Rent Control: Before Rent Control
After Rent Control
Modeling Rent Control
Price Ceilings, Shortages, and Deadweight Loss Deadweight Loss = Loss of Total Surplus due to an insufficient quantity of transactions
Price Ceilings, Shortages, and Deadweight Loss Deadweight Loss = Loss of Total Surplus due To an insufficient quantity of transactions
→ Illustrated using the yellow triangle
Landlords would be willing to rent out their Apartments at higher prices, and tenants would be willing to rent at those higher prices.
BUT the price ceiling inhibits this from occurring. → Less “good trades”, Missed Opportunities → Inefficiency
Price Ceilings, Shortages, and Deadweight Loss What’s the Deadweight Loss?
How big is the shortage?
Price Ceilings, Shortages, and Deadweight Loss What’s the Deadweight Loss?
(1200m-800m)*(.2)*(.5) = (400m)*(.1) = $40m
How big is the shortage? 2.2m - 1.8m = .4 m
Who “wins” and who “loses”? It’s complex. 1. Find the CS before and after. 2. Find the PS before and after 3. Find Deadweight Loss. 4. Find TS before and after.
Who “wins” and who “loses”? It’s complex. 1. Producers (i.e. landlords) seem to lose.
a. Some get paid less. b. Others miss out by not renting anymore c. PS definitely drops.
2. Consumers as a whole might gain. a. CS might increase or decrease. It depends
On the slope of the D and S curves. b. Those who keep their apartments are the
Clearest beneficiaries. c. Some will lose apartments. Some will now
Want an apartment, but won’t find one.
It depends on the slope? Producer Surplus = Sum of Price - Cost for all transactions
Higher Prices, lower costs, or more transactions → good for producers. Lower prices, higher costs or less transactions → bad for producers.
Consumer Surplus = Sum of WTP - Price for all transactions
Higher WTP, lower prices, or more transactions → good for consumers Lower WTP, higher prices, or less transactions → bad for consumers
If an event affects multiple things, but in one ways that both increase and decrease surplus in different ways → then the slope matters.
Unintended Consequences with Rent Control ● Model predicts potential problems ● Real life adds some other “issues”
○ “Key Money” ■ Black Markets
○ Discrimination ■ Lower “Cost” of racism
○ Lower quality ■ Shortage = can offer worse service
○ Worse allocation of apartments ■ Lower valuation people might
Get it over higher valuation people
Other Examples 1. Venezuelan Price Controls
a. Maximum Food Prices→ Food shortage b. Inflation makes problem worse c. Farmers are smuggling food to Colombia d. People are going hungry
i. 19 pound weight loss on average ii. Aisles are empty iii. Looting in the streets
2. If we controlled prescription drug prices: a. Less innovation?
Using Surplus to Analyze Policy: Price Floor
Price Floor = minimum price
For minimum wage:
1. Workers supply labor. 2. Businesses demand labor 3. Wage = Price of Labor
Minimum Wage = Minimum Price of Labor
Using Surplus to Analyze Policy: Price Floor
Surplus = Qs - Qd → Unemployment
Consumer Surplus definitely decreases → Companies are worse off.
Producer Surplus might increase.
1. It depends on the slopes. How many Jobs are lost?
2. It also depends on the level of the price Floor.
Using Surplus to Analyze Policy: Price Floor
What’s the surplus (Qs-Qd)?
Find original and new Producer Surplus.
Find original and new Consumer Surplus.
What’s the Deadweight loss?
Minimum Wage + Other Issues with Price Floors
1. It’s not clear whether or not it causes unemployment. a. In Europe → from what I hear, yes. b. In the US → minimum wage has never been much higher than the equilibrium wage
i. If there is an effect, economists are having a hard time scientifically showing it. ii. Unemployment changes for many reasons → just because a minimum wage
And unemployment are correlated, doesn’t imply that the minimum wage caused unemployment.
c. Discrimination? d. Misallocation? e. Skill development? f. Quality mismatch?
g. Black markets?
Summary 1. Markets (when working well) are efficient. We can’t increase surplus. 2. Markets often don’t work well. 3. Price Controls typically lead to shortages, surplus and deadweight loss. 4. Policies often have unintended consequences. 5. But there are arguments for these policies.