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Chapter 9 12005 Pearson Education, Inc.

Consumer and Producer

Surplus

To determine the welfare effect of agovernmental policy, we can measurethe gain or loss in consumer and

producer surplusWelfare Effects

Gains and losses to producers and

consumers

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Surplus

When government institutes a priceceiling (any real example?), the price of agood cant go above that price

With a binding price ceiling, producersand consumers are affected

How much they are affected can be

determined by measuring changes inconsumer and producer surplus

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Surplus

When price is held too low, the quantitydemanded increases and quantitysupplied decreases

Some consumers are worse off becausethey can no longer buy the goodDecrease in consumer surplus

Some consumers are better off because

they can buy it at a lower priceIncrease in consumer surplus

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Surplus

Producers sell less at a lower price

Some producers are no longer in themarket

Both of these producer groups lose andproducer surplus decreases

The economy as a whole is worse off

since surplus that used to belong toproducers or consumers is simply gone

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The loss to producersis the sum of

rectangleAandtriangle C

B

A C

Consumers that can

buy the good gain A

Price Control and Surplus

Changes

Quantity

Price

S

D

P0

Q0

Pmax

Q1 Q2

Consumers that

cannot buy, lose B

Triangles B and C arelosses to society

dead weight loss

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Price Controls and Welfare

Effects

The total loss is equal to area B + C

The deadweight lossis the inefficiencyof the price controls the total loss in

surplus (consumer plus producer)

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Price Controls and

Natural Gas Shortages

From example in Chapter 2, 1975 Pricecontrols created a shortage of naturalgas

What was the effect of those controls?Decreases in surplus and overall loss for

society

We can measure these welfare effects fromthe demand and supply of natural gas

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Price Controls and


QS= 14 + 2PG+ 0.25P

OQuantity supplied in trillion cubic feet (Tcf)

QD= -5PG+ 3.75PO

Quantity demanded (Tcf)PG = price of natural gas in $/thousand

cubic feet (mcf)

PO= price of oil in $/barrel

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Price Controls and


Using PO= $8/b and gives

equilibriumvalues for natural gas

PG= $2/mcf and QG= 20 Tcf

Price ceiling was set at $1/mcfShowing this graphically, we can see and

measure the effects on producer and

consumer surplus

G

S

G

D QQ =

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B

A

C

The gain to consumersis

rectangleAminustriangle B, and the loss

to producers is

rectangleA plustriangle C.

SD

2.00

2.40

Price($/mcf)

Quantity (Tcf)0 5 10 15 20 25 3018

(Pmax)1.00

Price Controls and


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Price Controls and


Measuring the Impact of Price Controls

A = (18 billion mcf) x ($1/mcf) =

$18 billion

B = (1/2) x (2 b. mcf) x ($0.40/mcf) =$0.4 billion

C = (1/2) x (2 b. mcf) x ($1/mcf) =

$1 billion

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Price Controls and


Measuring the Impact of Price Controls in1975 (You may want to check byyourself.)

Change in consumer surplus

= A - B = 18 - 0.4 = $17.6 billion Gain

Change in producer surplus

= A + C = 18 + 1 = $19.0 billion Loss

Dead Weight Loss

= B + C = 0.4 + 1 = $1.4 billion Loss

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The Efficiency of

a Competitive Market

In the evaluation of markets, we often talkabout whether it reaches economicefficiency

Maximization of aggregate consumer andproducer surplus

Policies such as price controls that cause

dead weight losses in society are said toimpose an efficiency coston theeconomy

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The Efficiency of

a Competitive Market

If efficiency is the goal, then you canargue that leaving markets alone is theanswer (Invisible hands bring efficiency!)

However, sometimes market failuresoccur

Prices fail to provide proper signals to

consumers and producersLeads to inefficient unregulated competitive

market

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Types of Market Failures

1. Externalities Costs or benefits that do not show up as part of the

market price (e.g. pollution, elementary education)

Costs or benefits are external to the market

2. Lack of Information Imperfect information prevents consumers from

making utility-maximizing decisions

Government intervention may be desirable in

these cases---e.g., imposing emissionregulations, compulsory education

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The Efficiency of a Competitive

Market

Other than market failures, unregulatedcompetitive markets lead to economicefficiency

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The Market for Human Kidneys(pp. 307-9)

The 1984 National Organ TransplantationAct prohibits the sale of organs fortransplantation

What has been the impact of the Act?

