When changes occur in a market—whether they are shifts in demand, shifts in supply, or government policies that interfere in the market’s workings—they affect the welfare that market participants gain by virtue of being in the market. We can understand these changes by analyzing producer and consumer surplus, and this is the focus of this lecture.
Taxicab medallions are distributed and restricted by the government, and have an impact on social welfare. Image courtesy of Vilseskogen on Flickr.
Keywords: Welfare economics; consumer surplus; producer surplus; social welfare; dead weight loss.
Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.
Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:
- [R&T] Chapter 6, “Markets, Maximizers, and Efficiency.”
- [Perloff] Chapter 9, “Welfare Economics.” (optional)
This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.
Consumers will generally have consumer surplus that is highest when the demand curve has what characteristic?
A horizontal demand curve signifies high elasticity, but consumer surplus is lowest in markets where demand is highly elastic. A downward-sloping demand curve is normally characterized by an intermediate degree of elasticity.
In the long-run, producer surplus is equal to what quantity?
In the long-run, profits are equal to producer surplus. Profits are not equal to total cost or revenue (they can also be calculated as revenue minus total cost, but that option is not included here.) Marginal cost is relevant to the determinant of the profit-maximizing point of production, but it does not directly determine profits.
What is the definition of social welfare?
The difference between producer and consumer surplus may be of interest from the point of view of equity, but it is not a well-defined concept in welfare economics. The area above the supply curve is also not well-defined. Deadweight loss is potential surplus that is lost due to market-distorting policies.
When is social welfare maximized?
It is important to note that if the government places price restrictions on a given market, this will result in deadweight loss corresponding to trades that are not made.
In the market for taxis, the government regulation that every taxi driver owns a medallion is a restriction on trade. This results in a change to social welfare in the medallion market. How can you describe that change?
First, there is deadweight loss because some trades are not made (some additional people would like to take cabs, and some additional people would like to drive them, but they cannot because they do not have medallions.) Second, the restriction on the entry of taxi drivers raises the prices of a taxi ride, and this is a transfer from the consumer to the producer.
These optional resources are provided for students that wish to explore this topic more fully.
Textbook Study Materials
See the course website for Econ 302, Intermediate Economics taught at Penn State in 2011.