Consumer and Producer Surplus In an un-regulated market, buyers and

sellers buy and sell at the prevailing market price. But, for some consumers the value of the good exceeds this market price. Consumer surplus is equal to the shaded area between market price and demand curve (Fig. 8.1).

Producers too enjoy a benefit i.e. the difference between the market price the producers receives and the marginal cost of producing this unit. Producer surplus is equal to the shaded area between the market price and the supply curve (Fig. 8.1)

Welfare Effects of Government Intervention

Consumer surplus measures the total net benefit to consumers, and thereby measure the gain or loss to consumers from a government intervention

Producer surplus measures the total net benefit to producers, and thereby measure the gain or loss to producers from a government intervention

Application of Consumer and Producer Surplus

With government intervention, the price gets reduced as well as production. This results in excess demand

Change in consumer surplus: The net change

in consumer surplus is equal to A – B (Fig. 8.2)

The rectangle A is larger than triangle B, therefore net change in consumer surplus

is positive

Change in Producer Surplus: With price controls, some producers will stay in the market but will receive a lower price for their output, while other producers will leave the market. The triangle C is the additional loss for those producers who have left the market and those who have stayed but are producing less. Therefore, the total loss is –A – C

Deadweight Loss: The loss to producers is much more than the gain to consumers (Fig8.2). This is known as deadweight loss. The change in consumer surplus is A – B and the change in producer surplus is -A – C. The total change in surplus is therefore (A – B)+ (- A – C)= - B – C, which is given by the two triangles B and C. The deadweight loss reflects an inefficiency caused by price controls, the loss in producer surplus exceeds the gain in consumer gain. ( Example. 8.1, Oil price controls leading to gasoline shortages)

The Efficiency of a Competitive Market: Economic efficiency implies the maximiza tion of aggregate consumer and producer

surplus. A deadweight loss does not always mean that a policy is bad, it may fulfill other

important objectives. Market Failure: market failure occurs because

prices fail to provide the proper signals to consu mers and producers. The unregulated com-

petitive market is inefficient because it does not maximise aggregate consumer and producer

surplus

Market failure can occur because of: Externalities- externalities are costs and benefits that do not show

up as part of the market price (e.g. cost to society of environmental pollution)

Lack of Information: market failure can also occur when consumers lack information about the quality or nature of a product, and therefore cannot make utility-maximizing purchasing decisions. Govt. intervention in the form of labeling may correct the failure

In the absence of externalities or lack of information, an unregulated competitive market does lead to the economically efficient output level

In Fig. 8.5, the price P2 is fixed above the market clearing price

Po. At a higher price, Q3 will be demanded and hence consumer loss is equal to B and producer loss is equal to C. The total deadweight loss B and C gives an optimistic assessment of the efficiency cost of policies that force price above market clearing levels (govt. might buy the unsold output or declares a support price)

Minimum Price Government policies sometimes seeks to

raise prices above market-clearing levels, rather than lower them (minimum wage –

law, resulting in unemployment Fig.8.8)

Government intervention in the form of minimum price can reduce

producers’ profits because of the cost of excess production (Fig. 8.7)

Price Support and Production Quotas The Government sets the market price of

a good above the free-market level and

buys up whatever output is needed to maintain

that price. The Government can also increase

prices by restricting production, either direct

ly or through incentives to producers

Price Supports: Under a Price Support Prog- ramme, the govt. sets a support price,

say Ps in Fig.8.9, and then buys up whatever output is needed to keep the market

price at this level. Impact of Price Support on: Consumers- consumers lose by an amount ∆CS = -A – B Producers- producers gain by an amount ∆PS = A + B + D

The Government: there is also a cost to the government which must be paid for by

taxes, and ultimately be borne by consumers. The cost is equal to (Q2 – Q1)Ps in Fig 8.9.

The cost may be reduced if the government can sell them abroad at a lower price.

The total welfare cost of the policy: ∆CS + ∆PS – Cost to Govt

=D – (Q2 – Q1)Ps

Production Quotas

The government can also cause the price of a good to rise by reducing supply. It can do this by setting quotas on how much each

firm can produce (e.g. control of liquor licen- ces by state governments). In this case the

deadweight loss is equal to triangles B and C. It would be better if Government gives additional

income to farmers equal to A + B + D than giving price supports costing consumers A + B

(Fig. 8.10)

The Impact of a Tax or Subsidy

Tax

What would happen to the price of widgets if the government imposed a $1 tax on every widget sold?

The burden of a tax falls partly on a consumer and partly on a producer

After the imposition of a tax, the price the buyer pays must exceed the net price the seller receives by t cents (Fig. 8.15)

Before the imposition of the tax Po and Qo represent the market price and quantity. After the imposition of a tax Pb is the price the buyer pays and Ps is the net price the seller receives

Buyers lose A + B, sellers lose D + C, and the Govt. earns A + D in revenue. The deadweight loss is B + C

If demand is relatively elastic and supply is relatively inelastic, the burden of the tax will fall more on sellers, and vice versa

In general, a tax falls mostly on the buyer if Ed/Es is small, and mostly on the seller if Ed/Es is large

When the pass-through fraction (Es/Es – Ed) is 1 (totally inelastic), all the tax is borne by consumers. When the pass-through is zero(totally elastic), all the tax is borne by producers

Subsidy A subsidy can be taken as a negative tax.

Like a tax a subsidy is split between buyers and sellers, depending on the relative elasticities of supply and demand

With a subsidy, the sellers’ price exceeds the buyers’ price, and the difference between the two is the subsidy.

In general, the benefit of a subsidy accrues mostly to buyers if Ed/Es is small and mostly to sellers if Ed/Es is large (8.17)