Objective : examine effects of policy

Consider a perfectly competitive market equilibrium

Consumer Surplus = difference between what a consumer is

willing to pay for a good and the amount actually paid
Consumer surplus

It is the area under the demand curve & above the price.
P
S

P*

D
Q* Q
For some producers, equilibrium price is
higher than the minimum price at which
they are willing to produce

For all the producers, this is called

producer surplus
Producer surplus
difference between what the producer receives for the good
and the amount the producer is willing to receive to provide
the good.
It is the area above the supply curve & below the price.
P
S

P*

D
Q* Q
 Social Welfare

Social welfare = consumer surplus + producer surplus.

P
S
P1

D
Q1 Q
As we increase the quantity & reduce the price,
the total area CS+PS increases

P
S
P2

D
Q2 Q
 and increases,

P
S

P3

D
Q3 Q
CS + PS is maximum when we reach the perfectly
competitive equilibrium.

P
S

P*

D
Q* Q
Implication:
social welfare (i.e. total surplus) = CS+ PS

is maximized at the perfectly competitive

equilibrium.
 How to compare the social welfare of
two different situations?
1. Calculate the welfare from situation 1 by summing its
consumer surplus and producer surplus:
W1 = CS1 + PS1.
2. Calculate the welfare from situation 2 by summing its
consumer surplus and producer surplus:
W2 = CS2 + PS2.
3. Calculate the difference,
W2 W1 = (CS2 + PS2) (CS1 + PS1).
This tells us the gain or loss of welfare of one situation
relative to the other.
When a policy results in a loss of welfare to society,
that loss is often referred to as the deadweight loss.
Change in welfare
W2 W1 = (CS2 + PS2) (CS1 + PS1)

An alternative equivalent way is the following.

1. Calculate the change in consumer surplus:

CS = CS2 CS1 .
2. Calculate the change in producer surplus:
PS = PS2 PS1 .
3. Add to get the total gain or loss in social welfare:
CS + PS = (CS2 CS1) + (PS2 PS1)
Why useful?

Examine the welfare effects of some government

policies.

Calculate the benefits and costs of various

economic policies
 Price Ceiling
Without the ceiling what is CS+PS ?
Suppose the Govt. considers the price P* to be too high

P
S

P*

D
Q* Q
With price ceiling, Pc , the consumer & producer
surpluses are as shown.

P
S

Pc

D
Qc Q
Consumers have lost area V but gained area U.

P
S

V
U
Pc

D
Qc Q
The consumers who gain are those who get the product at a lower price.

The consumers who lose are those who are no longer able to buy the
product because less quantity is being supplied.

P
S

V
U
Pc

Qc Q
 If area U > area V, so consumers as a whole gain.
However, if area U < area V, consumers would lose.

P
S

V
Pc U

D
Qc Q
Producers have lost areas U and W.

P
S

U W
Pc

D
Qc Q
 Observe: area U moved from producers to consumers,
But areas V and W are lost by society (consumers + producers)

P
S

V
U W
Pc

D
Qc Q
Area V+W is the difference in the total consumer and
producer surplus with and without the policy
(CS2 + PS2) (CS1 + PS1).
P
S

V V+ W= deadweight
W loss to society that
Pc results from the policy.

D
Qc Q
Price Ceiling Example:
Suppose in the absence of controls, equilibrium price = 8K
& equilibrium quantity = 2 million

8K

D
0 2
 Next suppose that a price ceiling =7 is imposed.
As a result the quantity supplied drops to 1.8 million.

8K
7K

D
0 1.8 2
 Based on the graph, determine the effects
on consumers, producers, & society as a whole.

S
9K
8K
7K

D
0 1.8 2.0
U = (1.8 million) (8,000 7,000) = 1,800 million
V = (1/2)(0.2 million)(1,000) = 100 million
W = (1/2)(0.2 million)(1,000) = 100 million

S
9K
V
8K W
U
7K

D
0 1.8 2.0
Consumers gain
U V = 1,800 million - 100 million = 1,700 million.
Producers lose
U + W = 1,800 million + 100 million = 1,900 million

S
9
V
8 W
U
7

D
0 1.8 2.0
Producers lose 200 million more than consumers gain.
So there is a deadweight loss of 200 million per year.

S
9
V
8 W
U
7

D
0 1.8 2.0
Price Floor
Without the floor, market clears at P*

P
S

P*

D
Q* Q
Suppose a price floor of Pf is imposed

P
S
Pf

D
Qf Q
Consumers lose areas U & V.

P
S
Pf
U V

D
Qf Q
Producers gain area U & lose area W.

P
S
Pf
U
W

D
Qf Q
Again the deadweight loss is area V+W .

P
S
Pf
V
W

D
Qf Q