Managerial Economics Lecture 4 Concepts

Managerial Economics
Semester 2, 2018
Lecture 4
Ivan Balbuzanov
Boon Han Koh
Announcements
1. Mid-Semester Exam
– Online-test containing 20 multiple-choice questions.
– Accessed via LMS.
– Starts Tuesday, 28 August at 10am. Ends Wednesday, 29 August at 5pm.
– Practice test will be made available this week.
2. Assignment
– Available on LMS by end of this week.
– Individual assignment.
– Due Monday, 1 October at 4pm. To be submitted on the LMS (Turnitin).
Managerial Economics (Semester 2, 2018) Lecture 4 2

Concept of Economic
Surplus and
Applications
Key Concepts
Recap: Market Equilibrium
• Recall that market equilibrium reflects the way markets allocate scarce resources.
• However, does the equilibrium price and quantity maximize the total welfare of buyers
and sellers?
• Is this allocation of resources efficient? What do we mean by efficiency?
• These questions can be addressed using the concepts of welfare economics.

Welfare Economics
Welfare economics is the study of how the allocation of resources affects economic
well-being.
• How do we measure well-being?
– Well-being = sum of benefits buyers and sellers receive from participation in market trade.
• How do we know what is a ‘good’ or ‘bad’ level of well-being?
– We use the benchmark of efficiency.
• The allocation of resources is efficient when we cannot produce more of a good or
service without giving up some other good or service that we value more highly.

Efficient Allocation of Resources
How do we determine whether a particular allocation of resources in a good or service is
efficient?
• Use marginal analysis, i.e., compare marginal costs (MC) and marginal benefits (MB).
– MB = value of one more unit of a good or service consumed.
– MC = opportunity cost of producing one more unit of a good or service.
• Therefore:
– If MB > MC  should produce more of good or service.
– If MB < MC  should produce less of good or service.
– If MB = MC  efficient allocation.

Efficient Allocation of Resources
How do we determine whether a particular allocation of resources in a good or service is
efficient?
• To investigate whether a competitive market is efficient, we need to learn more about
the link between:
– Demand and marginal benefit
– Supply and marginal cost
• We will start with a re-interpretation of the demand curve and then the supply curve.

Value, Willingness-to-Pay, and Demand
• Distinguish between value and price.
• The value we get from consuming an additional unit of a good = MB.
• Price = what consumer pays to consume the good.
• The consumer will continue to consume more of a good as long as MB > Price, up to the
point where MB = Price.
• As long as MB > Price, the consumer gets a net benefit from trade. This is referred to as
a consumer surplus.
• Therefore, MB is the maximum price a consumer is willing to pay for another unit or, in
other words, her willingness to pay (WTP).
– WTP determines demand.
Using the Demand Curve to Measure Consumer
Surplus
• Consumer surplus is closely related to the demand curve.
• We can use the WTP of consumers for a good to derive a demand schedule.
• Let us consider the example of the market for auto service in a local area.
• Suppose there are four potential buyers of auto service, each with a different WTP for
the service.

Surplus: Example
Willingness-to-
Consumer
Pay
Susan $100
Jim $80
Dan $60
Chen $40

Surplus: Example
Willingness-to- Quantity
Consumer Price Consumers
Pay Demanded
Susan $100 > $100 None 0

Recall that the market
Jim $80 $80 – $100 Susan 1 demand curve depicts the
various quantities that
buyers would be willing
Dan $60 $60 – $80 Susan, Jim 2 and able to purchase at
different prices.
Chen $40 $40 – $60 Susan, Jim, Dan 3
Susan, Jim, Dan,

≤ $40 4
Chen

Surplus: Example
Price of Auto
Service ($)
Susan’s
WTP
100
Jim’s
WTP
80
Dan’s
WTP
60
Chen’s
WTP
40
Demand = MB
Quantity of
Auto Services
1 2 3 4
How the Price Affects Consumer Surplus
P
Consumer Surplus at
Price P1 A
The area below the demand
curve and above the price =
Consumer Surplus
Consumer
Surplus
P1
B C
Demand
Q
0 Q1

How the Price Affects Consumer Surplus
P
Consumer Surplus at
Price P2 A
The area below the demand
curve and above the price =
Consumer Surplus
Initial Consumer surplus to
consumer new consumers
surplus
P1
Additional consumer B C
surplus to initial
consumers P2
D E F Demand
Q
0 Q1 Q2

