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Welfare Analysis

Welfare Analysis

Author: Kate Eskra
This lesson will explain Welfare Analysis
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Source: Image of Labor Market Graph with and without Price Floor created by Kate Eskra, Image of Apartment Market Graph with and without Price Ceiling created by Kate Eskra

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Hi. Welcome to economics, this is Kate. This tutorial is called Welfare Analysis. As always, my key terms are in red, and my examples are in green.

So in this tutorial we'll be talking about how we can use welfare analysis to see the impact of different government policies. We'll be comparing consumer and producer surplus, before and after, both a price ceiling and a price floor. I'll show you those on a graph. And finally you'll understand what welfare analysis can and cannot show us.

So first of all, we know that in most cases, free market function really well. And that's because producers have this profit motive to get us what we want, at prices that we're willing to pay. And it works out really nicely for us.

So usually the government does not need to intervene. And these unregulated, free markets produce the best outcome. And how we can say that it's the best outcome is through welfare analysis. We can see that welfare is maximized. The market's allowing for trade to occur between buyers and sellers. And when I show you a graph that's at equilibrium, you'll be able to see that consumers and producers are better off, and there's no dead weight loss.

But we notice sometimes the government does need to intervene for one reason or another. We need a way to kind of measure the impact that it has on consumers, producers, and society as a whole. And so that's where, again, we'll use this welfare analysis. We'll be comparing how well are consumers doing-- we'll compare consumer surplus with the producer surplus, before and after government intervention.

So as a reminder, consumer surplus is determined by the difference between the actual price we pay for a good, and the highest amount that we're willing to have pay for it. So, have you ever gotten a better deal on something than you expected? Maybe you're willing to pay $100 to go see a concert that you really wanted to see, but somebody else didn't value that as much as you, and sold you the ticket for $60. You just enjoyed a consumer surplus of $40.

Whereas producer surplus is the difference between the actual payment for a good and the least amount a producer would have actually agreed to receive for it. So my husband's been selling baseball cards on eBay, and he told me he was willing to accept as little as $25 for one. He woke up the next morning, someone had put in a bid and offered him $40. So while not huge, he enjoyed a producer surplus of $15 on that card.

OK. So let's look at a free market in equilibrium. And this is the labor market. So here, we're looking at the supply curve that represents the number of workers who are willing to supply their labor at various wage rates. Whereas the demands are employers. So this demand curve represents the number of the workers that employers are willing to hire at various wage rates.

If in fact we let the market come to equilibrium, that equilibrium would be established at $6 per hour. There are exactly three million workers willing to supply their labor, as there are three million workers being demanded by employers. There's no shortage of workers, there's no surplus of workers.

Also notice that here, using welfare analysis, we can see that consumer surplus-- all these people were willing to pay workers more, actually, then $6 an hour. So that's the consumer surplus here in green. All of these workers were willing to supply their labor for actually less than $6 per hour. So that's the producer surplus. The green plus the blue is the biggest it can get. OK.

We know though that the government does not allow companies to pay workers $6 per hour. Minimum wage law is going to prevent this market from establishing equilibrium. But notice here, that at equilibrium, there is no dead weight loss. OK.

That's going to change when we enact this minimum wage law. And remember dead weight loss is some variable that's decreasing the producer and consumer surplus due to something, whether it's a tax, or like I said, a minimum wage law will be a price floor or a price ceiling that you'll see you later on.

So now the market cannot establish equilibrium because the government is imposing-- no, no, no, you cannot pay $6 an hour. In fact you cannot pay workers any less than $7.25 an hour. So this line comes in to show that that is the minimum they can pay workers.

The impact of that-- well first of all, if we go along the supply curve, certainly more workers are willing to supply their labor now. So the quantity supplied of labor increases, while employers are not as willing to higher and higher wage. So the quantity demanded for labor falls.

Now we have a surplus situation. The two are not equal. The quantity supplied exceeds the quantity demanded and we have a surplus of workers. Not everyone searching for employment will be able to get a job.

So, you can see here that the green area that used to be this entire triangle, it shrank. Because now we only have so many employers willing to pay a little bit more than the $7.25. The producer surplus grew. So for the workers who are able to get a job, their producer surplus grows because those people who can still get a job, here, they're all willing to work for a little bit less.

But, notice they're not all going to get a job. This many would love a job and they can't find one now. That is going to create a dead weight loss, and the dead weight loss is this red area here.

And just so that you know, minimum wage is an example of a price floor. A floor is a minimum. So I know it seems odd that it's up above equilibrium, but it makes sense if you think about it. They cannot go any lower than a floor, or any lower than $7.25 per hour.

OK. Let's look at an opposite situation. If in fact this market for apartments were able to establish equilibrium-- I'm suggesting that that rent would be $2,000 per month. OK. We can see consumer surpluses in green, producer surpluses in blue. There is nothing other than this point here in equilibrium that would make that section any bigger. So consumer surplus and producer surplus are maximized here.

But, $2,000 a month-- as you know in some really expensive cities, it is incredibly expensive to live. And so many people would be unable to afford that high rent. And so often what the government will do is step in and control rent in a certain area. And they'll put a maximum price that landlords can charge.

So here's what that looks like. Let's say that they come in to a certain area of housing and say, no, no, no, you cannot charge $2,000. You can only charge $1,200 per month. OK.

Well, the effect of that is obviously, if we read along the demand curve, more people are going to be able to afford, and therefore willing to rent apartments. So that grows. But fewer landlords are willing to rent out apartments at that price. We can force them to charge a certain price with the government intervening here, but we can't force them to rent out the apartments. So their quantity supplied of apartments shrinks.

What does this do? It takes us out of equilibrium. Now the quantity demanded this time exceeds the quantity supplied and we have a shortage of apartments. So we have all of these people looking for apartments, but only this number, 600, will be able to actually find them.

So the producer surplus we know shrinks because producers are not able to charge as high of prices. The consumer surplus will grow, but only for these 600 customers who are able to find apartments. These people here are not able to find them, they can't get them because of the shortage. And so that creates a dead weight loss, this red area. And rent control is called a price ceiling because it is a maximum price that is able to be charged. OK.

So when we look at what happens to consumer and producer surplus, it's important to notice that people aren't actually losing financial money as they shrink, or gain physical money as they grow. It's really the impact on people's satisfaction, or kind of utility, that we're trying to illustrate.

And also note that these are abstract concepts, so it's really hard to quantify or estimate them completely accurately. It does allow us to visually show who benefits and who loses from certain policies and discuss the costs and benefits of those policies.

So you're able to see that green area grow or shrink. The blue area grow or shrink, and the red area, the dead weight loss. And so it does allow us to look at those things visually. But it is necessary to use our judgment, because it's not always going to be clear when the benefits are going to outweigh the costs of a certain policy, or when the costs outweigh the benefits.

So, in this tutorial we talked about how welfare analysis can be used to look at the effect of government policies. We talked about the impact on consumer and producer surplus when the government institutes both price ceilings and floors. And how these create shortages and surpluses, and a dead weight loss to society.

Remember, we have to use caution in judgment, as these are abstract concepts. Thank you so much for listening. Have a great day.

Notes on "Welfare Analysis"

Terms to Know

Consumer Surplus

Determined by the difference between actual price paid for a good and the highest amounts the consumer would have paid for the good.

Producer Surplus

The difference between actual payment for a good and the least amount a producer would have agreed to receive for the good.

Deadweight Loss

A variable that decreases the producer and consumer surplus due to a section of an incapacitated resource, such as tax.