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PROFESSOR: We want to turn
this course to now start
talking about some normative
economics, which is how do we
feel about the actions firms
and consumers take.
And to do that we need to
pause, and starting last
lecture now through this
lecture, talk about welfare.
Well-being.
How do we measure the well-being
implications of
individual and firm actions?
Now, we talked last time about
the first concept of this,
which was consumer surplus.
Consumer surplus was the amount
of utility consumers
derived above and beyond
the price they had
to pay for the good.
Now, since it's utility,
remember, it's not ordinal,
it's cardinal.
We redefine that.
That is the consumer's
willingness to pay above the
price that they pay
for a good.
So, anything a consumer's
willing to pay that was higher
than the price they actually
paid is consumer surplus.
And that was at the
individual level.
That was the individual
consumer surplus.
Now what we want to do is move
on and talk about market
consumer surplus.
So for an individual, consumer
surplus is a willingness to
pay above the price
actually paid.
At the market level, it's
the same thing.
It's just the aggregation of
individual consumer surpluses.
So let's think about
a simple example.
Let's think about the case of
the consumer surplus that you
derive from my lectures.
Let's think about the
consumer surplus you
derive from my lectures.
So we have some demand curve
for my lectures.
Let's look at figure 13-1.
Let's say this is the demand
curve for my lectures.
So basically, this is a
willingness to pay.
So the notion is that there's
some student who's willing to
pay a large amount because they
recognize the brilliance
of what they're hearing here.
And they're willing to pay a
large amount for my lectures.
Then the next student's willing
to pay slightly less.
All the way down to the student
who falls asleep every
time who's not willing to pay
anything for my lectures.
So you've got some demand
curve for my lectures.
And, once again, the key to
all this, the key to the
welfare analysis, is to remember
what this demand
curve represents.
It's a willingness
to pay curve.
But in this case, it's
not an individual's
willingness to pay.
It's the market's willingness
to pay.
Where each point is
a unit of demand.
So in this case, one unit
equals one person.
So each point represents
the willingness
to pay of that person.
So the point on the y-axis
represents the willingness to
pay of the person who most
enjoys my lectures.
Or derives the most
value out of them.
The intersection of that line
with the x-axis is a
willingness to pay of zero,
someone who's not willing to
pay anything for the lectures.
Obviously, could go negative.
People could be willing to pay
not have to come to the
lecture, but we won't
consider that.
We'll just say zero's
the minimum.
So, basically, what is the
key determinant of
the equilibrium outcome?
It is the point where,
equilibrium is the point,
where the price is set equal to
the willingness to pay of
the marginal consumer.
So if you think about typical
supply-demand diagram, and we
get some equilibrium price.
So here's our equilibrium
quantity, Q-star.
And here's our program
price, P-star.
Now, let's focus in on
this demand curve.
With that price P-star,
it represents--
it's on the demand curve, so
it's a willingness to pay.
Whose willingness
to pay is it?
It's the willingness to
pay of person Q-star.
It's the willingness to pay of
the person who's exactly
willing to pay the price.
That is, the equilibrium in a
perfectly competitive market,
of the kind we've discussed so
far, the price represents the
willingness to pay of the
marginal consumer.
The willingness to pay of the
consumer who exactly is
indifferent between consuming
and not consuming the good.
So this consumer, Q-star, this
person Q-star in our example,
is the person who's
indifferent.
Who derives, what, zero
consumer surplus.
This person, since their
willingness to pay equals the
price, equilibrium is achieved
where the price is set--
In equilibrium, you have that
the marginal consumer, the
last person consuming,
is deriving
zero consumer surplus.
They're indifferent between
consuming the good and not
consuming the good
at that price.
If it was free, they'd be happy
to consume it, but at
the price, at that equilibrium
price P-star, they're
indifferent.
So basically, looking at the
diagram, what this is saying
is that the price was
$100 a lecture.
Then person 100, that hundredth
person, would be the
marginal consumer who's
indifferent between paying the
$100 and hearing my lecture
or paying nothing
and skipping my lecture.
So that person 100 is the
person who's indifferent
between paying $100 and hearing
my lecture or paying
zero and not hearing
my lecture.
That person drives no
consumer surplus.
Because their willingness
to pay equals the price.
What that means is that every
consumer up to the first 100,
by definition, must be deriving
some consumer surplus.
As long as the demand curve
is downward sloping.
As long as the demand curve is
downward sloping, every person
to the left of person
100 must be deriving
some consumer surplus.
In particular, the first person
is driving enormous
consumer surplus.
How can we prove that?
Well, the proof is simple.
We know their willingness to pay
is higher than person 100.
And we know person 100 is
willing to pay $100.
Therefore, by definition anyone
to the left is deriving
consumer surplus from this.
Because we know they like it
more than person 100, and
person 100 is willing
to pay $100.
They only have to pay $100, it's
one price to everybody.
So by definition, they're
deriving consumer surplus.
