Notes Welfare Analysis

Professor Syon Bhanot

1/26/17

Building Blocks of Welfare Analysis Consumer Surplus, Producer Surplus, Social Surplus
- We need an easy way to look at the market and measure the benefit created by transactions
in that market
o Example to orient us: market for a grand piano
(Note: we use this because it will help with intuition to have a good for
which most people have very little marginal willingness to pay for a second
unit)
- Consumer Surplus: extra benefits received from consumers over and above the price they
must pay (in other words, the amount by which willingness to pay exceeds the price
consumers actually pay).
o RULE OF THUMB: Consumer Surplus is the area BELOW demand curve and
ABOVE the price consumers pay
- Producer Surplus: extra benefits received by producers relative to the price they receive (in
other words, the amount by which the price producers receive exceeds producer's
willingness to sell)
o RULE OF THUMB: Producer Surplus is the area ABOVE supply curve and
BELOW the amount of money producers get to keep from transaction
- Social Surplus: For our purposes, this is CS + PS + Tax Revenue/Expenditure
o Think of this as "the economic pie"

- Some key points

o CS,PS, SS measured in units of currency
o Remember to use the price consumers pay for CS, not just the price - this is a key
distinction once taxes/subsidies are introduced... For PS, similarly, use what
producers get to keep, not just the price
- Market efficiency
o In this model, SS maximized at equilibrium... why?
check SS at Q*-1 and Q*+1... in both cases, moving to Q* is an
improvement in overall surplus!
 o related point: Pareto efficiency, or the state in which no changes can be made that
make at least one person better off without making anyone worse off... show was
Q*-1 units produced is not Pareto efficient...
- DVD example...
o QD = 80000 - 2000P as market demand
o QS = 8000P as market supply
o Q*=64,000; P*=$8
o Solve for consumer and producer surplus!
CS = $32*64,000*0.5 = $1,024,000
PS = $8*64,000*0.5 = $256,000
SS = $1,280,000

Case study - Netflix

Limitations the Basic Welfare Analysis

- Is surplus really what matters?
o Surplus may not be the same as well-being or satisfaction for a consumer/producer
- The interrelatedness of products
o Markets for different products tend to interact in the real world but this model
of assessing welfare looks at markets in isolation, and essentially treats each as an
island producing surplus
- Additive utility?
o Can you simply add up the surplus you as a consumer get from markets you
participate in and use that as a measure of your wellbeing? This is especially
problematic if goods are inter-related
o Suppose I am in a desert with three loaves of bread. To the first I might attribute 200 units of
pleasure, as it would keep me alive; to the second, say 50 units, as it would make me comfortable; to
the third, say five units. If instead of bread I had three pounds of meat, I might attribute to the first
pound 300 units of pleasure; to the second 75 units; and to the third, say 10 units. If, as a third
hypothesis, I had both articles to the amount named, could I add the two surpluses (255-385) and
say I had 640 units of pleasure? Certainly not. (Simon Patten, 1893)
- Efficiency vs. equity questions
o Social surplus is essentially a pure efficiency criteria. It cannot speak directly to
equity questions without modification
o Also, who has a high willingness to pay for goods? Generally wealthier people so
their surplus is prioritized, to some extent
- Are different surpluses comparable?
o $10 in producer surplus is the same as $10 of government revenue or $10 in
consumer surplus here
o But are those really all the same? There may be differences across markets
o Indeed, even across consumers, $10 of surplus for me may not be the same as $10
for surplus for you, in terms of how it affects my/your wellbeing!
o Furthermore, from a social perspective, we might value the surplus of, say, low
income blue-collar workers in a certain consumer goods market more than, say,
people buying jetskis in the jetski market
o This supports the idea of welfare weights or some such adjustment (see below)
- Possible ways to improve the model
o Welfare weights on surplus for various actors in the model
 Consumer surplus in market A counts double, since people in that market
are lower-income
Such adjustments may validate policies/interventions that seemingly
reduce social surplus when it is not weighted
o A social welfare function that combines surpluses and other important factors into
an abstract equation representing the well-being of society
A common technique usually incorporates ideas like: A dollar for a poor
person has more value than a dollar for a rich person (diminishing marginal
utility of wealth); variance in outcomes in society has a negative impact on
social welfare; etc