The Economics of Public Sector,

Externalities -
Supply, Demand & Government Policies
Prof. Dr. Qais Aslam
UCP, Lahore
• Entrepreneur • Innovation Theory of • Productivity
• Wealth Profit • Inflation
• Rationality • Managerial Efficiency • Philips Curve
• Normal Profits Theory of Profit • Scientific Method
• Monopoly • Function of Profit • Economic Models
• Capital • sales maximization • Factors of Production
• Consumer Surplus Model • Production Possibility Frontier
• • Land (PPF)
Elasticity
• • Labor • Microeconomics
Producers surplus
• • Scarcity • Macroeconomics
Inferior goods
• • Economics • Positive Statement
Business versus
Economic Profit • Efficiency • Normative Statement
• Risk bearing Theories of • Equity • Law of demand
Profit • Opportunity Costs • Demand
• Frictional Theory of Profit • Marginal Change • Quantity demanded (dq)
• Monopoly Theory of • Market Economy • Excess demand
Profit • Invisible Hand • Law of supply
• Externality • Market Failures
• Market Power
• Monopoly
• ______________________________________________________________________
______________________________________________________________________
______________________________________________________________
• Stock
• Supply
• Quantity supplied (qs)
• Excess supply
• Market
• Equilibrium Price
• Equilibrium quantity
• Competitive market
• Market Power
• Monopoly
• Consumer loyalty
 Hand Written
To be submitted on the day of Mid Term
• Assignment 1 Elasticity of Demand & Supply and
• Assignment 2 Indifference Curve Analysis
To be submitted on day of Final Exam
• Assignment 3. Pricing of factors of Production and Cost of
Production. Costs curves
• Assignment 4. Revenue curves under Perfect Competition &
Monopoly
 Market Equilibrium and Price
•• Market
  equilibrium is a point at which the supply and
demand curves intersect.
• The prices of the two curves cross and therefore this is
the Market equilibrium Price for a good or service.
• Market price is only and only determined by the
equilibrium (intersection) of the forces of market
demand and market supply

qd = qs
Market Price and equilibrium
S

E
Price (P)

Quantity Demanded (qd) and quantity Supplied (qs)

 Consumer surplus
• Consumer surplus = a buyers willingness to pay minus the
amount the buyer actually pays
• Consumer surplus measures the benefit to buyers of
participating in a market
• When the price falls the quantity demanded rises and the
consumer surplus rises. The increase in surplus rises,
because the existing consumer now pays less and in part
because new consumer enter the market at a lower price
and vive versa
• consumer surplus reflects economic wellbeing of the
households
 Change in Price, Willingness to Pay & Consumer
Surplus
• Each buyer’s Utility maximum is called willingness to pay and it measures
how much that buyer values the good
• The height of the demand curve reflects the buyer’s willingness to pay
• At any price given by the demand curve shows the willingness to pay of
the marginal buyer, the buyer who would leave the market first if the
price were any higher
• Consumer Surplus is the amount a buyer is willing to pay for a good
minus the amount the buyer actually pays for it
• Consumer surplus is closely related to the demand curve
• The area below the demand curve and above the price measures the
consumer’s surplus in the market
• The difference between the willingness to pay and the market price is
each buyer’s consumer’s surplus
 Consumer Surplus: If Price of Good reduces from Rs. 100 to Rs. 80 Consumer
surplus is Rs. 20 & If price reduces to Rs. 70 Consumer surplus is Rs. 40
Price Price
(P) (P)
Willingness to pay of Consumer surplus to consumer
Rs. 100 consumer 1 1 of Rs. 20 at price Rs. 80
Consumer surplus of consumer
1 Rs. 20 at price Rs. 80 and is Willingness to pay of
Rs. 30 at price Rs. 70 consumer 2 Consumer surplus to consumer 2
Rs. 80 Consumer surplus of consumer 2
is Rs. 10 at price Rs. 70
is Rs. 10 at price Rs. 70 Willingness to pay of
Rs. 70
consumer 3
Total Consumer surplus of Additional Consumer surplus to
Willingness to pay of
consumer 1 & 2 is Rs. 40 consumer 1 of Rs. 10 at price Rs. 70
consumer4
at price Rs. 70

