  \input{../preamble-regulation.tex}
%\makeindex
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 \begin{document}
  \pagenumbering{arabic}


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\pagestyle{fancy} \lhead[\ref{chap01}--\thepage]{}    \chead{Markets}   \rhead[]
{\ref{chap01}--\thepage} \cfoot{}
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\begin{center}

\vspace*{\fill}

\begin{Huge}
{\bf \ref{chap01}:  Markets}   \label{s01.0}\\
\end{Huge}

\vspace*{\fill}
\begin{Large}
{\it ``De gustibus  non est disputandum''}
\end{Large}

%\vspace*{\fill}

%\includegraphics[width=\linewidth]{fig01-fish.jpg}

  \end{center}

\noindent
%     What prices should the fishmonger charge? Would it be better to have a %government official choose the prices? 
      

\vspace*{\fill}

{\small \hfill {\it August 23, 2019}}\\

\vspace{24pt}
   



%-------------------------------------------------------
 \newpage

\noindent
  {\bf 1.1:  Introduction: What Is Justice?}  \label{s01.1} \\


At the start of  Plato's most important dialog,   {\it The Republic}\index{The Republic},   Socrates  asks   Cephalus, and old man, 
for a definition of   justice, the subject of the dialogue.\footnote{\label{Plato} Plato
\index{Plato}, {\it The Republic},  translated by Allan Bloom   (1968) at 331c.} Cephalus says justice consists of   telling the truth and respecting other people's property. Reasonable enough, but Socrates sees a problem: 
\begin{bigquote}
 ``What you say is very fine indeed, Cephalus,'' I said. ``But as to this very thing, justice, shall
we so simply assert that it is the truth and giving back what a man has taken from another, or is to
do these very things sometimes just and sometimes unjust?

Take this case as an example of what I mean: everyone would surely say that if a man takes weapons
from a friend when the latter is of sound mind, and the friend demands them back when he is mad, one
shouldn't give back such things, and the man who gave them back would not be just, and moreover, one
should not be willing to tell someone in this state the whole truth.''

  ``What you say is right,'' he said.

  ``Then this isn't the definition of justice, speaking the truth and giving back what one takes.''
 \end{bigquote}

From ancient Greece to the present day, an  important function of government  is providing incentives for ``speaking the truth and giving back what one takes.''  That is what courts do when they enforce contracts--- promises to do something in exchange for something else--- and punish theft--- taking other people's property.  We all feel that it is good to be able to make contracts and do what you want with the things  you own. It's also very common, however, to think that the economy would work better if the government intervened to require contracts to be a certain way and to restrict what people can do with their property.  In particular, we think that maybe the economy 
  would work better if the government intervened to control the
prices people charge  when selling their property or the kinds of property they are allowed to sell. Or, one might think that the government should own businesses, and manufacturing in particular, rather than have them be owned by individual people as private companies or as corporations, and run the businesses for the public good rather than for profit. This is the idea of {\it socialism}, either in its communist form or in its milder democratic forms. And indeed, although in the United States (unlike in countries such as the United Kingdom) the government ran few businesses,  at one time government regulation of prices was common. From the 1930's to the 1980's, however, there was a considerable diminution in price regulation, and 
after experiencing deregulation
of industries such as air travel, trucking, and telephone sales,  the public is  less interested in government regulation of prices. The virtues of
laissez faire pricing are part of the conventional wisdom. At the same time, other forms of regulation have vastly increased--- regulation not of prices, but of what kinds of products businesses can sell,  how they sell them, and how they make them. 

  In this chapter we will start by thinking about  what it means for an economy to work
well, and what it means for a regulation to help the economy instead of hurting it.  Economists do not go much beyond Cephalus's common-sense notion of what justice means. We take the satisfaction of human wants to be society's   objective, with contracts and property rights as crucial means to that end. After the {\it Republic} passage I just quoted, Cephalus admits things are complicated and  goes off   to perform  religious sacrifices. He hands off the argument to his sons,  younger men, and in  the remaining 98\% of {\it The Republic} is devoted to exploring what justice really means, looking at it from all angles but in failing to come to a definite conclusion. Economists  leaves  the discussion of the  most difficult questions to other people. To be sure, much of what government does, and much of what justice is  revolves around the question of the meaning of life.  The discipline of economics just tries to figure out how to make a society wealthy, meaning how to organize production and consumption to satisfy people's desires, taking those desires as given rather than saying what desires are good and what are bad. The Latin phrase ``De gustibus non est disputandum'' sums up the attitude: ``About tastes there is no arguing.''  In this chapter you will see how  to pin down the meaning of satisfaction as a goal  and  you will  see that  private markets do surprisingly well at achieving it    even with a   government that does very little to help it. 


\bigskip

  %\newpage
%---------------------
\noindent
{\bf 1.2  Surplus  Maximization} \label{s01.2}


     How should we decide whether a regulation is good, or bad? The first step is to choose some
valuation rule---some way to compare two policies, and, if possible, to assign numerical values to
how good each policy is.\\
\hspace*{16pt}Suppose, for example, that we are trying to decide whether a rule requiring the
arsenic level in drinking water to be less than 23 parts per billion is a good rule or not. A
strident environmentalist might say that the more stringent the rule, the better---that a level of
23 parts per billion  is better than 30, but 4 parts per billion would be  even better.
Someone else might say that cost should be considered too, and that reducing the level to 4 parts
per billion would cost more than the entire budget of the city government, requiring taxes to
double. Still another person might say that ``the government is best which governs least,'' so there
should be no rule at all---the policy  should be {\bf laissez faire}\index{laissez faire},   French for  ``let them do it''.
\\
\hspace*{16pt}
      The standard valuation rule used by economists is   {\bf surplus maximization}.
    The idea is simple. Add up how much each person who likes the
regulation would pay to have it, and subtract out how much
each person who dislikes the regulation would need to be paid to accept it. If the resulting number
is positive, adopt the regulation.\footnote{There are variations on the rule---we could ask both
people how much they would pay to get their preferred rule, or ask both how much they would accept
to not have it, but we won't go into those subtleties.  }
\\
\hspace*{16pt}
A concrete example is the best way to understand surplus maximization. Suppose Anderson and Brown want a stricter arsenic
regulation and would pay up to \$30 and \$70 to get it, whereas Corman and Daniels don't want it,
and would require payments of at least \$20 and \$10 to balance out their dissatisfaction with the    new regulation. Since supporters would pay   \$100  and opponents would accept \$30, adopting
the regulation   maximizes surplus.

 The arsenic regulation maximizes surplus even if no payments actually take place. Corman and Daniels end up worse off, but their loss is less than the gain of Anderson and Brown. 
If   payments  do take place, on the other hand everybody can be made better off  after the new rule is adopted. 
If we adopt the regulation and make Anderson   pay \$25 to Corman   and Brown pay \$25 to  Daniels,
all four of them are  happy that the deal went through, compared to the initial situation. We call this a {\bf Pareto improvement}\index{Pareto
improvement},   after the economist  Wilfried Pareto  who came up with the criterion that   a policy
should be adopted if it makes some people better off and no one worse off.



\begin{wrapfigure}{L}{1.8in}
\begin{center}\vspace{-24pt}
{\sc Figure 1.\ref{fig01pareto.jpg}\\
 Wilfried Pareto (1848-1923)}\\
\vspace{6pt}
\includegraphics[width=1in]{fig01pareto.jpg}\\
 \refstepcounter{figurecounter} \label{fig01pareto.jpg}
\end{center}\vspace{-24pt}
\end{wrapfigure}



  Pareto optimality seems like an obvious idea--- too obvious for Pareto to deserve  getting   his  picture  as
Figure 1.\ref{fig01pareto.jpg}.   It isn't as simple   as it looks, though. Whose well-being
should count when we define ``some people'' and ``no one''?\footnote{See Figure
1.\ref{fig01-98ER.jpg} and Lawrence A. Hansen   \index{Hansen}
``Animal Research: Groupthink in Both Camps,''
 {\it   The Chronicle of Higher Education},
 (November 7, 2010).} What if  Person X
gets happier if Person Y's freedom is restricted?\footnote{See the Story of Prude and Lewd in:
Amartya Sen \index{Sen}, ``The Impossibility of a Paretian Liberal,'' {\it The  Journal of Political
Economy},  78 (1):   152--157  (January--February 1970).
} Those are more good questions for the philosophers. Economists evade them by saying that although we have
personal opinions as to the answers, for policy purposes we'll just take the answers you give us and
use them to do objective reasoning. After all, if you ask your doctor whether you should take blood
pressure medication, you don't expect him to supply an answer to the   question of
whether the world is better off if you're dead or if you're alive.  Doctors stick to the task of healing the sick, and try not to think about whether it's worth healing them, which is one reason why they are not the best people to ask about ways to control health care costs. Similarly, don't ask economists questions like whether legalizing marijuana is a good idea; they will have opinions, but your own ethical beliefs are just as good a guide. 

