Economics 2 Emmanuel Saez

Fall 2024

LECTURE 4
Welfare Analysis
 Welfare Analysis
• An extension of the supply and demand
framework:
• It is a tool that helps us evaluate the
desirability of market outcomes.
• It is a tool that we will use over and over:
• To evaluate the effects of government
intervention.
• To understand market failures.
I. CONCEPT OF ECONOMIC SURPLUS
 Economic Surplus
Economic surplus represents the net gains to society from all
trades that are made in a particular market, and it consists of
two components: consumer and producer surplus.

• Consumer surplus: The benefit that consumers derive

from consuming a good, above and beyond the price paid
for the good

• Producer surplus: The benefit producers derive from

selling a good, above and beyond the cost of producing
that good

• Total economic surplus: Consumer surplus + producer

surplus
 Marginal Benefit of Consumers
• The dollar value to consumers of another unit of a
good.

• What they would be willing to pay for one more

unit.

• The vertical distance of the demand curve gives

the marginal benefit of an extra unit of good

• Demand curve can be read as:

– Demand as a function of price: Q=D(P)

– Marginal benefit of Qth unit of good: P=MB(Q)

 Demand for a given good
P

D , MB
Q
 Consumer Surplus
P
Marginal Benefit (MB) of 1st unit of demand

D,MB
1 Q
 Consumer Surplus
P
Marginal Benefit (MB) of 2nd unit of demand

D,MB
12 Q
 Consumer Surplus
P
S

P1

D,MB
Q1 Q
 Consumer Surplus
Total benefit from consuming Q1
P

P1

D,MB
Q1 Q
 Consumer Surplus
Total cost of buying Q1 is P1*Q1
P

P1

D, MB
Q1 Q
 Consumer Surplus
P
S
Consumer Surplus

Consumer surplus is
difference between benefit
P1 and cost of buying Q1 units
at price P1

D, MB
Q1 Q
 Marginal Cost of Producers
• The dollar cost to producers of producing another
unit of a good.

• What they would be willing to sell for one more

unit of production.

• The vertical distance of the supply curve gives the

marginal cost of an extra unit of good produced

• Supply curve can be read as:

– Supply as a function of price: Q=S(P)

– Marginal cost of producing Qth unit of good: P=MC(Q)

 Supply of a given good
P

S, MC

Q
 Producer Surplus
P

S, MC

Marginal Cost (MC) of 1st unit produced

1 Q
 Producer Surplus
P

S, MC

Marginal Cost (MC) of 2nd unit produced

12 Q
 Producer Surplus
P S, MC

P1

D ,MB
Q1 Q
 Producer Surplus
Total cost of producing Q1
P

S, MC

P1

D, MB
Q1 Q
 Producer Surplus
Total revenue from selling Q1 is
P
P1*Q1
S

P1

D, MB
Q1 Q
 Producer Surplus
P S, MC

P1

Producer Surplus
D, MB
Q1 Q
 Consumer Surplus + Producer Surplus

P S, MC
Consumer Surplus

P1 Market Equilibrium

Producer Surplus
D, MB
Q1 Q
Area between the MB and MC curves up to the level bought and sold.
 Economic Surplus
Economic surplus represents the net gains to society from all
trades that are made in a particular market, and it consists of
two components: consumer and producer surplus.

• Consumer surplus: The benefit that consumers derive from

consuming a good, above and beyond the price paid for the
good = area below demand curve and above market price

• Producer surplus: The benefit producers derive from selling a

good, above and beyond the cost of producing that good =
area above supply curve and below market price

• Total economic surplus: Consumer surplus + producer

surplus = area above supply curve and below demand curve
II. ALLOCATIVE EFFICIENCY
 Allocative Efficiency (=Pareto Efficiency)
• Total surplus is as large as possible: impossible to
find an alternative allocation that delivers more
surplus to all parties

• It makes no judgment about which side of the

market we care about: one dollar is one dollar
– whether it goes to consumers or producers

– whether it goes to poor/rich consumers

– whether it goes to poor/rich producers

 Conditions for Allocative Efficiency
• The good is produced up to the point where MB
= MC.

• The good is allocated to the consumers with the

highest MB.

• The good is produced by the producers with the

lowest MC.
 Consumer Surplus + Producer Surplus

P S, MC
Consumer Surplus

P1 Market Equilibrium

Producer Surplus
D, MB
Q1 Q
Area between the MB and MC curves up to the level bought and sold.
Deadweight Loss when Q is below market equilibrium Q2

P S ,MC

Deadweight loss

P1

D ,MB
Q2 Q1 Q
Q2 does not realize all gains from trade: deadweight burden area =
lost surplus relative to market equilibrium (P1,Q1)
 Deadweight Loss also with production in excess of Q2