So the first guy, he or she gets
a big consumer surplus.
Then it dwindles and dwindles
and dwindles until the
hundredth person derives zero.
But, if you integrate, and the
entire consumer surplus for
the market is that entire
triangle, that
entire shaded triangle.
So market consumer surplus is
defined the same as individual
consumer surplus, as
the difference
between the demand curve.
It's the area under the demand
curve above the price.
So it's the integral of that
area, under the demand curve,
above the price.
But here we're thinking of it
not in terms of a person's
decision but the market's
decision.
And when you think about that,
it is the last unit be
representing the person
who's indifferent.
And everybody else deriving
surplus from it.
Questions about that?
Now, let's ask what, then would
happen if the price of
my lecture rate rose.
So let's say I was charging
$100 boxes at the door.
You guys are all the guys to
the left of person 100.
Those people who were here for
the first lecture and don't
show up any more, they're
the people to the
right of person 100.
And now let's say I change.
Instead of charging $100
at the door, I
charge $110 at the door.
So let's look at figure 13-2.
What happens there?
Well, in that case, if I charge
$110, the hundredth guy
is no longer willing
to come to lecture.
Remember, the hundredth guy,
he or she was indifferent
between paying $100 and hearing
my lecture and paying
nothing and missing
my lecture.
Well at $110, clearly, they'll
say forget it, it's not worth
it any more.
They'll drop out.
Likewise, the way I've drawn
this diagram, everybody above
person 90 will no
longer attend.
That is, person 90 is now the
person, where at a price of
$110 they're indifferent between
paying and attending
or not paying and
not attending.
Everybody to the left
of person 90 still
gets consumer surplus.
It's not shaded, but if you
shade the triangle above the
$110 dashed line, the triangle
under the demand curve and
above with a dashed line
at $110, that's the
new consumer surplus.
That's the new consumer
surplus.
Those people still derive
consumer surplus because they
love me so much that they're
willing to pay more than $110.
So even $110, and they
prefer to pay $100.
But even $110 they'll still
come and they'll still be
happy about it.
But now 10 people have dropped
out because they're not
willing to pay $110.
They were only willing
to pay $100.
So what we see is
that the total
consumer surplus has shrunk.
It's shrunk by this trapezoid,
by this shaded trapezoid.
And it's shrunk for
two reasons.
One reason is that some people
who used to derive consumer
surplus now are out
of the market.
That's the triangle.
That's the shaded triangle.
It's also shrunk because even
people staying in the market
are now sadder.
They've lost consumer surplus.
The consumer surplus
is still positive.
They're still coming to the
lecture, but it's smaller than
it was, and that's
the rectangle.
So the triangle is the people
who drop out of the market.
The rectangle is the reduced
consumer surplus, the reduced
consumer surplus of people who
stay in the market but now
have to pay $10 more.
The consumer surplus is still
positive, but it's smaller.
So, a question to you.
What is the key economic
concept that's going to
determine, for a given market,
whether the consumer surplus
is large or small?
Yeah?
AUDIENCE: Elasticity.
PROFESSOR: The elasticity.
And why is that?
AUDIENCE: Because it changes
how steeply--
PROFESSOR: Exactly.
So if we look at figure 13-3,
now here is a case with a
steeper elasticity
of demand, where
consumers are more inelastic.
If you compare it to figure
13-1, you'll see the consumer
surplus triangle
is much bigger.
Likewise, if we drew a flatter
demand curve, a more elastic
demand, the consumer surplus
would be much smaller.
So hopefully you can see
graphically what will
determine consumer surplus is
the elasticity of demand.
Now, can someone give me the
intuition for why that's true?
Graphically, I hope you
can see it's true.
The triangle will be smaller
as that curve is flatter.
Can someone give me the
intuition for why that's true?
Why is it that consumer surplus
is larger the more
inelastic is demand, and
consumer surplus is smaller
the more elastic is demand.
Want to give it a try?
AUDIENCE: I guess if it's more
inelastic, then consumers
don't have--
PROFESSOR: They don't
have what?
[UNINTELLIGIBLE]
What determines it?
AUDIENCE: As many choices,
I would say.
PROFESSOR: They don't have
as many substitutes.
So with inelastic demand is when
consumers don't have as
many substitutes.
In that case they get a
lot of surplus from
consuming this good.
So think about insulin
versus McDonald's.
The consumer surplus from
insulin is very, very high.
Because regardless of the
price, I die without it.
And there's no substitute.
So it's a very inelastically
demanded good, and as a
result, at any price, I derive
a huge consumer surplus
because as long as that price
is less than the value of my
life, I derive a big
consumer surplus.
Now let's take McDonald's.
I can always go to Burger King
and be equally happy.
Maybe not quite equally
happy, the curve
isn't perfectly elastic.
I like McDonald's a
little bit more.
I like the prizes in their
Happy Meals better.
So it's a little bit elastic,
but the point is, if
McDonald's raises the price,
I'm not that much sadder
because I just go to Burger
King where I was perfectly
happy as well.
