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Microeconomics

PGP-I

Session 9 & 10

Producer Surplus

Definition:
Definition: Producer
Producer Surplus
Surplus isis the
the area
area above
above the
the market
market
supply
supplycurve
curveand
andbelow
belowthe
themarket
marketprice.
price.
ItIt isis aa monetary
monetary measure
measure of
of the
the benefit
benefit that
that producers
producers
derive
derivefrom
fromproducing
producingaagood
goodatataaparticular
particularprice.
price.

Producer Surplus
Further, since the market supply curve is
simply the sum of the individual supply
curves
The difference between price and the
market supply curve measures the surplus
of all producers in the market.

Producer Surplus
P
Market Supply Curve
P*
Producer Surplus

The Costs of Four Possible Sellers

The Supply Schedule and the Supply


Curve
Price of House
Painting
Supply
Marys cost
$900
800

Fridas cost

600
500

Georgias cost
Grandmas cost

Quantity of Houses Painted

The table shows the supply schedule for the sellers . The graph shows the
corresponding supply curve. The height of the supply curve reflects sellers costs.
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Measuring Producer
with the Supply Curve(b) Price = $800
(a) PriceSurplus
=
$600Painting
Price of House

Price of House Painting


Supply

$900

$900

800

800

600
500

600
500

Grandmas producer
surplus ($100)

Supply

Total producer
surplus ($500)

Georgias producer
surplus ($200)
Grandmas producer
surplus ($300)

Quantity of Houses Painted

Quantity of Houses Painted

In panel (a), the price of the good is $600, and the producer surplus is $100. In
panel (b), the price of the good is $800, and the producer surplus is $500.

How the Price Affects Producer Surplus

(b) Producer Surplus At Price P2

(a) Producer Surplus At Price P1


Price

Price

Supply
P2
P1

B
Producer
surplus

P1

A
0

Additional producer surplus


to initial producers
F

Supply

B
C

Initial
producer
surplus

Producer surplus
to new producers

A
Q1

Quantity

Q1

Q2

Initial price P1 , quantity Q1, Producer surplus is the ABC.


New higher price P2, Quantity Q2,
Producer surplus rises and becomes ADF.
Increase : 1) from initial buyers BDEC and 2)from new buyers CEF
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Quantity

Market Efficiency
Economic well-being of a society
: Total surplus = Sum of consumer and producer surplus

Total surplus = Consumer surplus + Producer surplus


Consumer surplus = Value to buyers Amount paid by
buyers
Producer surplus = Amount received by sellers Cost to
sellers
Amount paid by buyers = Amount received by sellers
Total surplus = Value to buyers Cost to sellers

Market Efficiency
Market outcomes
1. Free markets allocate the supply of goods to the buyers who
value them most highly

Measured by their willingness to pay

2. Free markets allocate the demand for goods to the sellers who
can produce them at the least cost
3. Free markets produce the quantity of goods that
maximizes the sum of consumer and producer surplus

Market equilibrium
. Efficient allocation of resources

Market Efficiency
Adam Smiths invisible hand
Takes all the information about buyers and sellers into
account
Guides everyone in the market to the best outcome
Economic efficiency

Free markets = best way to organize economic


activity

Deadweight Loss
Deadweight Loss : Loss of Economic Efficiency
Either people who would have more marginal benefit
than marginal cost are not buying the product, or
people who have more marginal cost than marginal
benefit are buying the product.

Monopoly Pricing
Externalities
Taxes or Subsidies
Binding Price Ceiling or floors.

Policy: Excise Tax

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Policy: Excise Tax


With No Tax

With Tax

Impact of Tax

A+B+C+E

-B-C-E

F+G+H

-F-G

Government
Receipts from
Tax

Zero

B+C+G

B+C+G

Deadweight Loss

Zero

E+F

E+F

Consumer
Surplus
Producer Surplus

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Key Definitions
Definition:
Definition: Incidence
Incidence of
of aa tax
tax isis aa measure
measure of
of the
the effect
effect
of
of aa tax
tax on
on the
the prices
prices consumers
consumers pay
pay and
and sellers
sellers receive
receive
in
in aa market.
market.
Definition:
Definition: The
The amount
amount by
by which
which the
the price
price paid
paid by
by
d
buyers,
buyers, PPd,, rises
rises over
over the
the non-tax
non-tax equilibrium
equilibrium price,
price, P*,
P*,
isis the
the incidence
incidence of
of the
the tax
tax on
on consumers;
consumers;
s
The
The amount
amount by
by which
which the
the price
price received
received by
by sellers,
sellers, PPs,,
falls
falls below
below P*
P* isis called
called the
the incidence
incidence of
of the
the tax
tax on
on
producers.
producers.
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Incidence of Tax in Two Cases

