Supply and demand: Markets and welfare
- 1 Consumers, producers and the efficiency of markets
- 1.1 Consumer surplus
- 1.2 Producer surplus
- 1.3 Market efficiency
- 2 Application: the costs of taxation
Consumers, producers and the efficiency of markets
In this chapter we take up the topic of welfare economics, the study of how the allocation of resources affects economic well-being.
We begin our study of welfare economics by looking at the benefits buyer receive from participating in a market.
Willingness to pay
Each buyer’s maximum price is called his willingness to pay, and it measures how much that buyer values the good. Consumer surplus is the amount a buyer is willing to pay for a good minus the amount buyer actually pays for it.
Consumer surplus measures the benefit to buyers of participating in a market.
Using the demand curve to measure consumer surplus
Consumer surplus is closely related to the demand curve for a product. Because the demand curve reflects buyers’ willingness to pay, we can also use it to measure consumer surplus. The area below the demand curve and above the price measures the consumer surplus in a market. The reason is that the height of the demand curve measures the value buyers place on the good, as measured by their willingness to pay for it. The difference between this willingness to pay and the market price is each buyer’s consumer surplus. Thus, the total area below the demand curve and above the price is the sum of the consumer surplus of all buyers in the market for a good or service.
How a lower price raises consumer surplus
Because buyers always want to pay less for the goods they buy, a lower price makes buyers of a good better off. The increase in consumer surplus related to a lower price is composed of two parts. First, those buyers who were already buyer the good at the higher price are better off because they now pay less. Secondly, some new buyers enter the market because they are now willing to buy.
What does consumer surplus measure?
Our goal in developing the concept of consumer surplus is to make normative judgments about the desirability of market outcomes. Consumer surplus is a good measure of economic well-being. In most markets consumer surplus does reflect economic well-being. Economists normally presume that buyers are rational when they make decisions and that their preferences should be respected. In this case, consumers are the best judges of how much benefit they receive from the goods they buy.
We now turn to the other side of the market and consider the benefits sellers receive from participating in a market.
Cost and willingness to sell
Cost is the value of everything a seller must give up to produce a good.
Producer surplus is the amount a seller is paid minus the cost of production. Producer surplus measures the benefit to sellers of participating in a market.
Using the supply curve to measure producer surplus
Just as consumer surplus is closely related to the demand curve, producer surplus is closely related to the supply curve. The height of the supply curve measures sellers’ costs and the difference between the price and the cost of production is each seller’s producer surplus. Thus, the total area is the sum of the producer surplus of all sellers
How a higher price raises producer surplus
Sellers always want to receive a higher price for the goods they sell. When the price rises, the increase of producer surplus has two parts. First, those sellers who were already selling a quantity of a good at the lower price are better off because they now get more for what they sell. Secondly some new sellers enter the market because they are now willing to produce the good at the higher price, resulting in an increase in the quantity supplied.
Consumer surplus and producer surplus are the basic tools that economists use to study the welfare of buyers and sellers in a market.
To evaluate market outcomes, we introduce into our analysis a new, hypothetical character, the benevolent social planner – the BSP. The BSP is an omniscient, omnipotent, benign dictator. He wants to maximize the economic well-being of everyone in society.
The planner must first decide how to measure the economic well-being of a society. One possible measure is the sum of consumer and producer surplus, which we call total surplus.
Consumer surplus = value to buyers – amount paid by buyers
Producer surplus = amount received by sellers – cost to sellers. Total surplus = value to buyers – amount paid by buyers + amount received by sellers – cost to sellers
The amount paid by buyers equals the amount received by sellers, so the middle two terms cancel each other.
Total surplus = value to buyers – cost to sellers
Total surplus in a market is the total value to buyers of the goods, as measured by their willingness to pay, minus the total cost to sellers of providing those goods. If an allocation of resources maximizes total surplus, we say that the allocation exhibits efficiency. If an allocation is not efficient, then some of the gains from trade among buyers and sellers are not being realized.
In addition to efficiency, the BSP might also care about equity – the property of distributing economic prosperity fairly among the members of society. In essence, the gains from trade in a market are like a cake to be distributed among the market participants. The question of efficiency is whether the cake is as big as possible. The question of equity is whether the cake is divided fairly.
Evaluating the market equilibrium
The total area between the supply and demand curves up to the point of equilibrium represents the total surplus in the market.
The equilibrium outcome is an efficient allocation of resources in a competitive market.
Application: the costs of taxation
The deadweight loss of taxation
When a tax is levied on buyers, the demand curve shifts downward by the size of the tax; when it is levied on sellers, the supply curve shifts upward by that amount. In either case, when the tax is imposed, the price paid by buyers rises, and the price received by sellers falls. In the end, buyers and sellers share the burden of the tax regardless of how it is levied.
Which curve shifts by the levied tax depends on whether the tax is levied on sellers (supply curve shifts) or buyers (demand curve shifts).
How a tax affects market participants
Now let’s use the tool of welfare economics to measure the gains and losses from a tax on a good. To do this, we must take into account how the tax affects buyers, sellers and the government. The affect on buyers and sellers we can measure by consumer and producer surplus.
If T is the size of the tax and Q is the quantity of the good sold, then the government gets total tax revenue of T x Q. To analyze how taxes affect economic well-being, we use tax revenue to measure the government’s benefit from the tax.
To see how a tax affects welfare, we begin by considering welfare before the government has imposed a tax. Without a tax, the price and quantity are found at the intersection of the supply and demand curves. The price is P1 and the quantity sold is Q1. Because the demand curve reflects buyers’ willingness to pay, consumer surplus is the area between the demand curve and the price. Similarly, because the supply curve reflects sellers’ costs, producer surplus is the area between the supply curve and the price. Total surplus is the area between the supply and demand curves up to the equilibrium quantity. Now consider welfare after the tax is imposed. The price paid by buyers rises, the price received by sellers falls, the quantity sold falls and the government collects tax revenue.
To compute total surplus with the tax, we add consumer surplus producer surplus and tax revenue.
The tax causes consumer and producer surplus to fall. Not surprisingly, the tax makes buyers and sellers worse off and the government better off.
Thus, the losses to buyers and sellers from a tax exceeds the revenue raised by the government. The fall in total surplus that results when a tax distorts a market outcome is called the deadweight loss.
The determinants of the deadweight loss
The price elasticities of supply and demand, which measure how much the quantity supplied and the quantity demanded respond to changes is the price, determines whether the deadweight loss form a tax is large or small. The deadweight loss is larger when the supply or demand curve is more elastic.
A tax has a deadweight loss because it induces buyers and sellers to change their behavior, because the price changes. The elasticities of supply and demand measure how much sellers and buyers respond to the changes in price and, therefore, determine how much the tax distorts the market outcome. Hence, the greater the elasticities of supply and demand, the greater is the deadweight loss of a tax.
Deadweight loss and tax revenue as taxes vary
The deadweight loss of a tax rises even more rapidly than the size of the tax. The reason is that the deadweight loss is an area of a triangle and an area of a tringel depends on the square of its size.