 

Surplus maximization is more useful as a criterion than Pareto improvement, though. 
  We can not only say that the  arsenic regulation is a Pareto improvement; we can    put a number on the
size of the  improvement. The supporters would pay \$100 and the opponents would pay
\$30, so the surplus rises by \$70. In economics, we call this  the ``value'' created by the regulation.
We have actually made precise how good the regulation is, and done it in an objective way. That's
surprising---how can  a political issue, on which these four people disagree,  be made objective? The trick is that it is objective only
from the point of view of a neutral observer. Our basic data is the subjective values each of the
four people---Anderson, Brown, Corman, and Daniels--- put on the policy.\footnote{``Four people''
introduces another problem,  illustrated by  Figure   1.\ref{fig01-98ER.jpg}. Think too of the
\href{http://www.bearinsider.com/forums/showthread.php?t=5894&page=2 }  {1981 Gary Larson {\it Far
Side} cartoon} of three men and a dog in a boat with the caption ``Fair is fair, Larry... We're out
of food, we  drew straws, you lost.'' }   But once we have those values, we have an objective method
of putting them all together. It is  like determining the value of a corporation. Once we have the
sales figures, prices, and costs, determining the value of a company  is an objective process
(though not easy, since we're trying to forecast   future profits, and forecasters will disagree). Future sales, though,  depend
on how much consumers like the company's product, which depends on their subjective values.  Placing
a dollar value on the regulation's improvement combines subjective data objectively in the same way.




\vspace*{24pt}
\noindent
\begin{minipage}[c]{\linewidth}
\begin{center}
\noindent
 {\sc Figure   1.\ref{fig01-98ER.jpg} \\
 Pareto Optimality    } \\
 \vspace{12pt}
\refstepcounter{figurecounter} \label{fig01-98ER.jpg}
 \includegraphics[height=1in]{fig01-98ER.jpg}\hspace{.4in}
 \includegraphics[height=1in]{fig01-slave.jpg} \hspace{.3in}
 \includegraphics[height=1in]{fig01-hitler.jpg}\hspace{.25in}
 \includegraphics[height=1in]{fig01-dog.jpg} \\
\noindent
\hspace*{-24pt} (a)  Anderson   \hspace{24pt}     (b) Brown     \hspace{24pt}       (c) Corman
\hspace{18pt}    (d)  Daniels    \hspace*{12pt}
\end{center}
\end{minipage}


\vspace*{24pt}

   In practice, most government policies are not Pareto improvements. Almost always, at least one person loses from a change in policy, and the policies  do not include
  side payments to losers. Such payments   would be highly impractical to make. Imagine
trying to tax people whose preferred presidential candidate won so as to pay compensation to  the
voters who lost.  If we insist that every new policy make nobody worse off, we'd rule out virtually
all new policies. Surplus maximization is a more practical criterion. Whichever arsenic regulation
is chosen, someone is going to be unhappy, so it seems sensible to try to evaluate how strongly each
side feels. Moreover, since governments make policies on a vast number of subjects, anyone who loses from use of the surplus maximization criterion to change one policy is likely to win with its use for other policies. 

 Surplus analysis is also useful because even if  maximizing total surplus is not the goal, it is
useful to figure out who is helped and who is hurt by a policy, and by how much. This will help us
predict the political battlelines, as we will see in later chapters. 



\bigskip

%---------------------
\noindent
 {\bf  1.3: The  Surplus from a Single Transaction}\label{s01.3}


Let us  now apply the idea of surplus maximization to a market transaction instead of 
government policy. Buyer Brown approaches seller  Smith and asks if Smith will sell a bottle of whisky for \$10.
Smith agrees, and the whisky changes hands. Is the transfer of the bottle from Smith to Brown a good
thing?

 Surplus maximization says    it is. Since Brown offered a price of \$10, we know   his
willingness to pay was at least that high, and probably higher. Suppose it is \$15. Since Smith accepted
the price of \$10, we know  his value for the bottle was no more than that. Suppose it is \$8.
Using the figures of \$15 and \$8, the net benefit from Smith giving the bottle to Brown is \$7, an
increase in total surplus, an increase in value.  If we didn't know the number \$8 and \$15,  the gain  might be more than \$7, or    less, 
but since both parties agreed to the trade we know that Smith's value must be  below Brown's and the
gain in value is positive. Total surplus has risen. 

We  are calling this valuation rule ``surplus maximization,''  but it is also called {\bf  the
Kaldor-Hicks criterion} after the economists who first defined it, or   {\bf potential Pareto improvement}, or {\bf wealth maximization}, or
{\bf economic efficiency.}  These names all say things about the rule.  Kaldor-Hicks   tells  the names of
the two  English economists who came up with it in 1939.\footnote{ Nicholas     Kaldor,  \index{Kaldor}  { ``Welfare Propositions
in Economics and Interpersonal Comparisons of Utility,'' } {\it The Economic Journal},   49 (195):
549--552   (1939). John  Hicks,  \index{Hicks}    ``The
Foundations of Welfare Economics,''  {\it The Economic Journal},  49 (196): 696--712 (1939).
   }

\begin{center}
%\vspace*{24pt}
\noindent
\begin{minipage}[c] {.8\linewidth}
\begin{center}
\noindent
 {\sc Figure   1.\ref{fig01-nicholaskaldor.jpg}\\
  The Economists behind Kaldor-Hicks Efficiency  } \\
 \vspace{12pt}
\refstepcounter{figurecounter} \label{fig01-nicholaskaldor.jpg}
 \includegraphics[height=1in]{fig01-nicholaskaldor.jpg}\hspace{1in}
 \includegraphics[height=1in]{fig01-hicks.jpg}\\
    Nicholas Kaldor (1908-1986)   \hspace{12pt}     John  Hicks (1904-1989)
\end{center}
\end{minipage}
%\vspace*{24pt}
\end{center}

``Potential Pareto improvement'' is an idea we've already discussed. If surplus has increased, that means that potentially we could have a Pareto improvement by undertaking the new policy or transaction and then compensating any losers. Of course, in the case of a voluntary transaction, there are no losers, so the Pareto improvement is not just potential. 


How about ``wealth maximization''?  If Brown values the bottle of whisky at  \$15 and Smith
at  \$8, then   moving the bottle from Smith to Brown at a price of \$10 has a benefit of \$5 for
Brown and \$2 for Smith. The effect of the trade on their satisfaction is   the same as if Brown and
Smith had  never met,   but by a miracle \$5 suddenly appeared in Brown's pocket  and \$2 in Smith's.
Thus, the name ``wealth maximization'': a surplus-maximizing trade increases the dollar amount at
which people value their possessions. That is  the right way to think of society's wealth, as a concept.  It is
crucial  to realize that this  is {\it not} the same as the   market value of everybody's possessions, which is the usual way to measure wealth since we observe market prices but not the most people are willing to pay. 
Wealth  in the sense of total surplus measures how much people value their possessions, not how much
they had to pay for them or how much they could sell them for.  My surplus for example, would rise
if I  sold a \$200,000 house which I was barely willing to buy at that price and used the money to buy a different
\$200,000 house for which I would have been willing to pay \$300,000. My well-being has
risen after I make the change, but my dollar wealth  as measured  at market prices  has not.\footnote{  The concept of
``gross  domestic product ''\index{Gross  domestic product}   does use prices rather than values to
measure well-being.  GDP measures how much people pay for goods traded in markets.  It tries to get
at the idea of how much value is produced, but it's impossible to measure in practice  how much
Brown {\it would} pay for the whisky, and easier to measure how much he {\it does} pay.    Also, GDP
measures ``value-added''\index{value-added} to avoid double counting inputs, so if Smith paid \$7
for  corn   to make the whisky, GDP would increase by \$3 ( = \$10 - \$7) as a result of the trade,
and the other \$7  would be counted in GDP by looking at the trade the corn farmer made with Smith.
}


 The term ``economic efficiency''  has a similar motivation.  In everyday language, something is efficient if it achieves its goal with minimum effort or expense.     In economics, efficiency refers to
whether we could increase total surplus   without increasing the amount of   inputs. If we can, then
the original situation is inefficient, and the size of the inefficiency is the amount of potential surplus lost.
If the problem is {\bf productive inefficiency}\index{productive inefficiency},  the goods could be
produced more cheaply. If the problem is {\bf allocative inefficiency}\index{allocative
inefficiency},  total satisfaction-- that is, total surplus---  could be increased by rearranging who has which goods without
increasing the total amount. Moving the bottle from  Smith to  Brown   is
necessary for allocative efficiency because it increases satisfaction, even though there are no  more
bottles of whisky than before the transfer.   It is as if the economy had found a technology
that increased the amount of output by \$7.


   We've started with an easy case for our value criterion. It may seem obvious that it is good for
Smith to sell the bottle of whisky to Brown.  But notice that surplus maximization does not ``assume
the  answer,'' as would a criterion such as ``voluntary trades are good.''  Surplus maximization
applies generally. It is a multipurpose tool. We can compare any two outcomes by looking at whether surplus has
increased, so we don't need   one rule for whether voluntary transactions are good, another one for
whether government regulations are good and another one for whether innovation is good. Also,
surplus maximization allows  a numerical value to be put on how good the trade is, rather than just
saying it is good or bad.

