Chapter 7

Economic Welfare and

Income Distribution

Prepared by Murray Davidson, Centennial College.

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Learning Objectives
After this chapter you will be able to:
LO1 describe the concepts of consumer surplus,
producer surplus and deadweight loss, and explain how
these concepts can further our understanding of
the operation of markets
LO2 distinguish between spillover costs and benefits
and identify the ways that government addresses these issues
LO3 determine the impact of an excise tax on
consumers and producers
LO4 explain the effects of government price control
programs on consumers and producers
LO5 evaluate the effectiveness of government
intervention to change the distribution of
income
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Marginal and Total Benefit
 Both consumers and producers gain from
market activity.
 For consumers, these gains can be measured

by marginal and total benefit.

 Marginal benefit is the extra satisfaction,

expressed in dollar terms, from consuming a

certain unit of a product.
 Total benefit is the total satisfaction,

expressed in dollar terms, from consuming a

product.
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Consumer Surplus
 Consumer surplus shows the extent to which
consumers pay a lower price than the highest
one they are willing to pay.
 It is defined as the net benefit, expressed in

dollar terms, from buying a product at its

market price.
 It is found, either for an individual or in an

entire market, by subtracting total

expenditure from total benefit.
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Consumer Surplus for an Individual
FIGURE 7.1

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Consumer Surplus of a Market
FIGURE 7.2

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Producer Surplus
 Producer surplus shows the extent to
which producers receive a price
different from the lowest one they are
willing to accept.
 It is defined as the difference between

the price received from selling each unit

of a product and the marginal cost of
producing it.
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Producer Surplus for a Market
FIGURE 7.3

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The Case of Perfect Competition
 In a perfectly competitive market, the
requirement of marginal-cost pricing is
met.
 Based on this requirement, equilibrium

will occur where marginal benefit equals

marginal cost, and both consumer
surplus and producer surplus are
maximized.
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The Case of Perfect Competition
FIGURE 7.4

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When a Market Becomes
Uncompetitive
 A market may become uncompetitive - for
example due to government policy. Then
price rises. As a result a portion of the
consumer surplus becomes producer surplus.
 Also there is a net reduction in both the

consumer surplus and producer surplus due

to the reduction in market output. This net
reduction is known as the deadweight loss.

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When a Market Becomes
Uncompetitive FIGURE 7.5

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Spillover Effects and Excess
Benefit
 Spillover effects are external effects of
economic activity, which have an impact on
outsiders who are not producing or
consuming a product.
 In analyzing the impact of these effects we

use the concept of excess benefit, which is

the total difference between marginal benefit
and marginal cost for all units that are
produced and consumed in a market
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Spillover Costs (a)
Spillover costs are the negative external
effects of producing or consuming a
product.
 Adding these costs to private costs vertically
raises the supply curve.
 The preferred outcome is at a lower quantity

than in a perfectly competitive market.

 Government intervention (e.g. an excise tax)

can produce the preferred outcome.

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Spillover Costs
FIGURE 7.6

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Spillover Benefits (a)
Spillover benefits are the positive external
effects of producing or consuming a product.
 Adding these benefits to private benefits raises
the demand curve.
 The preferred outcome is at a higher quantity

than occurs in a perfectly competitive market.

 Government intervention (e.g. a consumer

subsidy) can produce the preferred outcome.

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Spillover Benefits
FIGURE 7.7

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Public Goods
 A public good is a product whose benefits
cannot be restricted to certain individuals. In
other words, while some consumers pay for
the product, others get a “free ride.”
 Lighthouses are an example

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Excise Taxes (a)
 An excise tax is a tax on a particular product
expressed as a dollar amount per unit of
quantity.

