Business 33001: Microeconomics - Booth School of...

Business 33001:Microeconomics

Owen Zidar

University of Chicago Booth School of Business

Week 2

Owen Zidar (Chicago Booth) Microeconomics Week 2 1 / 97

Today’s Class

1 Consumer and Producer Surplus

2 Efficiency

3 Government Intervention in the Economy

4 Taxes and RegulationEfficiencyIncidence


Motivation: why should you care?

1 Understand how much market participants, both consumers andproducers, benefit from consuming or producing a certain good

Relevant for consumer satisfaction and loyaltyRelevant from valuing existing firms and innovation

2 Deepen your insight into and influence on the debate over economicpolicy, taxation, and regulation

Private-sector managers are better able to position their organizations,both defensively and offensively, if they understand why and howgovernments actExceptional private-sector leaders are now widely expected to provideinformed, intelligent leadership on the policy issues


Consumer Surplus


Consumer Surplus

Definition

Consumer surplus is an individual’s gain from trade or simply total valueminus total expenditure (i.e., the amount she is willing to pay minus thequantity she actually had to pay)


Consumer Surplus - Unit Demand

Consider an individual Willing To Pay $5 for one unit:

Price Demand

$7 06 05 14 13 12 11 10 1

0 1 2Q

5

P

D

0 1 2Q0

p

5

P

D

How much value does she get if offered a price of...

$7? $5? $4? $0?

With a price of p and a Willingness-To-Pay of v , Consumer Surplus is

max {v − p , 0}


Consumer Surplus - Unit Demand

Multiple consumers:

Values v1 = 6, v2 = 4, v3 = 2

Price p = 3

CS: (6− 3) + (4− 3) = 4

Price D1 D2 D3

$7 0 0 06 1 0 05 1 0 04 1 1 03 1 1 02 1 1 11 1 1 10 1 1 1

0 1 2 3Q0

p

v1

v2

v3

P

D

0 1 2 3Q0

p

v1

v2

v3

P

D

CS

General Rule: Consumer Surplus is Area below Demand, above Price


Consumer Surplus - Non-Unit Demand

Individual Consumer:

Willing to buy up to 3 units

Willing to pay v1 = $6 for first ; v2 = $4 for second; v3 = $2 for third

Price P = 3

Price Demand

$7 06 15 14 23 22 31 30 3

0 1 2 3Q0

p

v1

v2

v3

P

D

0 1 2 3Q0

p

v1

v2

v3

P

D

CS

CS = (6− 3) + (4− 3) = 4

No difference: Area between demand curve and price line


Consumer Surplus

Height of demand curve at Q tells us willingness to pay for Qth unit(for individual or in aggregate)

Q

P

p

q

DA

B

(A+B) Area under demand curve: Total value of units up to q

(B) Area under price line: total cost paid for units up to q

⇒ (A) Area between demand and price: Consumer Surplus


Consumer Surplus

Q

P

p

q

DCS

Linear Demand ⇒ CS is the area of a triangle

CS = 12 × base × height

General Demand: Integrate to find area

Integrate PD(Q)− P∗ from Q = 0 to Q = Q∗

(PD(Q) is the “inverse demand”)


Consumer Surplus

Consumer Surplus: “Triangle under Demand Curve”

0 50 100 150 200Q0

10

20

30

40

50

P

p

q

DCS

Demand Curve: QD(P) = 250− 5PSuppose P = 30, so Q = 100. What is CS?

Area of triangle =1

2· 100 · 20 = 1000

Suppose price increases to P = 40. What is the change in CS?

New CS =1

2· 50 · 10 = 250, Change is − 750


Consumer Surplus Application #1: Google users

Back of the Envelope

Time using library treatment = 22 + travel

Time using web = 7

Questions per day now = 1 per capita

Answerable questions per day = 12 per capita

Questions per day then = close to zero

Problem

When getting answers was expensive we asked few questions

Now that getting answers is cheap we ask a lot of questions



Demand curve for questions

minutes

Questions per day

22+

7

1/2



Consumer surplus

minutes

Questions per day

22+

7

1/2

Area = base x height/2 = 15/4 = 3.75 minutes



Per Person

Average hourly earnings = $22

Save 3.75 minutes per day = $1.37/day

365 days in a year = $500

How many users?

130M people employed 130M x 500 = $65B

300M population 300M x 500 = $150B



Summary

Value to users in time saved ≈ $65B

Leaves out

Cost of trips to library

Unanswerable searches

Value to non-employed

Value of better matched purchases

Entertainment value

Improved decisions

Etc, etc, etc.


