Skip to main content

Welfare Analysis

Now that we know the basic principals that affect the market supply and demand curves, we can turn our attention to the welfare analysis of the market and see how the economic value  is divided between the producers and the consumers.
  • Consumer surplus is the difference between the price a consumer is willing to pay and the current market price. The consumer surplus is equal to the area bounded from above by the demand curve and bounded from below by the equilibrium price.
  • Producer Surplus is the difference between the price a producer is willing to sell and the current market price. This is equal to the area bounded from above by the equilibrium market price and bounded from below by the supply curve.
  • Total economic surplus is the sum of consumer and producer surpluses. It is maximized at the equilibrium price and quantity point.
  • Dead-weight loss is the sum producer and consumer surplus that could have been achieved had the equilibrium price and quantity prevailed in the market. Therefore, if the current price is the market clearing price, there is no dead-weight loss in the market.

Example: 

In this first example, the total economic surplus is maximized. The quantity and price are determined by the intersection of the supply and demand curve.

In the second graph, we see that due to a per unit tax, the supply curve shifts to the left.  A dead-weight loss is created (the triangle area between Qt and QE) and part of the consumer and producer surplus now goes to government. The area is denoted as "Government Surplus", and represents the total revenue created by the tax. Due to the dead-weight loss,  the total economic surplus is smaller than before.


Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 65-66.

Comments

Popular posts from this blog

Macroeconomics: multiplier and crowding out effects

Multiplier effect: whenever   any of the components of AD increases, the increase in GDP will be greater than the initial increase in expenditures. The impact on GDP of a particular increase in spending depends on the proportion of the new income that is taken out of the system to the proportion that continues to circulate in the economy. The multiplier effect tells us the impact a particular change in one the components of AD will have on the total income (GDP).  Let k denote the spending multiplier, which is a function of MPC and MPS. The larger the marginal propensity to consume, the larger the spending multiplier. Notice that the larger the MPC, the greater the impact a particular change in the spending variables will have on the nation's GDP. The crowding out effect: If government spending increases without an increase in taxes, the government must borrow funds from the private sector to finance its deficit, thereby increasing the interest rate. This increase in interest ...

Exercise: maximizing profit

Assume that you are the owner of a small business that produces T-shirts. Your the total revenue for your business can be modeled by the following equation: and your total cost corresponds to this function: Find the point at which your firm maximizes its profit. Then, find how much profit the firm if able to earn at that point. Using the total cost and total revenue functions we can set up the profit function: Then, realize that if you want to find the maximum profit, take the derivative of the function and set it up equal to zero, and solve for Q. This is equivalent of taking the derivative of the total cost and total revenue functions and setting them equal to each other. In this problem, I chose the latter option as it was explained in the previous lessons. Notice that profit is often denoted by a capital pi.  We are assuming that the TR>TC for some positive value, you can check for yourself. However, if we did not know that, we would first take the first ...

A short interlude...

Hello all, it's been quite some time since I have made any major announcements since the creation of this blog about a year and a half ago. I am currently in graduate school and will soon take a portion of my comprehensive examination (i.e exams in Micro, Macro, and Metrics that will allow me to continue my studies in my graduate program), wish me luck! Thus, I will not be able to post consistently until at least mid-June. The roadmap is as such, if I pass, I will start introductory lessons in Econometrics and Statistics (if not, then I'll have to study until I can retake the comps in August). I hope that once I am done, I will be able to add more advance materials to the blog, such as general equilibrium, indirect utility functions, and game theory/mechanism design for Micro. The Solow, Ramsey, RBC, New Keynesian models, permanent income hypothesis (PIH) and more for Macro. By the way I think I still need to add notes on the IS-LM curves, so I will do that before jumping to t...