Demand

q1 q2
Quantity Demanded (qd)
 Explanation of Consumer Surplus Graph
• On the right side is the downward sloping demand curve (Red line) which shows how much
market demand is going to contract or expand at different price levels
• On the left side is the participation of different consumers in the market at different price
levels (blue lines) and the consumer’s surplus (increase or decrease) as price rises or falls
• If the Market price is PRK 100 there is assumed one consumer in the market that can afford
the commodity at that price
• As Price decreases from PRK 100 to PRK 80 than a second consumer can afford the
commodity at that price and the first consumer will have a surplus of PRS 20 (marked with
red on the left panel) and
• it depends whether the PRK 20 surplus will be spent on the product (Price Effect), or on some
other product demand (Substitution effect) or will be saved by the consumer (Income effect)
• If the price falls to PRK 70, than a third consumer can afford the commodity at that price and
the second consumer has a surplus of PRK 10 (marked with blue on the left panel), while the
first consumer has a surplus of total of PRK 30.
• or a total of consumer surplus of PRK 40 in the market when Price falls from PRK 100 to PRK
70 = PRK to consumer 1 + PRK 10 to consumer 2
 What does Consumer Surplus Measures
• The goal in developing the concept of Consumer surplus is to make normative
judgements about desirability of market outcomes
• Consumer surplus, the amount that the buyers are willing to pay for a good
minus the amount they actually pay for it, measures the benefit that the
buyers receive from a good as the buyers themselves perceive it.
• Thus, consumer surplus is a good measure of economic wellbeing if
policymakers want to respect the preferences of the buyers
• (In some markets, consumer surplus does not reflect economic wellbeing)
• Economists normally presume that buyers are rational when they make
decisions and that their preferences should be respected, because consumers
are the best judge of how much benefit (utility) they receive from goods that
they buy
 Producer Surplus (Profits of the sellers)
• Producers surplus is the amount a seller is paid for a good
minus the sellers costs (Profits)
• When price rises, the quantity supplied increases, the
producers surplus rises. The increase in producers surplus
occurs in part because the existing producers now receive
more and in parts because new producers enter the market
at a higher price levels
• producer surplus also reflects economic wellbeing of the
sellers
Change in Price, Costs & Willingness to Sell
• Producers surplus is the amount a seller is paid minus
the cost of the product that is sold
• Producer surplus measures the benefit (Profit) to the
sellers of participating in the market
• Producers surplus is closely related to the supply
curve which is derived from the costs of all the sellers
of a particular good in the market
 If Price of Good Increases from Rs. 500 to Rs. 600 Producer surplus is Rs. 100
Supply
& If Price Increases from Rs. 600 to Rs. 800 Producer surplus is Rs. 300
Price
Pric (P)
Supply
e (P) Total Producer surplus of
producer 1 & 2 Rs. 300 Additional Producer surplus to
at price increase from producer 1 is Rs. 300 at price Rs. 800
Rs. 500 to Rs. 800
Rs. 900
Cost to producer 4
Rs. 800 Cost to producer 3
Producer surplus of
Producer surplus of producer 2 producer 2 Rs. 200 at price
Rs. 200 at price increase from increase from Rs. 600 to Rs.
Rs. 600 to Rs. 800 800
Rs. 600
Cost to producer 2
Rs. 500
Cost to producer 1 Initial Producer surplus of
Producer surplus of producer 1
Rs. 100 at price increase from producer 1 Rs. 100 at price
Rs. 500 to Rs. 600 and is increase from Rs. 500 to Rs. 600
Rs. 300 at price Rs. 800
q1 q2
Quantity supplied (qs)
 Explanation of Consumer Surplus Graph

• On the right side is the Supply curve in the market of a commodity

• On the left side is the participation of different sellers in the market at
different prices
• At Market Price PRS 500 only one seller supplies his commodities,
because his input cost is less than this price and he makes profits
• As price rises from PRK 500 to PRK 600, a second seller enters the market
while the first seller has a surplus (Profit) of an addition PRK 100.
• As Price rises to PRK 800, a third seller enters the market, the second
seller has a surplus of PRK 200, while the first seller now has a total
surplus (profit) of PRK 300
• A total Market surplus when price increases from PRK 500 to PRK 800 is
PRK 400 (100 plus 300) and so on as price would increase and vice versa
 What does Producer’s Surplus Measure
• The area below the Price and above the supply curve measures Producer’s
surplus
• The logic is straightforward: the height of the supply curve measures seller’s
costs and the difference between the price and the cost of production is each
seller’s producer surplus
• Thus the total area is the sum of the producer’s surplus of all the sellers
• The shaded area shows just how much the producers (seller’s) wellbeing
(Profit) for each producer rises in response to higher prices.
• The pink area shows the producer surplus of seller with the least costs of
production,
• while the blue area shows the producer surplus of the seller with the seller
who has the second least costs,
• while both the pink & blue areas show the producers surplus of both the
sellers with a rise in Price from Rs. 500 to Rs. 800
 Free Market Efficiency vs (Government Intervention) Benevolent Social Planner