Such a tax creates a new supply curve (S1)
seen by consumers. It is vertically above the
initial supply curve (S0) seen by producers.
 The reason for this difference is that the

price as seen by consumers is now higher

than that seen by producers.
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Excise Taxes (b)
The after-tax price for consumers is found
where S1 crosses the demand curve. The after-
tax equilibrium price for producers is the
corresponding price on S0.
 The total tax paid by consumers is found by
multiplying their tax-induced price rise by after-
tax quantity.
 Similarly, the total tax paid by consumers is

found by multiplying their corresponding price

drop by after-tax quantity.
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The Impact of an Excise Tax
FIGURE 7.8

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Price
Price Controls
Floors and Ceilings
 A price floor is a minimum price set
above the equilibrium price.
 It results in a surplus in the market.
 A price ceiling is a maximum price set
below the equilibrium price.
 It results in a shortage in the market.

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Agricultural Price
Price Supports Supports
in Agriculture
Price supports for agricultural goods
are an example of a price floor.
 They help overcome unstable
agricultural prices.
 Farmers win from these supports.

 Consumers and taxpayers lose from

these supports.

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Effects of Price Supports
FIGURE 7.11

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Rent
Rent Controls
Controls
Rent controls are an example of a
price ceiling.
 They keep down prices of controlled
rental accommodation.
 Some (especially middle-class) tenants

win from these controls.

 Other (especially poorer) tenants lose

from these controls.

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Effects of Rent Controls
FIGURE 7.12

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Canadian Distribution of Income
 Canada’s distribution of income can be
shown using the Lorenz curve.
 This curve is a graph showing the

cumulative distribution of income for

households categorized into five groups
based on their income levels.

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Income Distribution in Various Years
FIGURE 7.13

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The Lorenz Curve
FIGURE 7.14

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Interpreting the Lorenz Curve
In using the Lorenz curve as a distribution
measure, it is useful to compare it with
curves for two hypothetical economies:
 In an economy of perfect equality, where all
have identical incomes, the Lorenz curve is a
45-degree line emanating from the origin.
 In an economy of perfect inequality, where one

household receives all of the economy’s

income, the Lorenz curve follows the horizontal
and vertical axes of the graph.
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The Gini Coefficient
The Gini coefficient provides a single
numerical measure of income distribution.
 It is defined as the area between a Lorenz
curve and the 45-degree line of perfect
equality, divided by the entire triangular area
under the 45-degree line.
 The coefficient varies from 0 to 1, with 0

representing perfect equality and 1

representing perfect inequality.

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Wage
Wage Determinants
Determinants (a)
There are seven main wage
determinants:
 labour productivity
 education

 experience

 job conditions

 regional disparities

 market power

 discrimination

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Labour Productivity
In any given market, labour
productivity determines the wage of
that worker.
 Labour productivity is defined as
output per worker in a given time.
 It is the most important determinant

of wages.

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Education
Education
 Education:
 usually adds to a worker’s pay but has

opportunity costs as well

 serves two main purposes (consumption

and investment in human capital)

 A student will undertake an educational

program if its benefits (both monetary and

nonmonetary) exceed its opportunity costs.

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Labour
Unions Unions
There are two main types of labour
unions:
 Industrial unions include all workers in a
certain industry.
 Craft unions include workers in a particular

occupation and restrict who can be

members.

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Job
Job Discrimination
Discrimination
Job discrimination relates to hiring,
wage, and promotion decisions based on
criteria other than a worker’s credentials
or performance.
 Job discrimination can be direct, in which
case employees are paid different amounts
for substantially the same work.
 Job discrimination can also be indirect,

involving a discriminatory division of jobs.

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Reasons for Income Inequality (Other
Other Causes of Income Inequality
Incomes)
 There are three main reasons for
income inequality in addition to wage
determinants:
 risk-taking
 ability

 wealth

 Wealth is more unequally distributed

than income.
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Conclusion
Defined the concepts of consumer surplus,
producer surplus and deadweight loss.
Distinguished between spillover costs and benefits
and how government addresses these issues.
Analyzed the impact of an excise tax.
Described the two types of price controls - price
ceilings and price floors.
Looked at how the distribution of income is
measured and what are its major determinants.

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