So there's not much lost
consumer surplus if McDonald's
raises the price.
There's not much consumer
surplus arising.
There's not that much
consumer surplus--
forget the loss.
Go back.
That's a different issue.
I'm talking the sides of
the consumer surplus.
There's not much consumer
surplus arising from consuming
at McDonald's.
Not much consumer surplus
arises from consuming
McDonalds because I
can always just go
to Burger King instead.
So what determines consumer
surplus is the elasticity of
demand, which is fundamentally
about your willingness to pay.
Inelastic goods have higher
willingness to pay.
And so as a result, the
consumer surplus is
essentially inversely related
to the elasticity of demand.
The higher the elasticity, the
smaller the consumer surplus.
Now, let's shift and talk
about producers.
The analysis for producer
surplus is exactly the same
type of analysis, just
flipped to the
other side of the market.
Now, here the question is, what
determines my producer surplus?
Well, what determines
consumer surplus?
It's the difference between my
marginal willingness to pay
and the price.
What determines producer
surplus, that's going to be
the difference between the
firm's marginal willingness to
supply, and the price.
So my marginal willingness to
pay as a consumer is what
determines my consumer
surplus.
Producer surplus will be
determined by my marginal
willingness to supply.
My marginal is supply, which is
simply represented by the
supply curve.
A little bit easier for
producer surplus.
The supply curve represents the
price at which I'm willing
to supply a good.
That's what a supply curve is.
As we learned a couple lectures
ago, in the context
of competitive firms that's my
marginal cost. So the supply
curve is my marginal cost. That
says that is how much it
costs me to produce
the next unit.
In a perfectly competitive
long-run equilibrium, or short
run equilibrium, that is
basically what I'll
set my price to.
So if we go to figure
13-4, now let's look
at my producer surplus.
My surplus from delivering
lectures.
Let's say that--
this is a bit harder
to imagine--
but imagine that I prefer
deliver smaller lectures.
Maybe because as the number of
kids gets smaller I can learn
your names.
I don't have to look around as
much, I don't have to pace as
much, whatever.
So imagine that I'm most
happy delivering a
lecture to one student.
And that's the lowest cost
to me, the lowest effort.
I can just come in and sit down,
and we have coffee and I
just riff, and I don't have to
worry about notes or any of
that stuff.
But when there's two students
I feel a little bit guilty
doing that, so I make some
notes to myself.
When there's three students
I make some more notes.
By the time there's all you
students, I have to type up
all these notes.
So every student that adds to
my lecture, imagine, is a
marginal cost.
Now, you know that's not
true, of course.
I wouldn't change my notes if
six more students walked in.
But let's just imagine
that it's linear.
Imagine with every student that
comes in here, I have to
put in a little more effort
in my lecture.
So it's a marginal cost to me
with the additional students.
So that delivers the supply
curve, this upward sloping
supply curve.
Now let's say at a given price,
P, I'm willing to
lecture-- so that, given the
supply curve, if the price is
equal to p, I'm willing to
lecture to Q students.
That is, if you're going to give
me a price of P, at that
price my marginal willingness to
supply is that I'll supply
Q lectures.
So another way to say it is that
if you want me to supply
Q lectures, you've got to pay me
a price P. That's the point
where I derive no producer
surplus.
I'm indifferent at that point.
If at that point you said,
would you want the Q-th
student or not, I'd say
I don't really care.
I'm indifferent.
I get zero producer surplus.
But, I got a huge surplus
on that first student.
Because I was willing to work
with them and it wouldn't have
cost me anything.
But I'm getting paid P to
work with all of you.
So I make a producer
surplus on that.
So producer surplus is made on
every unit to the left of Q,
because those are units with a
positive producer surplus.
They're the units above
the supply curve
and below the price.
They're the units where it's
above the supply curve, so I'm
willing to supply, but below the
price which means that I'm
getting paid more than I would
have to to supply that unit.
Can anyone think of
another name for
this triangle, roughly?
How else you might think
about that triangle.
Well, I can talk about
producer surplus.
And I said, what's the
difference between the price
producers receive and the cost
that they have to produce it.
AUDIENCE: Profit.
PROFESSOR: Profit.
Roughly speaking, producer
surplus is profit.
Now, technically, in the short
run, that's not true.
Because in the short run there's
fixed costs and you
might lose money on fixed costs
and still make a long
run profit.
So in the short run it's
not technically true.
In the long run it is
technically true, and for the
purpose of this course we'll
say it's technically true.
So producer surplus is profit.
It's a lot easier
to think about.
Consumer surplus is this vague
concept we have to measure my
willingness to pay versus
what I pay.
Producer surplus is
easy, it's profit.
So producer surplus is profit,
it's the difference between
the price at which I'm willing
to produce the good and the
price you actually
pay me for it.
So that's producer surplus.
Questions about that?
OK.
