Managerial  

Economics
MBAFT 6103

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 Today
Applications

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Consumer  Surplus  &  Producer  Surplus

P
A Supply

C
B

D
Demand

Q* Q
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 Dead-­‐‑Weight  Loss

A deadweight loss is a reduction in net economic
benefits resulting from an inefficient allocation of
resources.

In per fectly competitive markets there is no

deadweight loss.

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 Economic  Efficiency

Economic Efficiency means that the total surplus is
maximized.

•  “ All gains from trade (between buyers and

suppliers) are exhausted at the efficient point.”

•  The perfectly competitive market attains economic

efficiency.

Some examples where Government intervention leads

to Economic Inefficiency.
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 Few  Application  of  PC  
Framework
We are going to cover
•  Trade --- Gains and Losses from International trade
•  Tariff
§  Excise Tax
§  Price Ceiling
§  Price Floor

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 From Mankiw: THE
DETERMINANTS OF TRADE
•  Equilibrium Without Trade
o  Assume:
•  A country is isolated from rest of the world and
produces steel.
•  The market for steel consists of the buyers and
sellers in the country.
•  No one in the country is allowed to import or
export steel.
 Equilibrium without International Trade

Price
of  Steel

Domestic
supply

Consumer
surplus
Equilibrium
price Producer
surplus

Domestic
demand
0 Equilibrium Quantity
quantity of  Steel
Copyright © 2004 South-Western
Equilibrium  Without  International  Trade
•  Equilibrium Without Trade
o  Results:
•  Domestic price adjusts to balance demand
and supply.
•  The sum of consumer and producer surplus
measures the total benefits that buyers and
sellers receive.
The  World  Price  &  Comparative  Advantage

If the country decides to engage in international

trade, will it be an importer or exporter of steel?
The  World  Price  &  Comparative  Advantage

•  The effects of free trade can be shown by
comparing the domestic price of a good without
trade and the world price of the good. The world
price refers to the price that prevails in the world
market for that good.
The  World  Price  &  Comparative  Advantage

•  If a country has a comparative advantage, then

the domestic price will be below the world price,
and the country will be an exporter of the good.
The  World  Price  &  Comparative  Advantage

•  If the country does not have a comparative

advantage, then the domestic price will be higher
than the world price, and the country will be an
importer of the good.
 International Trade in an Exporting Country

Price
of  Steel

Price Domestic
after supply
trade World
price
Price
before
trade

Domestic
Exports demand
0
Domestic Domestic Quantity
quantity quantity of  Steel
demanded supplied
Copyright © 2004 South-Western
How Free Trade Affects Welfare in an Exporting
Country

Price
of  Steel

Domestic
Price supply
after A Exports
trade World
B D price
Price
before
C
trade

Domestic
demand

0 Quantity
of  Steel
Copyright © 2004 South-Western
How Free Trade Affects Welfare in an Exporting
Country

Price
of  Steel
Consumer  surplus
before  trade Domestic
Price supply
after A Exports
trade World
B D price
Price
before
C
trade
Producer  surplus
before  trade Domestic
demand

0 Quantity
of  Steel
Copyright © 2004 South-Western
How Free Trade Affects Welfare in an Exporting
Country

Price
of  Steel
Consumer  surplus
after  trade Domestic
Price supply
after A Exports
trade World
B D price
Price
before
C
trade
Producer  surplus
after  trade Domestic
demand

0 Quantity
of  Steel
Copyright © 2004 South-Western
How  Free  Trade  Affects  Welfare  in  
an  Exporting  Country

 Winners & Losers from trade
The analysis of an exporting country yields two
conclusions:
o  Domestic producers of the good are better off,
and domestic consumers of the good are worse
off.
Gains  &  Losses  of  an  Importing  Country  
•  International Trade in an Importing Country
o  If the world price of steel is lower than the
domestic price, the country will be an importer of
steel when trade is permitted.
o  Domestic consumers will want to buy steel at the
lower world price.
o  Domestic producers of steel will have to lower
their output because the domestic price moves
to the world price.
 International Trade in an Importing Country
Price
of  Steel

Domestic
supply
Price
before
trade

Price World
after price
trade
Domestic
Imports
demand
0 Domestic Domestic Quantity
quantity quantity of  Steel
supplied demanded Copyright © 2004 South-Western
 How Free Trade Affects Welfare in an Importing
Country
Price
of  Steel

Domestic
supply

A
Price
before  trade B D
Price World
after  trade C price
Imports
Domestic
demand
0 Quantity
of  Steel
Copyright © 2004 South-Western
 How Free Trade Affects Welfare in an Importing
Country
Price
of  Steel
Consumer  surplus
before  trade Domestic
supply

