Theoretically the free market equilibrates supply and demand in such a way that the most efficient outcome is reached and both consumers and producers not only get or sell the goods that they want, but also get a benefit simply from participating in the free market. Of course there are exceptions in cases of market failure or market power and government intervention is required. This benefit that producers and consumers get together is called total surplus. One part of it is consumer surplus, which is the difference between consumers’ willingness to pay and the price. In a way it is the amount that some consumers saved by buying that good in the free market.
Producer surplus is the difference between the price and the cost of making that good. The question of how much of the surplus falls to the consumers and how much to the producers is an equity question, but the free markets invisible hand
concentrates on maximizing total surplus.
7.1. Consumer Surplus
The difference between willingness to pay and actual price is the benefit consumers get from participating in the free market and is called consumer surplus.
In essence consumer surplus is the extra benefit a consumer gets that he did not pay for. So, if a consumer is willing to pay 100 euros for item X and it only costs 60 euros, the consumer surplus is 100-60=40 euros. If the cost were 100 euros, the consumer surplus would have been 0 and if X cost more than 100 then the consumer would have not purchased the good. Since we operate under the assumption that consumers are rational and can evaluate their preferences the benefit the consumer gets from the good is equal to the amount he is willing to pay for it, so the extra money saved represents the benefit from participating in the market.
If we look at a normal demand curve, we see that for each price there’s a quantity demanded until the price is so large that 0 people would pay it. Everybody pays the equilibrium price, except for the people, who deem it too large - the ones to the right of the equilibrium, however there are those who pay the equilibrium price, but would have paid a much larger price as well - the consumers to the left of the demand curve.
Those people will get a consumer surplus: the larger their willingness to pay the larger the surplus and together they will represent the entire consumer surplus, which can be seen graphically, if we would simply draw a straight line from the equilibrium to the y axis – the area above the line represents the consumer surplus.
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Consumer surplus is an important concept because in most cases it reflects economic wellbeing. Policy makers try or at least should try to maximize it. Of course in cases such as harmful products, like drugs or cigarettes, policy makers will not care about consumer surplus, because it is not beneficial for them to consume the good entirely let alone be encouraged to consume it by making it easily and cheaply available.
7.2. Producer Surplus
The difference between price and costs of production is the benefit producers get from participating in the free market and is called producer surplus.
If we take a look at a normal supply curve we will see that it originates somewhere on the y-axis or price ordinate and then increases at some slope. It does not come out of the origin, because in order to produce the first unit a company has to incur some fixed costs like buying machinery. After that the curve slopes at a rate dependent on the variable costs. This is important to know in order to understand the concept of producer surplus. Just like consumers have a willingness to buy, producers have a willingness to sell, which depends on how much cost they have to incur to produce a certain quantity of goods. The higher the costs the larger will be the price producers are willing to sell their goods at. At the equilibrium price there will be some producers,
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curve. As the price increases more producers enter the market and the old producers get more surplus.
7.3. Market Efficiency
The free market adjusts to maximize both consumer and producer surplus and achieve market efficiency.
Consumer and producer surpluses combined are called total surplus, which is the value that buyers get minus the costs that sellers incur. We can imagine that there is a
benevolent social planner, who is an all-powerful dictator that tries to manage total surplus. He would mainly care about two things. The first is efficiency, which means that he needs to make sure that the total surplus is as large as possible, meaning that the goods are produced by the companies with the lowest costs and that the buyers who assign the largest value to them are actually buying the goods. Secondly the benevolent social planner might care about equality, so how to slice the pie of total surplus so that producers and consumers would have optimal and fair levels of well-being.
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Luckily we do not need such a dictator, because the free market under some
assumptions allocates everything efficiently at the equilibrium level. Buyers who value the good more than it costs buy it, this way the free market allocates the good to the consumers who extract most value from it. Also, the sellers who have the lowest costs can sell the good at the lowest prices, in this way the free market chooses the most efficient and cost minimizing firms. Thirdly, we know that in quantities bellow the equilibrium level the consumer gets more value than it costs the average producer to create it, therefore by increasing the quantity to equilibrium they become equal and in quantities above equilibrium level the reverse is true, therefore the free market
reduces the quantity and makes the marginal consumers value equal to the marginal producers costs, thus maximizing total surplus.