Putting this together, we can
now measure the total welfare
of society.
We now have it.
We can measure the entire
happiness of all of society.
And we define social welfare of
society as consumer surplus
plus producer surplus.
Now, that doesn't have to be.
You could say, gee, Jon, don't
you care more about consumers
than firms?
Or gee, Jon, don't
you care more
about firms than consumers.
I'm going to leave that
alone for now.
We're just going to do the
simplest thing and just say,
we're going to define social
welfare as simply the sum of
how much surplus consumers
get plus how much surplus
producers get.
OK?
This is a particular
representation.
When we talk about efficiency
and equilibrium, we're talking
about efficiency--
I'm sorry--
versus equity, which we'll talk
about towards the end of
the course.
We'll talk about alternative
definitions, and how we weigh
different definitions of this.
But for now, this is the
standard economic definition.
Which is, let's not draw
a judgment about
who's better than who.
Let's just talk about
the total amount
of surplus in society.
So the amount of social welfare,
is the total amount
of surplus in society.
And here's the key result.
That the competitive
equilibrium, where demand
equals supply, in competitive
equilibrium, is the welfare
maximizing outcome.
The competitive equilibrium of
the market, which is where
demand equals supply,
is also the
welfare maximizing outcome.
And that's the key thing we want
to go to now, which is
that basically moving away from
that equilibrium point,
where demand equals supply, will
by definition lower the
amount of social welfare.
So to see this, let's
go to Figure 13-5.
And we've got some supply
and demand curves.
This is from the book now.
We've got some supply
and demand curves.
And we're initially in
equilibrium at P1 Q1,
at the point E1.
So we're initially at
equilibrium at E1.
At E1, at that initial
equilibrium point, consumer
surplus is equal to R. Now,
going by the letters that
label the areas, R plus S plus
V. That's the amount of
consumer surplus.
The amount under the demand
curve, above the price.
That's consumer surplus.
Stop me if this is not clear,
this is important stuff.
So under the demand curve above
the price, R plus S plus
V. The producer surplus is T
plus U. The profit is the
amount above the supply curve
and below the price.
And so total social welfare
is the sum of all these.
R plus S plus V plus T plus U.
That's our starting point.
That's our competitive
equilibrium starting point.
Now, let's see.
You should be able to
immediately see, those of you
who are good with your geometry,
that there is no
point you could choose
which can make
social welfare larger.
As a simple comparative statics
exercise, imagine I
had the government come in and
say, we're going to raise the
prices in the market to P2.
We decide that producers
aren't making enough.
Look, the consumers get three
letters, the producers only
get two letters,
that's unfair.
So we're going to raise the
price to give the produces
more letters and the consumer
fewer letters.
That sounds like about the
rational basis for government
policy making these days.
So we're going to do that.
And so we're going to raise
the price to P2.
With a price of P2, we'll
have a new equilibrium.
If you force the
price up to P2.
You have a new equilibrium
at little e sub 2, and
a quantity of Q2.
What happens now?
What's happened to
consumer surplus?
Consumer surplus, you've now
lost S and V. Consumer surplus
is now just R. Because at that
new price, P2, that's the area
under the demand curve
above the price.
Producer surplus has
grown, however.
Now, instead of being T plus
U, it's now T plus S. So
what's happened, effectively,
is you've transferred S from
consumers to producers.
And you've lost V
plus U, forever.
So what's involved in
this change is a
transfer and a loss.
The transfer is the area S,
which used to belong to
consumers now belongs
to producers.
But now we have what we call
a dead weight loss.
Dead weight loss, of V plus
U. That's welfare that has
disappeared.
Welfare has disappeared.
And the definition of dead
weight loss is a net reduction
in efficiency from trades
that are not made.
Remember we talked
about efficiency
early on in the course.
We said the efficient outcome is
one where trades that make
both people better
off are made.
Here we have trades, which
absent the government would
have made both parties
better off,
and they're not happening.
That is surplus that's
just gone.
It's into the ether.
That is social surplus that is
now social welfare, that is
now gone because there are
trades that would have made
both parties happier that
are now not happening.
And that's a total waste from
society's perspective.
Because society's best off if
all the trades that make both
parties happier, happen.
So the bottom line is, any price
you would impose other
than the market price of P1, and
you can work this out for
yourself, any price you would
impose would by definition
lead to a lower social
welfare.
It may shift.
It may lead to a bigger or
smaller consumer surplus
relative to producer surplus.
Once again at this point we're
just using the sum of them as
a measure of social welfare.
Social welfare has fallen.
So social welfare is maximized
in this case.
So this gives us a framework
to think about.
We started the course with
supply and demand, and talking
about how things like the
minimum wage reduce
efficiency.
Well, this gives us a welfare
framework, a more formal
welfare framework, for
thinking about that.
I said it reduces efficiency
before because you had less
labor in the market.
But now we can actually more
formally say why does the
minimum wage reduce
efficiency?
We can actually look at that.