Consumer surplus + Producers Surplus = Total Surplus (or

Society's total wellbeing) = total value to buyers plus total
value to producers
Market Efficiency
• Customer’s surplus and the Producers surplus are the basic
tools that economists use to study the wellbeing of buyers
(utility) and sellers (Profits) which is the result of free market
interaction of forces of supply & demand through hidden
hand of self-interest
• If the allocation of resources maximizes surpluses there is
Efficient Allocation of Resources
 Benevolent Social Planner (Government) & Equity
Benevolent Social Planner is an all knowing, all powerful, well-
intentional dictator who wants to maximize the economic
wellbeing of every one in the society
If the Benevolent Social Planner increase price, the consumer
surplus will decrease while the producers surplus will increase (or
total surplus does not change) growth suffers
If the Benevolent Social Planner decreases price, the consumer
surplus will increase while the producers surplus will decrease (or
total surplus does not change) growth suffers
i.e. Nobody should interfere with market Price except free market
forces of demand and supply
 Governments can sometimes improve Market outcome or to ensure Equity

• There are three reasons why governments intervene in the economy

–
• Governments intervene to improve market efficiency :
Or
• Governments intervene to promote equity
Or
• Governments intervene when Markets fail
• Market failure - when the market fails to allocate resources
efficiently and does not promote welfare or wellbeing of the stake
holders because of (a) Monopoly on supply side and (b) poor people
(poverty) on demand side 19
 Price floor and Price ceiling
• Price floor: is a legal minimum on the price at which goods
can be sold
• Price ceiling: is a legal maximum at which goods can be sold
• Price control are often aimed to help the poor
• But price controls often hurt the poor
• Economists suggest rent and wage subsidies rather than
price controls in order to help the poor
• But subsidies increase government expenditures, therefore
require higher taxes
• Governments use taxes to raise revenues
 Control on Prices

• We will analyze various types of government policies using only

tools of supply & demand
• We start with policies that directly control Prices
• Because buyers always want to pay less prices for a product and
suppliers want higher prices for the same product, therefore
both the interests of these groups conflict
• There are two types of price control
1. Price Ceiling &
2. Floor Pricing
 How Pricing ceiling Effects Market outcomes
• With a Price ceiling on a competitive market, a shortage of the goods arises and
sellers must ration the scarce goods among the large number of potential buyers
• Rationing mechanism is undesirable, because
1. Long lines of buyers occur, which waste buyers time
2. Discrimination happens according to sellers bias towards consumers which is
both inefficient and potentially unfair
3. Reduces the incentive in producers to produce and supply more goods &
services
4. Although government prevents prices to rise for equity reasons and protecting
the poor, but it creates shortages and pricing policies do not create incentives
to ship supplies from other regions into the area where there is a deficit
• Rationing mechanism in a free competitive market (without government
intervention) is both efficient, desirable and impersonal
 How Price Ceiling Effect the Market
• Price Ceiling is a legal maximum on the price at which a good can be sold
• When the government wants to protect the buyers of a certain good i.e..
Bread, it imposes a price ceiling in the market for bread
• Two outcomes are possible: (Figure 1)
• (a) Not Binding price Ceiling (b)Binding Price Ceiling
Supply
Price
Price Supply
of
of
Bread Price Bread
Ceiling
Equilibrium Equilibrium
Price Price
Price
Ceiling
Shortages
Demand
Demand
Quantity Supplied (qs) Quantity Demand (qd)
Quantity (q)
 Explanation of Figure 1