Revealed Preference

“Revealed Preference”: By observing individual’s buying behavior(purchase or not), we can determine his or her value for a good

If the price is $P and you buy, value is at least $P

If the price is $P and you don’t buy, value is at most $P

If you don’t buy at $P+.01 and you buy at $P-.01, value is $P


Revealed Preference

“Revealed Preference”: By observing individual’s buying behavior(purchase or not), we can determine his or her value for a good

$45/month X X∼ $500/month X X


Revealed Preference

“Revealed Preference:” By observing demand curve, we can determinesociety’s value for a good

One point on curve: If 1000 people buy at price $7, society’s value for1000 units is at least $7000

Full curve: we see when every person starts buyingAdd it all up to get consumer surplus

0 50 100 150 200Q0

10

20

30

40

50

P

p

q

DCS


Consumer Surplus Application #2: Toll Roads

Alice and Bob both drive to work on a highway

Tolls on the highway jump up by $20 per trip

Alice keeps driving, Bob stops

Who is made more worse off by the toll hike?

Does it matter if I tell you Alice is rich and Bob is poor?Does it matter if I tell you Bob’s job lets him work from home now?Does it matter if I tell you Bob was already thinking of retiring?Does it matter if I tell you Bob switched to a super-slow bus?

What about a fast bus, with great wifi?

If we accept that dollars are equal across people, willingness to paycaptures all information


Consumer Surplus Application #3: Gentrification





Questions:

What is the economic logic behind the sentiment: “my neighborhoodgot better, this sucks?”

What can we infer about the effects on former residents if they moveout?

How can we relate gentrification to the toll road example?

How can we relate gentrification to supply and demand?


Producer Surplus


Producer Surplus (Profit)

Individual Firm:

Can produce up to 3 units

Cost of c1 = 2 for first unit; c2 = 4 for second; c3 = 6 for third

Price p = 5

Price Supply

$7 36 35 24 23 12 11 00 0

0 1 2 3Q0

p

c1

c2

c3

P

S

0 1 2 3Q0

p

c1

c2

c3

P

S

PS

PS = (5− 2) + (5− 4) = 4

What if c1 = 4, c2 = 2, c3 = 6? New Supply and PS?


Producer Surplus

Height of supply curve at Q tells us cost of production of Qth unit(for firm or industry)

Q

P

p

q

S

A

B

(B) Area under supply curve: Total cost of producing units up to q

(A+B) Area under price line: Total revenue from selling units up to q

⇒ (A) Area between price and supply: Producer Surplus (Profit)


Producer Surplus

Q

P

p

qS

PS

Linear Supply ⇒ PS is area of a triangle

PS = 12 × base × height

General Supply:

Integrate P∗ − PS(Q) from Q = 0 to Q = Q∗

(PS(Q) is the “inverse demand”)


Producer Surplus

Producer Surplus: “Triangle above Supply Curve”

0 50 100 150 200Q0

10

20

30

40

50

P

p

qS

PS

Supply Curve: QS(P) = 5P − 50Suppose P = 30, so Q = 100. What is PS?

Area of triangle =1

2· 100 · 20 = 1000

Suppose price increases to P = 40. What is the change in PS?

New PS =1

2· 150 · 30 = 2250, Change is + 1250


Producer Surplus Application #1: Uber Driver

Suppose an uber driver was willing to drive today


Producer Surplus Application #2: Airlines and 9/11

How much did 9/11 hurt the airline industry?


Producer Surplus Application #2: Airlines and Sept 11

In 2000, p = 122, q = 148 M passangers who got on a plane

After 9/11, p = 104, q = 125 M

Areas A+B in the prior slide amounted to $2.3 B in lost PS

Source: Goolsbee, Levitt, Syverson Fig 3.6


Efficiency


Definition: Economic Efficiency (Pareto Optimality)

Definition

An allocation of society’s resources is efficient if there is no otherallocation that would make someone better off without harming others.


Efficiency from a managerial perspective

Think of yourself as managing a large (or small) business organization.

Your job is to allocate the business’s resources such as its capital andemployees in order to achieve a goal–say maximizing shareholdervalue.

If by changing the way you do things–say by shortening the workweekor providing stronger incentives to the sales force–you can increaseshareholder wealth without harming employees, then the changeenhances efficiency.

Similarly, if some hypothetical change in procedures would makeemployees better off without harming shareholder wealth, then thatchange would also enhance efficiency. In other words, an efficientorganization satisfies Pareto’s definition.


