Welfare Analysis: The Efficiency of Markets
Christopher Makler
Stanford University Department of Economics
Econ 50: Lecture 24
pollev.com/chrismakler
Who is going to win the big game?
Who is going to win the big game?
Note: This is graded for correctness, not just completion.
Is this the “right" price and quantity?
If you were an omniscient social planner, could you do "better"
than the price the market "chooses"?
Welfare Analysis:
Consumer and Producer Surplus
Last time, we calculated the equilibrium price and quantity.
The Social Planner's Problem
Suppose you were in charge of the economy.
How would you answer the fundamental economic questions about a particular good?
How to produce it?
Want to produce any given quantity Q
at the lowest possible cost
Who gets to consume it?
How much to produce?
Want to distribute any given quantity Q
to the people who value it the most
Want to choose the quantity Q*
to maximize total surplus
(benefit to consumers minus costs of production)
Example: One Consumer, One Firm
FIRM
CONSUMER
Quasilinear utility function:
u(x_1,x_2) = 10x_1 - {1 \over 2}x_1^2 + x_2
Good 2 is "dollars spent on other goods"
p_2 = 1\text{, 1 util = 1 dollar}
Total benefit (in dollars)
from \(x_1\) units of good 1:
v(x_1) = 10x_1 - {1 \over 2}x_1^2
Total cost function:
c(q) = q + {1 \over 4}q^2
Note: variable costs only
GROSS CONSUMER'S SURPLUS
(total benefit, in dollars)
v(x_1) = 10x_1 - {1 \over 2}x_1^2
Marginal benefit,
in dollars per unit:
v'(x_1) = 10 - x_1
(also MRS, marginal willingness to pay)
TOTAL VARIABLE COST
(dollars)
c(q) = q + {1 \over 4}q^2
Marginal cost,
in dollars per unit:
c'(q) = 1 + {1 \over 2}q
What is the optimal quantity \(Q^*\) to produce and consume?
FIRM
CONSUMER
Total benefit:
v(Q) = 10Q - {1 \over 2}Q^2
Total cost:
c(Q) = Q + {1 \over 4}Q^2
Total welfare:
Marginal welfare from producing another unit:
W(Q) = 10Q - {1 \over 2}Q^2 - [Q + \tfrac{1}{4}Q^2]
W'(Q) = 10 - Q - [1 + \tfrac{1}{2}Q]
=0
10 - Q = 1 + \tfrac{1}{2}Q
Q^* = 6
TOTAL WELFARE
(dollars)
Marginal welfare,
in dollars per unit:
Total benefit to consumers minus total cost to firms
Marginal benefit to consumers minus marginal cost to firms
How do competitive markets
solve this problem?
FIRM
CONSUMER
Maximize net consumer surplus
v(x_1) - e(x_1) = 10x_1 - {1 \over 2}x_1^2 - p_1x_1
Maximize profits
r(q) - c(q) = pq - \left[q + {1 \over 4}q^2\right]
FIRM
CONSUMER
Net benefit from buying \(Q\) units at price \(P\):
TB(Q) - P \times Q
Net benefit from selling \(Q\) units at price \(P\):
P \times Q - TC(Q)
Total welfare:
Marginal welfare from producing another unit:
TB(Q) - P \times Q
P \times Q - TC(Q)
W(Q) =
+
MB(Q) - P
P - MC(Q)
W'(Q) =
+
profit-maximizing
firms set P = MC
utility-maximizing consumers set P = MB
as long as consumers and firms face the same price, markets set MB = MC and maximize total welfare!
What happens if not everyone is identical?
FIRMS: SUBWAY AND TOGO'S
CONSUMERS: ADAM AND EVE
A = number of sandwiches for Adam
v^A(A) = 8 \ln A
v^E(E) = 4 \ln E
S = number of sandwiches produced by Subway
E = number of sandwiches for Eve
T = number of sandwiches produced by Togo's
c^S(S) = S^2
c^T(T) = 2T^2
What happens in market equilibrium?
FIRMS: SUBWAY AND TOGO'S
CONSUMERS: ADAM AND EVE
A = number of sandwiches for Adam
v^A(A) = 8 \ln A
v^E(E) = 4 \ln E
S = number of sandwiches produced by Subway
E = number of sandwiches for Eve
T = number of sandwiches produced by Togo's
c^S(S) = S^2
c^T(T) = 2T^2
What happens in market equilibrium?
{8 \over A} = P
{4 \over E} = P
2S = P
4T = P
S+T
A + E
=
Firm Optimization:
Every firm produces up until the point where their marginal cost equals the market price (MC = P)
Market clearing: supply equals demand.
