How to measure the total economic well-being of a society?

Transcription

1 Welfare Economics continued Market efficiency How to measure the total economic well-being of a society? Suppose there is a all-powerful, well-intentioned dictator called a social planner who can allocate goods among members of society. This social planner wants to maximize the welfare of everyone in society. Should the social planner allow the economy to reach an equilibrium by itself and stay there, or alter the equilibrium in some way? How to measure welfare of everyone in society? One measure is the sum of everyone s surplus, called total surplus. This is consumer surplus plus producer surplus. Since consumer surplus measures the benefit consumers receive from participating in a market, and producer surplus measures the benefit producers receive from participating in a market, total surplus measures the sum of all individual benefits from participating in a market. Consumer surplus = Value to buyers Amount paid by buyers Producer surplus = Amount received by sellers Cost to sellers When there is no tax or other distortion of the market, amount paid by buyers equals amount received by sellers. So under these conditions, the total surplus equals Total surplus = total value to buyers total cost to sellers. An allocation is efficient if it maximizes total surplus. This means that the difference between value to buyers and cost to sellers is maximized. It is maximized when every buyer whose value of a good is higher than the cost to a seller of the good, buys the good from a seller whose cost is lower than the buyer s value. An allocation is inefficient if either a good is not being produced by sellers with lowest cost, or if it is not being bought by buyers with the highest valuation of the good. Moving production of a good from a high-cost to a low-cost producer will raise total surplus. Moving consumption from a low-valuation to a high-valuation consumer will raise total surplus. 1

2 Examples of inefficiency: Taxes. A fixed tax per unit traded places a wedge between what sellers receive and what buyers pay. By raising the amount per unit that buyers must pay above the equilibrium price, and lowering the amount per unit that sellers receive below the equilibrium price, a tax prevents some potential buyers and sellers from trading with each other. These are buyers whose valuation is higher than the cost to sellers of producing the good. Efficiency would require these buyers and sellers to trade with each other. Price floors/ceilings A binding price floor makes the price higher than the equilibrium price. This prevents some potential buyers from buying the good who would have bought it at the equilibrium price. Also, it shuts out of the market some sellers who would have been able to sell at the equilibrium price. Since these potential buyers have higher valuation than the potential sellers cost, the binding price floor causes inefficiency by preventing them from trading with each other. Similarly, a binding price ceiling prevents some sellers who would have been able to sell the good at the equilibrium price from selling their good to buyers whose valuation of the good is higher than their cost, creating inefficiency. Comparing these outcomes to the free competitive market, no externality, perfect information outcome, we see that the free market outcome maximizes total surplus. Buyers who value the good more than the price buy the good, and sellers whose cost of production is lower than the price produce and sell the good. Buyers who value the good less than the price do not buy the good and sellers whose cost of production is more than the price do not sell the good. Three observations about market outcomes under perfect competition, no externalities and perfect information : 1. Free markets allocate the supply of goods to the buyers who value them most highly (measured by their willingness to pay). 2. Free markets allocate the demand for goods to the sellers who can produce them at least cost. 3. Free markets produce the quantity of goods that maximizes total surplus. To see why the last observation is true, consider lowering the quantity from the equilibrium quantity. At any quantity lower than that, the marginal buyer s valuation is higher than the marginal seller s cost. It would be more efficient 2

3 to raise quantity produced up until where marginal buyer s valuation equals marginal seller s cost. At any quantity higher than equilibrium quantity, the marginal buyer s valuation is lower than the marginal seller s cost. So there is an area of negative total surplus that can be reduced by moving quantity down until marginal seller s cost equals marginal buyer s valuation. So in the case of perfect competition, no externalities and full information the social planner doesn t need to intervene. The term for this is laissezfaire. Suppose the social planner had to find the socially optimal outcome itself. Then it would need to know the willingness to pay of every potential buyer for every good and the cost of every seller of every good, an enormous amount of information. Example: Ticket scalping The prices for many tickets for sports games and concerts are often set below the equilibrium price. This may be done to make the event more exciting by having crowds waiting to get in. The effect is like a price ceiling. This leaves room for ticket scalpers to buy tickets at the lower price and sell them at the equilibrium price. But ticket scalping is illegal must pay a fine if caught scalping. Economists see the outlawing of scalping as wasting police s time, wasting people s time waiting in line. Should there be a market in organs? People are not allowed to sell their organs in any country as far as I know. This is equivalent to a price ceiling of zero. Result is a shortage of kidneys for transplant. If people needing a kidney transplant were allowed to buy one from people willing to sell a kidney, price would equalize supply and demand. What is the cost to each person of losing one kidney (when they start out with two)? Issues and problems: Do people willing to sell a kidney know the risks of death during the operation? How would poor people get kidney transplants if they cannot afford the equilibrium price? 3