  Since surplus maximization doesn't assume the answer, though, it may not always come up with the
answer you want.   What if Brown is only ten years old when he buys the whisky?   Or what if  Brown
steals the bottle of whisky  from Smith instead of buying it?  Surplus maximization says that this,
too, is a good thing. The effect on total surplus is exactly the same as the sale at the price of
\$10. The sale benefited Brown by \$5 and Smith by \$2, a total of \$7. The theft benefits Brown by
\$15 and hurt Smith by \$8, which also makes for a total benefit of \$7. Surplus maximization
doesn't care about how much each person gets as a result of the event. All that matters is that the
bottle has moved from someone who values it less to someone who values it more.

 Most people would say that Brown's theft\index{} is a bad thing, not a good one, even though it raises surplus. That's why we have
laws against theft.  But surplus maximization is morally neutral. It  leaves out
morality and just looks at personal satisfaction.

 You might feel like rejecting  surplus maximization  since it  can reach a perverse result  such as    theft being a good thing,
good, but  moral neutrality is   one reason economists use the concept. The best
moral rule is not
  controversial in the case of theft,   but for many government policies it's unclear how morality
would apply  or  whose moral belief  should   count.\footnote{Of course, if you ask
me, I'd could tell you exactly  whose moral beliefs should count---mine, since I hold the correct
moral beliefs. But people would rather hear what economists have to say about surplus than what they have to say about sin
and virtue, so that's what we talk about.}  But what is more important is that using a general  principle such as surplus maximization instead of a specific one such as ``stealing is sinful'' can often (though not always) help us  pin down what is bad about bad actions more precisely. 


    Surplus maximization, in fact, usually  agrees  with everyday morality when it comes to prescribing what the government should do.  
Surplus maximization actually does imply that stealing\index{stealing} should be illegal  and that  people
should have moral scruples against stealing.  In the
particular case of Brown and Smith, surplus maximization says that the theft is good. It is good,
however, only because we started with a story in which Brown was willing to pay as much as \$15 and
Smith was willing to accept as little as \$8.  That information is crucial to whether moving the
bottle from Smith to Brown was good or bad.

What would happen if we didn't know the particular values Brown and Smith put on the whisky?
Suppose the government  announced that it was going to simply give the bottle  to whoever valued it
most,  without actually requiring money to change hands.  Not knowing the numbers, the government
would have to ask   each person   his value. What would they say? Brown could  say he  should get
the bottle because he  wants  it so much   he would pay \$150 for it if he had to.   Smith could say
that he, too,  really wants that   bottle  and his value is \$500,  even more,  so  the
government shouldn't take it away from him and give it to  Brown.    They would lie---or at least,
they would   lie if they didn't have moral scruples. And even if we put aside the possibility of
lying,  until  someone has to actually pay for something  he usually doesn't know the absolute most he would pay for it
because he hasn't thought much about the question. He hasn't thought about it, because that absolute most number rarely matters. It's enough for me to know that my value for a cup of
coffee is greater than  the current Starbuck's  price; I don't have to calculate the most I
would pay if I had to.

  Without knowing everyone's   values, though, how can we use
  surplus maximization as  a  policy tool?   Sometimes the economist    just does  his best to try to
estimate values by looking at people and thinking how much that kind of person values something, or
by asking them and trusting to their honesty.
 The wonderful thing about market transactions, however,  is that market prices force people to
reveal their true values. Brown puts his money where his mouth is when he offers \$10 for the
bottle. He's not going to exaggerate and say he's willing to pay \$150 if he actually  has to pay
the money.   Smith reveals something about his value too, when he accepts \$10.  If he wants to
credibly claim his value is \$500, he has to give up on the \$10 sale.  When a voluntary transaction
takes place, we do not   learn the exact values, but we  learn a little bit more, and we  can deduce that there is a gain in social
surplus.

 Now let's go back to theft.
    After a theft, unlike after a voluntary transaction,  we do not know that surplus has increased.
We  learn something---that Brown was willing to go to the trouble of stealing the bottle, and
Smith was not willing to go to the trouble of guarding it effectively---but that is not enough to
guarantee surplus maximization.  Maybe Brown stole the bottle of whisky because he values it at \$3
(unlike in  our earlier example, where it was \$15)  and the effort of stealing  is only a cost of
\$1 for him.  If Smith's value is \$8, the theft has reduced social surplus\index{social surplus}.

 Notice, too, that using \$3 for Brown and \$8 for Smith, the social surplus is not just -\$5, the
difference between Jone's value and Brown's, but -\$6. That's because not only does the theft reduce
allocative efficiency, it also creates productive inefficiency: Brown bears that \$1 cost of
stealing, which isn't producing any new goods for anyone.

  The cost  rises even higher if Smith reacts by investing time and money to protect his goods
against Brown's thievery. Smith's defensive tactics  of buying locks and security guards may be
morally more justifiable than Brown's offensive expenditure on burglar tools and night-time outings,
but both offense and defense are a drain on society's wealth.
Thus, theft, while it may increase surplus  in particular cases, has a bad effect overall. Moreover,
if  the government forbids theft but allows selling, then if Brown really does value the whisky at
more than \$8 he can buy the bottle from Smith anyway.

In this way  we've derived a reason why theft is bad, a reason based on surplus maximization,  rather than
having to accept the evil of theft as  one on a list  of many separate   moral rules.   The Eighth
Commandment says  ``Thou shalt not steal,''   but even if you don't believe that God ordained the
Ten Commandments, if you accept  surplus maximization you come to the same conclusion.
We  can not only derive ``Thou shalt not steal,''  but ``Thou shalt not kill,''   ``Thou shalt not
commit adultery,'' and many other moral rules,  which become mere corollaries or surplus maximization.   In this way surplus
maximization   like the  Golden Rule: ``Love thy neighbor as thyself'' (\index{Matthew}Matthew  19:19). The Golden Rule\index{The Golden Rule} doesn't  say the decisionmaker should use
each person's own valuation to allocate goods in the economy, but like surplus maximization it is a
general guide to behavior and  treats  people in an unbiased way.


 %\begin{wrapfigure}{L}{2.8in}
%\refstepcounter{figurecounter} \label{fig01-walnut.jpg}
%\begin{center}
%\noindent
% {\sc Figure 1.\ref{fig01-walnut.jpg}\\
 %  A Good Piece of Timber } \\
%\vspace*{12pt}
 % \includegraphics[width=2.2in]{fig01-walnut.jpg}
%\end{center}
 %\end{wrapfigure}


   Think too about what surplus maximization is not. It is not  materialism, or
economic goals, or maximizing gross domestic product, or making a country as rich as possible, even
though it's measured in dollars.   Crucially, it's based on
how much people value things, not on the things themselves. Suppose Brown owns an old walnut tree
like the one in Figure 1.\ref{fig01-walnut.jpg}  and  refuses to sell it  to Smith for \$8,000 to cut
down as timber.\footnote{For a discussion of walnut tree prices, see
\url{http://www.woodweb.com/cgi-bin/forums/forestry.pl?read=512463}. Another tree one might use as an example is the Boole Tree, a giant sequoia, the largest sequoia in a grove and the only large one remaining after logging between 1892 and 1918, saved by the foreman of the operation. } That outcome maximizes
surplus, since clearly Brown values the walnut at more than \$8,000 and Smith at less. If Brown sold
the tree, however, GDP would rise by \$8,000, even though in a more precise sense ``wealth'' has
fallen.

      The most pernicious confusion policymakers have about economic goals is the idea of ``creating
jobs'' and ``reducing unemployment''.  I say ``confusion'' because although people talk about increased employment as the goal, that isn't really what they're after. 
  If reducing unemployment is really the goal, a  quick way to
achieve it would be to make unemployment illegal.  A law like this was actually passed once in Mississippi. It said:   
\begin{bigquote}
All freedmen, free negroes
and mulattoes in
this State, over the age
of eighteen years, found
on the second Monday
in January, 1866, or
thereafter, with no lawful
employment or business,.
. . shall be deemed vagrants, and on conviction thereof shall be
fined in a sum not exceeding, in the case of a freedman, free negro or
mulatto, fifty dollars,. . . If any freedman, free negro or mulatto shall
fail . . . to pay . . . it shall be, and is hereby, made the duty of the sheriff
of the proper county to hire out said freedman, free negro or mulatto,
to any person who will, for the shortest period of service, pay said
fine and forfeiture and all costs . . .\footnote{Mississippi Vagrant Law, \S  2 \url{http://wps.ablongman.com/long_longman_lahdemo_1/0,8259,1546454-,00.html}.  ``\S'' means ``Section''.}
\end{bigquote}

    Probably the authors of this law, passed while freedmen still were not able to vote, would have said this was for the freedmen's benefit, to prevent them from becoming  vagrants. It also helped white employers, though, because it meant that black workers could not be   choosy when it came to picking  a job. When unemployment is banned,  it is illegal to quit   without having a new job already in hand.  It's bad being unemployed when you want a job, but not so bad as being forced to take the first   miserable job you're offered.  What people mean when they say they want a job, or want to create jobs,  is that they want good job opportunities. 
    

