The following content is provided under a Creative
Commons license.
Your support will help MIT OpenCourseWare continue to
offer high quality educational resources for free.
To make a donation or view additional materials from
hundreds of MIT courses, visit MIT OpenCourseWare at
ocw.mit.edu.
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.