Let me just do the always-risky
thing of trying a
freehand diagram.
You remember our market for
labor, you had the amount of
labor on the x-axis, the
wage on the y-axis.
You had some supply of labor
that comes from workers
deciding to work as the
wage goes up, they
want to work more.
You've got demand for labor.
That comes from firms
demanding workers.
As the wage goes up, they
want fewer workers.
And you have some initial
equilibrium, L-star, W-star.
When the government came in with
its minimum wage and the
government said, we're going
to impose a minimum wage of
W-bar, W-super bar.
OK Remember, we said what
happened was, well, of course
then firms are only going
to want L1 workers.
We talked before about how that
led to some unemployment.
What we didn't mention is how
this leads to an efficiency
loss to society.
This area is now dead
weight loss.
These workers, who would have
been happy to work at the
prevailing wage, and firms would
have been happy to hire
the workers at the prevailing
wage, and those trades no
longer happen.
So here's an important question
to help you think--
you're going to have to draw
dead weight loss triangles in
your sleep now.
So here's the trick
with these.
Why is the dead weight loss
triangle smallest here and
grow like that?
Why does the dead weight loss
triangle grow as you move away
from the competitive
equilibrium?
Yeah.
AUDIENCE: There is less amount
of people who are willing to
work at that price.
PROFESSOR: Say it again?
AUDIENCE: So there's less people
that are willing to
work for that smaller price.
PROFESSOR: Well, here we're
imposing a higher-- less
people are willing to
work for, are you
referring to here or here?
AUDIENCE: To all the
way to the right.
PROFESSOR: All the way.
So basically, the point is--
another way to put it is, at
that wage the consumers there
are pretty indifferent.
So in other words, they're
willing to work but barely.
So at this wage, at this point
here, the L*-th worker is
getting no surplus
from working.
It's not a crappy wage,
he's happy to take it.
But he'd also be happy
to sit at home.
He's indifferent.
So for that L*-th worker,
you make him not
work, he doesn't care.
So if you raise the minimum wage
and this guy sits at home
instead of working,
he didn't care.
He was getting no surplus
from working anyway.
Likewise this firm, who's hiring
the L*-th worker, they
were paying this worker exactly
what he was producing.
The marginal cost of that worker
exactly equalled what
they were paying him.
What that worker's producing
was exactly equal to
what they paid him.
They were earning zero profit
on that worker.
So they don't care
if he stays home.
So if the government set a
minimum wage, such that one
guy stayed home, the minimum
wage was so close to market
wage that one guy stayed home,
there would be no social
welfare loss.
Or infinitesimally small.
Because that last guy, there was
indifference on both the
worker's side and
the firm's side.
However once you start
displacing more and more,
these workers aren't indifferent
anymore, right?
These are workers who
were making a lot of
surplus at that wage.
And firms that were earning a
lot of profit at that wage.
Now they're not indifferent.
So as you move farther and
farther from the competitive
equilibrium, the distortion
gets larger and larger.
Very important intuition to
have. That for that last
person, there's no distortion
from moving epsilon away from
the competitive equilibrium.
Because they weren't earning
any surplus anyway.
And the firm wasn't making
any surplus on them.
But as you move away, the loss
in social welfare gets larger
and larger because these are
people who are making all
sorts of surpluses on
these transactions.
And you're stopping them
from happening.
So if the government
interferes with the
transaction--
So imagine, this guy and I
were negotiating over a
baseball card and I ended up
paying him exactly what the
baseball card was
worth to him.
And I ended up paying exactly
what it was worth
to me to have it.
And then my parents come in and
say, you can't do that.
Then it doesn't really matter,
because we weren't making any
surplus of that trade anyway.
But, if he had three of these
cards and was delighted to get
rid of it for $50, and I have
always wanted this card and
valued it at $200, then if my
parents come and sink this
trade, then that's
a real bummer.
That's a huge loss in social
welfare, because the trade
that made both parties better
off is not happening.
Questions about that?
Let's look at a particularly
good example of this.
Of when the government
interferes with trades and the
implications of that.
The TAs on Friday are going
to go through a bunch of
interesting examples.
I'm just going to
do one today.
And then you'll do some more
in section, because this is
hard and important.
I want to today focus on the
example of taxicab medallions.
It's the example in the
book, which is a
particularly good example.
Taxi drivers, we've all taken
taxis, we know how they work.
But taxi drivers in virtually
all cities, you cannot just
start a cab and drive
people around.
In virtually all cities, you
need to get something from the
city that allows you to call
yourself a taxicab.
And that's typically called
a taxicab medallion.
It originally was literally
something you had on the hood
of your car.
Now it's a certificate you have
in the back of your car.
So you see the certificate
whenever you ride in a car,
which says, So-and-so is
licensed by the city of
whatever to drive this cab.
The government issues a certain
amount of these
taxicab medallions.
And almost always issues less
than would be demanded in the
free market for taxicabs.
And let's see what
effect that has.