The Condition for Economic Efficiency

Resources are efficiently allocated when the marginal value of each goodor service is equal to the marginal cost of producing it.


Consumer + Producer Surplus

qQ

p

P

S

D

CS

PS

Market equilibrium produces the right quantityAt quantity Q: (Height of D) - (Height of S) = Value - CostLeft of q: Value > CostRight of q: Value < Cost

The market equilibrium allocates this quantity correctlyConsumers: any buyer has higher WTP than any nonbuyerFirms: Any unit produced has a lower cost than any unit that isn’t

Market equilibrium maximizes total surplus (PS+CS)


Gas Rationing after Hurricane Sandy

After Hurricane Sandy, quantity of gas in NY/NJ limited in the short run

What happens in this market?

qQ

p

P

S

D

Normal Supply & Demand

qQ

p

P

S

S'

D

Sandy supply shockOwen Zidar (Chicago Booth) Microeconomics Week 2 37 / 97


“Equilibrium Market Price” spikes way above “Fair Price”

State Accuses 13 New York Gas Stations ofPrice-Gouging (NYT, 11/15/2012):

The stations accused of price-gouging charged $4.74 to $5.50a gallon in the days after the storm. Just before the storm, theaverage price for gasoline in New York City was about $3.91 agallon... After Tropical Storm Irene, a Yonkers gas station thathad raised its price by 97 cents a gallon agreed to pay a $7,500penalty.

Other policy responses to ration gas:Odd/Even rationing of gas salesFederal Government ships in gas, generators for gas stationsNat’l Guard gives away free gasWaive gas taxes

Do these policies solve the problem? Any other ideas?Do these policies create any new problems?



Gas Rationing is New Burden After Hurricane Sandy(NYTimes 11/3/2012): Tony Kurasz sat in his sport utilityvehicle for three hours on Saturday at an Exxon station inBayonne, N.J.; he was six cars away from the pump when thestation ran out of gas. It was his second gas line of the day. Thefirst station ran out, too.

What would have happened with a free market?

Who are the winners and losers from the non-free market policy?



Price Caps, Quantity Controls:

General problems:

Long linesBlack market?Misallocation to consumers

Can’t get gas when you “need” it

Poor incentives for suppliers

Short run: Bring in goods from outside, at a high costLong run: Build infrastructure / stock extra for extreme events

Rent controlled buildings, cabs, subsidized heating bills...Putting all the costs and benefits together,a free market is best – even after a hurricane. (Maybe)


Hurricane Sandy

After the hurricane, the market equilibrium has high prices for gas.

Are high prices inherently bad?

A dollar in gas station’s hand = a dollar in consumer’s handGiven a transaction, price is irrelevant to surplusMaximizing surplus is all about getting correct transactions to occur

Perfect allocation to consumers

Gas goes to highest value usersNo waiting in line, no wasted time

Perfect incentives to firms

If supply is perfectly inelastic, irrelevantIf we can bring in extra fuel at some cost, market prices give the“right” incentives

Bring if and only if cost is below marginal consumer’s value (WTP)


Government Intervention


Government Intervention in the Economy

Organizing framework: “ When is government intervention necessaryin a market economy?”

Market first, government second approach

Why? Private market outcome is efficient under a broad set ofconditions (1st welfare theorem)

This section can be split into two parts

How can govt. improve efficiency when private market is inefficient?

What can govt. do if private market outcome is undesirable due todistributional concerns?


Efficient Private Market Allocation of GoodsE¢cient Private Market Allocation of Goods

Amy’sConsumption

Bob’s Consumption

Public Economics Lectures () Part 1: Introduction 37 / 49Owen Zidar (Chicago Booth) Microeconomics Week 2 44 / 97

First Role for Government: Improve EfficiencyFirst Role for Government: Improve E¢ciency

Amy’sConsumption

Bob’s Consumption


Second Role for Government: Improve DistributionSecond Role for Government: Improve Distribution

Amy’sConsumption

Bob’s Consumption


First Welfare Theorem

Private market provides Pareto efficient outcome under three conditions

1 No externalities

2 Perfect information

3 Perfect competition

This theorem tells us when government should intervene


Failure 1: Externalities

Markets may be incomplete due to lack of prices (e.g. pollution)

Achieving an efficient solution requires an organization to coordinateindividuals – that is, a government

This is why govt. funds public goods (highways, education, defense)

Questions: What public goods to provide and how to correctexternalities?