Cost, Price, and Producer Surplus
• Distinguish between opportunity cost and price.
• Opportunity cost = what producer must give up to produce good.
• The opportunity cost of producing one more unit = MC.
– MC = minimum price that producers must receive to induce them to produce another unit.
– This minimum acceptable price determines supply.
• Price = what producer receives when good is sold.
• Producers will continue to supply another unit of a good so long as Price > MC, up till
the point where Price = MC.
• As long as Price > MC, the producer gets a net benefit from trade. This is referred to as a
producer surplus.
Using the Supply Curve to Measure Producer
Surplus
• Producer surplus is closely related to the supply curve.
• We can use the opportunity cost of producers for a good to derive a supply schedule.
• Let us consider the example of the market for auto service in a local area.
• Suppose there are four potential sellers of auto service, each with a different
opportunity cost of supply.

Surplus: Example
Opportunity
Producer
Cost
Jack $20
Long $40
Mario $60
Sam $80

Surplus: Example
Opportunity Quantity
Producer Price Consumers
Cost Demanded
Jack, Long,
Jack $20 ≥ $80 4
Mario, Sam
Recall that the market
Jack, Long, supply curve depicts the
Long $40 $60 – $80 3
Mario various quantities that
producers would be
Mario $60 $40 – $60 Jack, Long 2 willing and able to sell at
different prices.
Sam $80 $20 – $40 Jack 1
< $20 None 0

Surplus: Example
Price of Auto
Service ($)
Sam’s Supply = MC
cost
80
Mario’s
cost
60
Long’s
cost
40
Jack’s
cost
20
Quantity of
Auto Services
1 2 3 4
How the Price Affects Producer Surplus
P
Producer Surplus at
Price P1
The area above the supply
curve and below the price =
Producer Surplus
Supply
B
P1
Producer C
Surplus
A
Q
0 Q1

How the Price Affects Producer Surplus
P
Producer Surplus at
Price P2
The area above the supply
curve and below the price =
Producer Surplus
D E F Supply
Additional producer P2
surplus to initial
producers B Producer surplus to
P1
Producer C new producers
Surplus
A
Q
0 Q1 Q2

Market Equilibrium and Efficiency
The competitive market equilibrium is efficient.
Why?
• Recall that demand = MB and supply = MC.
• Hence, where demand = supply, MB = MC.
• Where MB = MC, all mutually beneficial trades have taken place.
• Therefore, there is an efficient use of resources. The sum of consumer surplus and
producer surplus is maximized.

Price of Auto
Service ($)
Susan Supply = MC
100
Jim
80
Sam
Dan
60
Mario
Chen
40
Long
20 Demand = MB
Jack
Quantity of
1 Auto Services
2 3 4
Price of Auto
Service ($)
Susan Supply = MC
100
Jim
80
Sam
Dan
P* = 60
Mario
Chen
40
Long
20 Demand = MB
Jack
Quantity of
1 2 4 Auto Services
Q* = 3
Price of Auto
Service ($)
Susan Supply = MC
100
Jim
80
Sam
CS = $60
Dan
P* = 60
Mario
PS = $60 Chen
40
Long
20 Demand = MB
Jack
Quantity of
1 2 4 Auto Services
Q* = 3
P
Supply = MC
Consumer
Surplus
Equilibrium
C
price B
Producer
Surplus
D Demand = MB
0 Equilibrium Q
quantity

P
Supply = MC
Value to
buyers
Equilibrium Cost to
price sellers
Cost to Value to
sellers buyers Demand = MB
0 Equilibrium Q
quantity
Value to buyers > Cost to sellers Value to buyers < Cost to sellers
Sources of Inefficiency: Market Failure
• Markets generally do a good job of sending resources to where they are most highly
valued, but sometimes they fail.
• Market failure represents a situation where markets overproduce or underproduce a
good or service.
• The most significant reasons for market failure are:
– Government price controls, taxes, subsidies and quotas.
– Imperfect competition, e.g., monopoly.
– Externalities.
• We will look at these cases of market failure over the coming lectures.

Measures of Inefficiency: Deadweight Loss
• The extent to which a market does not achieve an efficient level of resource allocation is
measured by the deadweight loss.
• The deadweight loss is the decrease in consumer surplus and producer surplus that
results from a inefficient level of production.
• It represents a loss of mutually beneficial trade, i.e., a loss of gains from trade.
• The deadweight loss is borne by the entire society.
– It is not a loss for consumers and a gain for producers. Rather, it is a social loss.

