14.01SC | Fall 2011 | Undergraduate

Principles of Microeconomics

Unit 4: Welfare Economics

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While we typically analyze the operation of markets by examining the movements of price or quantity, we may also be interested in asking broader questions about how much market participants, both consumers and producers, benefit from consuming or producing a certain good. In this unit, you will learn how to calculate producer and consumer welfare in a given market. You will also learn how to analyze the changes in social welfare that result when policies are implemented that alter the market equilibrium.

  Competition III

  Image courtesy of Lance Ball on Flickr.

  Principles of Welfare Economics

  Image courtesy of Vikseskogen on Flickr.

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Session Overview

Models are easy to construct, but they may not always exactly match reality. While we assume that firms maximize profits, this may not always be true, and in this lecture we start to learn why. We also start to think about how we can measure the welfare that consumers gain from participating in a market.

Stocks and stock options are commonly used to overcome the agency problem. Image courtesy of Lance Ball on Flickr.

Keywords: Agency problem; corporations; stock options; normative economics; welfare economics; consumer surplus.

Session Activities

Readings

Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:

  • [Perloff] Chapter 8, “Competitive Firms and Markets.” (optional)

Lecture Videos

Resources

Check Yourself

Concept Quiz

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.

Question 1

Which of the following is NOT an example of the agency problem?

 

The other two options are both examples of the agency problem. When it is hard to observe managers' actions, and their pay is not fully tied to performance, they may not maximize profits. However, when a company hires workers to expand its business but lacks equipment for them to work on, the resulting issue is not relevant to the agency problem. Rather, it is an example of suboptimal balance between labor and capital.

Question 2

What is a strategy that can be used to align the incentives of managers and owners in a given company?

 

Providing the managers with stocks or stock options gives them an incentive to raise shareholder value, because they will also benefit from higher value. Raising their salary, on the other hand, does not change their incentives.

Question 3

What is the definition of consumer surplus?

 

The area above the supply curve below the price line is producer surplus, and the sum of the area above the supply curve below the price line and the area below the demand curve above the price line is total surplus.

Question 4

Assume a consumer bought two concert tickets, and valued the first ticket at $50 and the second ticket at $30. The price of both tickets was $30. What is the consumer surplus for this consumer in the transaction?

 

The consumer gained no consumer surplus on the last ticket, since the price was equal to his valuation of the ticket. However, the surplus on the first ticket purchased was $20.

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Session Overview

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.

Session Activities

Readings

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)

Lecture Videos

Resources

Check Yourself

Concept Quiz

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.

Question 1

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.

Question 2

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.

Question 3

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.

Question 4

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.

Question 5

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.

Further Study

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. 

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Preparation

The problem set is comprised of challenging questions that test your understanding of the material covered in the course. Make sure you have mastered the concepts and problem solving techniques from the following sessions before attempting the problem set:

Problem Set and Solutions

Problem Solving Video

In the video below, a teaching assistant demonstrates his approach to the solution for problem 4 from the problem set. The teaching assistant notes common mistakes made by students and provides problem solving techniques for approaching similar questions on the problem set and exams.

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