Introductory Microeconomics
Economics 10004
Semester 1, 2021
Department of Economics
University of Melbourne
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Lecture overview
Welfare: how allocation of resources affects society’s well-being
É Consumer Surplus
É Producer Surplus
É Efficiency
Government Intervention in Perfectly Competitive Markets
É Indirect Intervention: Taxes on sellers/buyers
Applications: mining in Kakadu NP
É Efficiency and government regulation
É Welfare analysis to evaluate government policy
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Consumers’ welfare in perfectly competitive markets
How do we measure society’s well-being from market transactions?
For the demand side of the market:
É We compute the sum of individual benefits by totalling up their
willingness-to-pay
É Then we subtract the amount that they actually pay
The market demand curve maps out prices at which buyers are
willing to pay, the marginal benefit (MB)
⇒ The area under the demand curve that lies above the price,
represents their collective net benefit (or gains from trade)
Consumer surplus measures buyers’ willingness-to-pay, net of
the amount they actually pay
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Consumer surplus
P S
P*
Q* Q
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Consumer surplus
P S
Consumer Surplus
P*
D = MB
Q* Q
CS=MB-P 4
Producers’ welfare in perfectly competitive markets
Similarly, for the supply side, we compute the sum of all net
benefits by considering the difference between their opportunity
costs and the price that they received
Since the market supply curve maps out prices at which sellers
are willing to sell (MC), the amount they receive minus the area
below the supply curve represents their collective gains from
trade
Producer surplus measures the amount sellers receive, net of
their willingness-to-sell
The sum of consumer & producer surpluses therefore represent
society’s well-being from trade between buyers and sellers
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Producer surplus
P S = MC
P*
Producer Surplus
Q* Q
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Producer surplus
P S=MC
CS
TS = CS+PS
P*
PS
D = MB
Q* Q
PS=P-MC
TS=CS+PS=MB-P+P-MC ⇒ TS= MB-MC 7
Efficiency in perfectly competitive markets
Efficiency:
An allocation is said to be efficient when the total surplus is
maximised
This efficient arrangement then becomes the benchmark against
which we compare all other possible arrangements
Deadweight loss represents the decrease in total surplus relative
to the efficient benchmark
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Efficiency in perfectly competitive markets
Is the equilibrium quantity Q∗ (where quantity demanded equals
quantity supplied) the efficient allocation?
Deviations away from Q∗ generates total surpluses that are lower
than that under the market equilibrium
These deviations either:
(i) create possibilities for mutually-beneficial trade or
(ii) indicate the presence of mutually-harmful trade
⇒ none of them could provide as much welfare to the society as
the market equilibrium
Therefore, the equilibrium quantity Q∗ is efficient
In other words, at {P∗ ,Q∗ }, the society’s MB (for buyers) equals
its MC (for sellers)
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Efficiency in perfectly competitive markets
P S=MC
D = MB
Q* Q
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Welfare and efficiency if Q1 < Q∗
P S=MC
D = MB
Q1 Q* Q
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Welfare and efficiency if Q1 < Q∗
P S=MC
D = MB
Q1 Q* Q
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Welfare and efficiency if Q1 < Q∗
P S=MC
B
A
D = MB
Q1 Q* Q
Inefficient: Can ⇑ total surplus by red area if trade ⇑ from Q1 to Q∗
A<A+B
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Welfare and efficiency if Q2 > Q∗
P S=MC
D = MB
Q* Q2 Q
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Welfare and efficiency if Q2 > Q∗
P S=MC
TS = A+B-C
C
B
A
D = MB
Q* Q2 Q
Inefficient: Can ⇑ total surplus by blue area if trade ⇓ from Q2 to Q∗
A+B-C<A+B
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The invisible hand
Adam Smith, The Wealth of Nations (1776), Book IV, Chapter II,
Paragraph 9:
Every individual necessarily labours to render the annual revenue of the
society as great as he can. He generally, indeed, neither intends to
promote the public interest, nor knows how much he is promoting it...
he intends only his own security; and by directing that industry in such
a manner as its produce may be of the greatest value, he intends only his
own gain, and he is in this, as in many other cases, led by an invisible
hand to promote an end which was no part of his intention. ...