Deadweight Loss: Underproduction
P
Loss of PS & CS since
Suppose market
MB > MC
trades at Q1 < Q*
Hence, DWL = A + B
Supply = MC
A
P*
B
Demand = MB
0 Q1 Q* Q

Deadweight Loss: Overproduction
P
Negative PS & CS
Suppose market
since MC > MB
trades at Q2 > Q*
Hence, DWL = C + D
Supply = MC
C
P*
D
Demand = MB
0 Q* Q2 Q

Review: Market Efficiency
• Recall that competitive markets are efficient because they:
– allocate the supply of goods and services to the buyers who value them most highly;
– allocate the demand for goods to the sellers who can produce them at least cost; and
– produce the quantity of goods that maximizes the total surplus created from trade, i.e., the
sum of consumer and producer surplus.
• The deadweight loss is a measure of inefficiency (market failure).

Concept of Economic
Surplus and
Applications
Government Intervention
Impact of Government Intervention
• Many forms of government intervention (taxes, subsidies, price controls, and quotas)
will impact market outcomes and the well-being of consumers and producers.
• This can be measured by the effect on:
– market prices and quantities traded, and the creation of shortages and surpluses; and
– consumer and producer surplus, and the creation of DWL.

The Effects of a Tax
How does a sales tax affect market outcomes?
• 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.
• A sales 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 Effects of a Tax: Market Outcomes
P Supply + tax
Supply
Price consumers Size of tax
pay (Pc)
P*
Price producers
receive (Ps)
Demand
0 Qtax Q* Q

The Effects of a Tax: Welfare
P Supply + tax
Supply
A
Pc
B C
P*
D E
Ps
F
Demand
0 Qtax Q* Q

P Supply + tax
Surplus Without With tax Change
tax (effect on
welfare)
Supply
A Consumer A+B+C A –B–C
Pc Surplus (CS)
B C Producer D+E+F F –D–E
P* Surplus (PS)
D E Government 0 B+D +B+D
Ps Revenue
F
Demand Total A+B+C+ A+B+D+ –C–E
Surplus (TS) D+E+F F (DWL)
0 Qtax Q* Q

• Size of surplus:
– Society’s well-being is reduced by a tax (net change in total surplus is negative).
– Tax creates a deadweight loss = – (C + E). Why is this the case?
– Because the tax creates a wedge between buyers and sellers and prevents them from realizing
some of the gains from trade (i.e., the range of quantity where MB > MC).
• Distribution of surplus:
– The losses to buyers and sellers from a tax exceeds the revenue raised by the government.
– Producers are worse off = – (D + E) and consumers are worse off = – (B + C).
– The government is better off = (B + D).

The Effects of a Subsidy
How does a subsidy affect market outcomes?
• It does not matter whether a subsidy on a good is provided to buyers or sellers of the
good.
– The price paid by buyers lowers, and the price received by sellers increases.
• A subsidy places a wedge between the price buyers pay and the price sellers receive.
• Because of this subsidy wedge, the quantity sold increases above the level that would
be sold without a subsidy.

The Effects of a Subsidy: Market Outcomes
P
Size of subsidy Supply

Price producers
receive (Ps) Demand
+ subsidy
P*
Price consumers
pay (Pc)
Demand
0 Q* Qsubsidy Q

The Effects of a Subsidy: Welfare
P
Supply
A
Ps
Demand
B C
D + subsidy
P*
E G
F
Pc
H Demand
0 Q* Qsubsidy Q

P
Surplus Without With Change
subsidy subsidy (effect on
welfare)
Supply
A Consumer A+B A+B+E+ +E+F
Ps Surplus (CS) F
Demand
B C
D + subsidy Producer E+H B+C+E+ +B+C
P* Surplus (PS) H
E G Government 0 B+C+D+ – (B + C + D
F
Expenditure E+F+G + E + F + G)
Pc
H Demand Total A+B+E+ A+E+B+ –D–G
Surplus (TS) H H–D–G (DWL)
0 Q* Qsubsidy Q

– Society’s well-being is reduced by a subsidy (net change in total surplus is negative).
– Subsidy creates a deadweight loss = – (D + G). Why is this the case?
– Because the subsidy creates a wedge between what sellers receive and what buys pay,
creating an incentive for trade beyond the efficient level (i.e., the range of quantity where MC
> MB).
– The loss to the government exceeds the gains to buyers and sellers.
– Producers are better off = (B + C) and consumers are better off = (E + F).
– The government is worse off = – (B + C + D + E + F + G).