P S ,MC

Deadweight loss

P1

D ,MB
Q1 Q2 Q
Excessive Q2 is also inefficient: production above Q1 costs more to
producers than it creates benefit to consumers
 Deadweight loss (=deadweight burden)
• Deadweight loss: The reduction in economic
surplus from denying trades for which benefits
exceed costs when quantity differs from the
efficient quantity

• Implication: Both too little or too much

production relative to efficiency create
deadweight loss

• Key practical rule: Deadweight loss triangle points

toward the efficient allocation, and grows outward
to current quantity
 Competitive Equilibrium Maximizes
Economic Surplus
• First Theorem of Welfare Economics:
Competitive equilibrium where supply equals
demand, maximizes total economic surplus
(=efficiency)

• The simple efficiency result from the 1-good

diagram can be generalized into the first welfare
theorem (Arrow-Debreu, 1940s): competitive
markets are efficient.
III. EQUITY AND EFFICIENCY
 Equity Issues
• Willingness to pay (which underlies consumer
surplus) depends a lot on income.

• Economists’ measure of welfare doesn’t take into

account that consumers may enter the market
with vastly different incomes.

• Economic surplus just counts dollars regardless of

who gets them

• ⇒ 1st welfare theorem is blind to distributional

aspects
 Equity and Efficiency
• Allocative efficiency is still a worthy goal.

• Interfering with the price system to improve

equity may reduce efficiency.

• In general, there are equity vs. efficiency

tradeoffs: we have to sacrifice some economic
surplus to get a more equitable outcome
IV. WELFARE ANALYSIS OF PRICE CONTROLS
 Price Control
• Government sets the price of a good; it is not
allowed to go to its equilibrium level.

• Price Ceiling: Maximum price; price is held

below its equilibrium level.

• Price Floor: Minimum price; price is held

above its equilibrium level.

Example: Up until 1998, city of Berkeley

imposed rent price controls (since 1999, rent
price control only after lease starts)
 Effects of a Price Ceiling

P
S

P1
PC

QS Q1 QD Q

Shortage
 Effects of a Price Ceiling
• Will lead to a shortage.

• Good will have to be allocated in some way other

than by price:
– Queuing (people line up to get served)

– Government organized rationing (e.g. COVID vaccines in

2021): often used after disaster to ensure equal access
to essentials

• Discourages the decrease in quantity demanded

and increase in quantity supplied that
automatically occur as the price rises.
 Economic Surplus with no price ceiling

P S, MC
Consumer Surplus

P1 Market Equilibrium

Producer Surplus
D, MB
Q1 Q
Market equilibrium maximizes the sum of consumer surplus and
producer surplus
 Economic Surplus with a price ceiling

P
Consumer Surplus S ,MC

Deadweight loss

P1
PC

Producer Surplus
D ,MB
QS Q1 Q
Price ceiling PC reduces total surplus but it increases consumer
surplus (at the expense of producer surplus)
 Poll
• Value question: Rent control reduces economic
surplus but benefits poor renters at the expense of
wealthy landlords: Suppose that each $1 lost by
landlords translates into $.80 to renters and $.20
deadweight loss. What do you think ?

A. That’s good

B. I can’t judge if good or bad

C. That’s bad
 Deadweight Loss and Misallocation
• Graphical analysis assumed that higher value
consumers were served first

• When there is a shortage, we can’t be certain that

this assumption will be true:

• There could be misallocation among consumers:

those who consume the good may not be the
highest value consumers

• Example: low income elderly lady gets a rent

control apartment but rich college student able to
pay a lot more can’t get one.
 Rent Control Discussion
• In the model, rent control creates shortage and
reduces economic surplus

• But rent control also benefits consumers (those

who can find a rental unit)

• In real world: rent control also protects tenants

from price fluctuations due to D and S shifts

• Alternative to rent control: subsidized public

housing where government controls both price
and quantity. Widely used across the world
 Poll
• Value question: What is the best way for a city to
organize housing for residents?

A. Just let free markets of supply and demand work.

B. Add rent control once a lease has started to insulate

tenants from market price increases (current Berkeley
model)

C. Add rent control to protect both current and new

tenants from market price increases (old Berkeley
model)

D. Add public housing to increase supply and stabilize

prices.
Even without price controls, shortages and queuing can
happen in real world markets due to price rigidity
• Some goods are in higher demand at some times: e.g.,
restaurants on a Saturday night; parking on streets during
football games; etc.

• Not practical or upsetting to customers if sellers adjust prices

in real time (e.g. Uber surge pricing backlash).

• This creates shortages resolved through “inefficient” queuing

[rich person cannot bribe his way to the front]

• Labor market also has queuing: In recessions, unemployed

are queuing for jobs and can’t bid wages down
instantaneously. In booms, employers struggle to find
workers, and can’t bid up wages for new hires only
 References
• CORE-The Economy 2.0, micro, Unit 8.

• Principles of Economics, Chapters 5-6.

• Paul, Mark. 2023. Economists Hate Rent Control. H

ere’s Why They’re Wrong. American Prospect.