 

 So it isn't that we just want to reduce unemployment. Nor is it that we want to increase
{\it em}ployment. If
  we required all  women to work   and    forced  students into the workplace by closing  colleges,  that would
raise employment. Nor do we want to guarantee that anybody searching for a job gets one.   We could
 require them to take their best opportunity within six months--- fast-food    and
lawnmowing included--- or face penalties. Or, if it is  high-paying jobs that are the goal, we could have the government hire people  at \$100,000/year to
pick dandelions out of lawns. No--- what people really mean when they say they want there to be more
jobs is that they want there to be more ways that people can productively use their time. In other
words, they want to maximize surplus.  In the ideal world,  people standing idle are not
maximizing  surplus. In the actual world, we want them to stand idle till they find the right job. There is tremendous movement into and out of employment both
in good times  and bad.   Job movement is ordinarily good, not bad.   
Someone is worth less in their current job than in some other job, so he switches.   An economy cannot have people moving to better jobs unless they leave worse jobs.   Ideally, everyone would find a better job instantly, but
in reality workers have to search for a job   and  employers have to search for workers.  In a recession people stay unemployed for
longer than usual  because of a shock to the system. Overbuilding of housing followed by a banking crisis, for example, would mean that  a larger number of people (and   capital)   are in a job this is less productive than another  position  somewhere in the economy.  Finding that new position isn't easy, so unemployment rises.   Subsidizing housing jobs would reduce unemployment, but at the cost of building still  more   empty houses.    Jobs voluntarily created by employers, on the other hand,   will  produce goods that consumers want. Employers, too, need to figure out what those goods are that have higher value than the overbuilt housing. This takes time, and meanwhile both wages and profits suffer, but adjustment is necessary if the economy is to produce goods people want. 

  
 


\bigskip

 
%---------------------
\noindent
{\bf 1.4:  The Surplus  in an Entire Market} \label{s01.4}


      The first step to understanding why the  free market  maximizes surplus was to understand why the
single  transaction between Brown and Smith maximizes surplus.  We slid over the question of why
they traded at a price of \$10 rather than some other price between the \$8 that is the least Smith
would accept and the \$15 that is the most Brown would pay.  Now we will return to that.

 The  next step is to look at how the market price is chosen. Let us   look at the entire market for
whisky. Let the market  consist  of 300,000 potential buyers, each of whom would buy at most 1 bottle,  and
5,000  potential  sellers, each of whom might sell 100 bottles. Buyers  vary in their willingness to pay.
Some  buyers  would pay at most \$.01 per bottle, but others   would pay as much as \$30. (We say
that \$30 is the {\bf reservation price}\index{reservation price},  the most any buyer  would
pay.) Sellers vary in their minimum acceptable price. Some would accept as little   as \$4, but
others would require as much as   \$19. Figure 1.\ref{fig01social1.jpg}'s supply and demand diagrams
show this more precisely using the supply and demand equations  $P = 30 -0.1 Q^d$ and $P = 4 + 0.03
Q^s$ (with quantities of bottles measured in thousands). The demand curve shows that there are
100,000 consumers willing to pay at least \$20 and 200,000 willing to pay at least \$10.

  The supply curve in Figure 1.\ref{fig01social1.jpg} shows that there are 1,000 sellers (with a total of 100,000 bottles) willing to
take as little as \$7 and 2,000 willing to take as little as \$10. At the price of \$10, the quantity supplied equals the quantity demanded.
This price of \$10/bottle, the price generated by market forces,  is the {\bf   equilibrium price}.\index{equilibrium
price}

%\begin{wrapfigure}{L}{2.8in}
 \vspace*{24pt}
\noindent
\begin{minipage}[c]{.8\linewidth}
\refstepcounter{figurecounter} \label{fig01social1.jpg}
\begin{center}
 {\sc Figure 1.\ref{fig01social1.jpg}\\
  Producer and Consumer Surplus } \\

  \includegraphics[width=\linewidth]{fig01social1.jpg}
\end{center}
 \end{minipage}
% \vspace*{-48pt}
%\end{wrapfigure}

   Why do market forces generate a price of \$10 and not some other price?  One might answer
``because the supply and demand curves cross  at \$10'' or ``because supply equals demand  at \$10,'' but
those  answers are superficial. The real answer must explain why the equilibrium price is where
quantity supplied equals quantity demanded.

   Think about what would happen if the price were higher---say, \$20 per bottle. Sellers would be
delighted to sell everything they had, but only 100,000 consumers would be willing to buy. As a
result,  some sellers would end up unable to sell. Those  frustrated sellers would shave the price
to \$19.99, causing buyers   to switch to them. That would leave other sellers customerless,    and
those sellers would shave the price to \$19.98. The price of \$20 per bottle is thus unstable. And so is any other price above \$10.00. 

The    same reasoning shows that any price below \$10.00 is unstable.    At any price below \$10.00,
buyers are more eager to buy than sellers are to sell, and some buyers would be unable to find
a seller. Suppose the price were \$7.00/bottle. Consumers who couldn't find a willing seller because of the excess demand would offer \$7.01 to outcompete the other buyers.  The outcompeted
buyers would offer \$7.02 in response, and the process would continue  until the price was bid
up to \$10.00.

 At the price of \$10.00,  each buyer   willing to  buy at that price would  find a willing
seller, and there  would be  no incentive to  for any buyer   to offer a  higher price  or for any
seller to offer a lower price.

\bigskip

 This reasoning shows that  the free market equilibrium price is stable.  That it is stable,
however,   says nothing about whether  it is  good. Buyers would always like to pay less and
sellers would like to get more, so there are always people  ready to complain about the equilibrium
price.  Philosophers have put much thought into deciding when those complaints might be justified.  
What is  the ``just price'' for a bottle of cheap whisky,  the price that is fair?  Economists shy away from the words
``just'' or ''fair,'' but they   have their own criterion for whether a price is good: does it end up helping to maximize surplus? 
 And as it happens, the    equilibrium price  results in surplus being maximized.

\begin{wrapfigure}{L}{2.8in}
%\vspace*{24pt}
\noindent
\begin{minipage}[c]{\linewidth}
%\refstepcounter{figurecounter} \label{fig01social1.jpg}
\begin{center}
 {\sc Figure 1.\ref{fig01social1.jpg} (repeated from above)\\
  Producer and Consumer Surplus } \\

  \includegraphics[width=\linewidth]{fig01social1.jpg}
\end{center}
 \end{minipage}
% \vspace*{-48pt}
\end{wrapfigure}

To show that  the equilibrium price is efficient, we need to think about the  benefits of the
transactions  to buyers and sellers. First,  calculate the benefits  for the equilibrium price
of \$10.00 and quantity of 200,000 bottles, bought and sold by the buyers and sellers to the left of
the intersection of supply and demand in     Figure 1.\ref{fig01social1.jpg}.  Those are the
buyers with the highest  gross benefits from buying bottles (from  \$30 down to \$10)  and the
sellers with the lowest costs of parting with them (from  \$4 to \$10). (The {\bf gross benefit}
\index{gross benefit} is the value to the buyer of suddenly possessing a free bottle.  The {\bf net
benefit} \index{net benefit} is the gross value minus the price he has to pay.)    You will see
immediately that to maximize surplus we need  whisky to be bought     by these high-valuing buyers and
sold by these low-valuing sellers, as happens in the free market.  Government allocation of the whisky
might not reach the same result. Government allocation would reach a different result if it   gave the bottles to the consumers
with the lowest income, or   the most  morally deserving consumers, or  the consumers best-connected
politically,  rather than to the consumers  willing to pay the most.




   The gross benefit to the sellers who are selling those 200,000 bottles  is their sales revenue,
which is  (200,000 bottles) (\$10/bottle) = \$2,000,000.  This is not their net benefit,
because the sellers place positive value  on those bottles, even if their values are  not as high as
the buyers'. The seller  values range  from \$4/bottle to \$10/bottle,  as shown by the height of
the supply curve. Combined, the seller values are the area labelled ``Seller Cost'' in Figure
1.\ref{fig01social1.jpg}, since for typical sellers the value they place on what they are selling is
their acquisition or production cost (though the cost might also be an opportunity cost---that they
cannot drink the whisky themselves).



We can numerically calculate the size of the seller cost. Geometrically, it is the area of the
rectangle \$4/bottle high and 200,000 bottles wide (which is  \$800,000) plus the area of the
triangle with a height of (\$10/bottle - \$4/bottle) and a width of 200,000 bottles, which is (1/2)
(\$6/bottle)(200,000 bottles) = \$600,000. That sums to a seller cost of \$1,400,000.