Failure 2: Asymmetric Information and Incomplete Markets

When some agents have more information than others, markets fail1 Adverse selection in health insurance

Healthy people drop out of private market → unravelingMandated coverage could make everyone better off

2 Capital markets (credit constraints) and subsidies for education3 Markets for intergenerational goods

Future generation’s interests may not be fully reflected in marketoutcomes


Failure 3: Imperfect Competiton

When markets are not competitive, there is role for govt. regulation

Ex: natural monopolies such as electricity and telephones

We will discuss monopolies later in the course


Individual Failures

If agents do not optimize, government intervention (e.g. by forcingsaving via social security) may be desirable

This is an “individual” failure rather than a market failure

Conceptual challenge: how to avoid paternalism

Why does government know what is desirable for you (e.g. wearing aseatbelt, not smoking, saving more)

Difficult but central issues for optimal policy design


Redistribution Concerns

Even when the private market outcome is efficient, may not havegood distributional properties

Efficient markets generally seem to deliver very large rewards to asmall set of people (top incomes)

Government can redistribution income through tax and transfersystem


Why Limit Government Intervention?

One solution to these issues would be for the government to overseeall production and allocation in the economy (socialism).

Serious problems with this solution1 Information: how does government aggregate preferences and

technology to chose optimal production and allocation?2 Government policies distort incentives (behavioral responses in private

sector)

In practice, there are sharp tradeoffs between the costs and benefitsof government intervention


Equity-Efficiency TradeoffEquity-E¢ciency Tradeo§

Amy’sConsumption

Bob’s Consumption


Taxes


Outline

1 Example Tax Problem

2 EfficiencyKey lessons about efficiency costs of taxation

3 Equity3 key lessons about tax incidence

Applications


Per-Unit Taxes (Math)

General Approach:

Demand QD(PD), Supply QS(PS)Without taxes:

Set PS = PD

Set QS = QD

With per-unit tax of t:Set PS = PD − tSet QS = QD

Specific Example:

Demand: QD(PD) = 50− 2PD , Supply: QS(PS) = 3PS − 15Without taxes:

Quantity q = 24Prices PD = PS = p = 13

With per-unit tax of t = 5:Plug in PS = PD − 5Quantity q′ = 18Demand price PD = p′ = 16Supply price PS = p′ − t = 11


Per-Unit Taxes (Math Example – ctd)Demand QD(PD) = 50− 2PD , Supply QS(PS) = 3PS − 15

18 24Q

5

111316

25

PD

No taxes: q = 24, p = 13Consumer Surplus: 1

2 · 12 · 24 = 144Producer Surplus: 1

2 · 8 · 24 = 96

Tax of t = 5 per unit: q = 18, pD = 16, pS = 11Consumer Surplus: 1

2 · 9 · 18 = 81 – loss of 63Producer Surplus: 1

2 · 6 · 18 = 54 – loss of 42Government Revenue: 18 · 5 = 90

Net loss of surplus: 63 + 42− 90 = 15


Taxes

qQ

p

p�t

PD

S

D S'

t

Market Equilibrium with Taxes


Taxes

qQ

p

p�t

PD

S

D S'

CS

PS

t


Consumer Surplus

Producer Surplus


Taxes

qQ

p

p�t

PD

S

D S'

CS

PS

REV

t


Consumer Surplus

Producer Surplus

GovernmentRevenue


Taxes

qQ

p

p�t

PD

S

D S'

CS

PS

REV DWL

t


Consumer Surplus

Producer Surplus

GovernmentRevenue

Deadweight Loss


Deadweight Loss

Deadweight Loss is the “economic cost” of a tax

Taxes paid are not lost – they go to Gov’t

The loss is in transactions which don’t go through

Firm willing to produce a good for a price of $10Consumer willing to pay $11Transaction would create $1 in surplus

Tax of < $1: transaction goes through, no lossTax of > $1: no transaction, loss of $1

Marginal cost (extra DWL) of taxation increasing in the tax rate:

Say that every dollar of taxation reduces quantity by one unitTaxes go from 0 to 2 dollars per unit:

kill 2 transactions, each of surplus about $1Taxes go from $99 to $101:

kill 2 transactions, each of surplus about $100

Approximately 100 times as bad!


