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Welfare Analysis • Consumers buy and producer sells. Both benefit from the trade. • You do a hair cut for $80. Your gross benefit in term of money should be larger or at least equal to $80. What is you benefit net of the cost? • I offer the haircut to you for $80. It costs me $80 or less. What is my benefit net of the cost? Welfare Analysis • • • Concepts of these gain (or loss): Consumer surplus: consumer’s net benefit from transactions. Producer surplus: producer’s net benefit from transactions. In economics, these are called welfare analysis. Why welfare analysis? Only after we know the net benefit of some market situations can we decide: Do we need to implement some policies to change the current situation? Is the current institutional arrangement ideal? • Reading: 4.4 Consumer Surplus • The simplest way to evaluate consumers’ benefit from market exchange is to use demand curve. • The idea: People’s valuation of a good is different. The keenest person is willing to pay more. The least enthusiastic person is willing is pay less. However, in most situations (in a competitive market), price charged for the good is the same for all different people. → Those who voluntarily buy is expected to gain from the purchase. Demand • Back to the small town, the 4 long hairs’ maximum money that they are willing to pay for a haircut are: - Amy: $120 - Benny: $80 - Calvin: $50 - Dora: $30 Demand • If market price is $50, Amy, Benny, Calvin will do the deal. • The value of the haircut to Amy is $120. She indeed has a net gain of $70. • Benny’s net gain: $30. • Calvin’s net gain: $0. • Total net gain: $100 = consumer surplus Amy: $120 Benny: $80 Calvin: $50 Dora: $30 Consumer Surplus • Consumer surplus: - Adding up the blue charts. - Adding up the consumer value above the market price. - The part of demand charts (curve) that is above market price. Price of a Haircut 120 70 30 80 50 30 1 2 3 4 Quantity Demanded of Haircut (Unit: No. of Consumers on Saturday) • Another example: Each one may not buy just one unit of a good. Apple. Amy and Benny. • If market price is $4, Amy’s net gain is $6 (buy one apple). Benny’s net gain is $6+$1 (buy 2 apples). Price of Apple Price of Apple 10 Price of Apple 10 Amy 10 Benny Market Demand 5 5 5 2 2 2 1 2 Quantity Demanded of Apple 1 2 3 Quantity Demanded of Apple 1 2 3 4 5 Quantity Demanded of Apple Consumer Surplus Price 2000 A 1000 • If the good is highly divisible (not haircut), we have a demand curve, not charts. • Consumer surplus is the triangle area above price. Quantity 0 5 10 Producer Surplus • Producer surplus: In a competitive market, homogeneous products are sold at one price. • But producers produces products at different costs. Even though price is as low as $2, I may be willing to sell. But you won’t, you require at least $3. • If I can sell it at $3, I won’t sell it at $2, even though I will if I can only sell it at $2. • My surplus is $1 if price is $3. Supply • • • • • • Again, in our small town, four barbers. Kim Robertson requires at least $160 for a haircut. Mr Chan requires at least $110 for a haircut. X-man requires at least $80. Regina requires at least $60. Note that the lowest price required should reflect the barber’s cost of providing the service. The X-man doesn’t want to do the job because doing some other thing (e.g. sleeping) should give him a value of $80. • The value of the next best alternative to X-man is $80. The opportunity cost of the haircut job is $80. Supply • Suppose the market price is $100. • Only X-man and Regina do. • X-man’s net gain is $20. • Regina’s net gain is $40. • Total net gain is $60 = producer surplus. Kim: $160 Mr Chan: $110 X-man: $80 Regina: $60 Producer Surplus • Producer surplus: - Adding up the yellow charts - Adding up the value in excess of cost by suppliers - The area between price and supply charts. Price of Haircut 160 120 110 80 60 50 30 1 2 3 4 Quantity Demanded of Haircut (Unit: No. of Consumers on Saturday) Producer Surplus Price ($ per unit) S Quantity •Similarly, if quantity is highly divisible, we’ll get a smooth supply curve. •Producer surplus is the triangle below the price and above the supply curve. Welfare in Market Equilibrium • Surely, price is not arbitrarily determined. In equilibrium, there is only one price sustaining. • Equilibrium price is $80. • Consumer surplus: $40. • Producer surplus: $20. • Total surplus: $60. Price of Haircut 160 120 110 80 60 50 30 1 2 3 4 Quantity Demanded of Haircut (Unit: No. of Consumers on Saturday) Welfare in Market Equilibrium S Price ($ per unit) • Total welfare in this market situation is? • Why P0Q0 is not the welfare? P0 D Q0 Quantity