By pursuing his own interest he frequently promotes that of the society
more effectually than when he really intends to promote it.
What about equity?
É How is the pie distributed among market participants?
É Policymakers care also about distributional aspects of trade
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Critiques of economic efficiency
Distribution matters! It’s also important to account for equity
Willingness to pay reflects ability to pay, not just marginal benefit
The means matter, not just the ends
Most real-world policy debates reflect not only a technical
evaluation of economic efficiency, but also an analysis of
distributional and ethical consequences, and a broader notion of
fairness
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Welfare and government intervention
Government Intervention in Perfectly Competitive Markets
É Indirect Intervention (Taxes and Subsidies)
É Direct Intervention (Price Controls and Quotas)
How does government intervention affect welfare?
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Government intervention
There are two main types of government interventions
Indirect interventions (on demand or supply):
É taxes
É subsidies
Direct controls (on price or quantity):
É price ceiling
É price floor
É quota
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Government intervention: taxes
Tax: a payment to the government on each unit of a good
transacted
Taxation is commonly used by governments to raise revenue
It creates a tax wedge between the price paid by buyers and the
price received by sellers: t = PD − PS
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Government intervention: taxes on suppliers
Suppose the tax is imposed on sellers
At every quantity supplied, sellers are only willing to sell if the
price that they receive = PS + t
The tax therefore shifts the supply curve to the left
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Government intervention: taxes on suppliers
P S
P*
Q* Q
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Government intervention: taxes on suppliers
S + t
P S
P*
Q* Q
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Government intervention: taxes on suppliers
S + t
P S
PD
P*
PS
Q** Q* Q
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Government intervention: taxes on suppliers
S + t
P S
C
PD C= Consumers surplus with tax
P* A B B= Deadweight loss
D= Producers surplus with tax
PS
A= tax revenue
D
Q** Q* Q
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Government intervention: taxes on consumers
Suppose instead the tax is imposed on the buyers
At every quantity demanded, the buyers are only willing to buy
if the price that they pay =PD − t
The tax therefore shifts the demand curve to the left
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Government intervention: taxes on consumers
P S
PD
P*
PS
D + t D
Q** Q* Q
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Government intervention: taxes
Whenever quantity traded is not equal to equilibrium quantity
traded (Q 6= Q∗)
⇒ quantity traded is not efficient
All examples of government regulation cause quantity traded to
be different to quantity traded in PC market equilibrium:
(Q 6= Q∗)
⇒ Government regulation causes market outcomes that are not
efficient
That is, government regulation causes a deadweight loss
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An example: no taxation
As an example, consider the following:
QD = 120 − 20PD
QS = 20PS
Without a tax we have PD = PS
Setting QD = QS we have
120 − 20PD = 20PD → PD = 3
Thus PD = PS = 3 and QD = QS = 60.
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An example: tax on sellers
How does the equilibrium change if a $2 per unit tax is imposed
on sellers?
Here we have PS = PD − 2 since the government takes $2 from
the seller
Setting QD = QS we have
120 − 20PD = 20(PD − 2) → PD = 4
Thus PD = 4, PS = 2 and QD = QS = 40
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An example: tax on buyers
How does the equilibrium change if a $2 per unit tax is imposed
on buyer?
Here we have PD = PS + 2 since the government adds two dollars
to the buyer’s price
Setting QD = QS we have
120 − 20(PS + 2) = 20(PS ) → PS = 2
Thus PD = 4, PS = 2 and QD = QS = 40
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Should we allow mining at Kakadu? Case study 2.6
Can answer this question by analysing effect of allowing mining
on total surplus to society:
Benefit of mining to society = Extra producer surplus from
mining activity
Cost of mining activity to society = Loss in consumer surplus
associated with damage to environment
É Surveys used to elicit respondents’ willingness to pay to prevent
environmental damage
É Hypothetical payment as consumers welfare loss
Estimated that gain from mining would equal $102m compared
to loss in CS of $435m
Socially optimal decision was not to proceed with mining at
Kakadu
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