So go to 13-6.
This is getting kind of
complicated, but this is an
example of the kind of welfare
analysis we can do.
Once we understand
these concepts.
Let's say we start
at point E1.
Big E1 on the right, little
E1 on the left.
So on the right-hand side, this
is like our other profit
diagrams. The right-hand
side is the market.
The left-hand side is an
individual cab firm.
Initially, if the government
doesn't interfere, you are in
equilibrium at point E sub 1.
Which is, that the price is
P1, and the individual cab
firm delivers q sub 1 rides.
And let's assume cab firms
are identical,
just to make it easy.
And that there are n of them.
Well in that case, the total
amount delivered is N1 Q1.
So Q sub 1 is q sub 1, which is
the amount delivered by a
given cab firm at that price,
times the n cab
firms in the market.
N1 cab firms in the market.
So there's N1 firms.
Each delivers
little q sub 1 of rides.
And you can see at that point,
they each make some profit.
So what you can see at that
point is that at E1, at a
price of P1, they're
making some profit.
The price is set equal to
their marginal cost.
I'm sorry, they're not
making a profit.
My bad.
You see at that point they're
not making profit.
Because what you can see is
price is equal to the minimum
of average cost. Remember, the
no-profit condition is where
marginal cost equals average
cost. You can see at that
point, little e1 in
the diagram at the
left, there is no profit.
Because price equals marginal
cost, equals the average cost.
So we're making no profit, and
that's a perfectly competitive
equilibrium.
That's what we derived
last time.
Now, let's say the government
comes in and
says, you know what?
And the welfare here.
Just to do the welfare here.
You see that the welfare
of society is,
producers make no surplus.
There's no producer surplus,
there's no profits.
Consumers have surplus of A
plus B plus C. So consumer
surplus is the area on the
demand curve above the price.
That's A plus B plus C. Producer
surplus is profits,
which are zero.
Because it's perfectly
competitive.
So you end up with a total
social surplus of A plus B
plus C. And it all goes
to consumers.
Now let's say, the taxicab
owners aren't
so happy about this.
They don't like making
zero surplus.
And they manage to get
a restriction.
Such that the government says,
there's only a certain number
of medallions.
And we're only going to let
people drive the cabs if they
have a medallion.
Now, let's say that the taxicab
owners say, we're only
going to limit the number of
medallions to N sub 2.
Instead of there being n sub
1 cab firms-- let's say
medallions aren't for cabs,
they're for cab companies.
Instead of being n sub 1 cab
companies, we're going to
limit medallions so there can
only be n sub 2 cab companies.
So what happens?
Well, it's a little
complicated so
let's follow along.
If there's only n sub 2 cab
companies, then what that
means is that given the same
market demand, that means
firms are now going to be able
to make some profit.
So up to, if you look at the
right-hand side diagram up to
N2 Q1, the supply curve
is the same.
But at that point, once you pass
N2 Q1, then you have a
point where that's--
at the old, efficient level of
cab rides, the efficient level
is, each cab company provides
Q sub 1 rides.
Well, you then run
out of rides, but
people still want more.
So what happens?
Well, cab companies start to
be able to charge more.
The supply curve becomes
upward sloping.
They start to be able to charge
more for their rides.
Because now you don't have extra
cab companies entering
and competing those
profits away.
They start to be able to charge
more for their rides.
And you see that that upward
sloping supply curve meets the
demand curve at N2 Q2.
So up to N2 Q1 it's the
supply curve which it
was, which is flat.
Once you get beyond that,
now firms can
charge a higher price.
Because they don't have
to worry about entry.
So you get a new supply curve
that's flat until N2 Q1 then
starts to slope up.
That's S super 2.
And S super 2 intersects the
demand curve at point E sub 2.
And that is the new equilibrium,
with the higher
price of P2 and a lower
total quantity of Q2.
Now let's what that
does to the firm.
Well, a given firm at a
price P2, they now--
they always set the price
equal to marginal
cost. That's the rule.
Every profit maximizing
firm does that.
Well, they now are at a
point little e sub 2,
making a huge profit.
Because at that point, their
marginal cost is well above
their average cost. So at that
point, they make the profit of
the shaded area pi in the
left-hand side diagram.
They make the profit pi, because
once again [INAUDIBLE]
go to the right-hand and then
back to the left-hand side.
The right-hand side is, the new
supply curve intersects
the demand curve.
At point E2.
That's the price of P2.
Carry that over the left-hand
diagram, you see at a price of
P2, they make a profit, the
difference between that price
and the average cost curve,
which is that shaded pi box.
So firms now make profits.
And they didn't before.
What's happened to welfare
in the market?
Well, what's happened is
consumer surplus has now
fallen from A plus B to
just A. Because the
price is now P2.
The consumer surplus is the area
under the demand curve
above the price.
That's just the triangle A. Just
the triangle A. At that
new price, that's the
consumer surplus.
What's the producer surplus?
