WEBVTT 00:00:00.040 --> 00:00:02.460 The following content is provided under a Creative 00:00:02.460 --> 00:00:03.870 Commons license. 00:00:03.870 --> 00:00:06.910 Your support will help MIT OpenCourseWare continue to 00:00:06.910 --> 00:00:10.560 offer high quality educational resources for free. 00:00:10.560 --> 00:00:13.460 To make a donation or view additional materials from 00:00:13.460 --> 00:00:18.815 hundreds of MIT courses, visit MIT OpenCourseWare at 00:00:18.815 --> 00:00:20.065 ocw.mit.edu. 00:00:23.990 --> 00:00:25.830 PROFESSOR: We want to turn this course to now start 00:00:25.830 --> 00:00:28.270 talking about some normative economics, which is how do we 00:00:28.270 --> 00:00:31.030 feel about the actions firms and consumers take. 00:00:31.030 --> 00:00:33.640 And to do that we need to pause, and starting last 00:00:33.640 --> 00:00:36.970 lecture now through this lecture, talk about welfare. 00:00:36.970 --> 00:00:37.980 Well-being. 00:00:37.980 --> 00:00:41.530 How do we measure the well-being implications of 00:00:41.530 --> 00:00:44.910 individual and firm actions? 00:00:44.910 --> 00:00:48.770 Now, we talked last time about the first concept of this, 00:00:48.770 --> 00:00:51.010 which was consumer surplus. 00:00:51.010 --> 00:00:57.840 Consumer surplus was the amount of utility consumers 00:00:57.840 --> 00:01:00.640 derived above and beyond the price they had 00:01:00.640 --> 00:01:01.670 to pay for the good. 00:01:01.670 --> 00:01:03.285 Now, since it's utility, remember, it's not ordinal, 00:01:03.285 --> 00:01:04.569 it's cardinal. 00:01:04.569 --> 00:01:06.130 We redefine that. 00:01:06.130 --> 00:01:09.680 That is the consumer's willingness to pay above the 00:01:09.680 --> 00:01:11.490 price that they pay for a good. 00:01:11.490 --> 00:01:14.380 So, anything a consumer's willing to pay that was higher 00:01:14.380 --> 00:01:18.730 than the price they actually paid is consumer surplus. 00:01:18.730 --> 00:01:20.050 And that was at the individual level. 00:01:20.050 --> 00:01:22.180 That was the individual consumer surplus. 00:01:22.180 --> 00:01:24.810 Now what we want to do is move on and talk about market 00:01:24.810 --> 00:01:26.060 consumer surplus. 00:01:29.250 --> 00:01:33.110 So for an individual, consumer surplus is a willingness to 00:01:33.110 --> 00:01:35.490 pay above the price actually paid. 00:01:35.490 --> 00:01:38.510 At the market level, it's the same thing. 00:01:38.510 --> 00:01:43.850 It's just the aggregation of individual consumer surpluses. 00:01:43.850 --> 00:01:46.870 So let's think about a simple example. 00:01:46.870 --> 00:01:50.630 Let's think about the case of the consumer surplus that you 00:01:50.630 --> 00:01:53.270 derive from my lectures. 00:01:53.270 --> 00:01:54.420 Let's think about the consumer surplus you 00:01:54.420 --> 00:01:56.120 derive from my lectures. 00:01:56.120 --> 00:01:58.180 So we have some demand curve for my lectures. 00:01:58.180 --> 00:02:00.410 Let's look at figure 13-1. 00:02:00.410 --> 00:02:03.910 Let's say this is the demand curve for my lectures. 00:02:03.910 --> 00:02:07.040 So basically, this is a willingness to pay. 00:02:07.040 --> 00:02:10.600 So the notion is that there's some student who's willing to 00:02:10.600 --> 00:02:12.740 pay a large amount because they recognize the brilliance 00:02:12.740 --> 00:02:14.020 of what they're hearing here. 00:02:14.020 --> 00:02:16.890 And they're willing to pay a large amount for my lectures. 00:02:16.890 --> 00:02:18.990 Then the next student's willing to pay slightly less. 00:02:18.990 --> 00:02:22.220 All the way down to the student who falls asleep every 00:02:22.220 --> 00:02:25.050 time who's not willing to pay anything for my lectures. 00:02:25.050 --> 00:02:26.770 So you've got some demand curve for my lectures. 00:02:26.770 --> 00:02:29.320 And, once again, the key to all this, the key to the 00:02:29.320 --> 00:02:31.820 welfare analysis, is to remember what this demand 00:02:31.820 --> 00:02:32.390 curve represents. 00:02:32.390 --> 00:02:34.370 It's a willingness to pay curve. 00:02:34.370 --> 00:02:36.260 But in this case, it's not an individual's 00:02:36.260 --> 00:02:36.962 willingness to pay. 00:02:36.962 --> 00:02:38.620 It's the market's willingness to pay. 00:02:38.620 --> 00:02:41.220 Where each point is a unit of demand. 00:02:41.220 --> 00:02:44.350 So in this case, one unit equals one person. 00:02:44.350 --> 00:02:45.900 So each point represents the willingness 00:02:45.900 --> 00:02:47.430 to pay of that person. 00:02:47.430 --> 00:02:49.995 So the point on the y-axis represents the willingness to 00:02:49.995 --> 00:02:53.450 pay of the person who most enjoys my lectures. 00:02:53.450 --> 00:02:55.320 Or derives the most value out of them. 00:02:55.320 --> 00:02:58.470 The intersection of that line with the x-axis is a 00:02:58.470 --> 00:02:59.910 willingness to pay of zero, someone who's not willing to 00:02:59.910 --> 00:03:02.130 pay anything for the lectures. 00:03:02.130 --> 00:03:03.150 Obviously, could go negative. 00:03:03.150 --> 00:03:05.600 People could be willing to pay not have to come to the 00:03:05.600 --> 00:03:07.170 lecture, but we won't consider that. 00:03:07.170 --> 00:03:10.000 We'll just say zero's the minimum. 00:03:10.000 --> 00:03:13.900 So, basically, what is the key determinant of 00:03:13.900 --> 00:03:15.950 the equilibrium outcome? 00:03:15.950 --> 00:03:20.270 It is the point where, equilibrium is the point, 00:03:20.270 --> 00:03:24.870 where the price is set equal to the willingness to pay of 00:03:24.870 --> 00:03:26.450 the marginal consumer. 00:03:26.450 --> 00:03:30.610 So if you think about typical supply-demand diagram, and we 00:03:30.610 --> 00:03:32.760 get some equilibrium price. 00:03:32.760 --> 00:03:35.260 So here's our equilibrium quantity, Q-star. 00:03:35.260 --> 00:03:37.690 And here's our program price, P-star. 00:03:37.690 --> 00:03:40.090 Now, let's focus in on this demand curve. 00:03:40.090 --> 00:03:43.690 With that price P-star, it represents-- 00:03:43.690 --> 00:03:46.770 it's on the demand curve, so it's a willingness to pay. 00:03:46.770 --> 00:03:48.670 Whose willingness to pay is it? 00:03:48.670 --> 00:03:51.450 It's the willingness to pay of person Q-star. 00:03:51.450 --> 00:03:54.420 It's the willingness to pay of the person who's exactly 00:03:54.420 --> 00:03:56.740 willing to pay the price. 00:03:56.740 --> 00:04:00.290 That is, the equilibrium in a perfectly competitive market, 00:04:00.290 --> 00:04:05.620 of the kind we've discussed so far, the price represents the 00:04:05.620 --> 00:04:08.900 willingness to pay of the marginal consumer. 00:04:08.900 --> 00:04:13.410 The willingness to pay of the consumer who exactly is 00:04:13.410 --> 00:04:16.640 indifferent between consuming and not consuming the good. 00:04:16.640 --> 00:04:20.839 So this consumer, Q-star, this person Q-star in our example, 00:04:20.839 --> 00:04:22.980 is the person who's indifferent. 00:04:22.980 --> 00:04:27.040 Who derives, what, zero consumer surplus. 00:04:27.040 --> 00:04:30.170 This person, since their willingness to pay equals the 00:04:30.170 --> 00:04:36.550 price, equilibrium is achieved where the price is set-- 00:04:36.550 --> 00:04:39.950 In equilibrium, you have that the marginal consumer, the 00:04:39.950 --> 00:04:42.240 last person consuming, is deriving 00:04:42.240 --> 00:04:44.190 zero consumer surplus. 00:04:44.190 --> 00:04:47.470 They're indifferent between consuming the good and not 00:04:47.470 --> 00:04:49.550 consuming the good at that price. 00:04:49.550 --> 00:04:51.780 If it was free, they'd be happy to consume it, but at 00:04:51.780 --> 00:04:54.090 the price, at that equilibrium price P-star, they're 00:04:54.090 --> 00:04:55.950 indifferent. 00:04:55.950 --> 00:04:59.270 So basically, looking at the diagram, what this is saying 00:04:59.270 --> 00:05:03.170 is that the price was $100 a lecture. 00:05:03.170 --> 00:05:07.530 Then person 100, that hundredth person, would be the 00:05:07.530 --> 00:05:11.460 marginal consumer who's indifferent between paying the 00:05:11.460 --> 00:05:13.710 $100 and hearing my lecture or paying nothing 00:05:13.710 --> 00:05:15.860 and skipping my lecture. 00:05:15.860 --> 00:05:19.180 So that person 100 is the person who's indifferent 00:05:19.180 --> 00:05:22.375 between paying $100 and hearing my lecture or paying 00:05:22.375 --> 00:05:23.880 zero and not hearing my lecture. 00:05:23.880 --> 00:05:27.670 That person drives no consumer surplus. 00:05:27.670 --> 00:05:30.290 Because their willingness to pay equals the price. 00:05:30.290 --> 00:05:34.550 What that means is that every consumer up to the first 100, 00:05:34.550 --> 00:05:36.740 by definition, must be deriving 00:05:36.740 --> 00:05:38.570 some consumer surplus. 00:05:38.570 --> 00:05:41.770 As long as the demand curve is downward sloping. 00:05:41.770 --> 00:05:44.270 As long as the demand curve is downward sloping, every person 00:05:44.270 --> 00:05:46.800 to the left of person 100 must be deriving 00:05:46.800 --> 00:05:48.690 some consumer surplus. 00:05:48.690 --> 00:05:51.340 In particular, the first person is driving enormous 00:05:51.340 --> 00:05:52.450 consumer surplus. 00:05:52.450 --> 00:05:53.200 How can we prove that? 00:05:53.200 --> 00:05:54.180 Well, the proof is simple. 00:05:54.180 --> 00:05:59.590 We know their willingness to pay is higher than person 100. 00:05:59.590 --> 00:06:02.810 And we know person 100 is willing to pay $100. 