Policy Analysis Outline Welfare Analysis Consumer surplus Producer

Outline • Welfare Analysis – Consumer surplus – Producer surplus • Welfare consequences of

Economic Efficiency • A situation is economically inefficient if there is some way to

Assessing Benefits • • • Consumer Sovereignty “Willingness to Pay” = Consumer Benefit Consumer

Consumer Surplus -- Difference between Willingness to Pay and Price Paid by Buyer Price

Consumer Surplus Is Triangle Below Demand, Above Market Price Consumer Surplus P 0 Demand

Producer Surplus- Difference Between Opportunity Cost and Selling Price t 5 t 4 t

Producer Surplus Price Supply P 0=t 5 Producer Surplus Quantity

Consumer and Producer Surplus - Market Equilibrium Price Consumer Surplus Supply P 0 Producer

Impact of Price Floor on Efficiency A -- New CS A+B+E -- Old CS

Impact of Price Ceiling on Efficiency Demand A+B+C -- New CS A+B+E -- Old

SUMMARY • Market Equilibrium is Efficient. No Deadweight Loss. • Price controls create a

Comparison • If demand is elastic, minimum wage reduces employment • Benefits accrue to

Impact of Subsidy on Efficiency Price Sellers receive A+B+F+E = CS after Subsidy A+B

Tortillas On New Year’s Day 1999, Mexico ended price controls on tortillas. The price

Questions • What does the price increase suggest about the elasticity of demand for

P Elasticity of Demand for Tortillas? Supply PA Price ceiling PB Demand A Kilos

If All Consumers Received Subsidy: • If all consumers receive the subsidy, output is

Disadvantages of Subsidies • Control of subsidies by local bureaucrats created opportunties to exploit

Key Concepts • Impact of price controls and of subsidies depends on elasticity of

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Policy Analysis

Outline • Welfare Analysis – Consumer surplus – Producer surplus • Welfare consequences of minimum wage • Wage subsidy as alternative to minimum wage • Tortillas as a Cautionary Tale

Economic Efficiency • A situation is economically inefficient if there is some way to change it so that someone gains while no one else loses. • A change is a Pareto improvement if at least one person gains and no one loses • A change is economically efficient if the winners could compensate the losers by enough to make the change a Pareto improvement.

Assessing Benefits • • • Consumer Sovereignty “Willingness to Pay” = Consumer Benefit Consumer Surplus “Willingness to Sell” =Opportunity Cost Producer Surplus

Consumer Surplus -- Difference between Willingness to Pay and Price Paid by Buyer Price r 1 r 2 r 3 r 4 P 0 Demand 1 2 3 4 5 Quantity

Consumer Surplus Is Triangle Below Demand, Above Market Price Consumer Surplus P 0 Demand 5 Quantity Total Expenditure

Producer Surplus- Difference Between Opportunity Cost and Selling Price t 5 t 4 t 3 t 2 t 1 P 0=t 5 1 2 3 4 5 Quantity

Producer Surplus Price Supply P 0=t 5 Producer Surplus Quantity

Consumer and Producer Surplus - Market Equilibrium Price Consumer Surplus Supply P 0 Producer Surplus Q 0 Demand Quantity

Impact of Price Floor on Efficiency A -- New CS A+B+E -- Old CS B+C+D -- New PS C+F+D -- Old PS Supply A Price Floor B E F C Market clearing price D Demand Q 1 Q 0 E+F is deadweight loss associated with the price floor.

Impact of Price Ceiling on Efficiency Demand A+B+C -- New CS A+B+E -- Old CS D -- New PS C+D+F -- Old PS Supply A B C D E F Market Clearing Price Ceiling E+F is the Deadweight Loss Associated with Price Ceiling

SUMMARY • Market Equilibrium is Efficient. No Deadweight Loss. • Price controls create a deadweight loss • Also, there are costs associated with rationing mechanisms, black markets etc.

Impact of $12 Minimum Wage

$2 Wage Subsidy

Comparison • If demand is elastic, minimum wage reduces employment • Benefits accrue to workers who stay employed • Costs borne by employers and consumers • Wage subsidy increases employment • Benefits shared by employers and workers • Subsidy funded from general government revenues

Subsidy Benefits Employers and Workers

Impact of Subsidy on Efficiency Price Sellers receive A+B+F+E = CS after Subsidy A+B = CS before Subsidy B+C+F+G = PS after Subsidy F+G= PS before Subsidy B+C+D+E+F = Subsidy D=Deadweight Loss from Subsidy A B Price buyers pay F C E Pre Subsidy Price D G Pre Subsidy Q Post Subsidy Q

Tortillas On New Year’s Day 1999, Mexico ended price controls on tortillas. The price stood at 3 pesos per kilo (31 cents for 2. 2 pound stack). Some shops immediately raised their prices by 50%. In 1998, the government phased out subsidies to the tortilla industry that helped keep prices down. The tortilla subsidy was replaced with programs such as one that gives the 1. 2 million poorest Mexicans free tortillas each day. Source: Smith, James, Los Angeles Times, Jan 7, 1999

Questions • What does the price increase suggest about the elasticity of demand for tortillas? • How does the impact of a subsidy to consumers differ from the impact of a subsidy to producers? • What are the advantages of price controls as compared with subsidies?

P Elasticity of Demand for Tortillas? Supply PA Price ceiling PB Demand A Kilos of tortillas

Subsidy to Producers

Subsidy to Consumers

Another Approach

If All Consumers Received Subsidy: • If all consumers receive the subsidy, output is same • Price producers receive is same in two cases • Price consumers pay is same in two cases

Disadvantages of Subsidies • Control of subsidies by local bureaucrats created opportunties to exploit subsidies for political ends. Price controls anonymous. • Consumers not eligible for subsidies, but still relatively poor will pay a higher price for tortillas.

Key Concepts • Impact of price controls and of subsidies depends on elasticity of demand (and supply). • Price floors lead to surpluses. Price ceilings to shortages. • Price controls lead to a deadweight loss.