• In Panel (a), the government imposes a price ceiling on every piece of bread sold. If the market
price is below the price ceiling imposed by the government the price ceiling is not binding.
• Market forces naturally move the economy to the equilibrium, and the price ceiling has no
effect on the price or the quantity sold
• In Panel (b) the government imposes a price ceiling that is below the market price, therefore
the ceiling is binding constraint to the free flow of market forces.
• The forces of supply and demand tend to move the price towards the equilibrium price, but
when the market price hits the ceiling, it can not, by law, raise any further.
• Thus the market price equals the price ceiling.
• At this price, the quantity of bread demanded exceeds the quantity supplied
• There would be a shortage of bread at the low price ceiling
• Although the price ceiling was designed to help the buyers, it ends up sellers rationing bread
and not all buyers benefit
• Some buyers would benefit from this low price even if they have to wait in long lines to get this
cheap bread
• The result shows that when governments impose a binding price ceiling on a
competitive market, a shortage of the good arises, and sellers ration the scarce
good among the large number of potential buyers and a black market which is
near the market price occurs
• Rationing mechanism that develops under price ceiling are rarely desirable,
because
• Long lines are inefficient, they are often unfair and take away much needed
work time or leisure time from the buyers and reduces profits of the sellers
• By contrast the rationing mechanism of a free comparative markets is both
efficient and impersonal
• When the free market forces reaches its equilibrium only those who are
willing to pay the price buy the good, therefore
• Free market rations goods with price
 Fig 2. Market for Oil with Price Ceiling
Price s2
of Oil

s1
2. Supply falls
P2

3. Binding
Price Ceiling
4. Shortages

E
P1 1. Equilibrium Price determined by Market Forces

d1

qd q1 Quantity of Oil
qs
 Explanation of Figure 2.
• We know that OPEC reduces production of crude Oil, thereby increasing its price in the world
market
• Because crude oil is major input in petrol products, the higher oil prices reduces supply of petrol
products because costs increase and demand decreases and lines at petrol stations increase
• Although OPEC increased the price of input but people blame their own governments for
regulating the prices and supply of petroleum products that limit the price oil companies could
charge for petrol
In Figure 2.
1. The market price (P1) at market equilibrium of demand and supply
2. The increase in oil prices shift the supply curve leftwards from s1 to s2 raising the price to P2.
3. But there is a Price ceiling which is binding by government regulations and does not allow the
price to rise to p2
4. At the binging of price ceiling, consumers are willing to buy qd quantity while the sellers are
only willing to sell qs quantity, The difference between qs – qd represents shortages of petrol
in the market due to price ceiling
 How Pricing Floor Effects Market
outcomes
• Price floor: is a legal minimum on the price at which goods can be sold
• Binding price floor comes as a surplus
• With price floor some sellers are unable to sell and go out of business
• Sellers who appeal to personal bias of the buyers are better able to sell
• Price floor is a minimum wage and the impact of minimum wage depends
upon the skill of the worker
• Higher skilled worker are not effected by minimum wage, but low skilled
workers, women and teenagers usually accept wages below minimum wage
in exchange for a job – some economists think that minimum wage is a
poorly targeted policy
 How Price Floor Effect the Market
• Price Floor is a legal minimum on the price at which a good can be sold
• When the government wants to protect the sellers of a certain good i.e..
Bread, it imposes a price floor in the market for bread
• Two outcomes are possible: (Figure 3)
• (a) Not Binding price Floor (b)Binding Price Floor
Supply
Price
Price Supply
of
of Bread Surplus
Bread Price Floor

Equilibrium Equilibrium
Price Price

Price floor
Demand
Demand
Quantity Demand (qd) Quantity Supplied (qs)
Equilibrium Quantity (q)
 Explanation of Figure 3
• In Panel (a), the government imposes a price floor on every piece of bread sold. If
the market price is above the price floor imposed by the government the price
floor is not binding and has no effect on the market outcome.
• Market forces naturally move the economy to the equilibrium, and the price floor
has no effect on the price or the quantity bought (demand) and quantity sold
(supply)
• In Panel (b) the government imposes a price floor that is above the market price,
therefore the floor is binding constraint to the free flow of market forces.
• Because more quantity of bread is supplied when less is demanded, at price floor,
there occurs a surplus of bread and
• Sellers with personal ties to the buyers might be able to sell their goods, the rest
do not
• But in free Market the Market price serves as the rationing mechanism, and all
sellers can sell all their product at market price where it is demanded freely by
the buyers
 Fig 4. How Minim Wage Effect the Labor Market
• Panel (a) shows labor market in which the wage adjusted to balance labor supply to labor demand.
Experienced and skilled workers are not effected by minimum wage because their wages are well
Above The Minimum Wage
• Panel (b) shows the impact of a binding minimum wage as floor pricing
• Because the minimum wage is a price floor, it causes a surplus.
• The quantity of labor supplied exceeds the quantity demanded. The result is unemployment
• a)wage
Free Labor Market (b)Binding Price Floor as Minimum Wage on the Labor market
Labor
Labor wage Supply
of
Supply of
labor labor Labor Surplus &
Unemployment Price Floor