00:06:02.810 --> 00:06:05.470 Therefore, by definition anyone to the left is deriving 00:06:05.470 --> 00:06:07.860 consumer surplus from this. 00:06:07.860 --> 00:06:10.070 Because we know they like it more than person 100, and 00:06:10.070 --> 00:06:11.990 person 100 is willing to pay $100. 00:06:11.990 --> 00:06:15.000 They only have to pay $100, it's one price to everybody. 00:06:15.000 --> 00:06:18.540 So by definition, they're deriving consumer surplus. 00:06:18.540 --> 00:06:24.910 So the first guy, he or she gets a big consumer surplus. 00:06:24.910 --> 00:06:26.915 Then it dwindles and dwindles and dwindles until the 00:06:26.915 --> 00:06:28.670 hundredth person derives zero. 00:06:28.670 --> 00:06:32.250 But, if you integrate, and the entire consumer surplus for 00:06:32.250 --> 00:06:35.020 the market is that entire triangle, that 00:06:35.020 --> 00:06:36.570 entire shaded triangle. 00:06:36.570 --> 00:06:40.080 So market consumer surplus is defined the same as individual 00:06:40.080 --> 00:06:41.330 consumer surplus, as the difference 00:06:41.330 --> 00:06:42.420 between the demand curve. 00:06:42.420 --> 00:06:44.675 It's the area under the demand curve above the price. 00:06:44.675 --> 00:06:47.490 So it's the integral of that area, under the demand curve, 00:06:47.490 --> 00:06:49.250 above the price. 00:06:49.250 --> 00:06:51.220 But here we're thinking of it not in terms of a person's 00:06:51.220 --> 00:06:52.770 decision but the market's decision. 00:06:52.770 --> 00:06:54.870 And when you think about that, it is the last unit be 00:06:54.870 --> 00:06:56.730 representing the person who's indifferent. 00:06:56.730 --> 00:07:00.730 And everybody else deriving surplus from it. 00:07:00.730 --> 00:07:03.540 Questions about that? 00:07:03.540 --> 00:07:06.870 Now, let's ask what, then would happen if the price of 00:07:06.870 --> 00:07:08.750 my lecture rate rose. 00:07:08.750 --> 00:07:11.010 So let's say I was charging $100 boxes at the door. 00:07:11.010 --> 00:07:13.550 You guys are all the guys to the left of person 100. 00:07:13.550 --> 00:07:14.930 Those people who were here for the first lecture and don't 00:07:14.930 --> 00:07:16.620 show up any more, they're the people to the 00:07:16.620 --> 00:07:19.880 right of person 100. 00:07:19.880 --> 00:07:21.540 And now let's say I change. 00:07:21.540 --> 00:07:23.580 Instead of charging $100 at the door, I 00:07:23.580 --> 00:07:25.570 charge $110 at the door. 00:07:25.570 --> 00:07:29.350 So let's look at figure 13-2. 00:07:29.350 --> 00:07:31.630 What happens there? 00:07:31.630 --> 00:07:39.070 Well, in that case, if I charge $110, the hundredth guy 00:07:39.070 --> 00:07:41.190 is no longer willing to come to lecture. 00:07:41.190 --> 00:07:44.550 Remember, the hundredth guy, he or she was indifferent 00:07:44.550 --> 00:07:46.480 between paying $100 and hearing my lecture and paying 00:07:46.480 --> 00:07:47.840 nothing and missing my lecture. 00:07:47.840 --> 00:07:50.125 Well at $110, clearly, they'll say forget it, it's not worth 00:07:50.125 --> 00:07:50.900 it any more. 00:07:50.900 --> 00:07:52.450 They'll drop out. 00:07:52.450 --> 00:07:55.560 Likewise, the way I've drawn this diagram, everybody above 00:07:55.560 --> 00:07:58.960 person 90 will no longer attend. 00:07:58.960 --> 00:08:01.830 That is, person 90 is now the person, where at a price of 00:08:01.830 --> 00:08:04.820 $110 they're indifferent between paying and attending 00:08:04.820 --> 00:08:07.640 or not paying and not attending. 00:08:07.640 --> 00:08:09.830 Everybody to the left of person 90 still 00:08:09.830 --> 00:08:10.760 gets consumer surplus. 00:08:10.760 --> 00:08:12.990 It's not shaded, but if you shade the triangle above the 00:08:12.990 --> 00:08:16.230 $110 dashed line, the triangle under the demand curve and 00:08:16.230 --> 00:08:18.980 above with a dashed line at $110, that's the 00:08:18.980 --> 00:08:22.140 new consumer surplus. 00:08:22.140 --> 00:08:23.670 That's the new consumer surplus. 00:08:23.670 --> 00:08:25.280 Those people still derive consumer surplus because they 00:08:25.280 --> 00:08:29.250 love me so much that they're willing to pay more than $110. 00:08:29.250 --> 00:08:31.990 So even $110, and they prefer to pay $100. 00:08:31.990 --> 00:08:34.070 But even $110 they'll still come and they'll still be 00:08:34.070 --> 00:08:35.340 happy about it. 00:08:35.340 --> 00:08:37.940 But now 10 people have dropped out because they're not 00:08:37.940 --> 00:08:39.320 willing to pay $110. 00:08:39.320 --> 00:08:41.750 They were only willing to pay $100. 00:08:41.750 --> 00:08:44.540 So what we see is that the total 00:08:44.540 --> 00:08:46.450 consumer surplus has shrunk. 00:08:46.450 --> 00:08:51.910 It's shrunk by this trapezoid, by this shaded trapezoid. 00:08:51.910 --> 00:08:55.010 And it's shrunk for two reasons. 00:08:55.010 --> 00:08:59.180 One reason is that some people who used to derive consumer 00:08:59.180 --> 00:09:01.480 surplus now are out of the market. 00:09:01.480 --> 00:09:02.840 That's the triangle. 00:09:02.840 --> 00:09:05.240 That's the shaded triangle. 00:09:05.240 --> 00:09:08.730 It's also shrunk because even people staying in the market 00:09:08.730 --> 00:09:10.570 are now sadder. 00:09:10.570 --> 00:09:11.960 They've lost consumer surplus. 00:09:11.960 --> 00:09:14.010 The consumer surplus is still positive. 00:09:14.010 --> 00:09:16.400 They're still coming to the lecture, but it's smaller than 00:09:16.400 --> 00:09:18.860 it was, and that's the rectangle. 00:09:18.860 --> 00:09:22.530 So the triangle is the people who drop out of the market. 00:09:22.530 --> 00:09:27.210 The rectangle is the reduced consumer surplus, the reduced 00:09:27.210 --> 00:09:29.290 consumer surplus of people who stay in the market but now 00:09:29.290 --> 00:09:31.200 have to pay $10 more. 00:09:31.200 --> 00:09:33.100 The consumer surplus is still positive, but it's smaller. 00:09:35.960 --> 00:09:38.170 So, a question to you. 00:09:38.170 --> 00:09:44.170 What is the key economic concept that's going to 00:09:44.170 --> 00:09:48.360 determine, for a given market, whether the consumer surplus 00:09:48.360 --> 00:09:49.910 is large or small? 00:09:49.910 --> 00:09:50.760 Yeah? 00:09:50.760 --> 00:09:51.210 AUDIENCE: Elasticity. 00:09:51.210 --> 00:09:51.950 PROFESSOR: The elasticity. 00:09:51.950 --> 00:09:53.080 And why is that? 00:09:53.080 --> 00:09:56.890 AUDIENCE: Because it changes how steeply-- 00:09:56.890 --> 00:09:57.700 PROFESSOR: Exactly. 00:09:57.700 --> 00:10:04.820 So if we look at figure 13-3, now here is a case with a 00:10:04.820 --> 00:10:06.360 steeper elasticity of demand, where 00:10:06.360 --> 00:10:08.780 consumers are more inelastic. 00:10:08.780 --> 00:10:11.810 If you compare it to figure 13-1, you'll see the consumer 00:10:11.810 --> 00:10:15.660 surplus triangle is much bigger. 00:10:15.660 --> 00:10:20.030 Likewise, if we drew a flatter demand curve, a more elastic 00:10:20.030 --> 00:10:25.630 demand, the consumer surplus would be much smaller. 00:10:25.630 --> 00:10:27.450 So hopefully you can see graphically what will 00:10:27.450 --> 00:10:31.050 determine consumer surplus is the elasticity of demand. 00:10:31.050 --> 00:10:33.650 Now, can someone give me the intuition for why that's true? 00:10:33.650 --> 00:10:34.990 Graphically, I hope you can see it's true. 00:10:34.990 --> 00:10:38.030 The triangle will be smaller as that curve is flatter. 00:10:38.030 --> 00:10:40.010 Can someone give me the intuition for why that's true? 00:10:40.010 --> 00:10:42.890 Why is it that consumer surplus is larger the more 00:10:42.890 --> 00:10:45.575 inelastic is demand, and consumer surplus is smaller 00:10:45.575 --> 00:10:48.510 the more elastic is demand. 00:10:48.510 --> 00:10:50.294 Want to give it a try? 00:10:50.294 --> 00:10:52.754 AUDIENCE: I guess if it's more inelastic, then consumers 00:10:52.754 --> 00:10:56.200 don't have-- 00:10:56.200 --> 00:10:57.180 PROFESSOR: They don't have what? 00:10:57.180 --> 00:10:58.160 [UNINTELLIGIBLE] 00:10:58.160 --> 00:11:00.120 What determines it? 00:11:00.120 --> 00:11:00.420 AUDIENCE: As many choices, I would say. 00:11:00.420 --> 00:11:02.040 PROFESSOR: They don't have as many substitutes. 00:11:02.040 --> 00:11:05.500 So with inelastic demand is when consumers don't have as 00:11:05.500 --> 00:11:06.840 many substitutes. 00:11:06.840 --> 00:11:09.460 In that case they get a lot of surplus from 00:11:09.460 --> 00:11:10.850 consuming this good. 00:11:10.850 --> 00:11:14.310 So think about insulin versus McDonald's. 00:11:14.310 --> 00:11:17.980 The consumer surplus from insulin is very, very high. 00:11:17.980 --> 00:11:21.170 Because regardless of the price, I die without it. 00:11:21.170 --> 00:11:23.520 And there's no substitute. 00:11:23.520 --> 00:11:27.970 So it's a very inelastically demanded good, and as a 00:11:27.970 --> 00:11:31.670 result, at any price, I derive a huge consumer surplus 00:11:31.670 --> 00:11:33.730 because as long as that price is less than the value of my 00:11:33.730 --> 00:11:37.660 life, I derive a big consumer surplus. 00:11:37.660 --> 00:11:39.600 Now let's take McDonald's. 00:11:39.600 --> 00:11:42.780 I can always go to Burger King and be equally happy. 00:11:42.780 --> 00:11:44.280 Maybe not quite equally happy, the curve 00:11:44.280 --> 00:11:44.950 isn't perfectly elastic. 00:11:44.950 --> 00:11:46.160 I like McDonald's a little bit more. 00:11:46.160 --> 00:11:48.960 I like the prizes in their Happy Meals better. 