Welfare economics – part 2 (producer surplus)
Application of welfare economics:
The Costs of Taxation & International Trade
Dr. Anna Kowalska-Pyzalska
Department of Operations Research
Presentation is based on:
http://www.swlearning.com/economics/mankiw/mankiw3e/powerpoint_micro.html
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Cost
Producer surplus
Total surplus
Deadweight loss
Tax wedge
World price
Tariff

It measures the benefit to sellers participating
in a market.
Producer surplus is the amount a seller
is paid for a good minus the seller’s
cost.
Each painter is willing to do the
work, if the price is right...
The price must exceed the cost of
doing the work.
Copyright©2004 South-Western
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Because a painter’s cost is the lowest price he
would accept for his work,
Cost is a measure of his willingness to sell
the services.
Each painter would be:
◦ eager to sell the services at a price greater than the
cost.
◦ would refuse to sell the services at a price less than
the cost.
◦ indifferent about selling his services at a price
exactly equal to the cost.
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The job goes to the painter who can do the
work at the lowest cost…
If the painters compete for the job,
the price falls…
If Grandma bids $600,
she receives the
producer surplus of
$100.
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Producer surplus measures the benefits to
sellers of participating in a market.
Just as consumer surplus is related to the
demand curve, producer surplus is closely
related to the supply curve.
marignal seller – a seller who would leave the
market if the price were any lower.
At any quantity, the price given
by the supply curve shows the
cost of the marginal seller.
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The area below the price and above the supply
curve measures the producer surplus in a
market.
The height of the supply curve measures
seller’s cost, and the difference between the
price and the cost is each seller’s producer
surplus.
The total area is the sum of the producer
surplus of all sellers.
(a) Price = $600
Price of
House
Painting
Supply
$900
800
600
500
Grandma’ s producer
surplus ($100)
0
1
2
3
4
Quantity of
Houses Painted
Copyright©2003 Southwestern/Thomson Learning
(b) Price = $800
Price of
House
Painting
$900
Supply
Total
producer
surplus ($500)
800
600
Georgia’s producer
surplus ($200)
500
Grandma’s producer
surplus ($300)
0
1
2
3
4
Quantity of
Houses Painted
Copyright©2003 Southwestern/Thomson Learning
(a) Producer Surplus at Price P
Price
Supply
P1
B
Producer
surplus
C
Sellers always want to get a
higher price for the goods
they sell.
A
0
Q1
Quantity
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(b) Producer Surplus at Price P
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
D
E
F
B
Initial
producer
surplus
C
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
Copyright©2003 Southwestern/Thomson Learning
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Consumer surplus and producer surplus may
be used to address the following question:
◦ Is the allocation of resources determined by free
markets in any way desirable?
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
Total surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers – Cost to sellers
Efficiency is the property of a resource
allocation of maximizing the total
surplus received by all members of
society.
An allocation is inefficient if:
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◦
◦
a good is not being consumed by the buyers who
value it most highly.
is not being produced by the sellers who could
produce it with the lowest cost.
In addition to market efficiency, a social
planner might also care about:
Equity – the fairness of the
distribution of well-being among
the various buyers and sellers.
Price A
D
Consumer
surplus
Equilibrium
price
•
E
Producer
surplus
•
Supply
Those buyers who value the
good more than the price (AE)
will buy it.
Those sellers whose costs are
less than the price will produce
and sell the good (CE)
B
Demand
C
0
Equilibrium
quantity
Quantity
Copyright©2003 Southwestern/Thomson Learning
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Three Insights Concerning Market Outcomes:
◦ Free markets allocate the supply of goods to the
buyers who value them most highly, as measured
by their willingness to pay.
◦ Free markets allocate the demand for goods to the
sellers who can produce them at least cost.
◦ Free markets produce the quantity of goods that
maximizes the sum of consumer and producer
surplus.
Price
• At quantities
below
equilibrium
value to
buyers
exceeds the
cost to
sellers.
• In this region,
increasing
quantity
raises total
surplus, until
the quantity
reaches Eq. 0
Supply
Value
to
buyers
At quantities
above the
equilibrium the
value to buyers is
less than the cost
to sellers – it
would lower total
surplus
Cost
to
sellers
Cost
to
sellers
Value
to
buyers
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
Demand
Quantity
Value to buyers is less
than cost to sellers.
Copyright©2003 Southwestern/Thomson Learning
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How do taxes affect the economic well-being of
market participants?
It does not matter whether a tax on a good is
levied on buyers or sellers of the good . . .
…the price paid by buyers rises, and the price
received by sellers falls.
We must compare the reduced welfare of buyers
and sellers to the amount of revenue the
government gets.
Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
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A tax places a wedge between the price
buyers pay and the price sellers receive.
Because of this tax wedge, the quantity sold
falls below the level that would be sold
without a tax.
The size of the market for that good shrinks.