Consumer Optimization:
Every consumer buys up until the point where their marginal benefit equals the market price (MB = P)
Welfare Analysis
FIRMS: SUBWAY AND TOGO'S
CONSUMERS: ADAM AND EVE
A = number of sandwiches for Adam
v^A(A) = 8 \ln A
v^E(E) = 4 \ln E
S = number of sandwiches produced by Subway
E = number of sandwiches for Eve
T = number of sandwiches produced by Togo's
c^S(S) = S^2
c^T(T) = 2T^2
How can we choose A, E, S, and T to maximize total benefit minus total cost
subject to the constraint that the total amount produced is the total amount consumed?
v^A(A) = 8 \ln A
v^E(E) = 4 \ln E
c^S(S) = S^2
c^T(T) = 2T^2
How can we choose A, E, S, and T to maximize total benefit minus total cost
subject to the constraint that the total amount produced is the total amount consumed?
(S^2 + 2T^2)
(8 \ln A + 4 \ln E)
-
(S+T)
(A + E)
=
=0
-
Rewrite the constraint so that it's something equal to zero...
...and set up the Lagrangian!
v^A(A) = 8 \ln A
v^E(E) = 4 \ln E
c^S(S) = S^2
c^T(T) = 2T^2
How can we choose A, E, S, and T to maximize total benefit minus total cost
subject to the constraint that the total amount produced is the total amount consumed?
(S^2 + 2T^2)
(8 \ln A + 4 \ln E)
-
(S+T)
(A + E)
-
+ \lambda[
]
\mathcal{L}(A,E,S,T,\lambda)=
{\partial \mathcal{L} \over \partial A} = 0
{\partial \mathcal{L} \over \partial E} = 0
First order conditions:
\Rightarrow
{8 \over A} = \lambda
\Rightarrow
{4 \over E} = \lambda
{\partial \mathcal{L} \over \partial S} = 0
{\partial \mathcal{L} \over \partial E} = 0
\Rightarrow
2S = \lambda
\Rightarrow
4T = \lambda
{\partial \mathcal{L} \over \partial \lambda} = 0
\Rightarrow
(S+T)
(A + E)
=
{8 \over A} = \lambda
{4 \over E} = \lambda
2S = \lambda
4T = \lambda
S+T
A + E
=
What does an omniscient "social planner" do?
Productive Efficiency:
Allocate production so that each firm has the same marginal cost of making the last unit.
Don't overproduce or underproduce.
Allocative Efficiency:
Allocate consumption so that each person gets the same marginal utility from the last unit.
Ensure that the last unit consumed brings the same
marginal benefit to each consumer as the marginal cost it requires to produce.
{8 \over A} = P
{4 \over E} = P
2S = P
4T = P
S+T
A + E
=
What occurs in market equilibrium?
Firm Optimization:
Every firm produces up until the point where their marginal cost equals the market price (MC = P)
Market clearing: supply equals demand.
Consumer Optimization:
Every consumer buys up until the point where their marginal benefit equals the market price (MB = P)
Consumers and producers all face the same market price
"Individual ambition serves the common good." - Adam Smith
If there is a single price in the market that all consumers pay, and all producers receive, and all consumers and producers are “price takers,” then:
Every consumer sets MB = P:
- Everyone’s MB from the last unit bought is the same.
- Cannot increase total benefit by reallocating the good from one consumer to another
Every firm set MC = P:
-
Every firm’s MC from the last unit produced is the same.
-
Cannot reduce total costs by reallocating production from one firm to another
The MB of the last unit consumed by some person
equals the MC of the last unit produced by some firm
Effect of Taxes
- Last time, we saw how taxes affected the equilibrium quantity, as well as the price paid by consumers and the price received by firms.
- How does this affect overall welfare?
Consumers set \(P_C = MB\)
Firms set \(P_F = MC\)
\(P_C\)
\(MB\)
\(>\)
\(>\)
Since
\(P_F \)
\(MC \)
,
.
Why are Taxes Inefficient/Distortionary?
- Consumers no longer set their MB equal to
the same thing firms are setting their MC to. - Therefore, the quantity produced no longer sets MB of consumers equal to the MB of firms.
pollev.com/chrismakler
Why are taxes distortionary?
What do we have left to do?
- Weeks 1-4: how a single agent chooses to allocate resources among the production of different goods
- Weeks 5-6: how a consumer chooses how much of different goods to buy
- Weeks 7-8: how firms choose how much of a single good to sell
- Week 9: how markets "choose" how much of a single good society should have
- Week 10: how markets "choose" how to allocate resources across the production of different goods
Econ 50 | Lecture 24
By Chris Makler
Econ 50 | Lecture 24
Welfare Analysis of Equilibrium