Deadweight LossMarginal cost of taxation increasing in the tax rate

Q

P

t

�Q

DWL

Deadweight loss is approximately quadratic in the tax amount

DWL = 12 t ·∆Q

∆Q proportional to t (for linear supply & demand)So DWL goes as t2


Deadweight LossMore elastic supply & demand ⇒ More DWL

Two markets with same P & Q, but different supply and demand curves:

Q

P

t

�Q

DWL

Q

P

t

�Q

DWL

For a given tax t, DWL is bigger if supply & demand are more elasticDWL = 1

2 t ·∆QMore elastic supply and demand mean larger ∆Q for a given tIntuition: DWL is caused by loss of transactionsMore elastic S&D means more transactions destroyed


Tax Policy Implications

With many goods, most efficient way to raise revenue is:

1 Tax inelastic goods more (e.g. medical drugs, food)

2 Spread taxes across all goods to keep rates relatively low on all goods(broad tax base)

These are two countervailing forces; balancing them requires quantitivemeasure meant of deadweight loss


Efficiency and equity consequences of taxation

Definition

Efficiency costs: effect of policies on size of the pie

Focus in efficiency analysis is on quantities, not prices

Incidence: effect of policies on distribution of economic pie


Incidence

Definition

Tax incidence is the study of the effects of tax policies on prices and thedistribution of utilities


Incidence

Ideally, we would characterize the effect of a tax change on utilitylevels of all agents in the economy

Useful simplification in practice: aggregate economic agents into afew groups

Incidence analyzed at a number of levels:1 Producer vs. consumer (tax on cigarettes)2 Source of income (labor vs. capital)3 Income level (rich vs. poor)4 Region or country (local property taxes)5 Across generations (social security reform)


Key Lessons about Tax Incidence

1 Economic tax incidence separate from “legal incidence”

2 Taxing consumers and producers results in same economic impact1

1If taxes are fully salient (Chetty, Looney, Kroft (2009)). Recall ∆PB = ∆PS + τOwen Zidar (Chicago Booth) Microeconomics Week 2 70 / 97

D

S

B

Price

Quantity

$22.5$22.5

$19.5

D+t

$7.50

$27.0

$15.0$15.0

A

1250 1500

D

C

Tax Levied on Consumers

ConsumerBurden = $4.50

SupplierBurden = $3.00

Public Economics Lectures () Part 2: Tax Incidence 13 / 140


ConsumerBurden = $4.50

D

S

B

SupplierBurden = $3.00

Price

Quantity

$22.5$22.5

$19.5

$27.0

A

1250 1500

S+t

$7.50

$30.0

Tax Levied on Producers

C

D



Analytical Framework

We know a three things:2

%∆PD = %∆PS + τ

%∆QD = εD%∆PD

%∆QS = εS%∆PS

We also have market clearing:

%∆QD = %∆QS

εD%∆PD = εS(%∆PD − τ)

2where ∆Q is the percentage change in quantity generated by the tax and τ is alsomeasured in percentage terms.


Analytical Framework: Implications

%∆PD = τεS

εS − εD

%∆PS = τεD

εS − εD

%∆Q = τ1

1εD− 1

εS


3 Key Lessons about Tax Incidence

1 Economic tax incidence separate from “legal incidence”

2 Taxing consumers and producers results in same economic impact3

3 Incidence depends on relative elasticities

The more elastic agent is more able to avoid burden of the tax

%∆PD = τεS

εS − εD

%∆PS = τεD

εS − εD

The ratio %∆PD

%∆PS= εS

εDis the inverse of the elasticities

If the demand elasticity is twice as large as the supply elasticity, thensellers pay two-thirds of the tax and buyers pay only one-third

3If taxes are fully salient (Chetty, Looney, Kroft (2009)). Recall %∆PD = %∆PS + τOwen Zidar (Chicago Booth) Microeconomics Week 2 75 / 97

$27.0

$22.5

1500

DS

S+t

$7.50

Quantity

Price

Consumerburden

Perfectly Inelastic Demand

Public Economics Lectures () Part 2: Tax Incidence 15 / 140Owen Zidar (Chicago Booth) Microeconomics Week 2 76 / 97

SS+t

Quantity

Price

D

$7.50

Supplierburden

1500

$22.5

$15.0

Perfectly Elastic Demand



Example from my research on corporate tax incidence

“Who Benefits from State Corporate Tax Cuts? A Local Labor MarketsApproach with Heterogeneous Firms”


Equilibrium in the Local Labor Market


Equilibrium in the Local Labor Market


Regulation Example: Mandated Benefits

We have focused until now on incidence of price interventions (taxes)

Similar incidence/shifting issues arise in analyzing quantityintervention (regulations)

Leading case: mandated benefits – requirement that employers payfor health care, workers compensation benefits, child care, etc.