00:11:48.960 --> 00:11:51.580 So it's a little bit elastic, but the point is, if 00:11:51.580 --> 00:11:55.320 McDonald's raises the price, I'm not that much sadder 00:11:55.320 --> 00:11:57.340 because I just go to Burger King where I was perfectly 00:11:57.340 --> 00:11:58.500 happy as well. 00:11:58.500 --> 00:12:00.830 So there's not much lost consumer surplus if McDonald's 00:12:00.830 --> 00:12:01.490 raises the price. 00:12:01.490 --> 00:12:05.710 There's not much consumer surplus arising. 00:12:05.710 --> 00:12:07.410 There's not that much consumer surplus-- 00:12:07.410 --> 00:12:08.120 forget the loss. 00:12:08.120 --> 00:12:08.990 Go back. 00:12:08.990 --> 00:12:10.270 That's a different issue. 00:12:10.270 --> 00:12:12.020 I'm talking the sides of the consumer surplus. 00:12:12.020 --> 00:12:14.480 There's not much consumer surplus arising from consuming 00:12:14.480 --> 00:12:16.890 at McDonald's. 00:12:16.890 --> 00:12:18.330 Not much consumer surplus arises from consuming 00:12:18.330 --> 00:12:19.200 McDonalds because I can always just go 00:12:19.200 --> 00:12:20.640 to Burger King instead. 00:12:20.640 --> 00:12:23.310 So what determines consumer surplus is the elasticity of 00:12:23.310 --> 00:12:29.060 demand, which is fundamentally about your willingness to pay. 00:12:29.060 --> 00:12:33.930 Inelastic goods have higher willingness to pay. 00:12:33.930 --> 00:12:37.660 And so as a result, the consumer surplus is 00:12:37.660 --> 00:12:41.030 essentially inversely related to the elasticity of demand. 00:12:41.030 --> 00:12:43.535 The higher the elasticity, the smaller the consumer surplus. 00:12:48.970 --> 00:12:52.230 Now, let's shift and talk about producers. 00:12:52.230 --> 00:12:56.810 The analysis for producer surplus is exactly the same 00:12:56.810 --> 00:12:58.320 type of analysis, just flipped to the 00:12:58.320 --> 00:13:01.320 other side of the market. 00:13:01.320 --> 00:13:07.160 Now, here the question is, what 00:13:07.160 --> 00:13:08.650 determines my producer surplus? 00:13:08.650 --> 00:13:10.720 Well, what determines consumer surplus? 00:13:10.720 --> 00:13:13.330 It's the difference between my marginal willingness to pay 00:13:13.330 --> 00:13:14.820 and the price. 00:13:14.820 --> 00:13:17.540 What determines producer surplus, that's going to be 00:13:17.540 --> 00:13:20.880 the difference between the firm's marginal willingness to 00:13:20.880 --> 00:13:24.160 supply, and the price. 00:13:24.160 --> 00:13:28.140 So my marginal willingness to pay as a consumer is what 00:13:28.140 --> 00:13:30.190 determines my consumer surplus. 00:13:30.190 --> 00:13:32.890 Producer surplus will be determined by my marginal 00:13:32.890 --> 00:13:34.140 willingness to supply. 00:13:36.630 --> 00:13:39.730 My marginal is supply, which is simply represented by the 00:13:39.730 --> 00:13:41.820 supply curve. 00:13:41.820 --> 00:13:43.380 A little bit easier for producer surplus. 00:13:43.380 --> 00:13:46.970 The supply curve represents the price at which I'm willing 00:13:46.970 --> 00:13:48.350 to supply a good. 00:13:48.350 --> 00:13:49.820 That's what a supply curve is. 00:13:49.820 --> 00:13:53.440 As we learned a couple lectures ago, in the context 00:13:53.440 --> 00:13:57.580 of competitive firms that's my marginal cost. So the supply 00:13:57.580 --> 00:14:02.950 curve is my marginal cost. That says that is how much it 00:14:02.950 --> 00:14:05.490 costs me to produce the next unit. 00:14:05.490 --> 00:14:08.255 In a perfectly competitive long-run equilibrium, or short 00:14:08.255 --> 00:14:13.870 run equilibrium, that is basically what I'll 00:14:13.870 --> 00:14:17.240 set my price to. 00:14:17.240 --> 00:14:23.900 So if we go to figure 13-4, now let's look 00:14:23.900 --> 00:14:26.090 at my producer surplus. 00:14:26.090 --> 00:14:28.510 My surplus from delivering lectures. 00:14:28.510 --> 00:14:30.140 Let's say that-- 00:14:30.140 --> 00:14:31.290 this is a bit harder to imagine-- 00:14:31.290 --> 00:14:35.250 but imagine that I prefer deliver smaller lectures. 00:14:35.250 --> 00:14:38.310 Maybe because as the number of kids gets smaller I can learn 00:14:38.310 --> 00:14:38.745 your names. 00:14:38.745 --> 00:14:40.760 I don't have to look around as much, I don't have to pace as 00:14:40.760 --> 00:14:42.690 much, whatever. 00:14:42.690 --> 00:14:44.950 So imagine that I'm most happy delivering a 00:14:44.950 --> 00:14:47.010 lecture to one student. 00:14:47.010 --> 00:14:50.080 And that's the lowest cost to me, the lowest effort. 00:14:50.080 --> 00:14:52.320 I can just come in and sit down, and we have coffee and I 00:14:52.320 --> 00:14:54.020 just riff, and I don't have to worry about notes or any of 00:14:54.020 --> 00:14:55.080 that stuff. 00:14:55.080 --> 00:14:57.160 But when there's two students I feel a little bit guilty 00:14:57.160 --> 00:14:59.200 doing that, so I make some notes to myself. 00:14:59.200 --> 00:15:01.030 When there's three students I make some more notes. 00:15:01.030 --> 00:15:03.070 By the time there's all you students, I have to type up 00:15:03.070 --> 00:15:04.780 all these notes. 00:15:04.780 --> 00:15:08.520 So every student that adds to my lecture, imagine, is a 00:15:08.520 --> 00:15:09.130 marginal cost. 00:15:09.130 --> 00:15:10.200 Now, you know that's not true, of course. 00:15:10.200 --> 00:15:12.680 I wouldn't change my notes if six more students walked in. 00:15:12.680 --> 00:15:15.950 But let's just imagine that it's linear. 00:15:15.950 --> 00:15:19.000 Imagine with every student that comes in here, I have to 00:15:19.000 --> 00:15:21.580 put in a little more effort in my lecture. 00:15:21.580 --> 00:15:25.200 So it's a marginal cost to me with the additional students. 00:15:25.200 --> 00:15:27.680 So that delivers the supply curve, this upward sloping 00:15:27.680 --> 00:15:30.450 supply curve. 00:15:30.450 --> 00:15:34.040 Now let's say at a given price, P, I'm willing to 00:15:34.040 --> 00:15:37.100 lecture-- so that, given the supply curve, if the price is 00:15:37.100 --> 00:15:41.910 equal to p, I'm willing to lecture to Q students. 00:15:41.910 --> 00:15:45.940 That is, if you're going to give me a price of P, at that 00:15:45.940 --> 00:15:51.010 price my marginal willingness to supply is that I'll supply 00:15:51.010 --> 00:15:52.260 Q lectures. 00:15:54.800 --> 00:15:57.260 So another way to say it is that if you want me to supply 00:15:57.260 --> 00:16:00.880 Q lectures, you've got to pay me a price P. That's the point 00:16:00.880 --> 00:16:03.950 where I derive no producer surplus. 00:16:03.950 --> 00:16:06.080 I'm indifferent at that point. 00:16:06.080 --> 00:16:11.010 If at that point you said, would you want the Q-th 00:16:11.010 --> 00:16:12.910 student or not, I'd say I don't really care. 00:16:12.910 --> 00:16:14.750 I'm indifferent. 00:16:14.750 --> 00:16:16.300 I get zero producer surplus. 00:16:16.300 --> 00:16:18.770 But, I got a huge surplus on that first student. 00:16:18.770 --> 00:16:20.650 Because I was willing to work with them and it wouldn't have 00:16:20.650 --> 00:16:21.790 cost me anything. 00:16:21.790 --> 00:16:24.560 But I'm getting paid P to work with all of you. 00:16:24.560 --> 00:16:26.710 So I make a producer surplus on that. 00:16:26.710 --> 00:16:31.470 So producer surplus is made on every unit to the left of Q, 00:16:31.470 --> 00:16:36.250 because those are units with a positive producer surplus. 00:16:36.250 --> 00:16:39.810 They're the units above the supply curve 00:16:39.810 --> 00:16:42.200 and below the price. 00:16:42.200 --> 00:16:44.610 They're the units where it's above the supply curve, so I'm 00:16:44.610 --> 00:16:47.430 willing to supply, but below the price which means that I'm 00:16:47.430 --> 00:16:51.320 getting paid more than I would have to to supply that unit. 00:16:51.320 --> 00:16:52.850 Can anyone think of another name for 00:16:52.850 --> 00:16:54.130 this triangle, roughly? 00:16:54.130 --> 00:16:55.535 How else you might think about that triangle. 00:16:58.400 --> 00:16:59.770 Well, I can talk about producer surplus. 00:16:59.770 --> 00:17:02.340 And I said, what's the difference between the price 00:17:02.340 --> 00:17:05.819 producers receive and the cost that they have to produce it. 00:17:05.819 --> 00:17:06.359 AUDIENCE: Profit. 00:17:06.359 --> 00:17:07.720 PROFESSOR: Profit. 00:17:07.720 --> 00:17:10.750 Roughly speaking, producer surplus is profit. 00:17:10.750 --> 00:17:13.910 Now, technically, in the short run, that's not true. 00:17:13.910 --> 00:17:15.770 Because in the short run there's fixed costs and you 00:17:15.770 --> 00:17:17.740 might lose money on fixed costs and still make a long 00:17:17.740 --> 00:17:18.359 run profit. 00:17:18.359 --> 00:17:20.599 So in the short run it's not technically true. 00:17:20.599 --> 00:17:22.410 In the long run it is technically true, and for the 00:17:22.410 --> 00:17:24.780 purpose of this course we'll say it's technically true. 00:17:24.780 --> 00:17:26.440 So producer surplus is profit. 00:17:26.440 --> 00:17:28.010 It's a lot easier to think about. 00:17:28.010 --> 00:17:30.850 Consumer surplus is this vague concept we have to measure my 00:17:30.850 --> 00:17:33.300 willingness to pay versus what I pay. 00:17:33.300 --> 00:17:36.590 Producer surplus is easy, it's profit. 00:17:36.590 --> 00:17:41.070 So producer surplus is profit, it's the difference between 00:17:41.070 --> 00:17:43.160 the price at which I'm willing to produce the good and the 00:17:43.160 --> 00:17:46.150 price you actually pay me for it. 00:17:46.150 --> 00:17:48.400 So that's producer surplus. 