4 Might poor people be tricked or forced into giving up a kidney or other body parts? Summary of this chapter: In perfectly competitive markets, with no externalities and perfect information, the sum of the total benefit to buyers and the total benefit to sellers is maximized by free market action. The resulting allocation is efficient. Despite this, sometimes policymakers regulate such markets to achieve equity goals. When the market is not perfectly competitive, or there are externalities or imperfect information, the result of the free market need not be efficient. These are examples of market failure. In cases of market failure, there are sometimes ways for public policy to regulate the market to reach an efficient allocation, or at least a Pareto improvement (making some agents better off and the rest no worse off). Mankiw, page The cost of producing stereo systems has fallen over the past several decades. Let s consider some implications of this fact. a. Draw a supply-and-demand diagram to show the effect of falling production costs on the price and quantity of stereos sold. b. In your diagram, show what happens to producer surplus and consumer surplus. c. Suppose the supply of stereos is very elastic. Who benefits most from falling production costs consumers or producers of stereos? The costs of taxation This chapter analyzes how taxes affect welfare. Deadweight loss of taxation It doesn t matter whether a tax is levied on sellers or buyers of a good as far as amount paid by buyer, amount received by seller, tax incidence on buyer and on seller are concerned. Thus we can draw the effect of the tax as a wedge placed between supply and demand curves. A tax puts a wedge between the 4

5 price buyers pay and the price sellers receive. This causes quantity traded to decrease from the pre-tax equilibrium level. Using welfare economics we can measure the benefit to buyers, sellers and the government from participating in the market when there is a tax of size t. The benefit to buyers (consumer surplus) is the area above the post-tax amount paid by buyers and below the demand curve. The benefit to sellers (producer surplus) is the area below the post-tax amount received by sellers and above the supply curve. Tax revenue is used to measure government s benefit from the tax. However the benefit from the tax revenue really goes not to the government itself, but to services provided by the government such as roads, police, public education, defense, welfare, etc. The benefit to each set of agents can be represented in a graph: 5

6 Consumer surplus Tax revenue Producer surplus Deadweight loss Without the tax, consumer surplus plus producer surplus equals the whole area between the demand and supply curves to the left of their intersection point. We have seen that without the tax the sum of consumer and producer surpluses is maximized. Every consumer whose willingness to pay is higher than some producer s cost buys the good; every producer whose cost is less than some consumer s willingness to pay sells the good. With the tax, there is a deadweight loss a piece of this area between the demand and supply curves does not go to anyone. Total surplus with the tax equals tax revenue plus consumer surplus plus producer surplus. This sum is less than the total surplus in the no-tax case. The deadweight loss is the difference between the no-tax consumer surplus and the consumer surplus with the tax. An example that gives the intuition for why taxes cause deadweight loss. Suppose Joe cleans Jane s house each week for $100. The opportunity cost of Joe s time is $80. The value to Jane of a clean house is $120. They somehow (maybe through bargaining) arrived at the price of $100. Each of them receives a $20 benefit from the house-cleaning. So the total surplus is $40. This measures the gains from trade in this transaction. 6

7 Now suppose the government levies a $50 tax on providers on cleaning services. There is no price that Jane could pay Joe to clean her house that both would agree on. For Joe to be better off, he would need $130 with the tax, whereas Jane is willing to pay at most $120. So her house does not get cleaned. The total surplus is zero, because neither Jane nor Joe get any producer or consumer surplus, and the government gets no tax revenue because the transaction does not take place. In the usual supply and demand diagram, this would correspond to the government places such a high tax that the intersection of the new supply curve (if the tax is on sellers) with the demand curve is at a quantity of zero, or the intersection of the new demand curve (if the tax is on buyers) with the supply curve is at zero. I.e., the size of the tax is the vertical distance between the demand and supply curves at zero. What determines the size of the deadweight loss from a tax? The slopes ( P ) of supply and demand. When slope of demand and slope of supply are Q higher in absolute value, the deadweight loss of a given tax is smaller. Explanation: A tax has a deadweight loss because it causes sellers and buyers to change their behavior. The tax raises the price paid by buyers, causing them to buy less, and lowers the price paid by sellers, causing them to sell less. The higher the absolute value of the slope is, the less buyers and sellers change their amount sold or bought in response to a given tax. 7

8 Deadweight loss Deadweight loss It is the slopes that matter, and not the elasticity for determining deadweight loss from the tax. This can be shown by looking at the deadweight loss in two cases with the same slopes of supply and demand curves, but different elasticities. 8

9 (Why are the elasticities of supply and demand in the two graphs different?) These graphs show that with different elasticities of demand and supply, but the same slopes, the deadweight loss due to a tax is the same. The supply elasticities at the two equilibrium points are different because slopes are the same, price is the same, but quantity is different. The demand elasticities again are the same because slopes are the same, price is the same, but quantity is different. When comparing two graphs of supply and demand which intersect at the same equilibrium point, then the elasticities determine the size of the deadweight loss. If the supply and demand curves are linear, raising the tax raises distance between Q 0 and Q 1 (the pre-tax and post-tax quantities) proportionally. So the area of the deadweight loss triangle rises in proportion to the tax squared. 9