Mandates are attractive to government because they “off budget”;may reflect salience issues


Mandated Benefits

Tempting to view mandates as additional taxes on firms and applysame analysis as above

But mandated benefits have different effects on equilibrium wagesand employment differently than a tax (Summers 1989)

Key difference: mandates are a benefit for the worker, so effect onmarket equilibrium depends on benefits workers get from the program

Unlike a tax, may have no distortionary effect on employment andonly an incidence effect (lower wages)


Mandated Benefits: Simple Model

Labor demand (D) and labor supply (S) are functions of the wage w

Initial equilibrium:

D(w0) = S(w0)

Now government mandates employers provide a benefit with cost t

Workers value the benefit at αt dollars

Typically 0 < α < 1 but α > 1 possible with market failures

Labor cost is now w + t, effective wage w + αt

New equilibrium:

D(w + t) = S(w + αt)


Mandated Benefit

w1

L1

D1

S

A

WageRate

Labor Supply



w1

L1

D1

S

D2

$1

A

WageRate

Labor Supply

Mandated Benefit

B



w2

w1

L1

D1

S

D2

$1

A

WageRate

Labor Supply

$α

C

Mandated Benefit

B



Mandated Benefits Application: Disabilities Act

The 1993 Americans with Disabilities Act requires employers to:

Make accommodations for disables employeesPay same wages to disables employees as non-disabled workers

Cost to accommodate disabled workers: $1000 per person on average

Theory is ambiguous on net employment effect because of wagediscrimination clause


w2

w1

L1

D1

S

D2

AB

WageRate

Labor Supply

minimum wage

Mandated Benefit with Minimum Wage



Mandated Benefits Application: Disabilities Act

Employment of disabled workers fell after the reform (roughly 5-10%)

Wages did not change

Results consistent with a labor demand elasticity of −1 or −2.

ADA intended to help those with disabilities but appears to have hurtmany of them because of wage discrimination clause

Underscores importance of considering incidence effects beforeimplementing policies


Wrapping Up

qQ

p

p�t

PD

S

D S'

CS

PS

REV DWL

t

MarketEquilibrium with Taxes

Consumer Surplus

Producer Surplus

GovernmentRevenue

Deadweight Loss


Supplemental Material


Outline

1 Efficiency Costs

2 Subsidies

3 Externalities


Efficiency Cost: Properties

1 DWL increases with square of tax rate

2 DWL increases with elasticities


DWL is a triangle

Base of the triangle (measured vertically) is the change in prices: τP

The height of the triable (measured horizontally) is the change inquantities: Q%∆Q

Social Cost is:

=1

2τPQ (%∆Q)

=1

2τPQ

(τ

11εD− 1

εS

)

=1

2τ2 PQ︸︷︷︸

Tax Revenue

(1

1εD− 1

εS

)

Social Cost from increasing taxes is: d(Social Cost)dτ = τTR

(1

1

εD− 1

εS

).


Subsidies

Subsidies are negative taxes

PD < PS : Buyer pays less than seller receives

Inefficiency: Too many trades

Increase CS and PS, Negative government revenue

Firm willing to produce a good for a price of $10Consumer willing to pay $9Subsidy of < $1: no transaction, efficient outcomeSubsidy of > $1: transaction goes through, economic loss of $1

CS + PS goes up by less than cost to government


Subsidies

Subsidy (negative tax) of r per unit:

qQ

pS

pD

P

r

AB

C

DE F

Consumer surplus: C + B + D

Producer surplus: A + B + E

Cost to government: B + E + D + F

Net Surplus:(C + B + D) + (A + B + E )− (B + E + D + F ) = A + B + C − F

Surplus without a subsidy: A + B + C

Deadweight Loss: FOwen Zidar (Chicago Booth) Microeconomics Week 2 96 / 97

Externalities

Externalities: byproducts of market transactions which affect others

Negative externalities: my purchase or production hurts others

Factories emit pollution, alcohol leads to crime, antibiotic overuseGoods with negative externalities are overprovided by the marketWe can discourage production with Taxes, Production caps

Positive externalities: my purchase or production helps others

Knowledge spillovers, Vaccinations, Plastic Surgery (?)Goods with positive externalities are underprovided by the marketWe can encourage production with Subsidies, Mandates,

or Creation of property rights (patents)

Not an externality – part of the market:

You are better off because I buy a good from youYou are worse off because I bought a good you wantedMarket outcome still efficient


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