Market Interventions and Welfare Analysis

There are many different opinions about what welfare is. When one talk of welfare effects in microeconomics, then it is most often about how much utility different groups of people get from different allocations of goods. Usually, welfare analyses separate between producers and consumers, and make the following distinctions:

• Consumer surplus (CS). The consumers have a certain valuation of a good and pay a certain price to get it. The consumer surplus consists of the difference between how high their valuation is and how much they pay. In Figure 10.1, this corresponds to the triangular area labeled CS, i.e. the area between the demand curve and the price.

We can get an intuition of why this area is interesting in the following way. Suppose we are the customer with the highest valuation of the good. We would then be the customer that is willing to pay the highest price for it. In other words, we are the customer who defines the

left-most point on the demand curve, D. If the price were so high that only one unit was sold, we would be the buyer. However, at the equilibrium we do not have to pay that high price. We only have to pay p*. That means we get a surplus, as compared to what we are willing to pay, corresponding to the difference between the point on D and p*. If we apply the same reasoning to the consumer with the second highest valuation, and so forth for all consumers who buy the good, we get the result that the total consumer surplus corresponds to the area CS in the figure.

• Producer surplus (PS) is the difference between what the producers are paid for a good and the lowest price at which they would have corresponds to the triangular area labeled PS, i.e. the area between the price and the supply curve. The reasoning behind why this area is interestingparallels the one for the consumers.
• Social surplus is the sum of consumer and producer surplus: CS + PS. One may note that PS is directly related to profit. The area below the supply curve, S, i.e. the triangle labeled VC, corresponds to the variable cost of production.

The producers’ total

Furthermore, we know that profit is revenues minus costs. We can therefore get an expression for the profit:

In the short run, profit consequently equals PS minus fixed costs. In the long run, there are no fixed costs, and PS and profit are equal to each other.

Welfare Analysis

CS, PS, and social surplus are often used to evaluate the effects of market interventions. Such an analysis is called a welfare analysis. Let us use an earlier example.we studied the effect of a maximum price in a perfectly competitive market. With the help of Figure 10.2, we can now compare the social surplus with and without the maximum price.

The maximum price decreases the market price from p* to pmax and the quantity from Q* to Q2. Before the maximum price was introduced, CS = a + b, PS = c + d + e, and the social surplus equaled a + b + c + d + e. After the maximum price is introduced, CS = a + c, PS = e, and the social surplus is a + c + e. The producers have consequently lost c + d, and the total welfare has decreased by b + d. The consumers have lost b but gained c. Whether the consumers are better or worse off depends on if the area c is larger or smaller than b. However, social surplus is always diminished by introducing a maximum price in a perfectly competitive market. The amount of social surplus that is lost, b + d, is called the deadweight loss.

To get more help in Market Interventions and Welfare Analysis click the button below to submit your homework assignment