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Back of the Envelope

"Back of the Envelope" method to calculate


the incidence of a specific tax
=
where: is the own-price elasticity of supply
is the own-price elasticity of demand

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Back of the Envelope

Consider a small tax applied to an economy at point (Q*,P*)

= =
=

but for market to clear, Q/Q* must be the same for demand
and supply, hence
=
=

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Tax Effect

Example: Let = -.5 and = 2. What is the


relative incidence of a specific tax on consumers
and producers?
Pd/Ps = 2/-.5 = -4
interpretation: "consumers pay four times as
much as the decrease in price producers receive.
Hence, an excise tax of $1 results in an increase
in consumer price of $.8 and a decrease in price
received by producers of $.2"
Note: Subsidies are negative taxes.
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Incidence of Tax in Two Extreme Cases


P
Pd=P*+T

Ps = P*

S
P

Case II

Case I

Pd = P*
Ps = P*-T

T
D
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Subsidies : Negative Taxes


The as if supply curve S - $3 tells us how much producers will offer for
sale when the price received by producers includes the price consumers
Pay plus the subsidy

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Subsidies
With No Subsidy

With Subsidy

Impact of
Subsidy

Consumer
Surplus

A+B

A+ B + E + G + K

-B-C-E

Producer Surplus

E+F

B+C+E+F

-F-G

Impact on
Government
Budget

Zero

-B-C-E-G-K
-J

B+C+G

Net Benefits

A+B+E+F

A+B+E+FJ

-E-F

Zero

Deadweight Loss

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Policy: Price Ceilings

Definition:
Definition: A
A price
price ceiling
ceiling isis aa legal
legal
maximum
maximum on
on the
the price
price per
per unit
unit that
that aa
producer
producer can
can receive.
receive.
IfIf the
the price
price ceiling
ceiling isis below
below the
the pre-control
pre-control
competitive
competitive equilibrium
equilibrium price,
price, then
then the
the
ceiling
ceiling isis called
called binding.
binding.

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Policy: Price Ceilings

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Policy: Price Ceilings


With Price Ceiling
With No Price
Ceiling

With Maximum
Consumer Surplus
(Consumers with
highest willingness to
pay buy all the
available units)

With Minimum
Consumer Surplus
(Consumers with
lowest willingness
to pay buy all the
available units)

Consumer
Surplus

Area YAV

Area YTWS

Area URX

Producer Surplus

Area AVZ

Area SWZ

Area SWZ

Net Benefits

Area YZV

Area YTWZ

Areas URX +
SWZ

Zero

Area TWV

Area YZV Area


URX Area SWZ

Deadweight Loss

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Rent control in the short run and the long run


Adverse effects in the short run
(Supply and demand for housing are relatively inelastic)
Small shortage
Reduced rents
Adverse effects in the long run
(Supply and demand are more elastic)
Landlords
Are not building new apartments
Are failing to maintain existing ones
Discriminate on the basis of race or religion

People
Find difficult to find own apartments
Induce more people to move to suburbs
Large shortage of housing

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Policy: Price Floor

Definition:
Definition: A
A price
price floor
floor isis aa minimum
minimum price
price
that
that consumers
consumers can
can legally
legally pay
pay for
for aa good.
good. Price
Price
floors
floors sometimes
sometimes are
are referred
referred to
to as
as price
price
supports.
supports.
IfIf the
the price
price floor
floor isis above
above the
the pre-control
pre-control
competitive
competitive equilibrium
equilibrium price,
price, itit isis said
said to
to be
be
binding.
binding.

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Policy: Price Floor

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Policy: Price Floor


With Price Floor
With No Price
Floor

With Maximum
Producer Surplus
(the most
efficient workers
find jobs)

With Minimum
Producer Surplus
(the least efficient
workers find
jobs)

Consumer
Surplus

Area YAV

Area YTR

Area YTR

Producer Surplus

Area AVZ

Area RTWZ

Area MNV

Net Benefits

Area YZV

Area YTWZ

Areas YTR +
MNV

Zero

Area TWV

Area YZV Area


YTR Area MNV

Deadweight Loss

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The Minimum Wage


Price floor: minimum wage
Lowest price for labor that any employer may pay
Fair Labor Standards Act of 1938:
Ensure workers a minimally adequate standard of living
2009: federal minimum wage = $7.25 per hour
Some states mandate minimum wages even above the
federal level !!