Well, now producers are
making profits.
And what they're making a
surplus is the area below the
price above their
supply curve.
The supply curve is this funky
kinked thing I just described.
So their new producer surplus is
this, I don't know what the
name is for, like a trapezoid
with a curved side.
Does that have a name?
It's still a trapezoid?
I don't know.
Anyway.
Curvazoid.
B. Their new surplus is B. So
producers now make surplus B.
Consumer surplus is reduced to
A. And what's happened to C?
C is gone.
C is dead weight loss.
Consumer surplus is now A.
Producer surplus is now B. The
darkly shaded area C is now
the dead weight loss.
And that's the dead weight loss,
because once again, at
the old marginal cost curve, at
the old supply curve, these
are trades which both the
producer, which is the taxicab
company, and the consumer, which
is a person riding the
taxi, were happy to make.
And they're not being
made now.
So we've now lost an amount
C, dead weight loss.
Sorry about the confusion.
Questions about that?
Now, here's my question
for you.
You can go home and think about
that, and hopefully
it'll be clear in the
examples on Friday.
But let's ask a slightly
deeper question.
Does this mean that if you
become a taxi driver today,
you will derive producer
surplus of B
from driving a taxi?
Why not?
AUDIENCE: Because you have to
pay that lump sum to get--
PROFESSOR: Because the point is,
you have to get into the
market, and to get into the
market you need a medallion.
And the guys with the medallions
isn't going to hand
them over to you for free.
So let's say this guy's retiring
as a cab driver.
He's got his medallion.
You come up him and say, I
want to be a cab driver
because I see this big producer
surplus area B.
[INAUDIBLE] medallion.
What's this guy going to say?
He's going to say, well,
wait a second.
If I give you my medallion,
you're going to make that
profits of pi.
That's the profit you
make by being a taxi
driver in this market.
So what should he do?
What should he do?
AUDIENCE: Sell it to you.
PROFESSOR: He should
sell it to you.
And how much should he
sell it to you for?
Pi minus a penny.
And you might say, well,
that's ridiculous.
I won't pay pi minus a penny.
Then I'll make nothing.
Well, but he will.
He'll pay minus a penny
because at least
he'll make a penny.
Now, you might say a penny, a
dollar, $5, $10 whatever.
But the point is that he'll sell
it for very close to pi.
Because there's someone out
there who's willing to pay
close to pi to get that.
As long as there's a
little bit left.
So it's a little bit
less than pi.
They'll pay it.
But what that means is
having paid it, you
don't make any money.
So let's do the extreme example
where he's willing to
sell it for $1 less than pi.
What that means is you having
bought it for $1 less than pi,
you don't make any money
as a cab driver.
So wait a second.
This is weird.
We've just restricted
the market.
We've said there's all this
profit to be made.
And yet you're a cab driver
and you make no profit.
What happened to the profit?
Who got it?
AUDIENCE: [UNINTELLIGIBLE]
PROFESSOR: The cab drivers who
were originally issued the
medallions.
The first generation cab drivers
who got the medallions
got all the money.
So in fact, taxicab medallions
do nothing [INAUDIBLE]
taxi drivers.
All they do is enrich the set
of people who originally
lobbied for them and got them.
OK.
Yeah.
AUDIENCE: But wouldn't he make
his money back the same day he
sold it, given that he can get
the same price for his--
PROFESSOR: Wouldn't he--
No, but the point is that
basically, what he's done, or
you're saying that when
he goes to sell it.
So, in other words, the taxicab
medallion is worth a
certain amount of money.
But that would be embedded in
the money he would charge you.
So he's not dumb.
He's straightening out the
supply curve, he's a smart
guy, you should have
picked someone else
to negotiate with.
He's going to say, look, I'm
going to charge you enough so
that you'll only make $10
forever on having this.
I'm going to charge you enough
so that basically, you will
not make any money even when
you go to get rid of it.
So basically, what you'll
do is, you'll have
to pay him so much.
So let's say the way it works.
Let me give you an example.
Let me come back to that one in
the context of an example.
So what we know is
that basically--
and this is in Perloff,
give you some
interesting facts on this.
We know that taxicab
medallions are really limiting.
For example, we know that Tokyo
has five times as many
cabs as New York City, despite
the fact that New York City's
bigger than Tokyo.
And Washington DC
has ten times as
many cabs as San Francisco.
Despite the fact that Washington
DC is smaller than
San Francisco.
I'm not from San Francisco.
You can always get a cab in
Washington, I don't know how
hard it is to get in
San Francisco.
But there's 10 times as many
cabs in Washington.
And this is reflected in
the value of a permit.
So in San Francisco, what you
do, and this is sort of an
easier way to think about it.
What he does is, he doesn't
sell you the permit.
In San Francisco they
don't sell it.
He rents it to you.
So you never get to own it.
He rents it to you.
And in San Francisco, the
typical permit costs $42,000 a
year to rent.