00:17:48.400 --> 00:17:51.230 Questions about that? 00:17:51.230 --> 00:17:52.110 OK. 00:17:52.110 --> 00:17:55.950 Putting this together, we can now measure the total welfare 00:17:55.950 --> 00:17:56.970 of society. 00:17:56.970 --> 00:17:57.763 We now have it. 00:17:57.763 --> 00:18:00.650 We can measure the entire happiness of all of society. 00:18:00.650 --> 00:18:07.300 And we define social welfare of society as consumer surplus 00:18:07.300 --> 00:18:10.520 plus producer surplus. 00:18:10.520 --> 00:18:13.100 Now, that doesn't have to be. 00:18:13.100 --> 00:18:16.130 You could say, gee, Jon, don't you care more about consumers 00:18:16.130 --> 00:18:17.230 than firms? 00:18:17.230 --> 00:18:18.730 Or gee, Jon, don't you care more 00:18:18.730 --> 00:18:19.260 about firms than consumers. 00:18:19.260 --> 00:18:20.770 I'm going to leave that alone for now. 00:18:20.770 --> 00:18:23.380 We're just going to do the simplest thing and just say, 00:18:23.380 --> 00:18:27.670 we're going to define social welfare as simply the sum of 00:18:27.670 --> 00:18:30.300 how much surplus consumers get plus how much surplus 00:18:30.300 --> 00:18:32.730 producers get. 00:18:32.730 --> 00:18:33.420 OK? 00:18:33.420 --> 00:18:34.610 This is a particular representation. 00:18:34.610 --> 00:18:36.835 When we talk about efficiency and equilibrium, we're talking 00:18:36.835 --> 00:18:37.560 about efficiency-- 00:18:37.560 --> 00:18:38.400 I'm sorry-- 00:18:38.400 --> 00:18:41.260 versus equity, which we'll talk about towards the end of 00:18:41.260 --> 00:18:41.870 the course. 00:18:41.870 --> 00:18:45.080 We'll talk about alternative definitions, and how we weigh 00:18:45.080 --> 00:18:46.390 different definitions of this. 00:18:46.390 --> 00:18:48.760 But for now, this is the standard economic definition. 00:18:48.760 --> 00:18:50.460 Which is, let's not draw a judgment about 00:18:50.460 --> 00:18:51.910 who's better than who. 00:18:51.910 --> 00:18:53.230 Let's just talk about the total amount 00:18:53.230 --> 00:18:55.670 of surplus in society. 00:18:55.670 --> 00:18:58.940 So the amount of social welfare, is the total amount 00:18:58.940 --> 00:19:00.320 of surplus in society. 00:19:00.320 --> 00:19:03.440 And here's the key result. 00:19:03.440 --> 00:19:08.880 That the competitive equilibrium, where demand 00:19:08.880 --> 00:19:13.010 equals supply, in competitive equilibrium, is the welfare 00:19:13.010 --> 00:19:15.890 maximizing outcome. 00:19:15.890 --> 00:19:18.910 The competitive equilibrium of the market, which is where 00:19:18.910 --> 00:19:21.620 demand equals supply, is also the 00:19:21.620 --> 00:19:23.350 welfare maximizing outcome. 00:19:26.310 --> 00:19:29.220 And that's the key thing we want to go to now, which is 00:19:29.220 --> 00:19:32.700 that basically moving away from that equilibrium point, 00:19:32.700 --> 00:19:36.310 where demand equals supply, will by definition lower the 00:19:36.310 --> 00:19:38.490 amount of social welfare. 00:19:38.490 --> 00:19:45.430 So to see this, let's go to Figure 13-5. 00:19:45.430 --> 00:19:47.313 And we've got some supply and demand curves. 00:19:47.313 --> 00:19:48.280 This is from the book now. 00:19:48.280 --> 00:19:50.880 We've got some supply and demand curves. 00:19:50.880 --> 00:19:55.880 And we're initially in equilibrium at P1 Q1, 00:19:55.880 --> 00:19:57.520 at the point E1. 00:19:57.520 --> 00:20:01.350 So we're initially at equilibrium at E1. 00:20:01.350 --> 00:20:06.840 At E1, at that initial equilibrium point, consumer 00:20:06.840 --> 00:20:12.190 surplus is equal to R. Now, going by the letters that 00:20:12.190 --> 00:20:17.680 label the areas, R plus S plus V. That's the amount of 00:20:17.680 --> 00:20:18.020 consumer surplus. 00:20:18.020 --> 00:20:20.590 The amount under the demand curve, above the price. 00:20:23.110 --> 00:20:24.120 That's consumer surplus. 00:20:24.120 --> 00:20:27.120 Stop me if this is not clear, this is important stuff. 00:20:27.120 --> 00:20:29.560 So under the demand curve above the price, R plus S plus 00:20:29.560 --> 00:20:36.880 V. The producer surplus is T plus U. The profit is the 00:20:36.880 --> 00:20:40.800 amount above the supply curve and below the price. 00:20:40.800 --> 00:20:44.930 And so total social welfare is the sum of all these. 00:20:44.930 --> 00:20:50.170 R plus S plus V plus T plus U. That's our starting point. 00:20:50.170 --> 00:20:54.370 That's our competitive equilibrium starting point. 00:20:54.370 --> 00:20:56.400 Now, let's see. 00:20:56.400 --> 00:20:58.530 You should be able to immediately see, those of you 00:20:58.530 --> 00:21:01.160 who are good with your geometry, that there is no 00:21:01.160 --> 00:21:04.100 point you could choose which can make 00:21:04.100 --> 00:21:05.930 social welfare larger. 00:21:05.930 --> 00:21:08.840 As a simple comparative statics exercise, imagine I 00:21:08.840 --> 00:21:10.950 had the government come in and say, we're going to raise the 00:21:10.950 --> 00:21:13.210 prices in the market to P2. 00:21:13.210 --> 00:21:15.260 We decide that producers aren't making enough. 00:21:15.260 --> 00:21:17.770 Look, the consumers get three letters, the producers only 00:21:17.770 --> 00:21:20.460 get two letters, that's unfair. 00:21:20.460 --> 00:21:22.040 So we're going to raise the price to give the produces 00:21:22.040 --> 00:21:23.700 more letters and the consumer fewer letters. 00:21:23.700 --> 00:21:25.500 That sounds like about the rational basis for government 00:21:25.500 --> 00:21:27.770 policy making these days. 00:21:27.770 --> 00:21:29.870 So we're going to do that. 00:21:29.870 --> 00:21:32.460 And so we're going to raise the price to P2. 00:21:32.460 --> 00:21:37.160 With a price of P2, we'll have a new equilibrium. 00:21:37.160 --> 00:21:39.990 If you force the price up to P2. 00:21:39.990 --> 00:21:44.120 You have a new equilibrium at little e sub 2, and 00:21:44.120 --> 00:21:45.830 a quantity of Q2. 00:21:45.830 --> 00:21:46.680 What happens now? 00:21:46.680 --> 00:21:48.660 What's happened to consumer surplus? 00:21:48.660 --> 00:21:55.415 Consumer surplus, you've now lost S and V. Consumer surplus 00:21:55.415 --> 00:21:58.820 is now just R. Because at that new price, P2, that's the area 00:21:58.820 --> 00:22:01.620 under the demand curve above the price. 00:22:01.620 --> 00:22:03.150 Producer surplus has grown, however. 00:22:03.150 --> 00:22:10.580 Now, instead of being T plus U, it's now T plus S. So 00:22:10.580 --> 00:22:15.070 what's happened, effectively, is you've transferred S from 00:22:15.070 --> 00:22:18.650 consumers to producers. 00:22:18.650 --> 00:22:21.890 And you've lost V plus U, forever. 00:22:24.850 --> 00:22:26.790 So what's involved in this change is a 00:22:26.790 --> 00:22:28.800 transfer and a loss. 00:22:28.800 --> 00:22:31.710 The transfer is the area S, which used to belong to 00:22:31.710 --> 00:22:34.240 consumers now belongs to producers. 00:22:34.240 --> 00:22:39.770 But now we have what we call a dead weight loss. 00:22:39.770 --> 00:22:48.340 Dead weight loss, of V plus U. That's welfare that has 00:22:48.340 --> 00:22:49.590 disappeared. 00:22:51.470 --> 00:22:53.350 Welfare has disappeared. 00:22:53.350 --> 00:22:56.900 And the definition of dead weight loss is a net reduction 00:22:56.900 --> 00:23:01.190 in efficiency from trades that are not made. 00:23:01.190 --> 00:23:02.640 Remember we talked about efficiency 00:23:02.640 --> 00:23:04.040 early on in the course. 00:23:04.040 --> 00:23:08.470 We said the efficient outcome is one where trades that make 00:23:08.470 --> 00:23:11.810 both people better off are made. 00:23:11.810 --> 00:23:14.800 Here we have trades, which absent the government would 00:23:14.800 --> 00:23:17.790 have made both parties better off, 00:23:17.790 --> 00:23:19.960 and they're not happening. 00:23:19.960 --> 00:23:22.010 That is surplus that's just gone. 00:23:22.010 --> 00:23:24.660 It's into the ether. 00:23:24.660 --> 00:23:28.110 That is social surplus that is now social welfare, that is 00:23:28.110 --> 00:23:30.240 now gone because there are trades that would have made 00:23:30.240 --> 00:23:35.390 both parties happier that are now not happening. 00:23:35.390 --> 00:23:39.460 And that's a total waste from society's perspective. 00:23:39.460 --> 00:23:42.390 Because society's best off if all the trades that make both 00:23:42.390 --> 00:23:45.430 parties happier, happen. 00:23:45.430 --> 00:23:50.640 So the bottom line is, any price you would impose other 00:23:50.640 --> 00:23:54.060 than the market price of P1, and you can work this out for 00:23:54.060 --> 00:24:01.210 yourself, any price you would impose would by definition 00:24:01.210 --> 00:24:04.110 lead to a lower social welfare. 00:24:04.110 --> 00:24:05.090 It may shift. 00:24:05.090 --> 00:24:07.010 It may lead to a bigger or smaller consumer surplus 00:24:07.010 --> 00:24:08.860 relative to producer surplus. 00:24:08.860 --> 00:24:11.230 Once again at this point we're just using the sum of them as 00:24:11.230 --> 00:24:12.830 a measure of social welfare. 00:24:12.830 --> 00:24:15.940 Social welfare has fallen. 00:24:15.940 --> 00:24:19.250 So social welfare is maximized in this case. 00:24:19.250 --> 00:24:23.240 So this gives us a framework to think about. 00:24:23.240 --> 00:24:26.620 We started the course with supply and demand, and talking 00:24:26.620 --> 00:24:29.690 about how things like the minimum wage reduce 00:24:29.690 --> 00:24:30.910 efficiency. 