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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Evaluating Policy Interventions
In economics we like to measure the impact government policies have on the economy and
separate winners and losers. This way we can properly assess the effectiveness of the policy
and determine whether it is having its intended result.
Marginal Benefit - the extra happiness that a person receives from consuming one more
unit of a good or service.
Marginal Cost - the additional cost (including opportunity cost) of producing one more
unit of a good or service.
Willingness to Pay and Demand
Since we derived the demand curve by asking the question: If the price of the product is
$x how many units would you like to buy? Therefore, the demand curve is the maximum
amount that an individual is willing to pay for the last unit of a good or service consumed.
The maximum amount they are willing to pay for a particular unit is equal to the marginal
benefit they receive from consuming that unit.
Consumer Surplus (CS)
Since people are not forced to pay the maximum price they are willing to pay for each unit,
they receive a consumer surplus. The value of a good minus the price paid for each unit
consumed.
Consuming Infinitely Divisible Units Vs. Whole/Partial Units
Products are sold in either infinitely divisible units or whole units only. Products like gasoline
can be purchased in the exact amount you would like; these are infinitely divisible. Other
products can only be purchased in specific increments. It’s not possible to purchase half a
bottle of soda or half of a slice of pizza.
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Consumer Surplus with Whole Units
CSn =
n
X
(M Bi − P )
i=1
Assume QD = 10 - P and the P = $7
If the price of the product is $7 then the consumer will buy 3 units. The individual is willing
to pay $9 for the first unit, $8 for the second unit and $7 for the third unit.
P3 However she
pays only $5 for each unit. Therefore, the consumer surplus will be CS3 = i=1 (M Bi − P )
= (9 - 7) + (8 - 7) + (7 - 7) = $3.
Consumer Surplus with Infinitely Divisible Units
If however, the individual can consume infinitely divisible units then we calculate the Consumer Surplus as the area of the triangle between the demand curve and the price paid for
the product. Often times this is a triangle or trapezoid but this is not always the case.
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Producer Surplus (PS)
Since firms are not forced to receive the minimum price for which they are willing to sell
each unit, they receive a producer surplus. The producer surplus is the price of the good
received minus the minimum supply price for each unit consumed.
Producer Surplus with Whole Units
n
X
P Sn =
(P − M Ci )
i=1
Assume Qs = P and the P = $3
If the price of the product is $3 then the firm will sell 3 units. The firm is willing to sell the
first unit for $1, the second unit for $2 and the third unit P
for $3. However it receives $3 for
each unit. Therefore, the producer surplus will be P S3 = 3i=1 (P − M Ci ) = (3 - 1) + (3 2) + (3 - 3) = $3.
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Producer Surplus with Infinitely Divisible Units
If however, the firm can sell infinitely divisible units then we calculate the Producer Surplus
as the area of the triangle between the supply curve and the price received for the product.
Social Welfare1 (SW) - The aggregate benefit to society due to the existence of a good
or service. In the previous cases there are only two types of actors in the market consumers
and firms therefore Social Welfare is given by the following equation, SW = CS + PS. In
later cases government will levy a tax or provide a subsidy changing the Social Welfare to
the following equation, SW = CS + PS + TAX or SW = CS + PS - SUB.
1
Note: When determining the social welfare for a particular market you need to remember to include all
participants in the market and measure the amount of happiness they receive because the market exists.
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Underproduction
When the market produces a quantity less than the equilibrium quantity then the MSB>MSC.
Conceivably, we could pay firms a lump-sum to increase production.
Overproduction
When the market produces a quantity greater than the equilibrium quantity then the
MSC>MSB. If firms produce a lower quantity than equilibrium then a social planner could
make society better off by reducing the quantity produced.
Deadweight Loss - the decrease in social welfare that results from producing an inefficient
quantity.