So if you want to be a cab
driver, you've got to pay
$42,000 off the top before
you earn a dollar.
And then he rents to you, when
you're done, he takes it back.
So in substance the way-- now,
if he was selling it, I can
describe it to you.
Involves the fact that he would
embed your future asset
in his sale price.
That involves some complicated
finance that we'll get to
later in the course.
So think about renting
it, that's easier.
He'll rent it to you for
the entire surplus
pi, or pi minus $10.
And in San Francisco that
amounts to $42,000 a year.
In New York, New York originally
had 12,000 permits
they issued in 1937.
They issued 12,000 permits
for $10 each.
They have not issued
a new one since.
Literally, there are no more
cabs allowed in New York City
than there were in 1937.
A typical taxicab medallion,
which sold for $10 in 1937,
now sells for $400,000.
Now once again, you typically
don't sell.
You typically rent it out.
But the point is, that taxicab
medallion, which embeds the
entire future stream of having
the right to drive that
taxicab, is worth $400,000.
So what have we done here?
What we've done-- and in Boston,
by the way, a taxicab
medallion's worth
about $250,000.
Think about that the next time
you're standing in the rain
waiting for a cab.
You're standing in the rain
waiting for a cab because some
guy in 1930-something got a
grant from the government
worth $250,000.
But the current cab drivers
don't get crap.
A taxicab driver in your city
makes $10-12 an hour.
It's not a very fun job being
a taxicab driver in New York
City, unless you like taking
your life in your hands every
time you go out on the streets
of New York City.
They make $10 to $12 an hour.
After paying the enormous amount
they have to pay to
rent their taxicab medallion.
Now, this is not the only
example we have in the world
of something we call
occupational restrictions.
There's lots of examples.
Probably the most prominent
example, that may be relevant
to some of you.
I hope the taxi cab driver won't
be relevant to you guys.
But the doctor example
might be.
A great occupational restriction
is the AMA and the
education, the institute that
educates doctors puts a limit
on the number of medical
residency slots, that
determines how many doctors
there can be in America.
As a result, we all pay more
to go for our medical care,
than we would if more doctors
were allowed.
And you might say, that's
outrageous.
But why, obviously, how would
the AMA defend this?
And how would you defend any
occupational license?
Yeah.
AUDIENCE: The smaller the amount
of [UNINTELLIGIBLE].
PROFESSOR: Yeah.
You don't want everybody
being Dr. Nick.
You want--
come on, you guys got
to get Dr. Nick.
Raise your hand if you
know what I mean
when I say Dr. Nick.
Good lord, what is wrong
with you people?
OK, homework for this course,
you've got to watch one
episode of The Simpsons.
Before the end of the term.
This is crazy.
Dr. Nick is the terrible
doctor on The Simpsons.
You don't want this
terrible doctor.
You don't want these terrible
doctors operating on people,
so we have these restrictions to
make sure doctors are good.
And it sounds like
a good idea.
But next time you hear
it, remember.
It's not just making sure
there are good doctors.
There are probably plenty of
people who would be good
enough doctors who aren't let
in because there are not
enough slots.
It's also a way to make sure
doctors earn lots of money.
And it's not just the government
that does this.
There's no government
involvement here.
These are private associations
which license.
And they restrict, plumbers, and
doctors and optometrists,
and all these other things
are limited.
Ostensibly to keep quality up,
but in reality often to make
sure that there's some surplus
being earned by this initial
generation who puts puts
them in place.
Yeah.
AUDIENCE: So is the relative
effect on the market smaller
for doctors because they're not
selling each other permits?
PROFESSOR: Well, what's
different with the doctors is,
since it's not a permit but an
ongoing limit, then every
doctor makes the pi.
There's no selling.
So the effect on the market
is no different.
So imagine here, instead of it
being a medallion, there's a
limit on how many
cabs could run.
And that limit was randomly
reallocated.
Cab ran out, and then
new people went in.
Then each generation would--
then you wouldn't get the
thing where the first
generation wins.
Each generation should win.
But you still get the same
distortion of the market.
The same profit being made.
It's just that instead of the
profit all accruing to the
first generation, there'd be
an ongoing approval of that
profit to each generation
of doctors.
Yeah.
AUDIENCE: Professors
and tenure, is that
also related to--
PROFESSOR: Professors and tenure
would be another very
good example.
Basically, an occupational
restriction.
The difference is there's no
limit to how many tenured
professors there can be.
So basically there's no sense
in which, if there's more
demand for education, a new
university couldn't start up
and have tenured professors.
There's no situation in which
a university couldn't just
say, we're given tenure to any
Tom, Dick, and Harry who walks
in off the street.
There's no stopping that,
because tenure is determined
by the institution.
So in that sense it's not an
occupational license, because
there's no board which
determines tenure standards.
Thank goodness.
So we'll come back.
So that's what we were talking
about welfare.
You'll review this more
in section on Friday.
On Wednesday we'll come back
to talk about monopoly.