00:24:30.910 --> 00:24:33.190 Well, this gives us a welfare framework, a more formal 00:24:33.190 --> 00:24:35.690 welfare framework, for thinking about that. 00:24:35.690 --> 00:24:38.260 I said it reduces efficiency before because you had less 00:24:38.260 --> 00:24:39.450 labor in the market. 00:24:39.450 --> 00:24:41.740 But now we can actually more formally say why does the 00:24:41.740 --> 00:24:44.040 minimum wage reduce efficiency? 00:24:44.040 --> 00:24:45.040 We can actually look at that. 00:24:45.040 --> 00:24:47.500 Let me just do the always-risky thing of trying a 00:24:47.500 --> 00:24:49.790 freehand diagram. 00:24:49.790 --> 00:24:52.380 You remember our market for labor, you had the amount of 00:24:52.380 --> 00:24:58.160 labor on the x-axis, the wage on the y-axis. 00:24:58.160 --> 00:25:02.470 You had some supply of labor that comes from workers 00:25:02.470 --> 00:25:05.340 deciding to work as the wage goes up, they 00:25:05.340 --> 00:25:06.510 want to work more. 00:25:06.510 --> 00:25:08.440 You've got demand for labor. 00:25:08.440 --> 00:25:11.230 That comes from firms demanding workers. 00:25:11.230 --> 00:25:14.430 As the wage goes up, they want fewer workers. 00:25:14.430 --> 00:25:19.790 And you have some initial equilibrium, L-star, W-star. 00:25:19.790 --> 00:25:22.560 When the government came in with its minimum wage and the 00:25:22.560 --> 00:25:25.060 government said, we're going to impose a minimum wage of 00:25:25.060 --> 00:25:28.890 W-bar, W-super bar. 00:25:28.890 --> 00:25:31.200 OK Remember, we said what happened was, well, of course 00:25:31.200 --> 00:25:34.965 then firms are only going to want L1 workers. 00:25:38.250 --> 00:25:41.720 We talked before about how that led to some unemployment. 00:25:41.720 --> 00:25:43.850 What we didn't mention is how this leads to an efficiency 00:25:43.850 --> 00:25:45.910 loss to society. 00:25:45.910 --> 00:25:49.540 This area is now dead weight loss. 00:25:49.540 --> 00:25:55.020 These workers, who would have been happy to work at the 00:25:55.020 --> 00:25:58.210 prevailing wage, and firms would have been happy to hire 00:25:58.210 --> 00:26:00.830 the workers at the prevailing wage, and those trades no 00:26:00.830 --> 00:26:03.900 longer happen. 00:26:03.900 --> 00:26:06.750 So here's an important question to help you think-- 00:26:06.750 --> 00:26:08.580 you're going to have to draw dead weight loss triangles in 00:26:08.580 --> 00:26:09.310 your sleep now. 00:26:09.310 --> 00:26:12.970 So here's the trick with these. 00:26:12.970 --> 00:26:16.230 Why is the dead weight loss triangle smallest here and 00:26:16.230 --> 00:26:17.800 grow like that? 00:26:17.800 --> 00:26:21.690 Why does the dead weight loss triangle grow as you move away 00:26:21.690 --> 00:26:22.790 from the competitive equilibrium? 00:26:22.790 --> 00:26:23.143 Yeah. 00:26:23.143 --> 00:26:26.028 AUDIENCE: There is less amount of people who are willing to 00:26:26.028 --> 00:26:28.850 work at that price. 00:26:28.850 --> 00:26:30.129 PROFESSOR: Say it again? 00:26:30.129 --> 00:26:33.242 AUDIENCE: So there's less people that are willing to 00:26:33.242 --> 00:26:35.480 work for that smaller price. 00:26:35.480 --> 00:26:37.723 PROFESSOR: Well, here we're imposing a higher-- less 00:26:37.723 --> 00:26:39.250 people are willing to work for, are you 00:26:39.250 --> 00:26:40.320 referring to here or here? 00:26:40.320 --> 00:26:41.760 AUDIENCE: To all the way to the right. 00:26:41.760 --> 00:26:42.420 PROFESSOR: All the way. 00:26:42.420 --> 00:26:45.140 So basically, the point is-- another way to put it is, at 00:26:45.140 --> 00:26:49.330 that wage the consumers there are pretty indifferent. 00:26:49.330 --> 00:26:53.770 So in other words, they're willing to work but barely. 00:26:53.770 --> 00:26:59.420 So at this wage, at this point here, the L*-th worker is 00:26:59.420 --> 00:27:01.660 getting no surplus from working. 00:27:01.660 --> 00:27:03.640 It's not a crappy wage, he's happy to take it. 00:27:03.640 --> 00:27:05.290 But he'd also be happy to sit at home. 00:27:05.290 --> 00:27:06.600 He's indifferent. 00:27:06.600 --> 00:27:09.960 So for that L*-th worker, you make him not 00:27:09.960 --> 00:27:12.040 work, he doesn't care. 00:27:12.040 --> 00:27:14.660 So if you raise the minimum wage and this guy sits at home 00:27:14.660 --> 00:27:16.380 instead of working, he didn't care. 00:27:16.380 --> 00:27:18.610 He was getting no surplus from working anyway. 00:27:18.610 --> 00:27:21.560 Likewise this firm, who's hiring the L*-th worker, they 00:27:21.560 --> 00:27:25.110 were paying this worker exactly what he was producing. 00:27:25.110 --> 00:27:28.990 The marginal cost of that worker exactly equalled what 00:27:28.990 --> 00:27:30.200 they were paying him. 00:27:30.200 --> 00:27:31.662 What that worker's producing was exactly equal to 00:27:31.662 --> 00:27:32.170 what they paid him. 00:27:32.170 --> 00:27:34.260 They were earning zero profit on that worker. 00:27:34.260 --> 00:27:36.340 So they don't care if he stays home. 00:27:36.340 --> 00:27:39.480 So if the government set a minimum wage, such that one 00:27:39.480 --> 00:27:43.600 guy stayed home, the minimum wage was so close to market 00:27:43.600 --> 00:27:47.000 wage that one guy stayed home, there would be no social 00:27:47.000 --> 00:27:48.380 welfare loss. 00:27:48.380 --> 00:27:50.260 Or infinitesimally small. 00:27:50.260 --> 00:27:52.870 Because that last guy, there was indifference on both the 00:27:52.870 --> 00:27:55.640 worker's side and the firm's side. 00:27:55.640 --> 00:27:58.160 However once you start displacing more and more, 00:27:58.160 --> 00:27:59.910 these workers aren't indifferent anymore, right? 00:27:59.910 --> 00:28:01.470 These are workers who were making a lot of 00:28:01.470 --> 00:28:02.930 surplus at that wage. 00:28:02.930 --> 00:28:05.180 And firms that were earning a lot of profit at that wage. 00:28:05.180 --> 00:28:06.800 Now they're not indifferent. 00:28:06.800 --> 00:28:09.030 So as you move farther and farther from the competitive 00:28:09.030 --> 00:28:12.420 equilibrium, the distortion gets larger and larger. 00:28:12.420 --> 00:28:16.780 Very important intuition to have. That for that last 00:28:16.780 --> 00:28:22.150 person, there's no distortion from moving epsilon away from 00:28:22.150 --> 00:28:23.370 the competitive equilibrium. 00:28:23.370 --> 00:28:25.240 Because they weren't earning any surplus anyway. 00:28:25.240 --> 00:28:27.450 And the firm wasn't making any surplus on them. 00:28:27.450 --> 00:28:31.880 But as you move away, the loss in social welfare gets larger 00:28:31.880 --> 00:28:35.180 and larger because these are people who are making all 00:28:35.180 --> 00:28:37.070 sorts of surpluses on these transactions. 00:28:37.070 --> 00:28:38.740 And you're stopping them from happening. 00:28:38.740 --> 00:28:40.630 So if the government interferes with the 00:28:40.630 --> 00:28:42.530 transaction-- 00:28:42.530 --> 00:28:44.710 So imagine, this guy and I were negotiating over a 00:28:44.710 --> 00:28:49.020 baseball card and I ended up paying him exactly what the 00:28:49.020 --> 00:28:50.530 baseball card was worth to him. 00:28:50.530 --> 00:28:51.930 And I ended up paying exactly what it was worth 00:28:51.930 --> 00:28:53.690 to me to have it. 00:28:53.690 --> 00:28:56.950 And then my parents come in and say, you can't do that. 00:28:56.950 --> 00:28:59.180 Then it doesn't really matter, because we weren't making any 00:28:59.180 --> 00:29:01.180 surplus of that trade anyway. 00:29:01.180 --> 00:29:05.330 But, if he had three of these cards and was delighted to get 00:29:05.330 --> 00:29:08.293 rid of it for $50, and I have always wanted this card and 00:29:08.293 --> 00:29:11.730 valued it at $200, then if my parents come and sink this 00:29:11.730 --> 00:29:14.040 trade, then that's a real bummer. 00:29:14.040 --> 00:29:16.410 That's a huge loss in social welfare, because the trade 00:29:16.410 --> 00:29:20.060 that made both parties better off is not happening. 00:29:20.060 --> 00:29:23.050 Questions about that? 00:29:23.050 --> 00:29:26.510 Let's look at a particularly good example of this. 00:29:26.510 --> 00:29:29.060 Of when the government interferes with trades and the 00:29:29.060 --> 00:29:29.480 implications of that. 00:29:29.480 --> 00:29:31.340 The TAs on Friday are going to go through a bunch of 00:29:31.340 --> 00:29:32.530 interesting examples. 00:29:32.530 --> 00:29:34.000 I'm just going to do one today. 00:29:34.000 --> 00:29:35.560 And then you'll do some more in section, because this is 00:29:35.560 --> 00:29:36.930 hard and important. 00:29:36.930 --> 00:29:40.370 I want to today focus on the example of taxicab medallions. 00:29:40.370 --> 00:29:41.620 It's the example in the book, which is a 00:29:41.620 --> 00:29:43.850 particularly good example. 00:29:43.850 --> 00:29:47.850 Taxi drivers, we've all taken taxis, we know how they work. 00:29:47.850 --> 00:29:52.210 But taxi drivers in virtually all cities, you cannot just 00:29:52.210 --> 00:29:54.710 start a cab and drive people around. 00:29:54.710 --> 00:29:57.950 In virtually all cities, you need to get something from the 00:29:57.950 --> 00:30:01.660 city that allows you to call yourself a taxicab. 00:30:01.660 --> 00:30:04.080 And that's typically called a taxicab medallion. 00:30:04.080 --> 00:30:06.470 It originally was literally something you had on the hood 00:30:06.470 --> 00:30:07.360 of your car. 00:30:07.360 --> 00:30:10.150 Now it's a certificate you have in the back of your car. 00:30:10.150 --> 00:30:12.100 So you see the certificate whenever you ride in a car, 00:30:12.100 --> 00:30:14.700 which says, So-and-so is licensed by the city of 00:30:14.700 --> 00:30:17.760 whatever to drive this cab. 00:30:17.760 --> 00:30:20.300 The government issues a certain amount of these 00:30:20.300 --> 00:30:21.390 taxicab medallions. 