A
Price
before  trade B
Price World
after  trade C price

Producer  surplus Domestic

before  trade demand
0 Quantity
of  Steel
Copyright © 2004 South-Western
 How Free Trade Affects Welfare in an Importing
Country
Price
of  Steel
Consumer  surplus
after  trade Domestic
supply

A
Price
before  trade B D
Price World
after  trade C price
Imports
Producer  surplus Domestic
after  trade demand
0 Quantity
of  Steel
Copyright © 2004 South-Western
How Free Trade Affects Welfare in
an Importing Country
 Winners & Losers from trade
•  How Free Trade Affects Welfare in an Importing
Country
o  The analysis of an importing country yields two
conclusions:
•  Domestic producers of the good are worse
off, and domestic consumers of the good are
better off.
•  Trade raises the economic well-being of the
nation as a whole because the gains of
consumers exceed the losses of producers.
 Policy  1:  Import  Tariffs

Tariffs are taxes levied by a government on goods
imported into the government's own country. Tariffs
sometimes are called duties.

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 Import  Tariff
P

Domestic  Supply
A

P*

C B Foreign  Supply
PW
D
Domestic  Demand
Q1 Q4 Q
 Import  of  a  Good  with  Tariff
P

Domestic  Supply

PW+T
T
PW

Domestic  Demand
Q1 Q2 Q3 Q4 Q
 Import  of  a  Good  with  Tariff
P

Domestic  Supply

PW+T
T
PW D A C B

Domestic  Demand
Q1 Q2 Q3 Q4 Q
 Policy  2:  Excise  Tax

An excise tax (or a specific tax) is an amount paid by
either the consumer or the producer per unit of the
good at the point of sale.

The amount paid by the consumers exceeds the total

amount received by the sellers by amount T.

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 Excise  Tax
P
S

P*

Demand
Q* Q
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 Excise  Tax
P S’
S
A
T
F
Pd E
B C
P*
Ps H
G

D Demand
Q1 Q* Q
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 Excise  Tax:  What’s  
happening  here?
•  Now, consumer surplus (cs) = area AFE
Producer Surplus (ps) = area DGH
Government Receipts = area EFHG
Total surplus = cs+ps+Govt. receipts= area AFHD
Deadweight Loss = area FCH

•  Consumers pay price Pd for quantity Q1, but producers receive

only Ps=Pd-T. Government gets $T.
•  The amount by which the price paid by buyers, Pd, rises over the
non-tax equilibrium price, P*, is the incidence of the tax on
consumers; the amount by which the price received by sellers,
PS, falls below P* is called the incidence of the tax on producers.

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 Excise  Tax:  What’s  
happening  here?
•  Consumers pay price P d for quantity Q 1 , but
producers receive only Ps=Pd-T. Government gets $T.
•  The amount by which the price paid by buyers, Pd,
rises over the non-tax equilibrium price, P*, is the
incidence of the tax on consumers; the amount by
which the price received by sellers, PS, falls below P* is
called the incidence of the tax on producers.

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 Excise  Tax:  Incidence  of  
Tax
Who bears the burden of tax?

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 Excise  Tax:  Incidence  of  
Tax
Who bears the burden of tax?

Depends on the slopes of the demand and supply

function

Homework
•  Case 1: Demand curve is steeper (what does this
mean) than the supply. Check who bears more
burden.
•  Case 2: Demand curve is flatter (what does this
mean) than the supply. Check again
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 Policy  3:  Price  Ceiling  

A price ceiling is a legal maximum on the price per
unit that a producer can receive.

So consider a case where the market equilibrium price

is P* and the Government imposes a price ceiling of
PMAX .

Example: Rent Control.

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 Price  Ceiling
P

P*

D
Q
Q*

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 Price  Ceiling
P

A S

E F
C
P* B

G H
PMAX
Excess
D Demand
D
Qs Q* Qd Q

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 Price  Ceiling:  What’s  
happening  here?
•  Consumers pay a price (PMAX) lower than the market
equilibrium price, but there is excess demand (Qd-Qs)
at that price.

Now, consumer surplus (cs) = area AFHG

Producer Surplus (ps) = area DGH
Total surplus = area AFHD
Deadweight Loss = area FCH

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 Policy  4:  Price  Floor  

A price floor is a minimum price that consumers can
legally pay for a good. Price floors sometimes are
referred to as price supports.

Example: Price support for agricultural products.

Now draw the graph yourself. Find out CS, PS and

Deadweight loss.

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 Price  Floor
P

PMin

P*

D
Q* Q

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 Next

Monopoly

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