The Minimum Wage
The minimum wage is a price floor is imposed by the government. When binding, it forces
firms to pay a higher wage than what would have been determined in equilibrium. Since
firms are forced to pay a higher wage there is a decrease in the quantity of labor demanded.
Likewise, this higher wage induces individuals to increase their quantity of labor supplied,
creating an excess supply (or surplus) of labor and causes unemployment. Under normal
circumstances the wage would lower to achieve equilibrium, but due to governmental policy
this is prevented. Instead, firms decide to decrease the quantity of labor demanded leaving a
number of those who had jobs unemployed. In addition, since the number of people looking
for a job has increased and the number of available jobs has decreased it will be even more
difficult to move from being unemployed to employed.
Fair Labor Standards Act of 1938
• Established federal minimum wage at $0.25 an hour.
• Increased or expanded coverage to additional workers 29 times.
• Last change effective July 24, 2009 raised the minimum wage from $6.55 to $7.25 an
hour.
• Each state may set its minimum wage higher than the federal minimum. Currently
the minimum wage in New York State is $8 per hour. It will increase to $8.75 per hour
starting January 1, 2014 and to $9.00 per hour starting January 1, 2015.
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Taxes
In the previous discussion of equilibrium the price paid by consumers to purchase a product was equal to the price received by firms. When taxes are imposed the price paid by
the individual consumer (P P ) is greater than that received by the selling firm (P R ). The
relationship between the price paid and that received is:
PP = PR + T
(1)
where T is the per unit tax levied on consumers.
If the government imposes a per unit tax on firms the relationship is:
PR = PP − T
(2)
Government Imposes a Tax on Consumers
If government levies a per unit tax on consumers then we need to substitute Equation (1)
into the demand equation and then solve for equilibrium.
To illustrate this we will use the following information:
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
QD = 10 − P P
QS = P R
T = 2
(3)
From before we know that the equilibrium price is $5 and that the equilibrium quantity is 5
units. Setting supply and demand equal results in:
QD = Qs
10 − P P = P R
(4)
At this point we have 1 equation and 2 unknowns (P P , P R ). This is where we need the
information on taxes. Since, the tax is imposed on the buyer we use Equation (1).
10 − (P R + 2)
10 − P R − 2
8
R
P
=
=
=
=
PR
PR
2P R
4
Now that we know the price that sellers receive we can plug this into the supply equation to
calculate the equilibrium level of output. (Q∗T = 4) We can also find out the price purchasers
pay. (P P = P R + 2 = 6) Revenue raised from the tax is equal to T·Q∗T . (TR = $8)
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Government Imposes a Tax on Firms
When government enacts a per unit tax to be paid by firms we have to modify the supply
function by substituting Equation (2) into the supply equation. This is just like what we
did when calculating equilibrium with a tax on buyers. Using the same information we now
impose a $2 tax on firms.
10 − P P
10 − P P
12 − P P
12
PP
=
=
=
=
=
PR
(P P − 2)
PP
2P P
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Now that we know the price that consumers pay we can plug this into the demand equation
to calculate the equilibrium level of output. (Q∗T = 4) We can also calculate the price firms
receive. (P R = P P - 2 = 4) Revenue raised from the tax is equal to T·Q∗T . (TR = $8)
You should notice that it makes no difference if the tax is imposed on consumers or firms.
Consumers end up paying $6 and firms end up receiving $4 with an equilibrium quantity of
4 units. Furthermore, in this instance consumers and firms end up dividing the tax equally.
Consumers used to pay $5 for the product and are now forced to pay $6. So, they are paying
$1 more for the same product and therefore $1 of the $2 tax. Firms used to receive $5 for
their product but now they only get $4. So, they also pay $1 of the $2 tax.
In general, the largest tax burden is borne by the group that is less sensitive to price changes,
the elasticity of demand relative to that of supply. In this example the slope of the demand
curve (-1) is the same magnitude as that of the supply curve (1). This is why the tax is
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
divided equally.2 If the slope of the supply curve were greater than 1 in magnitude then
consumers would bear a larger portion of the tax.
