6 Surplus and Welfare

Question 1

What is the loss of overall surplus also known as?

Answer 1

Dead-weight loss (DWL)

Question 2

What are the two main types of price controls?

Answer 2

Minimum prices (price ceilings), and maximum prices (price floors).

Question 3

On what grounds are price control often justified on?

Answer 3

On distributional grounds. i.e. that they are welfare-improving for consumers (or particular groups of them)

Question 4

How must maximum prices relate to market equilibrium?

Answer 4

p_max < p* (duh)

Question 5

Supply-demand diagrams (with surpluses) before and after maximum price

Answer 5

Question 6

Pros and cons of a maximum price

Answer 6

While this means that producers get more surplus (usually), it inherently distorts the market, causing an inefficient allocation. This causes a DWL, and may take surplus away from struggling producers.

This also decreases quantity so may be more inaccessible arguably.

Question 7

Maximum prices and price elasticity of demand + diagram

Answer 7

If demand is price elastic, consumers tend to benefit more from a price cap.

If demand is price inelastic, their loss in surplus may outweigh the gain in surplus from a price cap:

Question 8

What are minimum wages examples of?

Answer 8

Minimum prices (price floors)

Question 9

What is important to remember about the labour market?

Answer 9

The producers (suppliers) of labour are the people ☭

The consumers (demanders) of labour are firms

Question 10

Supply-demand diagrams (with surpluses) before and after minimum price

Answer 10

Question 11

Pros and cons of a minimum price

Answer 11

While this means that the workers get more surplus (usually), it inherently distorts the market, causing an inefficient allocation. This causes a DWL, and may take surplus away from struggling producers.

This also decreases quantity so may be more inaccessible arguably (i.e. exclude other workers so they are left unemployed).

Question 12

Minimum prices and price elasticity of supply

Answer 12

If supply is price elastic, workers tend to benefit more from a price floor.

If supply is price inelastic, their loss in surplus may outweigh the gain in surplus from a price floor:

Question 13

What is meant by price support policy?

Answer 13

When governments influence markets by becoming a player themselves. By buying up quantities of goods and services.

Question 14

How do we show a price control diagrammatically?

Answer 14

A shift outwards of demand by G units

Question 15

How do price supports affect the private sector demand?

Answer 15

Competition → bad for private buyers.

Their consumer surplus decreases, they lose areas B and C.

Question 16

How do price supports affect the private sector supply?

Answer 16

Higher quantities supplied and at a higher price.

Producer surplus increases, gain of B, C, and F.

Question 17

What is the cost to the government of a price support?

Answer 17

Govt cost = p_gG

Question 18

How do we show deadweight loss of a price support?

Answer 18

Question 19

What are quotas?

Answer 19

A legally set limit on how much goods and services can be traded.

Question 20

How can we show a quota diagrammatically?

Answer 20

Question 21

How does a quota affect surpluses?

Answer 21

Consumers lose areas B and C.

Producers lose E but gain B.

Deadweight loss is areas C and E.

Question 22

Who benefits and who loses to a quota?

Answer 22

Consumers lose.

Producers often gain but may lose if area E > area B (depending on elasticity of supply and quota size).

NOTE: Loss in PS relates to the producers that can no longer produce. Whereas those who can can charge a higher price.

Thus, incentive to keep entrants out and against increases in quotas (usually citing the importance of “standards”).

Society loses: deadweight loss.

Question 23

Examples of quotas in use

Answer 23

Licences e.g. Taxi drivers in a certain city

Question 24

What does a tax effectively do?

Answer 24

Create a “wedge: between the price the consumer pays (p_D) and the price the supplier recieves (p_S).

Question 25

Two types of taxes and their equations

Answer 25

Question 26

Two types of tax incidence

Answer 26

Formal incidence

Effective incidence

Question 27

What is formal incidence?

Answer 27

The formal incidence of a tax is upon the entity which is responsible for remitting the tax.

Question 28

What is effective incidence?

Answer 28

The effective incidence of a tax is upon the entity which bears the economic cost.

Question 29

Who often bears the formal incidence? How do we write this?

Answer 29

Suppliers.

New supply curve of S(p_D - T).

Question 30

Specific tax diagrammatically

Answer 30

Question 31

Surpluses and revenue of specific taxes

Answer 31

Consumers lose areas B and C.

Producers lose areas D and E.

Government revenue of B and D.

Deadweight loss of C and E.

Question 32

How can we calculate effective incidence?

Answer 32

Question 33

Suppose the government taxes consumption instead? How do we write this?

Answer 33

Question 34

How does a tax on consumption change our analysis?

Answer 34

Entire analysis is identical. Effective incidence is unchanged.

Question 35

Ad valorem tax diagrammatically

Answer 35

Analysis is very similar to specific taxes.

Changes to formal incidence do not change effective incidence.

Question 36

What economic intuition underpins effective incidence?

Answer 36

Those who realise the least surplus from a trade can avoid the tax by walking away.

Those who make the greatest surplus could walk away, but won’t, and therefore bear the effective incidence.

Question 37

How does price elasticity affect effective tax incidence?

Answer 37

Price inelastic demand → greater loss in CS → greater tax incidence.

Price inelastic supply → greater loss in PS → greater tax incidence.

Question 38

How can we think of subsidies?

Answer 38

As negative taxes which move in the opposite way to a tax.

Remember the money has to come from somewhere so include it in analysis.

Question 39

5 major policy points of taxation

Answer 39

1. Taxes cause DWL’s in competitive markets
2. Formal incidence ≠ effective incidence
3. Effective incidence depends on relative price elasticities
4. The side of the market which is least able to “walk away: will end up bearing the tax
5. To tax consumers, you should target highly inelastic products such as petrol, water, highly addictive drugs etc.