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Tax Revenue
◦ T = the size of the tax
◦ Q = the quantity of the good sold
TQ=
= the government’s tax revenue
Tax revenue is spent on public
services: e.g. roads, public education,
transfer payments, etc.
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
A tax on a good reduces consumer
surplus (by the area B+C) and
producer surplus (by the area D+E).
Price
Price
buyers = PB
pay
Supply
A
B
C
Price
without tax = P1
Price
sellers = PS
receive
E
D
The tax is said to
impose a deadweight
loss (area C + E).
F
Demand
0
Q2
Because the fall in producer and
consumer surplus exceeds tax revenue
Quantity
(area B Q+1 D), the tax is said to impose
a
deadweight loss (area C + E).
Copyright © 2004 South-Western
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The change in total welfare includes:
The change in consumer surplus,
The change in producer surplus, and
The change in tax revenue.
The losses to buyers and sellers exceed the revenue
raised by the government.
◦ This fall in total surplus is called the deadweight
◦
◦
◦
◦
loss.
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Changes in Welfare
A deadweight loss is the fall
in total surplus that results
from a market distortion,
such as a tax.
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A tax is an incentive to buyers and sellers…
Taxes distort incentives. They cause markets
to allocate resources inefficiently.
Peter cleans Jane’s
house for $100
PETER:
OC = $80
PS = $100-$80=$20
JANE:
WTP = $120
CS = $120-$100=$20
Total surplus:
$20+$20=$40
Peter cleans Jane’s
house for $100
JANE:
WTP = $120
CS = $120-$100=$20
PETER:
OC = $80
PS = $100-$80=$20
Total surplus:
$20+$20=$40
If the tax $50 is levied on
supplier of the service, then…
PETER:
OC = $80
PS = $120-$50=$70<$80
JANE:
WTP = $120
She cannot pay more than
$120. She would need to pay
at least $130.
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Taxes cause deadweight losses because
they prevent buyers and sellers from
realizing some of the gains from trade.
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What determines whether the deadweight loss
from a tax is large or small?
◦ The magnitude of the deadweight loss depends on
how much the quantity supplied and quantity
demanded respond to changes in the price.
◦ That, in turn, depends on the price elasticities of
supply and demand.
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
Copyright © 2004 South-Western
(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
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(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
Copyright © 2004 South-Western
(d) Elastic Demand
Price
Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
0
Quantity
Copyright © 2004 South-Western
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The greater the elasticities of demand and
supply:
◦ the larger will be the decline in equilibrium
quantity and,
◦ the greater the deadweight loss of a tax.
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With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
(b) Medium Tax
Price
Deadweight
loss
PB
Supply
Tax revenue
PS
0
Demand
Q2
Q1 Quantity
Copyright © 2004 South-Western
(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
(a) Deadweight Loss
Deadweight
Loss
As the size of a
tax increases,
its deadweight
loss quickly
gets larger.
0
Tax Size
Copyright © 2004 South-Western
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For the small tax, tax revenue is small.
As the size of the tax rises, tax revenue
grows.
But as the size of the tax continues to rise,
tax revenue falls because the higher tax
reduces the size of the market.
(b) Revenue (the Laffer curve)
Tax
Revenue
Tax revenue first
rises with the
size of a tax, but
then, as the tax
gets larger, the
market shrinks
so much that tax
revenue starts to
fall.
0
Tax Size
Copyright © 2004 South-Western
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What determines whether a country imports
or exports a good?
Who gains and who loses from free trade
among countries?
What are the arguments that people use to
advocate trade restrictions?
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Equilibrium Without Trade
◦ Assume:
 A country is isolated from rest of the world and
produces steel.
 The market for steel consists of the buyers and
sellers in the country.
 No one in the country is allowed to import or
export steel.
Price
of Steel
Domestic
supply
Consumer
surplus
Equilibrium
price
Producer
surplus
Domestic
demand
0
Equilibrium
quantity
Quantity
of Steel
Copyright © 2004 South-Western
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Equilibrium Without Trade
◦ Results:
 Domestic price adjusts to balance demand and
supply.
 The sum of consumer and producer surplus
measures the total benefits that buyers and
sellers receive.
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If the country decides to engage in
international trade, will it be an importer or
exporter of steel?
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The effects of free trade can be shown by
comparing the domestic price of a good
without trade and the world price of the
good.
The world price refers to the
price that prevails in the world
market for that good.
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If a country has a comparative advantage, then the
domestic price will be below the world price, and
the country will be an exporter of the good.
If the country does not have a comparative
advantage, then the domestic price will be higher
than the world price, and the country will be an
importer of the good.