Social Welfare and Taxes
Earlier we analyzed the social benefit due to the existence of a market. Social benefit was
initially separated into consumer and producer surplus.
In the diagram above, the consumer surplus is the area of the upper left triangle ($12.50)
while the producer surplus is the area of the lower left triangle ($12.50). Social welfare is
the sum of all participants in the market ($12.50 + $12.50 = $25)
The addition of taxes causes each consumer to pay a higher price for the same product
and purchase fewer units. This means that the consumer surplus has decreased. (The new
consumer surplus is now $8) Likewise, the producer surplus decreases because firms receive
a lower price for their product and sell fewer units. (The new producer surplus is now $8.)
This reduction in consumer and producer surplus is illustrated in the graph below.
2
While it’s true that slope and elasticity are different measurements and we generally can’t compare them
it is possible in this instance because the units on both the x and y axis are exactly the same.
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
The imposition of a tax causes a new participant to gain from the market’s existence, government is going to generate tax revenue. (The amount of tax revenue generated is $8) When
tax revenue is added to the new consumer surplus and producer surplus the total benefit
to society is now $24. This is $1 less than the social welfare without the tax, so society is
worse off because of this policy. The lost $1 of social welfare is called the deadweight loss,
and is illustrated in the above diagram by the 2 very small triangles just to the left of the
intersection of the supply and demand curves.
Subsidies
In the previous discussion, taxes were imposed and the price paid by the individual consumer
(P P ) is greater than that received by the selling firm (P R ). In the case of a subsidy we get
the opposite relationship, the price received by the firm is greater than the price paid by the
consumer. The relationship between the price paid and that received is:
PR = PP + S
(5)
where S is the per unit subsidy given to firms.
If the government gives a per unit subsidy to consumers the relationship is:
PP = PR − S
(6)
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Government Gives a Subsidy to Firms
When government gives a per unit subsidy to firms we have to modify the supply function
by substituting Equation (5) into the supply equation. This is just like what we did when
calculating equilibrium with a tax. Using the same information as the tax example we now
give a $2 subsidy to firms.
10 − P P
10 − P P
8 − PP
8
P
P
=
=
=
=
=
PR
(P P + 2)
PP
2P P
4
Now that we know the price that consumers pay, we can plug this into the demand equation
to calculate the equilibrium level of output. (Q∗S = 6) We can also find out the price firms
receive. (P R = 4 + 2 = 6) The total amount of the subsidy given is equal to S·Q∗S . (Total
subsidy = $12)
You should notice that a subsidy has the opposite effect as a tax on quantity produced.
However, like taxes where the burden was split, the benefit of a subsidy is also divided up
between firms and consumers based upon the relative elasticities of supply and demand.
Here consumers used to pay $5 for the product and now only pay $4. So, they are receiving
$1 of the $2 subsidy. Firms used to receive $5 for their product but now receive $6. So, they
are getting $1 of the $2 subsidy.
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Market Basics - Econ of NA - RIT - Dr. Jeffrey Burnette
Social Welfare and Subsidies
A subsidy causes each consumer to pay a lower price for the same product and therefore she
purchases more units. This means that the consumer surplus increases. (The new consumer
surplus is now $18) Likewise, the producer surplus increases because they receive a higher
price for their product and sell more units. (The new producer surplus is now $18.)
Initially it might appear that society is better off and should therefore subsidize every product
however remember the government had to spend money increase production. When the
amount of the subsidy is subtracted from the sum of the new consumer surplus and producer
surplus the total benefit to society is now $24. ($18 + $18 - $12 = $24) This is $1 less than
the social welfare without the tax, so society is also worse off by this policy. The deadweight
loss is again $1 and is illustrated in the above diagram by the 2 small triangles just to the
right of the intersection of the supply and demand curves.
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