We can measure this using the supplyand demand for kidneys from estimateddata (P: the price of a kidney)

Supply: QS= 8,000 + 0.2PDemand: QD= 16,000 - 0.2P

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Since the sale of organs is not allowed,the amount available depends on theamount donated

Supply of donated kidneys is limited to 8,000

The welfare effect of this supplyconstraint can be analyzed using

consumer and producer surplus in thekidney market

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D

A and D measure thetotal value of

kidneys when supply

is constrained.A

C

The lossto suppliers

is seen in areas A + C.

The Market for Kidneys (pp. 307-9)

Quantity

Price

4,0000

$10,000

$30,000

$40,000

8,000

S

B

If kidneys are zero

cost, receipients gainwould beA minus B.

S

D

12,000

$20,000

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Suppliers:

Those who supply them are not paid themarket price, estimated at $20,000

Loss of surplus equal to area A = $160 million

Some who would donate for the equilibriumprice do not donate in the current market

Loss of surplus equal to area C = $40 million

Total loss of A + C in producers surplus =$200 million

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Recipients:

Since they do not have to pay for the kidney,they gainrectangle A ($140 million) sinceprice is $0

Those who cannot obtain a kidney losesurplus equal to triangle B ($40 million)

Net increase in surplus of recipients of $160

- $40 = $120 millionDead Weight Loss of C + B = $80 million

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Other Inefficiency Costs

Allocation is not necessarily to those whovalue the kidneys the most

Price may increase to $40,000, the

equilibrium price, with hospitals getting theprice

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Arguments in favor of prohibiting thesale of organs:

1. Imperfect information about donors healthand screening

2. Unfair to allocate according to the ability topay

Holding price below equilibrium will create

shortages Organs versus artificial substitutes

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Minimum Prices

Periodically, government policy seeks toraise prices above market-clearing levels

Minimum wage law

Regulation of airlines

Agricultural policies

We will investigate this by looking at the

minimum wage legislation

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Minimum Prices

When price is set above the marketclearing price:

Quantity demanded falls

Suppliers may, however, choose to increasequantity supplied in face of higher prices

This causes additional producer losses equalto the total cost of production above quantity

demanded

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BA

The change in producersurplus will be

A - C - D. Producersmay be worse off.

C

D

Minimum Prices

Quantity

Price

S

D

P0

Q0Q3 Q2

Pmin

If producers produceQ2, the amount Q2 - Q3

will go unsold.

D measures total cost

of increasedproduction not sold.

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Minimum Prices

Losses in consumer surplus are still thesame [-(A+B)]

Increased price leading to decreasedquantity equals area A

Those priced out of the market lose area B

Producer surplus similar

Increases from increased price for units soldequal to A

Losses from drop in sales equal to C

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Minimum Prices

What if producers expand production toQ2from the increased price?

Since they only sell Q3, there is no revenueto cover the additional production (Q2-Q3)

Supply curve measures MC of production sototal cost of additional production is areaunder the supply curve for the increased

production (Q2-Q3) = area DTotal change in producer surplus = A C D

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Minimum Wages

Wage is set higher than market clearing

wageDecreased quantity of workers

demanded

Those workers hired receive higherwages

Unemployment results, since not

everyone who wants to work at the newwage can

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B

The deadweight lossis given by

triangles B and C.

C

A

L1 L2

Unemployment

wmin

Firms are not allowed topay less than wmin. This

results in unemployment.S

D

w0

L0

The Minimum Wage

L

w

A is gain to workerswho find jobs at

higher wage.

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Airline Regulation

Before 1970, the airline industry was

heavily regulated by the Civil AeronauticsBoard (CAB)

During 1976-1981, the airline industry in

the U.S. changed dramatically asderegulation led to major changes

Some airlines merged or went out of

business as new airlines entered theindustry

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Airline Regulation

Although prices in the industry fell

considerably (helping consumers), profitsdid not.

Regulation caused significant inefficiencies

and artificially high costs

We can show the effects of thisregulation by looking at the effects onsurplus from the controlled prices

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BA

C

After deregulation:

Prices fell to PO. Thechange in consumersurplus is A + B.

Q3

D

Area Dis the costof unsold output.

Effect of Airline Regulation

Quantity

Price S

D

P0

Q0Q1

Pmin

Q2

Prior to deregulationprice was at Pmin.

Production was Q3hoping to outsell

competitors.

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Airline Industry Data

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Airline Industry Data

Airline industry data show:

1. Long-run adjustment as the number ofcarriers increased and prices decreased

2. Higher load factors indicating more

efficiency3. Falling rates

4. Real cost increased slightly (adjusted fuel

cost)5. Large welfare gain

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Effect of Airline Regulation

1. Large welfare gain

Consumers gain=A+B

Producers gain=C+D-A

Net welfare gain=B+C+D

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