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Taxes change the incentives that buyers and sellers have in a free market. This change causes a reduction in surplus, both consumer and producer. Since effectively a tax increases the price, sellers will now sell less and consumers will afford less. Some consumers will drop out of the market entirely and will lose their entire surplus. This reduction in surplus is referred to as deadweight loss. Of course the government collects tax revenue, which is part of the surplus, however, this is usually smaller than the deadweight loss that comes from distorted incentives. The more elastic supply and demand are the larger the deadweight loss will be. Also, the loss increases with the size of the tax and eventually the incentives are distorted enough for tax revenue to begin to decrease with the size of the tax.
8.1. The Deadweight Loss of Taxation
Taxes change incentives in a market, which causes inefficiency or deadweight loss.
In an efficient market, as we’ve learnt in previous chapters, consumer and producer or total surplus is maximized, however there are things which can distort this. As a result of a distortion, the loss in total surplus is called a deadweight loss. Probably the most well-known market distortion is taxes. The exact effect depends on whether the tax is levied on the buyers (demand curve shifts) or the sellers (supply curve shifts), but in both cases the price to the consumer increases and the price to the sellers decreases. In this chapter we assume that both curves stay put. This changes the incentives both parties have: producers will want to produce less and people will be able to buy less as well. This is where the distortion comes from. However it is also true that there will be a public benefit or tax revenue for the government. Even though this money will be spent on some members of society we will call it a public benefit and assume that all get it.
After the tax is introduced the price in the graph of supply and demand will move to the left and there will be a wedge between the curves, the size of that wedge is the size of the tax. Both, consume and producer, surplus will decrease, but total surplus will not decrease by the same amount because some of it will become public benefit or government tax revenue. However the triangle area bordered by a straight line from the new price points on the supply and demand curves and the curves themselves will be surplus lost, and this is called the deadweight loss. As we‘ve learnt before market participants get a benefit just from participating in the free market, which we call gains from trade. When there is deadweight loss we say that there is a loss in the gains from trade.
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8.2. The Determinants of Deadweight Loss
Deadweight loss of taxation increases with the elasticity of supply and demand.
Deadweight loss of taxation is mainly determined by the elasticity of supply and demand. If the elasticity of supply is small, meaning that supply cannot well adjust to price changes the deadweight loss is small as well. When supply is more elastic this means that it will respond in larger quantities to the increase in price due to the tax, therefore the deadweight loss will be large. The same logic applies to the elasticity of demand. Low elasticity means that demand will not respond much and there will not be much deadweight loss.
Example:
The concept of deadweight loss has a lot of influence on current political debate, such
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as the appropriate size of the government. If taxes do not cause large deadweight losses then perhaps the government should be quite big, since it can be beneficial, but if the losses are large then that is a good argument for smaller governments. The largest tax in the US is the labour tax, which, taking into account all of the types of labour taxes, amounts to about 40%. Some economists say that labour supply is inelastic and that this tax does not have a large deadweight loss. Others say that labour supply is elastic and this tax causes people to work less hours, some not to work at all, elderly retire early and some to enter into illegal activities. Which is true is subject to debate and requires a lot of investigation.
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9. Application: International Trade
In order to determine the effects of international trade on a countries economy, we should compare the world price and the domestic price with no trade. If the world price is greater than the domestic price it is likely that the country will be an exporter, which will be beneficial for its producers, but damaging to the consumers, since their prices will rise. If the world price is smaller than the domestic one, the country is likely to become an importer, which will reduce the prices for consumers and benefit them, yet will be damaging to local producers. However, in each case free trade will have a net benefit on society. Countries may choose to impose tariffs, which are taxes on imported goods, however this removes some of the benefits of free trade. There are reasonable arguments to restrict trade sometimes, like in order to protect infant industries, retaliate to other countries trade restrictions or protect national security.
However, they are all debatable.
9.1. The Determinants of Trade
The difference between domestic and world price determines, whether a country is an exporter or an importer.
Under autarky, which is a situation when a country does not engage in trade at all, a small country’s economy would work according to the basic principles of supply and demand, price would equilibrate the quantity of a product in the market and consumers and producers would share a particular amount of surplus. When the country opens up to international trade, since it is a small country it cannot influence the world price for whatever good it is producing. Depending on whether the domestic price is smaller or larger than the world price we can say if the country has or has not a comparative advantage for that good. If the domestic price is lower than the world price, the country has a comparative advantage and shall start to export the good, but if the price is higher it will become an importer. Even though we may think that this would harm the
producers of the good, which will now be pushed out of business by imports, trade will still be beneficial to the economy as a whole, because now the country will be able to specialize in what it does relatively best and buy the good it used to make for a smaller price from importers.