Market for labor


Workers supply of labor
Firms demand for labor
If minimum wage is above equilibrium
Unemployment
Higher income for workers who have jobs
Lower income for workers who cannot find jobs

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The Minimum Wage


Impact of the minimum wage
Highly skilled and experienced workers
Not affected, their equilibrium wages are well above the minimum
(Minimum wage - not binding)
Teenage labor least skilled and least experienced
Low equilibrium wages
Willing to accept a lower wage in exchange for on-the-job training
(Minimum wage binding)
Teenage labor market ( IL0)
A 10% increase in the minimum wage depresses teenage
employment between 1 and 3%
Some teenagers who are still attending high school choose to drop
out and take jobs
Displace other teenagers who had already dropped out of school
and who now become unemployed
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Policy: Production Quotas

Definition:
Definition: A
A production
production quota
quota isis aa limit
limit on
on
either
either the
the number
number of
of producers
producers in
in the
the market
market
or
or on
on the
the amount
amount that
that each
each producer
producer can
can
sell.
sell.
The
The quota
quota usually
usually has
has aa goal
goal of
of placing
placing aa limit
limit
on
on the
the total
total quantity
quantity that
that producers
producers can
can
supply
supply to
to the
the market.
market.
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Policy: Production Quotas

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Policy: Production Quotas

Consumer
Surplus
Producer Surplus
Net Benefits
Deadweight Loss

With No Quota

With Quota

Impact of Quota

A+B+F

- A- B

C+E

A+E

A-C

A+B+C+E+F

A+E+F

-B-C

Zero

B+C

B+C

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Policy: Import Tariffs & Quotas

Definition:
Definition: Tariffs
Tariffs are
are taxes
taxes levied
levied by
by aa government
government on
on
goods
goods imported
imported into
into the
the government's
government's own
own country.
country.
Tariffs
Tariffssometimes
sometimesare
arecalled
calledduties.
duties.

Definition:
Definition: An
An import
import quota
quota isis aa limit
limit on
on the
the total
total
number
number of
of units
units of
of aa good
good that
that can
can be
be imported
imported into
into the
the
country.
country.

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Policy: Import Quotas

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Policy: Import Quotas


Free Trade
(with no
quota)

With Quota

Impact of Quota

Trade
Prohibition
(quota = 0)

Quota = 3
Million Units
per year

Impact of
Trade
Prohibition

Impact of
Quota = 3
Million Units
per year

Consumer
Surplus

A+ B + C + E
+F+G+H+
J+K

A+ B + C + E

-B-C-E-FG-H-JK

-F-G-H-JK

Producer
Surplus

B+F+L

F+L

B+F

Net Benefits

A+ B + C + E
+F+G+H+
J+K+L

A+ B + F + L

A+ B + C + E
+F+L

-C-E-G-H
-J-K

-G-H-J-K

Deadweight
Loss

Zero

C+E+G+H
+J+K

G+H+J+K

C+E+G+H
+J+K

G+H+J+K

Producer
Surplus
(foreign)

Zero

Zero

H+J

Zero

H+J

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Policy: Import Tariffs

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Policy: Import Tariffs


Free Trade (with
no tariff)

With Tariff

Impact of Tariff

A+B+C+E+F
+G+H+J+K

A+B+C+E

-F-G-H-J-K

F+L

Impact on
Government
Budget

Zero

H+J

H+J

Net Benefits

A+B+C+E+F
+G+H+J+K+
L

A+ B + C + E + F
+L

-G-H-JK

Deadweight Loss

Zero

G+K

G+K

Producer Surplus
(foreign)

Zero

Zero

Zero

Consumer
Surplus
Producer Surplus

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Comparing a Tariff to a Quota

IsIsthere
thereaadifference?
difference?

The
Thequota
quotagenerates
generatesno
nogovernment
governmentrevenue
revenue!!!
!!!

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Arguments For Restricting Trade


The jobs argument
Trade with other countries destroys domestic jobs
The national-security argument
The industry is vital for national security
The infant-industry argument
New industries need temporary trade restriction to help them get
started
The unfair-competition argument
Free trade is desirable only if all countries play by the same rules
The protection-as-a-bargaining-chip argument
Trade restrictions can be useful when we bargain with our trading
partners
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