Welfare & Efficiency

Welfare & Efficiency

► Welfare Economics is the branch of Economics that examines-

► Allocation of Resources and Well-being
► How does resources allocation affect the well-being?”
► On the whole, examines what is best for the society
► People are economic agents and rational beings (Assumption) And They would maximize their
benefits; driven by self-interests.
► We will cover the basics of Welfare Economic
Welfare & Efficiency

► In the market economy, there are buyers and sellers

► The market is efficient at the equilibrium.
► Market failure occurs when it is not at the equilibrium (e.g. shortage
and surplus)
Pareto efficiency: Resources are allocated in the most
economically efficient way, if there is any change then the
market will not be at pareto optimum state because an individual can not be
better off without another individual worse off.
Welfare & Efficiency

Welfare can be measured by-

► Consumer Surplus
► Producer Surplus
► Total Surplus
 Consumer Surplus
► Consumer surplus is the amount a buyer is willing to pay minus the amount it pays −→ measures the
benefits of consumers/buyers.
► Demand for a product or service means that you want that good and you are willing to pay for it
► How much you are willing to pay for it can be observed from the demand function and/or demand
curve.
► Thus, Consumer surplus is measured using the demand curve.
► Consumer Surplus (CS) = Willingness to Pay (WTP) - Amount Paid
► Graphically, the area under the demand curve and above the paid price depicts your CS
 Consumer Surplus

► To understand consumer surplus, let’s look at Lisa’s

demand for pizza in Figure 5.3. Lisa likes pizza, but the
marginal benefit she gets from it decreases quickly as her
consumption increases.
► Figure 5.3 also shows Lisa’s consumer surplus from pizza
when the price is £1 a slice. At this price, she buys 20
slices a week.
► But, Lisa is willing to pay almost £1.40 for the first
slice. So the marginal benefit from this slice is close to
40 pence more than she pays for it. So on her first slice of
pizza, she receives a consumer surplus of almost 40
pence.
 Consumer Surplus

► Calculating the Consumer Surplus:

Formula: 1 2 X ∆ Price X Quantity Demanded
Following Figure shows Demand and consumer
surplus of pizza when the price is £8 a slice.
At this price, 5 slices are demanded.
Therefore,
Consumer Surplus= The purple area
=1/2 X(10-8) X5
=5
Consumer Surplus- Changes in price
► If the price of pizza falls to $6 ,the consumer surplus changes.
► New consumer surplus=1/2 X(10-6) X7
=14
As price falls, two things happen,
1. CS to initial consumer rises
2. Additional CS goes to new customers.
 Producer Surplus
► A producer surplus is the price of
a good minus the opportunity cost of producing it,
summed over the quantity sold.
► Graphically, the area above the supply curve and
below the market price measures PS
► To understand producer surplus, let’s look at Mario’s
supply of pizza in Figure 5.5.
► Mario’s supply curve of pizza is also his minimum
supply price curve. It tells us that if Mario can sell
only one pizza a day, the minimum that he must be
paid for it
is £6.
► If the price of a pizza is £10 Mario plans to sell 100
pizzas a day.
► His Producer surplus will be given by the blue
rectangular area.
Calculating the Producer Surplus.
► Formula: 1/2X ∆ Price X Quantity Supplied.
► Following Figure shows Supply and
Producer surplus of pizza when the price is £8
a slice.At this price, 5 slices are sold.

Therefore PS= The purple area

=1/2 X (8-5) X5
=7.5
Calculating the Producer Surplus.

► If the price of pizza rises to $10 ,the producer surplus changes.

► New producer surplus=1/2 X(10-5) X15
=37.5
As price rises, two things happen,
1. PS to initial producers rise
2. Additional PS goes to new producers.
 Market Efficiency

► The demand curve tells us the marginal benefit from pizza.

If the only people who benefit from pizza are the people
who buy it, then the demand curve for pizza measures the
marginal benefit to the entire society from pizza. (MSB)
► The supply curve tells us the marginal cost of pizza. If the
only people who bear the cost of pizza are the people who
produce it, then the supply curve of pizza measures the
marginal cost to the entire society of pizza(MSC)
► The competitive market pushes the quantity of pizza
produced to its efficient level of 10,000 a day.
► When the efficient quantity is produced, the sum of
consumer surplus and producer surplus ,Total Surplus is
maximized.
 Obstacles to Efficiency

► Markets do not always get it right. Sometimes, markets produce too much of a good or service, and
sometimes they produce too little. The most significant obstacles to achieving an efficient allocation of
resources in a market economy are:
► Price ceilings and price floors
► Taxes, subsidies and quotas
► Monopoly
► External costs and external benefits
► Public goods and common resources
Tax

► Everything you earn and almost everything you buy is taxed.

► Income taxes and social security contributions are deducted from your earnings and sales taxes
are added to the bill when you buy something.
► Tax incidence is the division of the burden of a tax between the buyer and the seller.
► Tax can be imposed on Both sellers and consumers.
► When a tax is imposed, it distorts our well fair and thus reduces Consumer and Producer surplus.
 A Tax on Sellers
► To examine the impact of tax on sellers, lets consider that the
percentage tax increase over the year is equivalent to 1.50 a
pack of cigarette.
► We begin by examining the effects on demand and supply in the
market for cigarettes. In Figure 6.7, the demand curve is D, and
the supply curve is S. With no tax, the equilibrium price is at 3
per pack and 350 million packs a year are bought and sold.
► A tax on sellers is like an increase in cost, so it decreases supply.
► To determine the position of the new supply curve, we add the
tax to the minimum price that sellers are willing to accept for
each quantity sold.
► Without the tax, sellers are willing to offer 350 million packs. So
with a 1.50 tax, they will offer 350 million packs a year only if
the price is 4.50 a pack. The supply curve shifts to the red curve
labelled S + tax on sellers.
► Equilibrium occurs where the new supply curve intersects the
demand curve at 325 million packs a year. The price paid by
buyers rises by a1 to a 4 a pack.
► The price received by sellers falls by 50 cents to 2.50 a pack. So
buyers pay 1 of the tax and sellers pay the other 50 cents.
A Tax on Buyers

► Suppose that instead of taxing sellers, the government taxes

cigarette buyers a1.50 a pack.
► A tax on buyers lowers the amount they are willing to pay
the seller, so it decreases demand and shifts the demand
curve leftward.
► To determine the position of this new demand curve, we
subtract the tax from the maximum price that buyers are
willing to pay for each quantity bought.
► Without the tax, buyers are willing to buy 350 million packs
a year for $3 a pack.
► With a a1.50 tax, they will buy 350 packs a year only if the
price including the tax is $3 a pack, which means that
they’re willing to pay the seller only $1.50 a pack. The
demand curve shifts to become the red curve labelled D –
tax on buyers.
► Equilibrium occurs where the new demand curve intersects
the supply curve at a quantity of 325 million
packs a year. The price received by sellers is $2.50 a pack,
and the price paid by buyers is $4 a pack .
 Taxes and Efficiency
► Because a tax puts a wedge between the buyers’ price and the
sellers’ price, it also puts a wedge between marginal benefit
and marginal cost and creates inefficiency.
► With a higher buyers’ price and a lower sellers’ price, the tax
decreases the quantity produced and consumed and a
deadweight loss arises.
► Figure 6.11 shows the inefficiency of a tax. With a tax, both
consumer surplus and producer surplus shrink.
► Part of each surplus goes to the government in tax revenue the
purple area in the figure.
► And part of each surplus becomes a deadweight loss – the grey
area