Applied welfare econ cost benefit analysis ch11

Chapter 11 APPLIED COMPETITIVE ANALYSIS Economic Efficiency and Welfare Analysis • The area between the demand and the supply curve represents the sum of consumer and producer surplus – measures the total additional value obtained by market participants by being able to make market transactions • This area is maximized at the competitive market equilibrium Economic Efficiency and Welfare Analysis Price S Consumer surplus is the area above price and below demand P* Producer surplus is the area below price and above supply D Q* Quantity Economic Efficiency and Welfare Analysis Price S At output Q1, total surplus will be smaller At outputs between Q1 and Q*, demanders would value an additional unit more than it would cost suppliers to produce P* D Q1 Q* Quantity Economic Efficiency and Welfare Analysis • Mathematically, we wish to maximize consumer surplus + producer surplus = Q Q 0 [U (Q ) − PQ] + [PQ − ∫ P (Q )dQ ] = U (Q ) − ∫ P (Q )dQ • In long-run equilibria along the long-run supply curve, P(Q) = AC = MC Economic Efficiency and Welfare Analysis • Maximizing total surplus with respect to Q yields U’(Q) = P(Q) = AC = MC – maximization occurs where the marginal value of Q to the representative consumer is equal to market price • the market equilibrium Welfare Loss Computations • Use of consumer and producer surplus notions makes possible the explicit calculation of welfare losses caused by restrictions on voluntary transactions – in the case of linear demand and supply curves, the calculation is simple because the areas of loss are often triangular Welfare Loss Computations • Suppose that the demand is given by QD = 10 - P and supply is given by QS = P - • Market equilibrium occurs where P* = and Q* = Welfare Loss Computations • Restriction of output to Q0 = would create a gap between what demanders are willing to pay (PD) and what suppliers require (PS) PD = 10 - = PS = + = Welfare Loss Computations The welfare loss from restricting output to is the area of a triangle Price S The loss = (0.5)(2)(1) = D Quantity 10 Gains from International Trade Price S If the world price (PW) is less than the domestic price, the price will fall to PW Quantity demanded will rise to Q1 and quantity supplied will fall to Q2 P* PW D Q2 Q* Q1 imports Imports = Q1 - Q2 Quantity 36 Gains from International Trade Price S Consumer surplus rises Producer surplus falls There is an unambiguous welfare gain P* PW D Q1 Q* Q2 Quantity 37 Effects of a Tariff Price S Suppose that the government creates a tariff that raises the price to PR Quantity demanded falls to Q3 and quantity supplied rises to Q4 PR PW Imports are now Q3 - Q4 D Q2 Q4 Q3 Q imports Quantity 38 Effects of a Tariff Price S Consumer surplus falls Producer surplus rises The government gets tariff revenue PR PW These two triangles represent deadweight loss D Q2 Q4 Q3 Q Quantity 39 Quantitative Estimates of Deadweight Losses • Estimates of the sizes of the welfare loss triangle can be calculated • Because PR = (1+t)PW, the proportional change in quantity demanded is Q3 − Q1 PR − PW = ⋅ eD = teD Q1 PW 40 Price Quantitative Estimates of Deadweight Losses S The areas of these two triangles are DW1 = 0.5(PR − PW )(Q1 − Q3 ) DW1 = −0.5t 2eDPW Q1 PR PW DW2 = 0.5(PR − PW )(Q4 − Q2 ) D Q2 Q4 Q3 Q DW2 = −0.5t 2eS PW Q2 Quantity 41 Other Trade Restrictions • A quota that limits imports to Q3 - Q4 would have effects that are similar to those for the tariff – same decline in consumer surplus – same increase in producer surplus • One big difference is that the quota does not give the government any tariff revenue – the deadweight loss will be larger 42 Trade and Tariffs • If the market demand curve is QD = 200P-1.2 and the market supply curve is QS = 1.3P, the domestic long-run equilibrium will occur where P* = 9.87 and Q* = 12.8 43 Trade and Tariffs • If the world price was PW = 9, QD would be 14.3 and QS would be 11.7 – imports will be 2.6 • If the government placed a tariff of 0.5 on each unit sold, the world price will be PW = 9.5 – imports will fall to 1.0 44 Trade and Tariffs • The welfare effect of the tariff can be calculated DW1 = 0.5(0.5)(14.3 - 13.4) = 0.225 DW2 = 0.5(0.5)(12.4 - 11.7) = 0.175 • Thus, total deadweight loss from the tariff is 0.225 + 0.175 = 0.4 45 Important Points to Note: • The concepts of consumer and producer surplus provide useful ways of analyzing the effects of economic changes on the welfare of market participants – changes in consumer surplus represent changes in the overall utility consumers receive from consuming a particular good – changes in long-run producer surplus represent changes in the returns product inputs receive 46 Important Points to Note: • Price controls involve both transfers between producers and consumers and losses of transactions that could benefit both consumers and producers 47 Important Points to Note: • Tax incidence analysis concerns the determination of which economic actor ultimately bears the burden of a tax – this incidence will fall mainly on the actors who exhibit inelastic responses to price changes – taxes also involve deadweight losses that constitute an excess burden in addition to the burden imposed by the actual tax revenues collected 48 Important Points to Note: • Transaction costs can sometimes be modeled as taxes – both taxes and transaction costs may affect the attributes of transactions depending on the basis on which the costs are incurred 49 Important Points to Note: • Trade restrictions such as tariffs or quotas create transfers between consumers and producers and deadweight losses of economic welfare – the effects of many types of trade restrictions can be modeled as being equivalent to a per-unit tariff 50 ... equilibrium Economic Efficiency and Welfare Analysis Price S Consumer surplus is the area above price and below demand P* Producer surplus is the area below price and above supply D Q* Quantity Economic... PS = + = Welfare Loss Computations The welfare loss from restricting output to is the area of a triangle Price S The loss = (0.5)(2)(1) = D Quantity 10 Welfare Loss Computations • The welfare. .. Economic Efficiency and Welfare Analysis Price S At output Q1, total surplus will be smaller At outputs between Q1 and Q*, demanders would value an additional unit more than it would cost suppliers to