Price
of Steel
Domestic
supply
Price
after
trade
World
price
Price
before
trade
Exports
0
Domestic
quantity
demanded
Domestic
demand
Domestic
quantity
supplied
Quantity
of Steel
Copyright © 2004 South-Western
Price
of Steel
Consumer surplus
before trade
Price
after
trade
Exports
A
B
Price
before
trade
World
price
D
C
Producer surplus
before trade
0
Domestic
supply
Domestic
demand
Quantity
of Steel
Copyright © 2004 South-Western
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The analysis of an exporting country yields
two conclusions:
◦ Domestic producers of the good are better off,
and domestic consumers of the good are worse
off.
◦ Trade raises the economic well-being of the
nation as a whole.
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International Trade in an importing Country
◦ If the world price of steel is lower than the domestic
price, the country will be an importer of steel when
trade is permitted.
◦ Domestic consumers will want to buy steel at the
lower world price.
◦ Domestic producers of steel will have to lower their
output because the domestic price moves to the
world price.
Price
of Steel
Domestic
supply
Price
before
trade
Price
after
trade
World
price
Imports
0
Domestic
quantity
supplied
Domestic
quantity
demanded
Domestic
demand
Quantity
of Steel
Copyright © 2004 South-Western
Price
of Steel
Consumer surplus
after trade
Domestic
supply
A
Price
before trade
Price
after trade
0
B
C
D
Imports
Producer surplus
after trade
World
price
Domestic
demand
Quantity
of Steel
Copyright © 2004 South-Western
 The analysis of an importing country yields two
conclusions:
 Domestic producers of the good are worse off,
and domestic consumers of the good are better
off.
 Trade raises the economic well-being of the
nation as a whole because the gains of
consumers exceed the losses of producers.
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The gains of the winners exceed the losses of
the losers.
The winners could compensate the losers.
The net change in total surplus is positive.
But will trade make EVERYONE better off?
In practice, compensation for the losers from
international trade is rare…
Without such compensation,
opening up to international trade is
a policy that
expands the size of the economic
pie, while perhaps leaving some
participants in
the economy with a smaller slice...
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Tariffs raise the price of imported goods
above the world price by the amount of the
tariff.
A tariff is a tax on goods
produced abroad and sold
domestically.
Price
of Steel
Domestic
supply
Equilibrium
without trade
Price
with tariff
Tariff
Price
without tariff
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
Copyright © 2004 South-Western
Price
of Steel
Consumer surplus
before tariff
Producer
surplus
before tariff
Domestic
supply
Equilibrium
without trade
Price
without tariff
0
Domestic
demand
S
D
Q
Q
Imports
without tariff
World
price
Quantity
of Steel
Copyright © 2004 South-Western
Price
of Steel
Consumer surplus
with tariff
A
Domestic
supply
Equilibrium
without trade
B
Price
with tariff
Tariff
Price
without tariff
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
Copyright © 2004 South-Western
Price
of Steel
Domestic
supply
Producer
surplus
after tariff
Price
with tariff
Equilibrium
without trade
Tariff
C
Price
without tariff G
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
Copyright © 2004 South-Western
Price
of Steel
Domestic
supply
Tariff Revenue
Price
with tariff
Tariff
E
Price
without tariff
0
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
Copyright © 2004 South-Western
Price
of Steel
Domestic
supply
A
Deadweight Loss
B
Price
with tariff
Tariff
C
D
Price
without tariff G
0
E
F
Imports
with tariff
S
Q
S
Domestic
demand
D
Q
Q
Imports
without tariff
D
Q
World
price
Quantity
of Steel
Copyright © 2004 South-Western
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A tariff reduces the quantity of imports and
moves the domestic market closer to its
equilibrium without trade.
With a tariff, total surplus in the market
decreases by an amount referred to as a
deadweight loss.
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An allocation of resources that maximizes the
sum of consumer and producer surplus is
said to be efficient.
The equilibrium of demand and supply
maximizes the sum of consumer and
producer surplus.
This is as if the invisible hand of the
marketplace leads buyers and sellers to
allocate resources efficiently.
Markets do not allocate resources efficiently
in the presence of market failures.
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
A tax on a good reduces the welfare of buyers
and sellers of the good, and the reduction in
consumer and producer surplus usually
exceeds the revenues raised by the
government.
The fall in total surplus—the sum of
consumer surplus, producer surplus, and tax
revenue — is called the deadweight loss of
the tax.

The effects of free trade can be determined
by comparing the domestic price without
trade to the world price.
◦ A low domestic price indicates that the country has
a comparative advantage in producing the good and
that the country will become an exporter.
◦ A high domestic price indicates that the rest of the
world has a comparative advantage in producing
the good and that the country will become an
importer.
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
When a country allows trade and becomes an
exporter of a good, producers of the good are
better off, and consumers of the good are worse
off.
When a country allows trade and becomes an
importer of a good, consumers of the good are
better off, and producers are worse off.
A tariff—a tax on imports—moves a market closer
to the equilibrium than would exist without trade,
and therefore reduces the gains from trade.