Since the sellers' net benefit is their gross benefit (the revenue) of \$2,000,000 minus their lost
value (the production cost) of \$1,400,000, their net benefit is \$600,000. This is the area
labelled ``producer surplus'' in Figure 1.\ref{fig01social1.jpg}. Producer surplus  is the standard
name  for net seller benefit.\footnote{Sometimes the concept of producer surplus is taught   a
different way, calculating the area of the producer surplus directly as a triangle rather than as
the revenue rectangle minus the cost trapezoid. I'm using the slower way here so the reader will
understand the concept better.} More formally: \\

\noindent
 {\bf Producer surplus}\index{Producer surplus} is   the sum across sellers of  how much they
receive in actual prices   minus the minimum prices they would accept. \\


 Producer surplus is not   the same as profit. Profit as used in ordinary language includes the
business's return to its equity capital.  Those costs will  often  show up in the height of the
supply curve, since a business will not be willing to keep supplying a given quantity if it is not
earning a competitive return to its capital. Instead, the business will shrink or go out of
business. On the other hand, in the short run the capital of a business is sunk, like certain
its  costs  (e.g. an office lease that can't be terminated early), so it may be earning
positive producer surplus but not be making an accounting profit  or   a long-run economic profit.
Although producer surplus and profit are similar, they are not identical concepts.


\begin{wrapfigure}{L}{2.8in}
%\vspace*{24pt}
\noindent
\begin{minipage}[c]{\linewidth}
%\refstepcounter{figurecounter} \label{fig01social1.jpg}
\begin{center}
 {\sc Figure 1.\ref{fig01social1.jpg}  (repeated from above)\\
    Producer and Consumer Surplus } \\

  \includegraphics[width=\linewidth]{fig01social1.jpg}
\end{center}
 \end{minipage}
% \vspace*{-48pt}
\end{wrapfigure}


Now think about the buyers of   whisky. Their gross benefit from the 200,000 bottles is the
sum of the values for each of the buyers.   Some buyers have a value of \$30, some   \$29,
some  \$28, and so forth down to the last buyer who actually makes a purchase, whose   value is
only \$10. (There exist other ``buyers'' who are inactive, but they will not be getting any benefit, so
we can ignore them.) The sum of the values is the area under the demand curve up to 200,000 bottles.
This equals the area of the rectangle \$10/bottle high and 200,000 bottles wide, which is
\$2,000,000; plus the area of the triangle above it with height (\$30/bottle - \$10/bottle) and
width 200,000 bottles, which is (1/2) (\$20/bottle) (200,000 bottles) = \$2,000,000. Adding up the
two areas (which  have the same size here--- pure coincidence) yields the gross benefit of the
consumers,   which is \$4,000,000.

The net value for the buyers is less than the gross value, because they have to pay the sellers
\$10/bottle. This is a payment of \$2,000,000 for all 200,000 bottles, so the net value is
\$4,000,000 - \$2,000,000 = \$2,000,000. In Figure 1.\ref{fig01social1.jpg}, this is the area
labelled ``consumer surplus''.  \\


\noindent
 {\bf Consumer surplus} \index{Consumer surplus} is   the sum across buyers of   the maximum prices
they would pay      minus the  actual  prices they do  pay. \\

Why is this called  ``consumer surplus'' rather than ``buyer surplus''? Historical accident.   I wish we used ``buyer surplus'' instead,    because sometimes the buyers are not individual people, but companies.  Even in that situation, though,  we refer to  the surplus of the buyer as ``consumer surplus''. 

Adding together the producer surplus and the consumer surplus gives  the total surplus created by
the existence of this market. When the quantity is 200,000 bottles and the price is \$10/bottle, the
total surplus is thus \$600,000 + \$2,000,000 = \$2,600,000.\\



\noindent
 {\bf Total surplus}\index{Total surplus} is   the  sum across everyone in society of  the net
benefits   received from the market for a good.   \\

 Usually  total surplus is  just the sum of consumer and producer surplus, but it could also include
benefits to taxpayers from taxes  buyers and sellers pay,  or costs and benefits to  external bystanders
such as neighbors of the liquor store who don't participate directly (the ``externalities''  that
we will come to in the next chapter).

 Notice that consumer and producer surplus don't equal each other. Indeed, often producer surplus is zero.  That happens if producers are all so similar that they all have the same cost of production. Usually, though, there is surplus on both sides, but it is unequal. Is this unfair? Hard to say--- it depends on what you mean by `fair'.   But if we want prices to signal the marginal benefit of the most reluctant active buyer and the most reluctant active seller, we can't obscure that information by deciding that one side or the other deserves more of the surplus. George Orwell said of the economist F. A. Hayek,``He does not see, or will not admit, that a return to `free' competition means for the great mass of people a tyranny probably worse, because more irresponsible, than that of the State. The trouble with competitions is that somebody wins them."\footnote{\href{http://thomasgwyndunbar.wordpress.com/2008/10/09/george-orwell-review/}{Review by George  Orwell: ``The Road to Serfdom by F.A. Hayek / The Mirror of the Past by K. Zilliacus,''} {\it The Observer}, 9 April 1944.}     Orwell, a socialist, didn't like having the free market deciding prices without some wise hand to guide it, and he trusted the government to provide that wisdom. Orwell was a good writer, so he knows how to turn a phrase. But, of course, in the competitions of the marketplace, it is not a bad thing that someone wins. That winner is whichever company provides the best product at the lowest price. The company that wins, gets a profit. But  consumers win too,   no matter which company is the winner. The ``great mass of people'' always wins from free competition; it is the companies which wish the competition was replaced by some kind of cartel that let them all charge high prices and earn high profits. And of course the tyranny of the company winning the competition is merely the ability to attract voluntary purchases from consumers. It can't compare with the tyranny of the State, which consists of the ability to take people's money without giving anything in return, and to put them in prison or execute them if they refuse to pay up. Moreover, a company selling products is responsible to consumers in the sense of losing their business if the company does a bad job. The State may or may not be responsible to the citizens, depending on whether the regime is democratic and on the power of the unelected judiciary and bureaucracy, but the penalty the State pays for poor performance is less immediate than that of the business that fails to provide an adequate product. We will return to this in detail later when we discuss government failure and government design. 


At any rate, having  calculated the total  surplus created by the free market, we must now see whether
government regulation could do better, as Orwell thinks is the case.    Here we come to  a remarkable fact:  it is the quantity of
200,000 bottles that determines the total surplus, not the price of \$10/bottle. If we change the
price, but keep the quantity the same, total surplus won't change.




 To see this, suppose that  the quantity  traded remains  200,000, being bought by the same
consumers and sold by the same sellers as in the free market,   but the price  rises to \$20/bottle.
This must be backed up by government force, as a two-part regulation. The first part is that those
200,000 consumers must be forced to buy whisky on pain of prison, since many of them would rather
not buy at such a high price. The second part is that sellers must be forbidden to reduce their
price, on pain of prison, since there won't be enough customers to satisfy all the sellers  at that
high price and sellers will be tempted to offer discounts. 


Calculate the surpluses again with that two-part regulation. The gross consumer benefit\index{gross consumer benefit} and the seller cost have not changed
from their free market levels. Since the same people are buying and selling the same 200,000
bottles, the buyers still value the bottles at \$4,000,000 and the sellers still value them at
\$1,400,000. All that has changed is that the buyers now pay a much higher price---a total amount
of (\$20/bottle) (200,000 bottles) = \$4,000,000---and the sellers get  higher revenue. Thus, now
the consumer surplus is $(\$4,000,000- \$4,000,000) = \$0$, and the producer surplus is
$(\$4,000,000- \$1,400,000)= \$2,600,000$. The total surplus is unchanged from its free market level
of \$2,600,000; all that has happened is that now the sellers get all of it and the buyers get none
of it.

Whatever price is chosen under this two-part regulation,  the  total surplus will stay the same.
When the quantity is fixed, the price is just a transfer from buyer to seller. The total surplus is
$$
\begin{array}{lll}
(Consumer \; Surplus) & +& (Producer \; Surplus)\\
 & \\
(Gross \; Buyer\; Benefit - Price*Quantity) &+& (Price*Quantity - Seller\; Cost) \\
& \\
(Gross \; Buyer\; Benefit ) &-& (Seller\; Cost) \\
\end{array}
$$

 The $Price*Quantity$ terms cancel each other, so the total surplus is {\it (Gross Buyer Benefit -
Seller Cost)}, which does not depend on the price.

The total surplus does depend on the quantity, however, which we were keeping fixed at 200,000
bottles. To see why, consider increasing the quantity. We will need the most
reluctant seller to become active, one whose value for a bottle is \$10.00 and  who has already sold
some but not all of his 100 bottles, since sellers with lower values are already selling. We will
need a new buyer to become active too, one whose value is less than \$10.00, since buyers with
higher values are already buying. Even if the new seller's value is \$10.00 and the new buyer's
value is \$9.99,  this new exchange reduces total surplus by \$.01 rather than increasing it.
Increasing sales further would reduce total surplus by even more.



\begin{wrapfigure}{L}{2.8in}
%\vspace*{24pt}
\noindent
\begin{minipage}[c]{\linewidth}
%\refstepcounter{figurecounter} \label{fig01social1.jpg}
\begin{center}
 {\sc Figure 1.\ref{fig01social1.jpg} (repeated from above)\\
  Consumer and Producer Surplus } \\

  \includegraphics[width=\linewidth]{fig01social1.jpg}
\end{center}
 \end{minipage}
% \vspace*{-48pt}
\end{wrapfigure}

How about reducing the quantity below 200,000? If a buyer with a value of \$10.01   stops buying
from the most reluctant seller, the seller whose value  is \$10.00, then total surplus drops by  \$.01.
Reducing the quantity below the free market equilibrium level loses some of the gains from trade
between active sellers  and  active buyers.

