Economics Midterm 2 Review
• Welfare economics:
- The study of how the allocation of resources affects economic well being
- Buyers and sellers receive benefits from participating in the market
- Equilibrium maximum benefits and therefore maximum total welfare
for all buyers and sellers
o Every buyer in an economy is only willing to pay up to a certain
amount for a good or service. We define:
The maximum amount that a buyer will pay for a good
Measures the value the buyer places on the good
also referred to as the reservation price
• When a buyer actually pays less than he/she is willing to pay, they enjoy a
benefit. We define:
• Consumer surplus:
- The buyer’s willingness to pay minus the amount that the
buyer actually has to pay
- i.e your reservation price (what you pay) Producer Surplus
o The amount a seller actually receives for a good minus their
willingness to sell
o Measures the benefit to sellers participating in a market
Willingness-to-sell: Lowest price a seller will take to produce a good and
offer it for sale
o It refers the seller’s cost production
o Producers surplus is related to the supply curve which reflects a
Just as consumer surplus is related to the demand curve, producer surplus is
closely related to the supply curve.
o The supply curve reflects a producer’s costs
o The area below the selling price and above the supply curve measures
the producer surplus in a market
Consumer Surplus = Value to buyers – Amount buyer pays
Producer Surplus = Amount sellers receive – Cost to sellers
Since amount buyer pays = amount sellers receive
Total Surplus = Consumer Surplus + Producer Surplus
Total Surplus = Value to buyers – Cost to sellers If a allocation of resources maximizes total surplus, we say that allocation is
If an allocation of resources leads to well-being that’s fairly distributed
among society’s members, that’s equity.
We can illustrate total surplus for a market equilibrium:
Free markets do 3 things:
*You can only get CS or PS if good are actually bought and sold Deadweight Losses
o Whenever the market outcome is one of equilibrium, total surplus (as
we just saw) is maximized.
o This isn’t always the case.
o A loss in total surplus happens when the quantity traded is less than
what would be traded when the market is in equilibrium • Because the equilibrium outcome is an efficient allocation of resources
and maximizes total surplus (welfare), a social planner can leave the
market outcome as he/she finds it.
• This policy of leaving well enough alone goes by the French expression
*Refer to Text Book For Calculation Understanding
Chapter 6 & 8
o Are usually enacted when policymakers believe the market price is
unfair to buyers or sellers.
o The government will freeze prices at a predetermined level that they
feel will make members of society better off.
o A price ceiling: is a legal maximum on the price at which a good can
o The price ceiling is not binding (not effective) if it is set above
o The price ceiling is binding (effective) if set below equilibrium price,
leading to a shortage.
Example: Rent Control
o The government’s goal: to help the poor by making housing more
o It sets a maximum price (rent) for housing that is below equilibrium
o In the SR(Short Run), the number of apartments is fixed, so Supply of
housing is inelastic.
o Potential renters may not be highly responsive to rents because they
take time to adjust their housing arrangements (eg. give notice to
current landlord), so Demand for housing in the SR is relatively
inelastic. o In the LR, low rents can mean that landlords may convert to condos,
get out of the rental business and/or won’t maintain existing
apartments, so Supply is elastic.
o Low rents encourage people to look for housing (move out from your
parents if the price is right), so Demand is elastic.
Price ceilings can lead to:
o shortages that worsen over time
o Inefficient allocation to consumers
o People who want the good badly may not be the ones who actually get
to buy it
o Wasted resources
o You spend a lot of time looking for an apt, leave work early
Inefficient low quality
No incentive for land lords to maintain apartments Black Markets
o Example: “I’ll rent you an apartment if you slip me an extra $500 a
month under the table.”
o Illegal, but they often occur.
At Q ceiling, consumers would be willing to pay up to the black market
price for housing.
The landlord would legally claim rent = rent ceiling and charge the
renter the difference under the table.
o A price floor: a legal minimum on the price at which a good can be
o The price floor is not binding if set below the equilibrium price.
o The price floor is binding if set above the equilibrium price, leading to
a surplus. Example: Minimum Wage
o The government’s goal: to ensure at least a certain wage for workers.
o It sets a minimum price of labour (wage) that is above equilibrium
-usually, only affects low paid workers.