00:30:21.390 --> 00:30:25.570 And almost always issues less than would be demanded in the 00:30:25.570 --> 00:30:27.940 free market for taxicabs. 00:30:27.940 --> 00:30:30.510 And let's see what effect that has. 00:30:30.510 --> 00:30:31.750 So go to 13-6. 00:30:31.750 --> 00:30:33.130 This is getting kind of complicated, but this is an 00:30:33.130 --> 00:30:36.460 example of the kind of welfare analysis we can do. 00:30:36.460 --> 00:30:39.720 Once we understand these concepts. 00:30:39.720 --> 00:30:43.440 Let's say we start at point E1. 00:30:43.440 --> 00:30:45.670 Big E1 on the right, little E1 on the left. 00:30:45.670 --> 00:30:49.880 So on the right-hand side, this is like our other profit 00:30:49.880 --> 00:30:52.380 diagrams. The right-hand side is the market. 00:30:52.380 --> 00:30:56.890 The left-hand side is an individual cab firm. 00:30:56.890 --> 00:31:01.470 Initially, if the government doesn't interfere, you are in 00:31:01.470 --> 00:31:05.270 equilibrium at point E sub 1. 00:31:05.270 --> 00:31:13.110 Which is, that the price is P1, and the individual cab 00:31:13.110 --> 00:31:15.740 firm delivers q sub 1 rides. 00:31:15.740 --> 00:31:18.090 And let's assume cab firms are identical, 00:31:18.090 --> 00:31:18.790 just to make it easy. 00:31:18.790 --> 00:31:20.280 And that there are n of them. 00:31:20.280 --> 00:31:24.230 Well in that case, the total amount delivered is N1 Q1. 00:31:24.230 --> 00:31:29.610 So Q sub 1 is q sub 1, which is the amount delivered by a 00:31:29.610 --> 00:31:32.860 given cab firm at that price, times the n cab 00:31:32.860 --> 00:31:34.190 firms in the market. 00:31:34.190 --> 00:31:36.990 N1 cab firms in the market. 00:31:36.990 --> 00:31:38.630 So there's N1 firms. Each delivers 00:31:38.630 --> 00:31:40.580 little q sub 1 of rides. 00:31:40.580 --> 00:31:44.820 And you can see at that point, they each make some profit. 00:31:44.820 --> 00:31:48.030 So what you can see at that point is that at E1, at a 00:31:48.030 --> 00:31:54.910 price of P1, they're making some profit. 00:31:54.910 --> 00:31:57.850 The price is set equal to their marginal cost. 00:31:57.850 --> 00:31:58.610 I'm sorry, they're not making a profit. 00:31:58.610 --> 00:31:59.150 My bad. 00:31:59.150 --> 00:32:01.690 You see at that point they're not making profit. 00:32:01.690 --> 00:32:03.545 Because what you can see is price is equal to the minimum 00:32:03.545 --> 00:32:06.550 of average cost. Remember, the no-profit condition is where 00:32:06.550 --> 00:32:09.980 marginal cost equals average cost. You can see at that 00:32:09.980 --> 00:32:11.630 point, little e1 in the diagram at the 00:32:11.630 --> 00:32:14.960 left, there is no profit. 00:32:14.960 --> 00:32:18.440 Because price equals marginal cost, equals the average cost. 00:32:18.440 --> 00:32:20.590 So we're making no profit, and that's a perfectly competitive 00:32:20.590 --> 00:32:21.020 equilibrium. 00:32:21.020 --> 00:32:23.510 That's what we derived last time. 00:32:23.510 --> 00:32:24.910 Now, let's say the government comes in and 00:32:24.910 --> 00:32:26.160 says, you know what? 00:32:28.840 --> 00:32:29.750 And the welfare here. 00:32:29.750 --> 00:32:31.040 Just to do the welfare here. 00:32:31.040 --> 00:32:33.550 You see that the welfare of society is, 00:32:33.550 --> 00:32:35.920 producers make no surplus. 00:32:35.920 --> 00:32:38.140 There's no producer surplus, there's no profits. 00:32:38.140 --> 00:32:42.720 Consumers have surplus of A plus B plus C. So consumer 00:32:42.720 --> 00:32:45.730 surplus is the area on the demand curve above the price. 00:32:45.730 --> 00:32:48.470 That's A plus B plus C. Producer surplus is profits, 00:32:48.470 --> 00:32:49.660 which are zero. 00:32:49.660 --> 00:32:51.440 Because it's perfectly competitive. 00:32:51.440 --> 00:32:55.370 So you end up with a total social surplus of A plus B 00:32:55.370 --> 00:32:59.850 plus C. And it all goes to consumers. 00:32:59.850 --> 00:33:03.360 Now let's say, the taxicab owners aren't 00:33:03.360 --> 00:33:05.210 so happy about this. 00:33:05.210 --> 00:33:07.120 They don't like making zero surplus. 00:33:07.120 --> 00:33:10.400 And they manage to get a restriction. 00:33:10.400 --> 00:33:12.480 Such that the government says, there's only a certain number 00:33:12.480 --> 00:33:13.950 of medallions. 00:33:13.950 --> 00:33:17.630 And we're only going to let people drive the cabs if they 00:33:17.630 --> 00:33:18.880 have a medallion. 00:33:22.110 --> 00:33:25.900 Now, let's say that the taxicab owners say, we're only 00:33:25.900 --> 00:33:29.000 going to limit the number of medallions to N sub 2. 00:33:29.000 --> 00:33:31.530 Instead of there being n sub 1 cab firms-- let's say 00:33:31.530 --> 00:33:33.730 medallions aren't for cabs, they're for cab companies. 00:33:33.730 --> 00:33:37.040 Instead of being n sub 1 cab companies, we're going to 00:33:37.040 --> 00:33:40.960 limit medallions so there can only be n sub 2 cab companies. 00:33:40.960 --> 00:33:42.120 So what happens? 00:33:42.120 --> 00:33:43.210 Well, it's a little complicated so 00:33:43.210 --> 00:33:44.530 let's follow along. 00:33:44.530 --> 00:33:49.250 If there's only n sub 2 cab companies, then what that 00:33:49.250 --> 00:33:55.480 means is that given the same market demand, that means 00:33:55.480 --> 00:33:59.530 firms are now going to be able to make some profit. 00:33:59.530 --> 00:34:05.140 So up to, if you look at the right-hand side diagram up to 00:34:05.140 --> 00:34:09.600 N2 Q1, the supply curve is the same. 00:34:09.600 --> 00:34:15.670 But at that point, once you pass N2 Q1, then you have a 00:34:15.670 --> 00:34:19.320 point where that's-- 00:34:19.320 --> 00:34:22.834 at the old, efficient level of cab rides, the efficient level 00:34:22.834 --> 00:34:25.860 is, each cab company provides Q sub 1 rides. 00:34:25.860 --> 00:34:27.080 Well, you then run out of rides, but 00:34:27.080 --> 00:34:28.469 people still want more. 00:34:28.469 --> 00:34:29.590 So what happens? 00:34:29.590 --> 00:34:33.199 Well, cab companies start to be able to charge more. 00:34:33.199 --> 00:34:36.150 The supply curve becomes upward sloping. 00:34:36.150 --> 00:34:38.540 They start to be able to charge more for their rides. 00:34:38.540 --> 00:34:41.730 Because now you don't have extra cab companies entering 00:34:41.730 --> 00:34:43.989 and competing those profits away. 00:34:43.989 --> 00:34:47.320 They start to be able to charge more for their rides. 00:34:47.320 --> 00:34:51.489 And you see that that upward sloping supply curve meets the 00:34:51.489 --> 00:34:56.639 demand curve at N2 Q2. 00:34:56.639 --> 00:34:59.490 So up to N2 Q1 it's the supply curve which it 00:34:59.490 --> 00:35:00.770 was, which is flat. 00:35:00.770 --> 00:35:03.000 Once you get beyond that, now firms can 00:35:03.000 --> 00:35:04.230 charge a higher price. 00:35:04.230 --> 00:35:06.330 Because they don't have to worry about entry. 00:35:06.330 --> 00:35:09.390 So you get a new supply curve that's flat until N2 Q1 then 00:35:09.390 --> 00:35:10.300 starts to slope up. 00:35:10.300 --> 00:35:12.210 That's S super 2. 00:35:12.210 --> 00:35:17.960 And S super 2 intersects the demand curve at point E sub 2. 00:35:17.960 --> 00:35:20.600 And that is the new equilibrium, with the higher 00:35:20.600 --> 00:35:26.880 price of P2 and a lower total quantity of Q2. 00:35:26.880 --> 00:35:28.390 Now let's what that does to the firm. 00:35:28.390 --> 00:35:33.980 Well, a given firm at a price P2, they now-- 00:35:33.980 --> 00:35:35.270 they always set the price equal to marginal 00:35:35.270 --> 00:35:36.430 cost. That's the rule. 00:35:36.430 --> 00:35:38.810 Every profit maximizing firm does that. 00:35:38.810 --> 00:35:43.160 Well, they now are at a point little e sub 2, 00:35:43.160 --> 00:35:44.950 making a huge profit. 00:35:44.950 --> 00:35:47.860 Because at that point, their marginal cost is well above 00:35:47.860 --> 00:35:52.100 their average cost. So at that point, they make the profit of 00:35:52.100 --> 00:35:55.750 the shaded area pi in the left-hand side diagram. 00:35:55.750 --> 00:35:58.560 They make the profit pi, because once again [INAUDIBLE] 00:35:58.560 --> 00:36:00.613 go to the right-hand and then back to the left-hand side. 00:36:00.613 --> 00:36:02.940 The right-hand side is, the new supply curve intersects 00:36:02.940 --> 00:36:04.330 the demand curve. 00:36:04.330 --> 00:36:05.850 At point E2. 00:36:05.850 --> 00:36:07.780 That's the price of P2. 00:36:07.780 --> 00:36:10.930 Carry that over the left-hand diagram, you see at a price of 00:36:10.930 --> 00:36:13.960 P2, they make a profit, the difference between that price 00:36:13.960 --> 00:36:18.580 and the average cost curve, which is that shaded pi box. 00:36:18.580 --> 00:36:21.010 So firms now make profits. 00:36:21.010 --> 00:36:23.030 And they didn't before. 00:36:23.030 --> 00:36:26.700 What's happened to welfare in the market? 00:36:26.700 --> 00:36:29.980 Well, what's happened is consumer surplus has now 00:36:29.980 --> 00:36:35.410 fallen from A plus B to just A. Because the 00:36:35.410 --> 00:36:37.280 price is now P2. 00:36:37.280 --> 00:36:39.490 The consumer surplus is the area under the demand curve 00:36:39.490 --> 00:36:40.450 above the price. 