Thus, we see that the workings of the free market maximize surplus. First, the free market arrives
at the equilibrium price, without any government intervention necessary. Then,   the
equilibrium price elicits an equilibrium quantity which maximizes the sum of producer and consumer
surplus.

The fact that this is a two-step process is why the price actually does matter in the end. Earlier, we saw that
if the government required the quantity to be  200,000, with the same buyers and sellers as in the
free market, then the government could require any level it wanted to for the price,  without altering
total surplus. The two-part regulation maximized surplus just as well as the free market could, even
if the regulation could not do any better. But notice what we  took for granted: that the government
had detailed information at its disposal and   could enforce its regulation costlessly.

How would the government know that the optimal quantity was 200,000? Supply and demand curves are not
written down in books that the government can consult. Economists measure them with intricate
statistical procedures  using market-generated data. Simply asking people how much they would pay
won't work, in the same way   it didn't work for Brown and Smith.   People don't think hard
enough about it if they don't really have to pay, and   they  don't tell the truth. What would
happen if  the government said it was going to set the price of a bottle of whisky to one penny per
bottle, and asked buyers to step forward if they were one of the 200,000 buyers with  
values above \$10? Moral scruples about lying  aside, all 300,000  consumers would step forward, since
all of them would like the chance to buy whisky at that price. If the government  then asked
which 2,000 sellers had   costs below \$10/bottle, no seller would step forward, since none of them want to be forced to sell at a price of a penny per bottle. 

The free market,  unlike the government, needs very little information. The competitive process of bidding up or discounting  moves the price to \$10.00 without any need for people to tell the truth. In an actual
market, a buyer has no reason to claim that he would only pay \$5.00   if his true value is \$13.00
and the result of his claim is that he loses the chance to buy at \$10.00. A seller has no reason to
claim that his minimum acceptable price is \$11.00 if  it is  really  \$9.00 and his lie will lose
him the sale. Economizing on information is a huge advantage of the marketplace, even more important
than the fact that it does not need to pay police to enforce its prices and quantities.\footnote{It is for the insight that information aggregation is a key accomplishment of the free market that Frederick Hayek received the Nobel Prize in economics. Every economics student should view the video, ``\href{http://cafehayek.com/2010/01/keynes-vs-hayek-rap-video.html}{Fear the Boom and Bust: The Original Keynes vs. Hayek Rap Battle},''  by Russell Roberts, {\it Cafe Hayek: Where Orders Emerge} blog (January 25, 2010).}
 

The logic   is similar to   why the single transaction between Brown and Smith maximized surplus.
Brown and Smith are just two of the thousands of participants in the market, and the members of each
pair are    trading because   both benefit. What is different in the case of the market is that
anonymous market forces determine that the price will be \$10, whereas in the single transaction
example I said that Brown offered Smith a price of \$10 without explaining where that price came
from. But in both the single transaction and the market, the essential idea is that if both buyer
and seller voluntarily agree to a transaction, it   benefits both of them, and  it   increases total
surplus.

 
%\begin{wrapfigure}{l}{3.2in}
\refstepcounter{figurecounter} \label{fig01-wealth-of-nations.jpg}
\begin{center}
\noindent
 {\sc Figure 1.\ref{fig01-wealth-of-nations.jpg}\\
  The Wealth of Nations  } \\
  \includegraphics[width=4in]{fig01-wealth-of-nations.jpg}
\end{center}
%\end{wrapfigure}


In ordinary economic transactions  the free market maximizes surplus without the need for government
intervention. This is  a modern interpretation of Adam Smith's idea of the  {\b   Invisible Hand}
\index{ Invisible Hand} in his 1776 book, {\it The Wealth of Nations.}\index{The Wealth of
Nations}\footnote{Smith, Adam,\index{Smith}   {\it An Inquiry into the Nature and Causes of the Wealth
of Nations} (1st ed. 1776).  . A good way to appreciate the beauty of the idea is to read Leonard E.
Read\index{Read}, `` 'I, Pencil: My Family Tree as told to Leonard E. Read,'' {\it The Freeman}
(December 1958).  } In competition with
each other, producers  bid down the price to where the price equals the benefit to the lowest-valuing customer in the market. If a little more were produced, its marginal cost would be greater
than the marginal benefit to consumers. If a little less were produced,  we would lose a little
bit of consumer  and producer surplus.





 The Invisible Hand   is why
  economists  criticize   many  regulations.    Markets generally achieve good results on their
own, without the need for anyone to intervene to change the market price or quantity.   The idea of
the Invisible Hand is  exceedingly important, and much of an introductory economics class is devoted
to trying to explain it. But economists also recognize that   situations do  exist in which some
premises underlying the reasoning fails, so  government regulation could help increase total
surplus. These   situations of ``market failure''    will be discussed in the next chapter. First, though, we will look at what happens with misguided government regulation of prices. 



\bigskip


%---------------------
\noindent
 {\bf  1.5: Measuring the   Surplus  under  Rent Control  } \label{s01.5}


  I have taken some care in explaining how surplus is measured, because it is so fundamental.  Now
let's think about how to tackle a given policy change.  Rent control\index{Rent control} is a
classic example.  Suppose that due to increasing demand  the rental rate for  a one-bedroom
apartment has risen to \$500/month, so the city council passes an ordinance saying that rents can be
no more than \$400/month (a {\bf price ceiling}).\index{price ceiling}

 In  Figure 1.\ref{fig01rentcontrola.pdf}a, I drew the curves and  decided what the equilibria were.
In Figure 1.\ref{fig01rentcontrola.pdf}b,  I cut the areas up into triangles and rectangles.  Once
the areas were cut up and labelled,     I  could make up  lists of rectangles and triangles. We'll
now  go through that  step by step.


 \vspace*{8pt}
\noindent
\begin{minipage}[c]{\linewidth}
\begin{center}
 {\sc Figure   1.\ref{fig01rentcontrola.pdf} \\
    Rent Control   } \\

\refstepcounter{figurecounter} \label{fig01rentcontrola.pdf}
 \includegraphics[width=.4\linewidth]{fig01rentcontrola.pdf}
 \includegraphics[width=.4\linewidth]{fig01rentcontrolb.pdf}\\
 \vspace*{-8pt}
  (a)  \hspace{1.8in}     (b)
\end{center}
\end{minipage}\\

\vspace*{8pt}




 \noindent
\begin{minipage}[c]{\linewidth}
\noindent
  {\it  1.   Draw the supply and demand curves and find the
  free market equilibrium price and quantity.} \\
 \hspace*{16pt}       Landlords are supplying apartment units, and potential
tenants are demanding them.  Figure 1.\ref{fig01rentcontrola.pdf}a shows how as   the price falls  the
quantity of apartments demanded increases because more people prefer substitute from  owning their residences  and  more want to live
in the city instead of the suburbs. Thus,    the demand curve slopes down.
\end{minipage}

 Should the supply curve be vertical, or should it slope up? It would be vertical if the quantity
supplied of apartments did not depend on the price---{\bf perfectly inelastic}\index{perfectly
inelastic}, perfectly insensitive to price. That could be a good approximation, but I've drawn the
supply curve slanted, to represent the long-run situation in which the number of apartment does
rise with rents because suppliers     construct new apartment buildings,  rent out  condominium 
units,  convert   office buildings into apartments,   and so forth.

    The laissez faire equilibrium is where quantity supplied equals quantity demanded, the
intersection of the two curves. I've labelled that price and quantity $P^*$ and $Q^*$. \\


 
 \noindent
%\begin{minipage}[c]{\linewidth}
\noindent
  {\it 2. Find   the   market equilibrium price and quantity after the policy or other change.  }\\
    \hspace*{16pt}      The regulation imposes a price ceiling, which I've labelled as $\overline{P}
$. That price ceiling is less than the free market price, so now the quantity landlords are willing
to supply is less than the quantity tenants demand, the situation called {\bf excess demand}.
\index{excess demand}   The rent control regulation doesn't say that landlords must rent out their
units, only that they can't charge more than $\overline{P}$,  so the quantity rented out will be the
landlords'  quantity supplied ($Q_1$ in  Figure 1.\ref{fig01rentcontrola.pdf}a), rather than the
tenants' quantity demanded.  \\
%\end{minipage}

 \noindent
%\begin{minipage}[c]{\linewidth}
\noindent
  {\it 3.  Cut up the possible surplus area into as many rectangles and triangles as you think will
be relevant, labelling them with letters.  It's better to make too many than too  few. }\\
  \hspace*{16pt}     I've done that chopping in  Figure 1.\ref{fig01rentcontrola.pdf}a, which I've
drawn separately from Figure    1.\ref{fig01rentcontrola.pdf}b so you would be less distracted by
all the surplus areas when I was explaining the earlier steps.  


