Economics 111.3 Winter 14

January 29th, 2014Lecture 9

Ch. 5 : pp. 108-115; Ch. 6 (up to p. 138)

Welfare Economics: an Introduction

Ch. 5: pp. 108-115

Consumer Surplus (CS)

• CS – a buyer’s willingness to pay minus the amount the buyer actually pays

• CS is represented by the area BELOW the demand curve and ABOVE the equilibrium market price

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• Producer surplus - if a producer receives more than the price she would be willing to sell the good for, she receives a net benefit.

• If a firm sells something for more that it costs to produce, the firm obtains a producer surplus.

Producer Surplus (PS)

• PS is the amount a seller is paid for a good minus the seller’s cost.

• PS is represented by the area ABOVE the supply curve and BELOW the equilibrium market price

Desirable Characteristics of Free Market Equilibrium

• What's good about equilibrium is that it makes the combination of consumer and producer surplus as large as it can be.

An Efficient Market for Pizza

Quantity (thousands of pizzas per day)0 5 10 15 20P

rice

(d

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ars

per

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Marginal cost (opportunity cost)of pizza

Marginal benefit (value) of pizza10

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Consumersurplus

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Consumer’sexpenditure

=Producer’s

revenueEfficient quantityof pizzas

Underproduction and Overproduction

Deadweight Loss The decrease in consumer and producer

surplus that results from an inefficient allocation of resources.

For any quantity other than the competitive equilibrium quantity, there is a gap between marginal benefit and marginal cost.

The deadweight loss is a social loss.

Price Floors• A price floor is a government-

imposed limit on how low a price can be charged.

• When the government imposes a price floor, two outcomes are possible.– The price floor is not

binding if set below the equilibrium price.

– The price floor is binding if set above the equilibrium price, leading to a surplus.

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D S

S

P0

P

QQ0

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D S

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Q

PF

SURPLUS

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Minimum Wage• The minimum wage is an example of a

price floor.• A minimum wage is set by

government specifying the lowest wage a firm can legally pay an employee.– In 2009, the minimum wage rate

ranged from a low of $7.50 an hour in New Brunswick to a high of $10.00 an hour in Nunavut.

– Most economists believe that minimum wage laws increase the unemployment rate of low-skilled younger workers.

The minimum wage creates winners and losers:

– Those who can find work earn a higher wage.

– Others become unemployed.– Production costs increase.– Consumers pay higher prices.

• The min. wage may exceed the equilibrium wage of unskilled workers, especially teenagers.

• Studies: a 10% increase in min. wage reduces teen employment by 1-3%

• But, the min. wage cannot explain the majority of unemployment, as most workers’ wages are well above the min. wage.

Minimum Wage Rates in Canada by Province

Source: Ministry of Labour

Market Power of Trade Unions

• A union is a worker association that bargains with employers over wages and working conditions

• Unions exercise monopoly power to secure higher wages for their members.

• When the union wage exceeds the equilibrium wage, unemployment results.

• On average, union workers earn 10 to 20 percent more than nonunion workers.

Wage of unionized workers

Trade unions, cont’d• Insiders: Employed union workers

whose interest is to keep wages high.• Outsiders: Unemployed non-union

workers who prefer equilibrium wages, so there would be enough jobs for them.

• As of 2009, 38 percent of all Canadian workers belonged to unions (In 2008, about 18% of all workers in the U.S. were members of unions).

• In the 1940s and 1950s, union membership as a fraction of the labour force was considerably smaller, at just 10 percent in 1941 and 20 percent in 1951.

Study question• Suppose the labour market is

segmented into two distinct markets: the market for low-skill workers and the market for high-skill workers. Further, suppose the competitive equilibrium wage in the low-skill market is $5.00/hour, while the competitive equilibrium wage in the high-skill market is $15/hour.

Study question, cont’d• If the minimum wage is set at $8.00/hour, which

market will exhibit the greatest amount of unemployment? Demonstrate it graphically.

• Does the minimum wage have any impact in the high-skill market?

• Suppose the high-skill market becomes unionized, and the new negotiated wage is $18.00/hour. Will this have any effect on the low-skill market?

Notion of RESPONSIVENESS

Elasticity gives us a measure of RESPONSIVENESS