00:36:40.450 --> 00:36:45.370 That's just the triangle A. Just the triangle A. At that 00:36:45.370 --> 00:36:46.940 new price, that's the consumer surplus. 00:36:46.940 --> 00:36:48.880 What's the producer surplus? 00:36:48.880 --> 00:36:51.120 Well, now producers are making profits. 00:36:51.120 --> 00:36:53.320 And what they're making a surplus is the area below the 00:36:53.320 --> 00:36:55.700 price above their supply curve. 00:36:55.700 --> 00:36:58.940 The supply curve is this funky kinked thing I just described. 00:36:58.940 --> 00:37:02.480 So their new producer surplus is this, I don't know what the 00:37:02.480 --> 00:37:04.530 name is for, like a trapezoid with a curved side. 00:37:04.530 --> 00:37:06.050 Does that have a name? 00:37:06.050 --> 00:37:06.575 It's still a trapezoid? 00:37:06.575 --> 00:37:07.770 I don't know. 00:37:07.770 --> 00:37:08.700 Anyway. 00:37:08.700 --> 00:37:10.890 Curvazoid. 00:37:10.890 --> 00:37:16.810 B. Their new surplus is B. So producers now make surplus B. 00:37:16.810 --> 00:37:20.230 Consumer surplus is reduced to A. And what's happened to C? 00:37:20.230 --> 00:37:21.620 C is gone. 00:37:21.620 --> 00:37:23.200 C is dead weight loss. 00:37:23.200 --> 00:37:27.080 Consumer surplus is now A. Producer surplus is now B. The 00:37:27.080 --> 00:37:30.640 darkly shaded area C is now the dead weight loss. 00:37:30.640 --> 00:37:33.150 And that's the dead weight loss, because once again, at 00:37:33.150 --> 00:37:35.920 the old marginal cost curve, at the old supply curve, these 00:37:35.920 --> 00:37:39.910 are trades which both the producer, which is the taxicab 00:37:39.910 --> 00:37:42.690 company, and the consumer, which is a person riding the 00:37:42.690 --> 00:37:44.820 taxi, were happy to make. 00:37:44.820 --> 00:37:46.460 And they're not being made now. 00:37:46.460 --> 00:37:55.880 So we've now lost an amount C, dead weight loss. 00:37:55.880 --> 00:37:56.610 Sorry about the confusion. 00:37:56.610 --> 00:37:59.730 Questions about that? 00:37:59.730 --> 00:38:02.260 Now, here's my question for you. 00:38:02.260 --> 00:38:04.170 You can go home and think about that, and hopefully 00:38:04.170 --> 00:38:05.450 it'll be clear in the examples on Friday. 00:38:05.450 --> 00:38:07.920 But let's ask a slightly deeper question. 00:38:07.920 --> 00:38:14.020 Does this mean that if you become a taxi driver today, 00:38:14.020 --> 00:38:16.910 you will derive producer surplus of B 00:38:16.910 --> 00:38:19.270 from driving a taxi? 00:38:19.270 --> 00:38:19.860 Why not? 00:38:19.860 --> 00:38:23.030 AUDIENCE: Because you have to pay that lump sum to get-- 00:38:23.030 --> 00:38:25.830 PROFESSOR: Because the point is, you have to get into the 00:38:25.830 --> 00:38:28.560 market, and to get into the market you need a medallion. 00:38:28.560 --> 00:38:30.010 And the guys with the medallions isn't going to hand 00:38:30.010 --> 00:38:30.710 them over to you for free. 00:38:30.710 --> 00:38:33.780 So let's say this guy's retiring as a cab driver. 00:38:33.780 --> 00:38:35.390 He's got his medallion. 00:38:35.390 --> 00:38:36.870 You come up him and say, I want to be a cab driver 00:38:36.870 --> 00:38:40.320 because I see this big producer surplus area B. 00:38:40.320 --> 00:38:41.890 [INAUDIBLE] medallion. 00:38:41.890 --> 00:38:43.240 What's this guy going to say? 00:38:43.240 --> 00:38:44.590 He's going to say, well, wait a second. 00:38:44.590 --> 00:38:46.680 If I give you my medallion, you're going to make that 00:38:46.680 --> 00:38:49.130 profits of pi. 00:38:49.130 --> 00:38:50.750 That's the profit you make by being a taxi 00:38:50.750 --> 00:38:52.970 driver in this market. 00:38:52.970 --> 00:38:57.420 So what should he do? 00:38:57.420 --> 00:38:58.760 What should he do? 00:38:58.760 --> 00:38:59.615 AUDIENCE: Sell it to you. 00:38:59.615 --> 00:39:00.830 PROFESSOR: He should sell it to you. 00:39:00.830 --> 00:39:03.820 And how much should he sell it to you for? 00:39:03.820 --> 00:39:06.360 Pi minus a penny. 00:39:06.360 --> 00:39:07.740 And you might say, well, that's ridiculous. 00:39:07.740 --> 00:39:08.850 I won't pay pi minus a penny. 00:39:08.850 --> 00:39:09.670 Then I'll make nothing. 00:39:09.670 --> 00:39:10.910 Well, but he will. 00:39:10.910 --> 00:39:12.435 He'll pay minus a penny because at least 00:39:12.435 --> 00:39:14.520 he'll make a penny. 00:39:14.520 --> 00:39:17.470 Now, you might say a penny, a dollar, $5, $10 whatever. 00:39:17.470 --> 00:39:20.870 But the point is that he'll sell it for very close to pi. 00:39:20.870 --> 00:39:25.780 Because there's someone out there who's willing to pay 00:39:25.780 --> 00:39:27.000 close to pi to get that. 00:39:27.000 --> 00:39:28.210 As long as there's a little bit left. 00:39:28.210 --> 00:39:31.600 So it's a little bit less than pi. 00:39:31.600 --> 00:39:32.540 They'll pay it. 00:39:32.540 --> 00:39:34.640 But what that means is having paid it, you 00:39:34.640 --> 00:39:36.280 don't make any money. 00:39:36.280 --> 00:39:39.970 So let's do the extreme example where he's willing to 00:39:39.970 --> 00:39:42.240 sell it for $1 less than pi. 00:39:42.240 --> 00:39:44.420 What that means is you having bought it for $1 less than pi, 00:39:44.420 --> 00:39:47.350 you don't make any money as a cab driver. 00:39:47.350 --> 00:39:47.990 So wait a second. 00:39:47.990 --> 00:39:48.690 This is weird. 00:39:48.690 --> 00:39:51.200 We've just restricted the market. 00:39:51.200 --> 00:39:53.170 We've said there's all this profit to be made. 00:39:53.170 --> 00:39:55.730 And yet you're a cab driver and you make no profit. 00:39:55.730 --> 00:39:58.050 What happened to the profit? 00:39:58.050 --> 00:39:59.194 Who got it? 00:39:59.194 --> 00:40:01.010 AUDIENCE: [UNINTELLIGIBLE] 00:40:01.010 --> 00:40:03.140 PROFESSOR: The cab drivers who were originally issued the 00:40:03.140 --> 00:40:04.260 medallions. 00:40:04.260 --> 00:40:06.310 The first generation cab drivers who got the medallions 00:40:06.310 --> 00:40:08.580 got all the money. 00:40:08.580 --> 00:40:14.560 So in fact, taxicab medallions do nothing [INAUDIBLE] 00:40:14.560 --> 00:40:16.800 taxi drivers. 00:40:16.800 --> 00:40:19.160 All they do is enrich the set of people who originally 00:40:19.160 --> 00:40:22.090 lobbied for them and got them. 00:40:22.090 --> 00:40:22.450 OK. 00:40:22.450 --> 00:40:22.870 Yeah. 00:40:22.870 --> 00:40:25.270 AUDIENCE: But wouldn't he make his money back the same day he 00:40:25.270 --> 00:40:31.380 sold it, given that he can get the same price for his-- 00:40:31.380 --> 00:40:33.520 PROFESSOR: Wouldn't he-- 00:40:33.520 --> 00:40:36.350 No, but the point is that basically, what he's done, or 00:40:36.350 --> 00:40:37.830 you're saying that when he goes to sell it. 00:40:37.830 --> 00:40:39.900 So, in other words, the taxicab medallion is worth a 00:40:39.900 --> 00:40:41.660 certain amount of money. 00:40:41.660 --> 00:40:45.470 But that would be embedded in the money he would charge you. 00:40:45.470 --> 00:40:46.810 So he's not dumb. 00:40:46.810 --> 00:40:48.763 He's straightening out the supply curve, he's a smart 00:40:48.763 --> 00:40:49.710 guy, you should have picked someone else 00:40:49.710 --> 00:40:51.550 to negotiate with. 00:40:51.550 --> 00:40:54.050 He's going to say, look, I'm going to charge you enough so 00:40:54.050 --> 00:40:59.316 that you'll only make $10 forever on having this. 00:40:59.316 --> 00:41:02.150 I'm going to charge you enough so that basically, you will 00:41:02.150 --> 00:41:06.900 not make any money even when you go to get rid of it. 00:41:06.900 --> 00:41:08.410 So basically, what you'll do is, you'll have 00:41:08.410 --> 00:41:09.310 to pay him so much. 00:41:09.310 --> 00:41:12.150 So let's say the way it works. 00:41:12.150 --> 00:41:12.990 Let me give you an example. 00:41:12.990 --> 00:41:14.970 Let me come back to that one in the context of an example. 00:41:14.970 --> 00:41:17.390 So what we know is that basically-- 00:41:17.390 --> 00:41:18.500 and this is in Perloff, give you some 00:41:18.500 --> 00:41:19.650 interesting facts on this. 00:41:19.650 --> 00:41:20.660 We know that taxicab 00:41:20.660 --> 00:41:22.410 medallions are really limiting. 00:41:22.410 --> 00:41:24.590 For example, we know that Tokyo has five times as many 00:41:24.590 --> 00:41:26.840 cabs as New York City, despite the fact that New York City's 00:41:26.840 --> 00:41:27.850 bigger than Tokyo. 00:41:27.850 --> 00:41:29.670 And Washington DC has ten times as 00:41:29.670 --> 00:41:31.170 many cabs as San Francisco. 00:41:31.170 --> 00:41:33.180 Despite the fact that Washington DC is smaller than 00:41:33.180 --> 00:41:33.830 San Francisco. 00:41:33.830 --> 00:41:34.630 I'm not from San Francisco. 00:41:34.630 --> 00:41:36.210 You can always get a cab in Washington, I don't know how 00:41:36.210 --> 00:41:37.710 hard it is to get in San Francisco. 00:41:37.710 --> 00:41:40.140 But there's 10 times as many cabs in Washington. 00:41:40.140 --> 00:41:42.120 And this is reflected in the value of a permit. 00:41:42.120 --> 00:41:47.660 So in San Francisco, what you do, and this is sort of an 00:41:47.660 --> 00:41:49.870 easier way to think about it. 00:41:49.870 --> 00:41:51.550 What he does is, he doesn't sell you the permit. 00:41:51.550 --> 00:41:52.900 In San Francisco they don't sell it. 00:41:52.900 --> 00:41:54.680 He rents it to you. 00:41:54.680 --> 00:41:55.930 So you never get to own it. 00:41:55.930 --> 00:41:57.360 He rents it to you. 00:41:57.360 --> 00:42:02.380 And in San Francisco, the typical permit costs $42,000 a 00:42:02.380 --> 00:42:03.650 year to rent. 00:42:03.650 --> 00:42:06.310 So if you want to be a cab driver, you've got to pay 00:42:06.310 --> 00:42:11.650 $42,000 off the top before you earn a dollar. 