Lecture 4

Agenda:
 Review of Chapter 3
 Chapter 4
 Describe consumer and producer surplus
 Describe deadweight loss
 Describe marginal benefits/marginal costs
 Describe the justification and positive and normative economic consequences of
price floors and price ceilings
 How to calculate the consumer and producer surplus areas
 Black market

 Chapter 4

 Marginal benefit The additional benefit to a consumer from consuming one more unit
of a good or service.
 Consumer surplus The difference between the highest price a consumer is willing to pay
and the price the consumer actually pays.

The Demand Curve is Also the

Marginal Benefit Curve

 Consumer surplus – the difference between the maximum price a buyer is willing and
able to pay for a good or service and the price actually paid
 CS = maximum buying price – price paid

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  Marginal cost The additional cost to a firm of producing one more unit of a good
or service.
 Producer surplus The difference between the lowest price a firm would have
been willing to accept and the price it actually receives.

Producer Surplus

 The marginal benefit equals the marginal cost in a competitive equilibrium

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
Marginal Benefit Equals Marginal
Cost Only at Competitive
Equilibrium

 Read another way, there is maximization to total benefits with respect to costs.
Alternatively, there is a maximization of consumer surplus with respect to producer
surplus.
 When the market is not at an equilibrium, a deadweight loss exists.

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
4-
6
When a Market Is Not in
Equilibrium There is a
Deadweight Loss

Deadweight loss The

reduction in economic
surplus resulting from a
market not being in
competitive equilibrium.

 At equilibrium, both consumer surplus and producer surplus are maximized

 When economic well-being or welfare is measured as the summation of consumer and
producer surplus, economists argue that markets work
 The market equilibrium is optimal – it maximizes economic well-being
 Up to now, price has been the only rationing device of scarce resources
 Sometimes, for a variety of equity reasons, the price is controlled
 There are two types of price controls: price ceilings and price floors

 Price ceiling: a government-mandated maximum price above which legal trades cannot
be made
 An effective price ceiling is set below the equilibrium price
o Price ceilings are used for goods like health care, housing, energy, and loans
o Price ceilings generate shortages (quantity demanded exceeds quantity supplied)
o Leads to temptation to use the black market in order to satisfy demand

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

 The deadweight loss is the sum of the total loss in producer and consumer surplus
 In the case of this price ceiling, the consumer surplus is the green triangle, producer
surplus is the blue triangle, and the deadweight loss is the grey triangle
 If the consumer does not spend any time searching for scarce housing, the consumer
surplus is also the pink square
 However, renters may spend resources searching for an apartment equal to the pink
square

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

 Price floor: a government-mandated minimum price below which legal trades cannot be
made
 An effective price floor is set above the equilibrium price
 A price floor exists in the United States labor market (the minimum wage)
 A price floor generates a surplus (in the case of the labor market, a surplus of workers)

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

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 The deadweight loss is the sum of the total loss in producer and consumer surplus
 Remember, in the case of the labor market the worker is the producer and the firm is the
consumer
 In the case of this price floor, the consumer (firm) surplus is the blue triangle, producer
(worker) surplus is the green triangle, and the deadweight loss is the grey triangle
 If the worker does not spend any time searching for scarce jobs, the producer (worker)
surplus is also the pink square
 However, workers may spend resources searching for an job equal to the pink square



 The Results of Government Intervention: Winners, Losers, and Inefficiency
 When the government imposes price floors or price ceilings, three important results
occur:
o Some people win.
o Some people lose.
o There is a loss of economic efficiency.
 Positive and Normative Analysis of Price Ceilings and Price Floors
 Whether rent controls are desirable or undesirable is a normative question. Whether the
gains to the winners more than make up for the losses to the losers and for the decline in
economic efficiency is a matter of judgment and not strictly an economic question.
 Taxes also create a deadweight loss but also create revenue

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Tax of $1.05 on producer


p, $ per kg S2

e2  = $1.05
p 2 = 4.00 S1
e1
p 1 = 3.30
T = $216.3 million
p 2 –  = 2.95

0 176 Q 2 = 206 Q 1 = 220

Q, Million kg of pork per year

Interestingly, taxing the consumer rather than the producer makes no difference

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 p, $ per kg

e 2 Wedge,  = $1.05
p 2 = 4.00 S
e1
p 1 = 3.30
T = $216.3 million
p 2 –  = 2.95

 = $1.05

D1

D2

0 176 Q 2 = 206 Q 1 = 220 Q, Million kg of pork per year

 When a tax is present in a market, there are two prices of interest: the price the demander
pays and the price the supplier gets
 These prices will differ by the amount of the tax
 It doesn’t matter who is responsible for paying the tax (the legal incidence)
 Our focus here will be on the economic incidence (whether consumers or producers bear
the tax burden)

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