Control on Prices
• Price controls are usually enacted when policy-makers believe the market price is unfair
to buyers or sellers.
• Result in government-created price ceilings and floors.
– Price ceiling: A legal maximum on the price at which a good can be sold.
– Price floor: A legal minimum on the price at which a good can be sold.

Price Ceiling in the Rental Apartment Market:
Market Outcomes
Rent
Supply
P*
Demand
0 Q* Quantity of
Apartments

Market Outcomes
Rent
Supply
P*
Rent ceiling
Pceiling
Shortage Demand
0 Qs Q* Qd Quantity of
(Qty supplied) (Qty demanded)
Apartments

Market Outcomes
• A binding price ceiling prevents the forces of supply and demand moving the price
towards the equilibrium price and quantity.
• When the market price hits the ceiling, it can rise no further, and the market price
equals the price ceiling.
• Hence, price is lower than equilibrium price, and quantity is less than equilibrium
quantity.
• A price ceiling causes a shortage because Qd > Qs.
• Non-price rationing is an alternative mechanism for rationing the good, e.g., using
discrimination criteria, waitlists (queuing), etc.

Welfare
Rent
Supply
A
B C
P*
D E
Rent ceiling
Pceiling
F
Demand
Apartments

Welfare
Rent
Surplus No With rent Change
Regulation ceiling (effect on
welfare)
Supply
A Consumer A+B+C A+B+D D–C
Surplus (CS)
B C Producer D+E+F F –D–E
P* Surplus (PS)
D E Total A+B+C+ A+B+D+ –C–E
Rent ceiling
Pceiling Surplus (TS) D+E+F F (DWL)
F
Demand
Apartments

Welfare
– Society’s well-being is reduced by a price ceiling (net change in total surplus is negative).
– Price ceiling creates a deadweight loss = – (C + E). Why is this the case?
– Because the price ceiling prevents some buyers and sellers from realizing the gains from trade
(i.e., the range of quantity where MB > MC).
– Producers are worse off = – (D + E).
– Consumers may be worse off or better off, depending on whether D > C or D < C.

Price Floor in the Labor Market: Market Outcomes
Wage
Supply
P*
Demand
0 Q* Quantity of
Labor

Wage
Unemployment Supply
Pfloor
Minimum
P* wage
Demand
0 Qd Q* Qs Quantity of
(Qty demanded) (Qty supplied)
Labor

• A binding price floor prevents the forces of supply and demand moving the price
towards the equilibrium price and quantity.
• When the market price hits the floor, it can fall no further, and the market price equals
the floor price.
• Hence, price is higher than equilibrium price, and quantity is less than equilibrium
quantity.
• A price floor causes a surplus because Qs > Qd.
• Non-price rationing is an alternative mechanism for rationing the good, e.g., using
discrimination criteria.

Price Floor in the Labor Market: Welfare
Wage
Supply
A
Pfloor
B C Minimum
P* wage
D E
F
Demand
Labor

Wage
Surplus No With Change
Regulation minimum (effect on
wage welfare)
Supply
Pfloor Surplus (CS)
B C Minimum Producer D+E+F B+D+F B–E
P* wage Surplus (PS)
D E Total A+B+C+ A+B+D+ –C–E
Surplus (TS) D+E+F F (DWL)
F
Demand
Labor

– Society’s well-being is reduced by a price floor (net change in total surplus is negative).
– Price floor creates a deadweight loss = – (C + E). Why is this the case?
– Because the price floor prevents some buyers and sellers from realizing the gains from trade
(i.e., the range of quantity where MB > MC).
– Consumers (firms) are worse off = – (B + C).
– Producers (workers) may be worse off or better off, depending on whether B > E or B < E.

Production Quota: Examples
• In the U.S., producers of tobacco, peanuts, hops, California oranges, and other products
have production quotas based on their historical production.
– Tobacco quotas were established in the 1930s (and ended in 2005). When the quotas were in
place, a tobacco farmer’s quota was a percentage of the 1930s level of production. The
Secretary of Agriculture set the percentage annually.
• The right to drive a taxi in New York requires a medallion issued by the city, and there
are a limited number of medallions.
– This is a quota. Is it a restrictive quota? The price of a New York taxi medallion — the right to
drive a taxi legally in New York City — is $413,000 (as of 2008).
– This adds approximately $30,000 to $40,000 annually to the cost of operating a taxi in New
York, using a risk-adjusted interest rate.