  \vspace*{ 18pt}

\begin{minipage}[c]{\linewidth}
\begin{center}
 {\sc Figure   1.\ref{fig01rentcontrola.pdf}  (repeated from above)\\
    Rent Control   } \\



%\refstepcounter{figurecounter} \label{fig01rentcontrola.pdf}
 \includegraphics[width=.45\linewidth]{fig01rentcontrola.pdf}
 \includegraphics[width=.45\linewidth]{fig01rentcontrolb.pdf}\\
 \vspace*{-8pt}
  (a)  \hspace{1.5in}     (b)
\end{center}
\end{minipage}
%\end{minipage}
 \vfill
 
 \vspace*{8pt}

 
 \noindent
\begin{minipage}[c]{\linewidth}
\noindent
  {\it 4.    Figure out for the free market which areas are in producer surplus, consumer surplus,   effects on third
parties (for example, tax revenue), and total surplus. }\\
 \hspace*{16pt}   In the free market, the quantity is $Q^*$, so the surpluses will only cover areas
from the quantity 0 to the quantity  $Q^*$.  Consumers'   total benefit (the tenants') is the area
under the demand curve from quantity 0 to quantity  $Q^*$, but they have to pay $P^*$, so their
surplus is the area between the demand curve and the $P^*$ flat line, area A+B+C.  Producers'
total benefit (the landlords') is their revenue, $P^*\cdot Q^*$, but their surplus is the difference
between that revenue and   their costs, which is the  area  D+E+G between the supply curve and the
$P^*$ flat line.  There are no effects on third parties---no tax revenue, for example. The total
surplus is therefore  A+B+C+D+E+G.    \\
\end{minipage}
 \noindent
\begin{minipage}[c]{\linewidth}
\noindent
 CS (laissez faire) = A+B+C\\
 PS (laissez faire) = D+E+G\\
TS (laissez faire) = A+B+C+D+E+G \\
\end{minipage}

\begin{center}
 {\sc Figure   1.\ref{fig01rentcontrola.pdf} (repeated from above) \\
    Rent Control   } \\

%\refstepcounter{figurecounter} \label{fig01rentcontrola.pdf}
 \includegraphics[width=.3\linewidth]{fig01rentcontrola.pdf}
 \includegraphics[width=.3\linewidth]{fig01rentcontrolb.pdf}\\
 \vspace*{-8pt}
  (a)  \hspace{1.5in}     (b)
\end{center}

Notice that areas F, H, and I end up not being part of anybody's surplus.  I didn't have to label
them, but I did it anyway  to illustrate how it doesn't do any harm to label   areas   you don't end
up using.  Also, I could have labelled area A+B+C just as one area, going straight to consumer
surplus, but we'll see that not all that area will be surplus under the regulation, so chopping it into pieces will make  comparison easier.  \\

\newpage
 \noindent
\begin{minipage}[c]{\linewidth}
\noindent
  {\it  5. Figure out for the regulated market which areas are in producer surplus, consumer surplus,   effects on third
parties (for example, tax revenue), and total surplus.  }\\
 \hspace*{16pt} With rent control,  the quantity is $Q_1$, so the surpluses will only cover areas
from quantity  0 to    $Q_1$.  Consumers'  total benefit is the area under the demand curve from quantities 0
to    $Q_1$, but they have to pay $\overline{P}$,  so their surplus is the area A+B+D between the
demand curve and the $\overline{P}$ flat line.  Producers'     total benefit (the landlords') is
their revenue,  $\overline{P}\cdot Q_1$, but their surplus is the difference between that revenue
and  their costs,   the  area  G between the supply curve and the $\overline{P}$ flat line.  There
are no effects on third parties. The total surplus  adds up to   A+B+D+G.  \\
 \end{minipage}



 \vspace*{8pt}
\noindent
\begin{minipage}[c]{\linewidth}
\begin{center}
 {\sc Figure   1.\ref{fig01rentcontrola.pdf} (repeated from above) \\
    Rent Control   } \\

%\refstepcounter{figurecounter} \label{fig01rentcontrola.pdf}
 \includegraphics[width=.4\linewidth]{fig01rentcontrola.pdf}
 \includegraphics[width=.4\linewidth]{fig01rentcontrolb.pdf}\\
 \vspace*{-8pt}
  (a)  \hspace{1.8in}     (b)
\end{center}
\end{minipage}\\

\vspace*{8pt}


 \noindent
\begin{minipage}[c]{\linewidth}
\noindent
 CS (rent control) = A+B+D\\
 PS (rent control) =  G\\
TS (rent control) =  A+B+D+G \\
\end{minipage}


 \noindent
\begin{minipage}[c]{\linewidth}
\noindent
  {\it 6.  See which has the bigger total surplus, the free market or the regulated market.  }\\
 \hspace*{16pt}   The free market has the biggest total surplus,  because it includes all the areas
in the regulated surplus plus C+E.  This difference C+E is called the {\bf deadweight loss}
\index{deadweight loss} or {\bf triangle loss}\index{triangle loss} or {\bf allocative inefficiency}.
\index{allocative inefficiency}  Consumer surplus has risen  by amount D-C because of rent control,
but producer surplus has fallen by D+E. The losers lose more than the winners gain, so rent control
does not maximize surplus. \\
\end{minipage}


\noindent
\begin{minipage}[c]{\linewidth}
%---------------------
\noindent
 {\bf 1.6 Quality,   Rationing,  and Rent-Seeking }  \label{s01.6}
\end{minipage}

 Our  surplus calculations  have  been based on hidden assumptions that simplify the analysis but leave out important effects of what happens when regulation leaves  a market with excess supply or excess demand. 

Our first assumption was that product quality was the same before and after price controls. In fact, if sellers cannot  lower their prices below a government ceiling, so the market has excess supply, they will start raising quality to compete for the scarce customers. This was the case when airline fares were regulated in the 1960's; airlines competed on the quality of their service and their meals, which dropped once the market was deregulated and they could compete on price instead. If there is a price floor, such as with rent control, there is excess demand, and so sellers can  spend less on quality and still find buyers. 

  Before rent control, landlords had to maintain
the quality of their apartments to attract tenants willing to pay the equilibrium  rent of \$500 in our example.
Rent control reduces the rent   to \$400, so even if the landlord stops maintaining the apartment
he will still find tenants willing to rent it. Landlords will paint the walls less often, make
repairs more slowly, and  in general try to pass along all the costs they can to the tenants.
Regulators know about this effect, so   rent control is accompanied by regulations to try to force
landlords to provide maintenance, but since it is hard to specify and enforce everything a landlord
does to make his apartments attractive,  apartment quality in rent controlled areas falls over time.
If  quality falls enough, the rent of \$400 actually becomes the equilibrium price and there is no
excess demand, but there is still  a surplus loss because of the inefficiently low level of quality.


\begin{wrapfigure}{L}{2.6in}
\noindent
 \begin{boxedminipage}[c]{\linewidth}
%\vspace*{-12pt}
\refstepcounter{sidebarcounter} \label{sidebar01-1}
 \renewcommand{\baselinestretch}{0.9}
\begin{footnotesize}
{\sc Box 1.1\\
 Rent Control in New York}\\
\hspace*{16pt}       New York   instituted rent control  after World War II because of  ``the
postwar rental housing emergency''.   By 2010,     only 40,000 apartments were still covered---
just ones built before 1947 and still occupied by the same family as in 1971. Whoever does live in
one is paying a below-market rent  and won't want to move, even if someone else  would get more
value from it.    Something over one million apartments     are ``rent stabilized'', a form of rent control in which 
rents can only rise at a certain rate each year.  
\end{footnotesize}
\vspace*{-6pt}
     \end{boxedminipage}
\vspace*{-6pt}
\end{wrapfigure}


   Changes in quality actually reduce the deadweight loss from price controls, but we neglected a second feature of markets that increases it: rent seeking. {\bf Rent seeking} refers to people  engaging in activities that transfer surplus from other people to themselves.  
The transfer itself does not change total surplus; it is just redistributed. Rent-seeking activities often are costly, however, and those costs  can cause real surplus loss in the same way that production costs do. Production costs create surplus,   but rent-seeking costs just take it away from somebody else.  

The  phrase  ``rent seeking'' is standard, but it was chosen badly by Anne Krueger in 1974 when she picked a phrase to describe Gordon Tullock's 1967 idea of costs that just transfer surplus.\footnote{See Gordon Tullock (1967) ``The Welfare Cost of Tariffs, Monopolies, and Theft,'' {\it Western Economic Review} and  Anne O. Krueger (1974) ``The Political Economy of the Rent-Seeking Society,'' {\it American Economic Review}.} In the early 1800's David Ricardo used the word  ``rents'' to refer to producer surplus of any kind, taking the word from the payment to land. There is nothing inefficient about seeking producer surplus--- that's what motivates sellers. But ``rent seeking'' is now used by economists to refer to costs that take surplus rather than making it. 

   In the context of rent control,  the extra search time spent   trying to find a rent-controlled apartment is a form of rent-seeking cost. Suppose in a city that is phasing out rent control  Mr. Smith has a choice between immediately taking an uncontrolled  new apartment at a rent of \$500 or waiting and searching further for a rent-controlled old apartment at a rent of \$400.  Smith would be willing to spend hundreds of dollars of his time--- up to the equivalent of \$100/month--- to find one of the old apartments that was available. 