Equilibrium Equilibrium
wage wage

Labor Labor
Demand Demand
Quantity Demand (qd) Quantity Supplied (qs)
Equilibrium Quantity (q)
 Evaluating Price Control
• Markets are usually a good way to organize economic activity
• To economists market Price is the result of millions of business decisions by buyers
(demand) and sellers (supply) in different markets every day
• When policy makers set legal limits (ceiling or floor) to Price they obstruct the signals that
normally guide the allocation of societies resources
• At the same time there are markets failures (monopoly on the supply side and poverty on
the demand side)
• Therefore governments can some time improve market outcomes and if policymakers
think that the market outcome is unfair they are motivated to control prices to help the
poor (demand) or the sellers (supply)
• Yet price control often hurt those that they are trying to help
• Therefore often government resorts to alternate non-price measures to help the poor
• Although these alternate policies are often better than price control but they are costly
and not perfect. i.e. rent and wage subsidies or taxation
 Cost of Taxation
• All governments, federal and local use taxes to raise revenue for public projects, such as
roads, schools and national defense etc.
• Because taxes are an important policy instruments and effect our life it is important to
see how taxes affect the economy
• Tax incidence is the manner in which the burden of a tax is shared among the
participants in the Market
How Taxes on Sellers Affect market Outcome?
• When governments impose a tax on the sellers (indirect Tax) of x commodity
• Tax put a wedge between quantity of goods demanded and quantity of goods supplied
• (a) The immediate impact is on the sellers.
• Because tax is not levied on the buyers, the quantity of good x, the qd does not
immediately change.
• Tax on sellers makes the sale of good x less profitable at any given price, therefore there
is a shift of the supply curve to the left
 Fig. 5 Tax on Sellers With tax supply
curve shifts
Explanation of Fig. 5
S2 leftwards Tax on Sellers
• would shift the supply curve
S1
leftwards from s1 to s2
• The equilibrium quantity falls from
P3 Price E2 Equilibrium with tax
buyers pay q1 to q2
with tax
Tax
• Price increases from P2 to P3 due
P2 Market E1 equilibrium without tax
Price without to tax
tax • The buyers pay more from p2 to
P1 Price p3
sellers
receive • The sellers get less from p2 to p1
• The difference between p2 and p3
D1 is taken by the government as tax
• Even though the tax is levied on
sellers, the buyers and sellers
q2 q1 share the burden of tax depending
on elasticity of demand
• When the government imposes tax on the buyers
• (b) The immediate impact is on the buyers from a tax on buyers
• because the demand of commodity x would fall from q1 to q2. the demand
curve would shift from d1 to d2
• The buyers would pay a price to the sellers and a tax to the government for
the same commodity, therefore tax would shift the demand curve leftwards
• Because the buyers look at the final price which includes the tax as the
buying price, the demand therefore falls
• Tax on commodity x reduces its quantity in the market therefore the buyers
and sellers share the burden of the tax
• Therefore tax levied on the sellers and tax levied on the buyers are
equivalent
• The only difference is who sends the money to the government
 Fig. 6 Tax on Buyers
Explanation of Fig. 6
Tax on Buyers
• would shift the demand curve
leftwards from d1 to d2
s1 • The equilibrium quantity falls
P3 Price
buyers pay from q1 to q2
with tax
P2 Market Tax
• Price increases from P2 to P3
Price without E1 equilibrium without tax due to tax
tax
P1 Price E2 Equilibrium with tax
• The buyers pay more from p2 to
sellers
receive
p3
• The sellers get less from p2 to p1
d1 • The difference between p2 and
d2
With tax p3 is taken by the government
demand curve as tax
shifts leftwards
• Even though the tax is levied on
q2 q1 buyers, the sellers and buyers
share the burden of tax
 Elasticity and Tax Burden
• When a good is taxed, buyers and sellers of the good share the burden of the
tax. But how the tax burden is divided? Fig 8. When
• Rarely Tax burden is shared equally demand is
more elastic
P3 Price P3 Price s than supply
buyers pay s buyers pay the
with tax with tax
incidence of
P2 Market tax falls
Price without more
Tax tax Tax
P2 Market heavily on
Price without
tax
Fig 7. When supply suppliers &
is more elastic than producers
P1 Price demand the
sellers
P1 Price (P1-P2)
receive incidence of tax sellers d than on
receive
d falls more heavily buyers (P2-
on consumers (P2- P3)
P3) Than on sellers
(P1-P2)