Production Quota: Market Outcomes
Price
Supply
P*
Demand
0 Q* Quantity

Price
Supply with quota
(S1)
Supply
Pquota
P*
Demand
0 Q1 Q* Q2 Quantity

• A legally binding production quota prevents the forces of supply and demand moving
the price towards the equilibrium price and quantity.
• At the quota level the effective supply curve becomes S1, so the quantity traded is
restricted to Q1 and the price is increased to Pquota.
• Hence, price is higher than equilibrium price, and quantity traded is less than
equilibrium quantity.
• At Pquota there is a surplus of producers willing to supply more at this price [Q2 > Q1].

Production Quota: Welfare
Price
Supply with quota
(S1)
Supply
A
Pquota
B C
P*
D E
Demand
0 Q1 Q* Quantity

Production Quota: Welfare
Price
Supply with quota Surplus No With quota Change
(S1) Regulation (effect on
welfare)
Supply
Pquota Surplus (CS)
B C Producer D+E B+D B–E
P* Surplus (PS)
D E Total A+B+C+ A+B+D –C–E
Surplus (TS) D+E (DWL)
Demand
0 Q1 Q* Quantity

Voluntary Production Quota: Examples
The higher price can be also be supported by a voluntary quota where the government
pays producers to restrict output to Q1.
• An example of a voluntary production quota is in U.S. agricultural policy, where output
is reduced by incentives rather than by outright quota.
• Acreage-limitation programs gave farmers financial incentives to leave some of their
acreage idle.
• Because farmers agreed to accept the payment and reduce output to the targeted
output (Q1), the supply curve becomes vertical at the targeted output level.
• The government payment is equal to the producer surplus the farmers would have got
had they produced an output at the higher price Pquota.

Voluntary Production Quota: Welfare
Price
Supply with quota Surplus No With Change
(S1) Regulation voluntary (effect on
quota welfare)
Supply
Pquota Surplus (CS)
F
B C Producer D+E B+C+D+ B+C+F
P* Surplus (PS) E+F
D E Government 0 C+E+F – (C + E + F)
Expenditure
Demand Total A+B+C+ A+B+D –C–E

Surplus (TS) D+E (DWL)
0 Q1 Q* Quantity

Price Supports: Examples
• An example of a price support scheme is the Australian reserve price scheme for wool.
It was introduced in 1974 to provide growers with a guaranteed minimum price for
wool.
• The scheme was funded by tax paid by growers and administered by the Australian
Wool Corporation, which bought all the wool not meeting the minimum reserve price at
auctions. This wool was later sold during periods of higher prices.
• Having increased the floor price by 70 per cent in the last two years to February 1991,
the reserve price scheme collapsed.
• The size of the Australian Wool Corporation stockpile had reached 4.7 million bales. It
took 10 years for the stockpile to be sold. The market for wool has never recovered.

Price Supports: Market Outcomes
Price
Supply
P*
Demand
0 Q* Quantity

Price Supports: Market Outcomes
Price
To maintain a price Ps,

Qg Supply the government buys
quantity Qg or (Q1 – Q2).
Ps
Demand + Qg
P*
Demand
0 Q1 Q* Q2 Quantity

Price Supports: Welfare
Price
Supply
A
Ps
B C F
Demand + Qg
P* I
E
D
G H
Demand
0 Q1 Q* Q2 Quantity

Price Supports: Welfare
Price
Surplus No With price Change
Regulation support (effect on
welfare)
Supply
Surplus (CS)
Ps
B C F Producer D+E B+C+D+ B+C+F
Demand + Qg
P* I Surplus (PS) E+F
E
D Government 0 C+E+F+ – (C + E + F
Expenditure G+H+I + G + H + I)
G H
Demand Total A+B+C+ A+B+D– –C–E–G
Surplus (TS) D+E G–H–I –H–I
(DWL)
0 Q1 Q* Q2 Quantity

Implications for Managerial Decision Making
• Government policies such as taxes, subsidies, price controls, and quotas affect the costs
and benefits of managerial decisions.
• For example, a production tax increases the costs of supply and provides an incentive to
reduce production, while a production subsidy reduces the costs of supply and provides
an incentive to increase production.

Managerial Economics Lecture 4 Concepts

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Susan $100 > $100 None 0

Susan, Jim, Dan,

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Size of subsidy Supply

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Demand Total A+B+C+ A+B+D –C–E

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To maintain a price Ps,