Chapter 8 Welfare Economics
and The Gains From Trade
1
review
1) Competitive markets operate where S = D.
2) Firms and individuals are price takers in competitive
markets.
3) Individuals and firms seek to make themselves as well
off as possible:
individuals maximize utility by getting to the
highest indifference curve as they can;
firms maximize profit
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what’s next
We want to see how economists measure the gains from
trade. We will focus on the concepts consumers’ and
producers’ surplus.
The efficiency criterion is a normative criterion that
basically says that you can vote for a policy and you can
vote 1 time for each dollar that you are willing to pay for
the policy.
Normative means what should be. Who knows what
should be? I should be taller, right? In economics many
look to the efficiency criterion to argue for or against a
social policy.
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consumers’ surplus
consumers’ surplus = the maximum amount consumers
are willing to pay for units of a good minus what they
have to pay for those units.
Interpretation:
P
a
one unit will be demanded
d
when the price is P1. If the
P1
price is any higher no units
P2 b
are demanded. Thus P1 is the
c e
maximum someone is willing
to pay for 1 unit of the good.
D
Q
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consumers’ surplus
P2 is the maximum someone is willing to pay for the 2nd
unit. At any higher price the second unit was not
demanded.
P2 is less than P1 because of the concept that additional
units give us less and less additional satisfaction and thus
additional units will only be demanded at lower prices.
area b + c = (P1)(1) = P1
area e = (P2)(2 - 1) = P2.
Area b + c + e is the major area under the demand curve
out to quantity 2. If we only had to look at a couple, or
three or so units, we would look at these areas as
willingness to pay.
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consumers’ surplus
Areas a and d are a small part of the area under the
demand curve and in fact these areas have no economic
interpretation. But to make our life easier we assume
areas a and d can be treated like b, c, and e, particularly
when we have a boat load of units to consider.
Thus the area under the demand curve out to the quantity
in question is the maximum amount consumers are
willing to pay for those units. In other words this area is
the total value of the units to the consumer.
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consumers’ surplus
How much do consumers have to pay in the market?
At this stage of our study we have assumed if the price of
the product is x amount for one consumer then it is this
amount for all consumers.
P
Thus if the price is P1 consumers
have to pay P1Q1 for the Q1 units.
P1
Q1
D
Q
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consumers’ surplus
Consumers’ surplus in a graph.
area a + b = maximum consumers
would willingly pay for Q1 units.
area b = amount consumers have to
pay for the Q1 units.
P
P1
area a = consumers’ surplus.
a
b
Q1
D
Q
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producers’ surplus
producers’ surplus = amount producers actually receive
for their output minus the minimum they would have
willingly accepted for those units.
s = mc
P
Recall that for a
competitive firm the
supply curve is the
P2
c
marginal cost curve.
d
P1 a
b e
Q
Q1 Q2
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producers’s surplus
If the price is P1 the producer will only produce 1 unit.
Here MR = MC and thus is the best the producer can do.
Now if the price was higher more would be produced, but
at a lower price the first unit would not be produced.
P2 is the lowest price at which the producer would be
willing to sell the second unit for.
area a + b = P1 = minimum amount to sell the first unit,
area c + d + e = P2 = minimum amount to sell the second
unit.
Note that a and c are above the supply curve and use this
method if only a few units are considered.
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producers’s surplus
a and c are really part of the minimum payments suppliers
need to make them want to sell. But to make life easier for
us we will ignore a and c and only concentrate on the area
under the supply curve up to a Q as the minimum amount
producers need to supply that Q.
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producers’s surplus
What do producers actually receive in the market?
P
s
Producers actually get
P1(Q1) if the price is P1.
In terms of areas it is a + b.
P1
a
b
Q1
Q
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producers’s surplus
a + b = what producers
receive,
b = what producers would
have accepted and still
supplied Q,
P
s
P1
a = producers’ surplus.
a
b
Q1
Q
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Gains in the market
P
s
a
P1
b
Q1
a = consumers’ surplus
b = producers’ surplus
a + b = social gain or
welfare from trade in
markets.
In the market for a
product producers and
consumers 1) make
transactions to meet their
D own objectives, 2) both
receive surplus value from
Q
the market transaction.
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applying the concepts - a
sales tax
b
Sbt
Pat +
tax
c
Pbt
f
Pat
i
a
d
e
g h
Dat
Dbt
Qat Qbt
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applying the concepts - a
sales tax
before tax
consumers’
surplus
a+b+c+d+e
producers’
surplus
f+g+h+i
social gain = a + b + c + d
e+f+g+h+i
after tax
a+b
i
a + b + i.
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applying the concepts - a
sales tax
The change in social welfare from the tax is the welfare
after the tax minus the welfare before the tax:
change in social welfare = a + b + i a + b + c + d +e + f + g + h + i
- c - d - e - f -g - h
It looks like the sales tax is really a bad idea for producers
and consumers of the product. It is, but the government
collects the tax and this can be put to good use in the
world. The tax amount is c + d + f + h.
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applying the concepts - a
sales tax
If you add the tax revenue to the change in social welfare
amount you are left with the true change in social welfare
as - e - h.
You will notice that areas e and h occur in the area above
the reduction in output. What the area represents is the
loss in output to producers and consumers that is not
made up by something else in the form of what the tax
revenue could buy. We call this a deadweight or efficiency
loss due to the tax.
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