00:42:11.650 --> 00:42:13.430 And then he rents to you, when you're done, he takes it back. 00:42:13.430 --> 00:42:15.690 So in substance the way-- now, if he was selling it, I can 00:42:15.690 --> 00:42:16.220 describe it to you. 00:42:16.220 --> 00:42:18.550 Involves the fact that he would embed your future asset 00:42:18.550 --> 00:42:20.050 in his sale price. 00:42:20.050 --> 00:42:22.130 That involves some complicated finance that we'll get to 00:42:22.130 --> 00:42:23.370 later in the course. 00:42:23.370 --> 00:42:25.310 So think about renting it, that's easier. 00:42:25.310 --> 00:42:27.840 He'll rent it to you for the entire surplus 00:42:27.840 --> 00:42:30.050 pi, or pi minus $10. 00:42:30.050 --> 00:42:33.020 And in San Francisco that amounts to $42,000 a year. 00:42:33.020 --> 00:42:36.590 In New York, New York originally had 12,000 permits 00:42:36.590 --> 00:42:40.380 they issued in 1937. 00:42:40.380 --> 00:42:43.380 They issued 12,000 permits for $10 each. 00:42:43.380 --> 00:42:46.740 They have not issued a new one since. 00:42:46.740 --> 00:42:49.250 Literally, there are no more cabs allowed in New York City 00:42:49.250 --> 00:42:52.740 than there were in 1937. 00:42:52.740 --> 00:42:57.960 A typical taxicab medallion, which sold for $10 in 1937, 00:42:57.960 --> 00:43:02.570 now sells for $400,000. 00:43:02.570 --> 00:43:03.820 Now once again, you typically don't sell. 00:43:03.820 --> 00:43:05.090 You typically rent it out. 00:43:05.090 --> 00:43:07.610 But the point is, that taxicab medallion, which embeds the 00:43:07.610 --> 00:43:09.880 entire future stream of having the right to drive that 00:43:09.880 --> 00:43:11.920 taxicab, is worth $400,000. 00:43:11.920 --> 00:43:13.870 So what have we done here? 00:43:13.870 --> 00:43:17.580 What we've done-- and in Boston, by the way, a taxicab 00:43:17.580 --> 00:43:19.100 medallion's worth about $250,000. 00:43:19.100 --> 00:43:21.010 Think about that the next time you're standing in the rain 00:43:21.010 --> 00:43:23.340 waiting for a cab. 00:43:23.340 --> 00:43:25.010 You're standing in the rain waiting for a cab because some 00:43:25.010 --> 00:43:28.480 guy in 1930-something got a grant from the government 00:43:28.480 --> 00:43:30.230 worth $250,000. 00:43:30.230 --> 00:43:33.270 But the current cab drivers don't get crap. 00:43:33.270 --> 00:43:36.690 A taxicab driver in your city makes $10-12 an hour. 00:43:36.690 --> 00:43:38.920 It's not a very fun job being a taxicab driver in New York 00:43:38.920 --> 00:43:41.010 City, unless you like taking your life in your hands every 00:43:41.010 --> 00:43:43.950 time you go out on the streets of New York City. 00:43:43.950 --> 00:43:46.400 They make $10 to $12 an hour. 00:43:46.400 --> 00:43:48.210 After paying the enormous amount they have to pay to 00:43:48.210 --> 00:43:50.600 rent their taxicab medallion. 00:43:50.600 --> 00:43:53.870 Now, this is not the only example we have in the world 00:43:53.870 --> 00:43:56.940 of something we call occupational restrictions. 00:43:56.940 --> 00:43:58.690 There's lots of examples. 00:43:58.690 --> 00:44:00.580 Probably the most prominent example, that may be relevant 00:44:00.580 --> 00:44:00.980 to some of you. 00:44:00.980 --> 00:44:03.480 I hope the taxi cab driver won't be relevant to you guys. 00:44:03.480 --> 00:44:06.440 But the doctor example might be. 00:44:06.440 --> 00:44:09.370 A great occupational restriction is the AMA and the 00:44:09.370 --> 00:44:12.060 education, the institute that educates doctors puts a limit 00:44:12.060 --> 00:44:15.180 on the number of medical residency slots, that 00:44:15.180 --> 00:44:17.750 determines how many doctors there can be in America. 00:44:17.750 --> 00:44:22.280 As a result, we all pay more to go for our medical care, 00:44:22.280 --> 00:44:25.010 than we would if more doctors were allowed. 00:44:25.010 --> 00:44:26.200 And you might say, that's outrageous. 00:44:26.200 --> 00:44:30.200 But why, obviously, how would the AMA defend this? 00:44:30.200 --> 00:44:34.560 And how would you defend any occupational license? 00:44:34.560 --> 00:44:35.422 Yeah. 00:44:35.422 --> 00:44:38.380 AUDIENCE: The smaller the amount of [UNINTELLIGIBLE]. 00:44:38.380 --> 00:44:38.586 PROFESSOR: Yeah. 00:44:38.586 --> 00:44:40.980 You don't want everybody being Dr. Nick. 00:44:40.980 --> 00:44:41.710 You want-- 00:44:41.710 --> 00:44:44.040 come on, you guys got to get Dr. Nick. 00:44:44.040 --> 00:44:44.938 Raise your hand if you know what I mean 00:44:44.938 --> 00:44:48.090 when I say Dr. Nick. 00:44:48.090 --> 00:44:50.590 Good lord, what is wrong with you people? 00:44:50.590 --> 00:44:54.496 OK, homework for this course, you've got to watch one 00:44:54.496 --> 00:44:55.430 episode of The Simpsons. 00:44:55.430 --> 00:44:56.770 Before the end of the term. 00:44:56.770 --> 00:44:58.440 This is crazy. 00:44:58.440 --> 00:45:00.060 Dr. Nick is the terrible doctor on The Simpsons. 00:45:00.060 --> 00:45:03.680 You don't want this terrible doctor. 00:45:03.680 --> 00:45:05.270 You don't want these terrible doctors operating on people, 00:45:05.270 --> 00:45:08.170 so we have these restrictions to make sure doctors are good. 00:45:08.170 --> 00:45:09.910 And it sounds like a good idea. 00:45:09.910 --> 00:45:11.400 But next time you hear it, remember. 00:45:11.400 --> 00:45:13.540 It's not just making sure there are good doctors. 00:45:13.540 --> 00:45:14.860 There are probably plenty of people who would be good 00:45:14.860 --> 00:45:16.420 enough doctors who aren't let in because there are not 00:45:16.420 --> 00:45:17.190 enough slots. 00:45:17.190 --> 00:45:19.330 It's also a way to make sure doctors earn lots of money. 00:45:19.330 --> 00:45:21.250 And it's not just the government that does this. 00:45:21.250 --> 00:45:22.880 There's no government involvement here. 00:45:22.880 --> 00:45:26.050 These are private associations which license. 00:45:26.050 --> 00:45:31.720 And they restrict, plumbers, and doctors and optometrists, 00:45:31.720 --> 00:45:34.270 and all these other things are limited. 00:45:34.270 --> 00:45:38.630 Ostensibly to keep quality up, but in reality often to make 00:45:38.630 --> 00:45:40.970 sure that there's some surplus being earned by this initial 00:45:40.970 --> 00:45:42.490 generation who puts puts them in place. 00:45:42.490 --> 00:45:43.250 Yeah. 00:45:43.250 --> 00:45:46.696 AUDIENCE: So is the relative effect on the market smaller 00:45:46.696 --> 00:45:48.655 for doctors because they're not 00:45:48.655 --> 00:45:50.950 selling each other permits? 00:45:50.950 --> 00:45:52.210 PROFESSOR: Well, what's different with the doctors is, 00:45:52.210 --> 00:45:55.620 since it's not a permit but an ongoing limit, then every 00:45:55.620 --> 00:45:56.710 doctor makes the pi. 00:45:56.710 --> 00:45:57.920 There's no selling. 00:45:57.920 --> 00:46:00.940 So the effect on the market is no different. 00:46:00.940 --> 00:46:03.500 So imagine here, instead of it being a medallion, there's a 00:46:03.500 --> 00:46:06.030 limit on how many cabs could run. 00:46:06.030 --> 00:46:08.920 And that limit was randomly reallocated. 00:46:08.920 --> 00:46:12.180 Cab ran out, and then new people went in. 00:46:12.180 --> 00:46:14.280 Then each generation would-- then you wouldn't get the 00:46:14.280 --> 00:46:15.340 thing where the first generation wins. 00:46:15.340 --> 00:46:16.070 Each generation should win. 00:46:16.070 --> 00:46:18.420 But you still get the same distortion of the market. 00:46:18.420 --> 00:46:19.400 The same profit being made. 00:46:19.400 --> 00:46:20.850 It's just that instead of the profit all accruing to the 00:46:20.850 --> 00:46:23.260 first generation, there'd be an ongoing approval of that 00:46:23.260 --> 00:46:25.300 profit to each generation of doctors. 00:46:25.300 --> 00:46:25.892 Yeah. 00:46:25.892 --> 00:46:27.614 AUDIENCE: Professors and tenure, is that 00:46:27.614 --> 00:46:28.850 also related to-- 00:46:28.850 --> 00:46:30.340 PROFESSOR: Professors and tenure would be another very 00:46:30.340 --> 00:46:32.030 good example. 00:46:32.030 --> 00:46:34.400 Basically, an occupational restriction. 00:46:34.400 --> 00:46:38.410 The difference is there's no limit to how many tenured 00:46:38.410 --> 00:46:39.740 professors there can be. 00:46:39.740 --> 00:46:42.040 So basically there's no sense in which, if there's more 00:46:42.040 --> 00:46:43.940 demand for education, a new university couldn't start up 00:46:43.940 --> 00:46:45.320 and have tenured professors. 00:46:45.320 --> 00:46:46.750 There's no situation in which a university couldn't just 00:46:46.750 --> 00:46:48.670 say, we're given tenure to any Tom, Dick, and Harry who walks 00:46:48.670 --> 00:46:49.810 in off the street. 00:46:49.810 --> 00:46:51.490 There's no stopping that, because tenure is determined 00:46:51.490 --> 00:46:52.750 by the institution. 00:46:52.750 --> 00:46:54.680 So in that sense it's not an occupational license, because 00:46:54.680 --> 00:46:56.910 there's no board which determines tenure standards. 00:46:56.910 --> 00:46:58.160 Thank goodness. 00:47:00.140 --> 00:47:01.060 So we'll come back. 00:47:01.060 --> 00:47:02.230 So that's what we were talking about welfare. 00:47:02.230 --> 00:47:04.000 You'll review this more in section on Friday. 00:47:04.000 --> 00:47:05.760 On Wednesday we'll come back to talk about monopoly.