 Of course, ``rent seeking'' applies to any kind of product, not just apartments. One example is fresh fruit in the Soviet Union in the 1970's. The socialist government set the price of fruit low,  so there was excess demand. The result was long lines of consumers showing up early to stores wanting to buy fruit when it was available. The time spent standing in line was a rent-seeking cost, that did not increase the total amount of fruit. 

    A third assumption that was behind the surplus analysis in the previous sections was that  the people who were able to rent the scarce apartments were the ones who valued them the most. In a free market with a market price of \$500, we know that anybody who values the good at more than \$500--- that is, the people who make up the top part of the demand curve--- will be able to buy it. At the rent-controlled price of \$400, however, it  might be that someone willing to pay \$600 cannot find an apartment but someone willing to pay just \$450 can find one. Whether this happens or not depends on the form of rationing. 

   {\bf Rationing}\index{Rationing}   means
the allocation   of goods by some means other than price when there is excess demand or supply (if
it's excess supply, the rationing determine which sellers are the ones lucky enough to be able to
sell).  Under socialism and during wartime in capitalist economies, there is often excess demand
because the government imposes price ceilings. Sometimes  the government distributes ration tickets
to consumers that they have to present to a seller whenever they buy something.  That is one form of rationing, but the term refers to whatever mechanism determines who gets to buy and sell.  Ration tickets, political influence, willingness to stand in line,  and willingness to wait for delivery are all rationing mechanisms. 

  {\bf Inefficient rationing}\index{Inefficient rationing} occurs when not only is the quantity too
low because of some flaw in the market or in policy, but the buyers who are able to find a seller
are not the buyers who value the product the most. If the rent is set at \$400, below the market
price of \$500, then consumer Brown, with valuation \$425, and  consumer Smith, with valuation
\$800, are both willing to pay that \$400 rent. The landlord doesn't care, because he gets \$400
either way. Thus, he might well rent the apartment to Brown instead of Smith. Ration tickets also
result in inefficient rationing, because the people who value the good the most usually  aren't
given enough ration tickets to be able to buy it.

Our analysis above assumed that    whichever consumer valued the apartment the most would get it, so
the consumers left apartmentless are the  consumers  with the lowest values. That form of priority
is {\bf efficient rationing}\index{efficient rationing}, because it gives the apartments to the
people who value  the good the most. Any kind of excess demand or supply and rationing creates
inefficiency--- to have excess demand because at the regulated price
more units are demanded than are supplied--- but at least under efficient rationing the deadweight
loss is  smaller than it might be.  Oddly enough, the rent seeking   discussed earlier can actually make rationing efficient.  Consumers with higher valuations are willing to spend more on rent seeking, and this will tend to make them obtain more of the scarce good than low-valuation consumers. 


 \vspace*{8pt}
\noindent
\begin{minipage}[c]{\linewidth}
\begin{center}
 {\sc Figure   1.8 \\
Three Ways Rationing Might Work Out   } \\

\refstepcounter{figurecounter} \label{fig01-rationing.png}
 
 \includegraphics[width=.5\linewidth]{fig01-rationing.png}\\
 \vspace*{-8pt}
 
\end{center}
\end{minipage}\\


  Figure   1.8 shows how three different kinds of rationing would affect surplus. At the price ceiling, the quantity supplied is 500, but the quantity demanded is 600.  The producer surplus is going to be area $A_5$ regardless of how consumers are rationed, because it is precisely the suppliers lowest on the supply curve who are willing to supply. With efficient rationing, the top 500 consumers on the demand curve are the ones who get to rent apartments, so consumer surplus is $A_1+A_2$.  We can imagine {\bf perfectly inefficient rationing}, which would give the apartments to the 500 consumers who {\it least} value them but are still willing to pay the price ceiling for them. Those are the consumers between $Q=100$ and $Q=600$ on the demand curve; the highest-valuing consumers are rationed out and don't get apartments. The consumer surplus from perfectly inefficient rationing would thus be $A_2+A_3+A_4$.  The third type of rationing in   Figure   1.8 is {\bf random rationing}, in which each type of consumer has an equal chance of getting an apartment. Since there are 500 apartments and 600 consumers who want them, that means each type of consumer has a 5/6 chance. It's easier to think of the equation for the resulting size of consumer surplus than to draw areas. That equation will be that consumer surplus is $5/6(A_1+A_2+A_3+A_4)$--- that is, it's 5/6 of what the consumer surplus would be if {\it all} the 600 consumers could find apartments.  Each type of consumer will have a 5/6 chance of getting his valuation height minus the price ceiling and a 1/6 chance of getting zero consumer surplus. Random rationing is quite realistic. It generate more consumer surplus than perfectly inefficient rationing but more than efficient rationing. 

 
\bigskip

 \noindent
\begin{minipage}[c]{\linewidth}
%---------------------
\noindent
 {\bf 1.7 Conclusion: Markets    Work}  \label{s01.6} 
\end{minipage}\\
 


   Before we start talking about regulations in particular industries, we need to establish a
theoretical framework for talking about regulation at all. Basic microeconomics is the  framework
we'll use,  with particular focus on supply and demand and surplus analysis.

  This chapter has talked about how free markets work and what it means for a market to work well.
The policy objective economists focus on is     efficiency:   the maximizing of total surplus. Total
surplus, in turn,  is the sum of the benefits the various players in the economy receive from the
market for a particular good. Maximizing surplus is a reasonable goal, but a limited one. It ignores
considerations of morality, fairness, and equality.   That sounds like a serious drawback, but it is
actually an advantage. It allows us to focus on the  dollar effects of policies first, and doesn't
prevent the application of other criteria afterwards.

   Before looking at regulation, one must understand what happens in unregulated markets, so we
reviewed the theory of supply and demand.   The  free market equilibrium price leads to the
efficient quantity being traded, so that surplus is maximized by the free market. A price ceiling
such as rent control   or a government-imposed cost such as a tax  reduces the quantity traded to
below the efficient level and thus reduces total surplus.

 If willingness to buy and prices do not decide who produces which things and who consumes which things, then something else decides it. When rent control is imposed, for example, the people who get to rent apartments are those who are best at searching or those whom the landlord thinks will be the best tenants. If the landlord is indifferent otherwise, he might break his tie by something arbitrary such as only renting to handsome people, since he cannot  decide based on who is willing to pay the most. If the government were to set the price of cars based on what it considered fair, there would be shortages or surpluses and someone--- in government or in the regulated business--- would use his personal likes and dislikes to decide who gets the scarce cars or the scarce customers.  Such regulation would replace competition based on wealth and tastes with competition based on political power. 

 This chapter has taught  that  markets work well in maximizing surplus. That is a good starting
point for thinking about regulation, but not a good stopping point. We will see in the next chapter
that there are situations of ``market failure'' in which the standard model of supply and demand
does not tell the whole story and where government intervention can actually increase total surplus.
We will also see that besides the Invisible Hand of the market helping to maximize surplus, there is
also an invisible effect of government that has been in the background even in this chapter.
Governments enforce property rights, and without property rights, our supply and demand curves
wouldn't apply---there would be stealing instead of buying and selling.    So don't stop here---
read on to learn when markets go wrong and what's  good about government.

\newpage
%-----------------------------
%\vfill
\vspace{.5in}
%\cleardoublepage
\begin{center}
{\sc   Review Questions }
\end{center}
 \begin{enumerate}
\item
  How do supply and demand reach the  equilibrium price and quantity?
 \item
 What does surplus maximization mean, and what are its limitations as an objective?
\item
  How is it that the market maximizes surplus, and why is it more difficult for a planner to do the
same thing?
\item
  What is the effect of government-imposed prices or quantities on social surplus?
\item
  How does the type of  rationing   when there is excess supply  or demand affect surplus?
\end{enumerate}

 

  

\vspace{.2in}
%\cleardoublepage
\begin{center}
{\sc  Readings}
\end{center}
 \begin{enumerate}
\item
\href{http://plus.maths.org/content/adam-smith-and-invisible-hand} {``Adam Smith and the Invisible Hand,'' } Helen Joyce, {\it PlusMath.org}. 
 

\item
\href{http://shakespeare.mit.edu/merchant/full.html} {{\it The Merchant of Venice}}, William Shakespeare, Antonio in Act III, Scene iii. Shylock in Act IV, Scene i. 
See \url{https://www.youtube.com/watch?v=gSUuczZcUaU}. 

\item
\href{
http://marginalrevolution.com/marginalrevolution/2015/11/free-market-food-banks.html}{``Free Market Food Banks,''}  Alex Tabarrok, {\it Marginal Revolution} weblog.

   


\item
 \href{http://www.econlib.org/library/Essays/rdPncl1.html}{``I, Pencil,'' }  Leonard Reed,  {\it The Freeman} (1958).

\item
\href{ https://ag.ny.gov/press-release/ag-schneiderman-warns-against-price-gouging-during-winter-storm-stella-new-york-state}{``A.G. Schneiderman Warns against Price Gouging during Winter Storm Stella in New York State,'' } press release,  https://ag.ny.gov/press-release/ag-schneiderman-warns-against-price-gouging-during-winter-storm-stella-new-york-state.
 


\end{enumerate}

 
 \end{document}