At a wage above equilibrium wage, S of labour > D for labour
o There’s an excess supply of labour, a surplus
o Excess supply = Qs – Qd
Price floors can lead to:
o Surplus production:
Producers will want to supply more at the higher price
Surplus may be stored, destroyed, exported, given away
Can’t sell surpluses on the domestic market or selling
Price can’t fall below floor level
o A quota: a quantity control
An upper limit on the quantity of a good that can be sold
Gov’t usually issues quota licenses that give producers a right
to produce a specified amount of a good
o Examples: the number of taxis in a city
amount of fish you can catch + sell often seen with dairy + (Check Podcast for other)
In an unregulated market, eqm P = $1 and Q = 13 million litres per
o The Canadian Dairy Association decides to limit output to increase
prices received by producers and avoid surplus production.
o It makes sure the gov’t backs it up by imposing tariffs on imports of
milk from the US. This will make milk expensive enough so that
consumers won’t buy US milk.
The quota is set at 9 million litres per week.
o At Q = 9 million, consumers are willing to pay $1.80 per litre (this is
the demand price).
o But, at that Q, producers would normally be happy to receive $ .60 per
litre. The difference between these 2 prices is the quota rent: quota owners receive
an additional $1.20 per litre per week.
This is also the value of the quota.
o Someone who wanted to produce milk would be willing to pay up to
$1.20 per litre per week to acquire the rights to produce milk, sell it at
$1.80 and net $.60 per litre per week.
o Governments levy taxes to raise revenue for public projects.
o Tax incidence: the distribution of a tax burden
A Tax Levied on Consumers
o Example: The Market for Beer
P is the price per bottle.
Q is the number of bottles sold per week at a very small bar in a
In equilibrium, P = $3.00 and Q = 100
o Now, suppose the government imposes a tax of $ .50 per bottle on
consumers of beer.
o Consumers will demand less beer.
o The gov’t doesn’t care what the eqm price is, and the $ .50 tax will apply
no matter what the price of beer happens to be.
o Consumers will want less beer at any price.
o This means the demand curve will shift down by the amount of the tax. o Notice that the burden of the tax doesn’t fall equally on consumers and
Before the tax, the consumers paid $3.00 and sellers received
$3.00 per bottle.
o After the tax,
Consumers pay $ .30 more per bottle.
Sellers receive $ .20 less per bottle.
In this case, the consumers bear the larger burden of the tax: $.30
A Tax Levied on Suppliers
o Now, suppose instead that the government levies the tax on bar
Sellers react by supplying less beer at every price.
The supply curve will shift up by the amount of the tax.
Again, there’s a new eqm P = $3.30 and Q = 90.
o Consumers pay P = $C.30
o Sellers receive P = $2.80 (they get $3.30 from the consumer and
remit $ .50 to the government for a net take of $2.80)
o The gov’t receives $ .50 x 90 = $45.00 in tax revenue.
Taxes on consumers and taxes on suppliers are equivalent = end result
doesn’t matter on whom the tax is levied
o Taxes reduce the quantity traded, increase price consumers pay and
lower the price that suppliers (firms ,producers) receive
o In our example, the consumers bore the larger burden of the tax. o That’s because the demand curve is actually steeper than the supply
*The side of the market which is more inelastic (steeper curve) bears a larger
burden of the tax.
o Less responsive to change
o Can’t adjust to compensate to any great extent in the short run
o You get stuck with the larger share of the tax
Elastic Supply, Inelastic Demand
Elastic Demand, Inelastic Supply The Deadweight loss of Taxation
o Since a tax places a burden on consumers and suppliers and reduces
the quantity traded in the market compared to the non-tax
equilibrium quantity, we know there will be a deadweight loss.
o The government’s tax revenues are a benefit for them and a benefit
for the recipients when the gov’t spends that revenue on social
o But ultimately, consumers and producers lose out.
Changes in Welfare
o A tax on a good reduces consumer surplus and producer surplus.
o On the following diagram, total surplus is the area of ABC.
o A tax reduces the quantity traded, increases the price consumers pay
and decreases the price suppliers receive.
o The new CS is A on the following diagram.
o The new PS is F.
o The tax revenue is the sum of rectangle B (lost CS) and rectangle D
Determinants of the DWL due to Tax
o Depends on the price elasticities of demand and supply
The following examples show what happens to deadweight loss when the
size of the tax remains the same and the
o demand curve is the same but supply elasticity changes.
o supply curve is the same but demand elasticity changes. The greater the elasticities of demand and supply:
- The larger the decrease in eqm. Qty due to a tax
- The greater the deadweight loss of a tax With each increase in the tax rate, the deadweight loss of the tax rises even
more rapidly than the size of the tax.
Consider the following 3 diagrams:
• For the small tax, tax revenue is
• As the size of the tax rises, tax
• But as the size of the tax continues