Chapter 15Economic Efficiency and Welfare AnalysisSlide 3Slide 4Slide 5Slide 6Welfare Loss ComputationsSlide 8Slide 9Slide 10Slide 11Price ControlsSlide 13Slide 14Slide 15Slide 16Slide 17Slide 18Slide 19Slide 20Disequilibrium BehaviorTax IncidenceSlide 23Slide 24Slide 25Slide 26Slide 27Slide 28Slide 29Slide 30Deadweight Loss and ElasticitySlide 32Slide 33Transactions CostsGains from International TradeSlide 36Slide 37Effects of a TariffSlide 39Estimates of Deadweight LossesSlide 41Other Trade RestrictionsImportant Points to Note:Slide 44Slide 45Slide 46Slide 47Chapter 15APPLIED COMPETITIVE ANALYSISCopyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.MICROECONOMIC THEORYBASIC PRINCIPLES AND EXTENSIONSEIGHTH EDITIONWALTER NICHOLSONEconomic Efficiency and Welfare Analysis•The area between the demand and the supply curve represents the sum of consumer and producer surplus•This area is maximized at the competitive market equilibriumEconomic Efficiency and Welfare AnalysisQuantityPriceP *Q *SDConsumer surplus is thearea above price and belowdemandProducer surplus is thearea below price andabove supplyAt output Q1, total surpluswill be smallerEconomic Efficiency and Welfare AnalysisQuantityPriceP *Q *SDQ1At outputs between Q1 andQ*, demanders would valuean additional unit more thanit would cost suppliers toproduceEconomic Efficiency and Welfare Analysis•Mathematically, we wish to maximizeconsumer surplus + producer surplus =  Q QdQQPQUdQQPPQPQQU0 0)()(])([])([•For the equilibria along the long-run supply curve, P(Q)=AC=MCEconomic Efficiency and Welfare Analysis•Maximizing total surplus with respect to Q yieldsU’(Q)=P(Q)=AC=MC•This implies that maximization occurs where the marginal value of Q to the representative consumer is equal to market price–this occurs at the market equilibriumWelfare Loss Computations•Use of consumer and producer surplus notions makes possible the explicit calculation of welfare losses caused by restrictions on voluntary transactions–in the case of linear demand and supply curves, the calculation is simple because the areas of loss are often triangularWelfare Loss Computations•Suppose that the demand is given byQD = 10 - P and supply is given byQS = P - 2•Market equilibrium occurs where P*=6 and Q*=4Welfare Loss Computations•Restriction of output to Q0=3 would create a gap between what demanders are willing to pay (PD) and what suppliers require (PS)PD = 10 - 3 = 7PS = 2 + 3 = 5The welfare loss from restricting outputto 3 is the area of a triangleWelfare Loss ComputationsQuantityPriceSD64753The loss = (0.5)(2)(1) = 1Welfare Loss Computations•The welfare loss will be shared by producers and consumers•In general, it will depend on the price elasticity of demand and the price elasticity of supply to determine who bears the larger portion of the loss–the side of the market with the smallest price elasticity (in absolute value)Price Controls•Sometimes the government may seek to control prices at below equilibrium levels–will lead to a shortage•We can look at the changes in producer and consumer surplus from this policy to analyze its impact on welfarePrice ControlsQuantityPriceSSDLSP1Q1Initially, the market isin long-run equilibriumat P1, Q1Demand increases to D’D’Price ControlsQuantityPriceSSDLSP1Q1D’Firms would begin toenter the industryIn the short run, pricerises to P2P2The price would endup at P3P3Price ControlsQuantityPriceSSDLSP1Q1D’P3There will be a shortage equal toQ2 - Q1Q2Suppose that thegovernment imposesa price ceiling at P1This gain in consumersurplus is the shadedrectanglePrice ControlsQuantityPriceSSDLSP1Q1D’P3Q2Some buyers will gain because they can purchase the good for a lower priceThe shaded rectangletherefore represents apure transfer fromproducers to consumersPrice ControlsQuantityPriceSSDLSP1Q1D’P3Q2The gain to consumers is also a loss to producers who now receive a lower priceNo welfare loss thereThis shaded trianglerepresents the value of additional consumer surplus that would have been attained without the price controlPrice ControlsQuantityPriceSSDLSP1Q1D’P3Q2This shaded trianglerepresents the value of additional producer surplus that would have been attained without the price controlPrice ControlsQuantityPriceSSDLSP1Q1D’P3Q2This shaded arearepresents the total value of mutually beneficial transactions that are prevented by the governmentPrice ControlsQuantityPriceSSDLSP1Q1D’P3Q2This is a measure of the pure welfare costs of this policyDisequilibrium Behavior•Assuming that observed market outcomes are generated byQ(P1) = min [QD(P1),QS(P1)] suppliers will be content with the outcome but demanders will not•This could lead to black marketsTax Incidence•To discuss the effects of a per-unit tax (t), we need to make a distinction between the price paid by buyers (PD) and the price received by sellers (PS)PD - PS = t•In terms of small price changes, we wish to examinedPD - dPS = dtTax Incidence•Maintenance of equilibrium in the market requiresdQD = dQS orDPdPD = SPdPS•Substituting, we getDPdPD = SPdPS = SP(dPD - dt)Tax Incidence•We can now solve for the effect of the tax on PDDSSPPPDeeeDSSdtdP•Similarly,DSDPPPSeeeDSDdtdPTax Incidence•Because eD  0 and eS  0, dPD /dt  0 and dPS /dt  0•If demand is perfectly inelastic (eD=0), the per-unit tax is completely paid by demanders•If demand is perfectly elastic (eD=), the per-unit tax is completely paid by suppliersTax Incidence•In general, the actor with the less elastic responses (in absolute value) will experience most of the price change caused by the taxSDDSeedtdPdtdP//Tax IncidenceQuantityPriceSDP*Q*PDPSA per-unit tax creates awedge between the pricethat buyers pay (PD) andthe price that sellers receive (PS)tQ**Buyers incur a welfare lossequal to the shaded areaTax IncidenceQuantityPriceSDP*Q*PDPSQ**But some of this loss goesto the government in theform of tax revenueSellers also incur a welfareloss equal to the shaded areaTax IncidenceQuantityPriceSDP*Q*PDPSQ**But some of this loss goesto the government in theform of tax revenueTherefore, this is the dead-weight loss from the taxTax IncidenceQuantityPriceSDP*Q*PDPSQ**Deadweight Loss and Elasticity•All nonlump-sum taxes involve deadweight losses–the size of the losses will depend on the elasticities of supply and demand•A linear approximation to the