L15 - Welfare Applications of the Competitive Model

Question 1

How do we measure the welfare of firms?

Answer 1

• An appropriate measure of a firm’s welfare is its profits, π . Profits should be carefully defined as π (q) = p(q)q – VC(q) – F.
• But here, under our assumption of perfect competition, we assume pricetaking and so p(q) = p.

However, using either method, we can simply add up the profits across all relevant firms to gain a measure of total profits within an industry

Question 2

How do you calculate profits from the Supply curve?

Answer 2

Question 3

How do you calculate profits from the MC and AC curves?

Answer 3

Question 4

What is Producer Surplus?

Answer 4

• Instead of profits, Perloff puts more emphasis on a different concept of firm’s welfare, producer surplus (PS). Producer surplus omits any fixed costs, PS = pq – VC(q).
• Hence, PS is the same as profits, π (q) = pq – VC(q) – F, if fixed costs, F, are zero.
• Under perfect competition, this does not matter much as fixed costs are often zero in the long run. Consequently, much of Perloff’s chapter is still applicable whether one uses profit or producer surplus.
• However, I want you to stick to profits because for more advanced topics, profits is the more relevant and intuitive measure as fixed costs are likely to exist in equilibrium.

Question 5

How do you calculate total Welfare?

Answer 5

• For a market without any government activity, it is standard to calculate Total Welfare as the sum of CS and profits: W = CS + π
• However, once a government is active, total welfare needs to incorporate the government as well as firms and consumer. We do this by including tax revenues, T, such that W = CS + π + T
• Intuitively, we can think of tax revenues as creating welfare through the social value that they can create when spent within the economy.
• We assume that there is no wastage or inefficiencies in government expenditure, such that all tax revenue goes to welfare. However, the model can be modified to allow for other possibilities.

Question 6

When is Total Welfare maximised?

Answer 6

when price equal MC

Question 7

Why does Producing Less than the competitive output lower welfare?

Answer 7

• the deadweight loss results because consumers value extra output more than the marginal cost of producing it, or is the opportunity cost of giving up some of this good to buy more of another good

Question 8

Why does producing more than the competitive output lower welfare?

Answer 8

• the cost of producing this extra output exceeds the value consumers place on it

Question 9

What is a price ceiling?

Answer 9

Governments sometimes regulate firms by enforcing laws that prevent firms from pricing above a certain level, p(bar)

• Examples includes, energy martkets and rented property
• this may be used to help vunerable consumers being exploited by a company
• this is a problem in the long-run their is a reduced incentive to produce more goods, which would then actualy reduce the deadweight loss to society
• you also have the problem of allocative cost to society - the people that want it the most may not recieve it

Question 10

What is a price floor?

Answer 10

A minimum price, which is the lowest price a consumer can legally pay for the good e.g. alcohol

• there are two types of price support (argricultural sector in the 1930’s):
• traditional –> by setting a price support, and the government buying the excess supply due to the higher prices) –> not very good as a larger amount of the good is just bought by the government try to clear the market, these goods cant be sold domestically (would drive down prices) or must be exported or end up spoiling –> inefficiency in consumption occured as consumers are still willing to buy at higher price than MC even without the support
• alternative –> the government would set the support price and the supplier would decide how much to produce and sell it all at that price, and for any deficiency payments equal to the difference between the support and actual price were subsidied by the government.

Question 11

What is Sales Tax and how does it affect welfare?

Answer 11

• A new sales tax causes the price that consumers pay to rise, resulting in a loss of consumer surplus and the price that firms receive to fall result in a drop in producer surplus
• producer surplus (Profit) is still taken from the original supply curve?
• however, this tax provides the government with more tax revenue
• tax revenue is now the difference between the new equilibrium price - the price on the original supply curve, multiplied by the quantity
• the reason this creates deadweight loss is because consumer are still willing to pay more for the good than MC? shouldnt more be produced if consumers are willing to Pay more than it costs for producing it .

Question 12

Why may government impose Entry Restrictions?

Answer 12

• if there were concerns about the suppliers e.g. safety consider with Uber
• This policy is sometimes implemented due to concerns about maintaining product quality
• governments may be pressurised to do so by lobbying (dont want more firms coming in a stealing away business)

Question 13

How does entry restrictions effect the NYC taxi market?

Answer 13

• To operate as a cab driver you need a taxi medallion license - there is only a fixed number of these however, so they are auction of at ludicrous prices –> excess of $1 million
• Before any restrictions, we’ll assume the eqm is at E1 (and e₁) where free entry in the LR ensures a flat market supply curve, S₁, such that p₁=AC₁ and profits are zero.
• Regulation then restricts the number of firms.(n₂)
• The new mkt supply curve must now only reflect the MC curves of the limited number of active firms. Hence, S₂ is now increasing. (The lack of entry prevents LR supply from being flat)
• The eqm then moves to E₂ with price p₂, where the active firms initially earn positive profits, π=B
• However, in the longer run, the licenses will put up for auction. The many nonactive firms will create competition for the profitable licenses and will be willing to bid up the price of each license until the price equals its associated profit, π.
• Any active firms’ profits are then completely offset by the license price - the new license acts as an increased fixed cost shifting AC₁ to AC₂. However, the license issuers now collect all the original profits in license fees (rent) –> government takes all the profit from the lisenses
• Restrictions in entry reduce competition and welfare. License issuers, not taxi drivers, benefit. Must weigh up this deadweight loss with any potential benefits in quality.

Question 14

How do Exit Restriction shift supply curves?

Answer 14

• US, European and other governments have laws that delay how quickly some (typically large) firms may go out of business so that workers can receive advance warning that they will be laid off.
• Although tbese restrictions keep the number of firms in am arket relatively high in the short run, but will reduce the number of firms in a market in the long run
• E.g. imagine you were a construction company, but during the winter, to avoid losses you will be shutting down during low-demand periods.
• But if there is a law that requires you to give your workers six months’ warning before laying them off prevents your firm from shutting down quickly
• You wouldnt want to move into a market where you would suffer regular losses, by paying workers for up to six months during period when you have nothing for them to do?
• Unless the economic profits during good periods are much higher than the losses you will incur you will not enter the market.
• Thus, ecit barriers may raise prices, lower consumer surplus, and reduce welfare.