9.2. The Winners and Losers from Trade
Domestic producers are harmed by imports and domestic consumers are harmed by price increases due to exports, but society and economy as a whole win from
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international trade.
When an economy opens up to trade and it turns out that the world price is higher than the domestic equilibrium price, which means that the country has a comparative
advantage, the country and producers of the good in question certainly do benefit. Now the world price becomes the price of the good not only in the world but also in the domestic market. This means that producers can raise their price and not lose
customers because they can export as much as desired into other countries, which is what they do, however consumers now have to face a higher price domestically and some of them do not want to produce at the higher price therefore consumers lose some of their surplus, yet the extra surplus that the producers get more than compensates for the loss and the country as a whole experiences gains from trade.
If it turns out that the world price is lower than the domestic equilibrium price it is bad news for producers since some of them will not be able to produce the same quantities at a new lower world price and they will lose some of their surplus. On the other hand the consumers will not be able to buy more at the lower price and their surplus shall increase. As a whole the country will benefit because the surplus gained by consumers will outweigh the losses of producers and there will be more gains from trade for the country.
A government may want to protect its disadvantaged producers by imposing a tariff on imports. This is simply a tax that you make importers pay for the foreign goods when they come into the country. Of course, if the country, when stepped out of autarky, becomes and exporter then the tariff doesn’t matter, yet if it is an importer it benefits the local producers at the disadvantage of everyone else. A tariff will increase the domestic price, which will allow more domestic producers to be competitive, yet domestic consumers will reduce their demand depending on the actual price increase and buy less. This means that there will be fewer consumers to buy both local and foreign goods. Since some consumers will no longer be able to afford the good they will lose surplus and since some local producers will be able to stay in business they will gain surplus in comparison to when there was trade yet no tariff. Also the government will claim the money, raised from foreign companies through the tariff. All in all surplus will be lost and this is called deadweight loss from a tariff.
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competing on a global level with many players. Lastly with trade come new ideas and technological spill overs that can have huge benefits for the country.
9.3. The Arguments for the Restriction of Trade
It is argued that trade can be restricted in cases of job or industry protection, national security, bargaining, retaliation or infant industry protection.
There are several arguments almost always put forward by free trade sceptics in various discussions. Firstly there is the argument that a country may lose jobs if an industry is competed out by imports. It is true that that industry will lose jobs, however the workers will simply relocate to making goods for which the country has a
comparative advantage. Also there is the argument of national security, which states that if a country cannot make its own steal and has to import it this reduce its security because it may not be able to produce weapons if foreign firms refuse to sell. This is farfetched, even though economists agree that a country may in some cases have to sacrifice economic efficiency for security, this argument should not be used hastily, only in times when there is reason to believe that a country is under threat. Otherwise it will simply have a pile of weapons it doesn’t use and at the cost of consumers. Another argument is called the infant industry argument, which states that some industries may be very young and small, therefore at the time not able to compete with importers, but they may also have potential to eventually become much more profitable than foreign producers. Therefore some say they should be protected. This is first of all very
politically difficult and subject to manipulation, because it is notoriously difficult to predict which companies and industries will become successful and which won’t. Also company owners if they really believe in the company should be willing to incur losses in the first years. Thirdly some say that trade can be unfair because some countries can subsidize their industries. This is true for producers who may be unfairly competed out, but the consumers of the imported goods will greatly benefit from the subsidized price.
Also these subsidies will almost certainly be costly to the governments that impose them. Lastly some will advocate trade restrictions as bargaining chips, which can work, but it can also fail. If one country tells the other it will remove a tariff on their goods if the other country will remove theirs, this may result in freer trade, but the foreign country may also reject leaving the offering country in an uncomfortable position.
Example:
There are two ways for a country to reduce its limitations on trade. First is the unilateral approach, where one country voluntarily removes its restrictions on all countries. The other approach is the multilateral, where countries bargain on their restrictions and reduce them if another country does the same. Right after WWII the average worldwide tariff was about 40%, today it is around 5%. This is due to the
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