Question

Consumer Surplus Background: There has been a lot of talk about trade restrictions, in the hopes that such policies will encourage production and hence job growth in this country. Economists, generally, are skeptical of policies that reduce or restrict international trade. A historical example can help illustrate some, although not all, of that economic skepticism. In 1980, the United States negotiated a Voluntary Export Restraint Agreement (VER) with Japan. The VER limited Japanese automobile exports to the United States. This drop in supply caused the price of domestically (U.S.) produced autos to rise. Basic stylized data are below

• Price of a typical U.S.-produced car (pre-VER) = $6,000

• Price of a typical U.S.-produced car (post-VER) = $7,000

• Number of U.S.-produced cars sold in United States (pre-VER) = 8 million

• Price elasticity of demand for U.S. autos (pre-VER) = -1.5

Prices are loosely typical of 1980, in case you’re wondering why these cars are so inexpensive.

Problem

(a) Draw a graph showing the consumer surplus before and after the VER. Label the initial pre-VER price and quantity (using the numbers above) and the post-VER price and quantity (you do not yet know post-VER quantity but you know pre-VER quantity) and show the pre-VER consumer surplus, the post-VER consumer surplus, and the change in consumer surplus.

(b) Use the above data to calculate the change in consumer surplus that resulted from the VER. Assume a linear market demand curve. Also assume that the demand curve does not shift during the period of interest, and that cars are a sufficiently homogenous commodity that you can analyze this with one demand curve. Calculate the change in consumer surplus as a number (the units will be dollars), and show your work.

Hint: Recall the definition of elasticity, ? = %∆? %∆? = ∆? ∆? ? ?

You can calculate, from the data above, the %ΔP, and you know ε, so you can solve for %ΔQ = ε*%ΔP where the symbol * denotes multiplication. Knowing %ΔQ and initial (preVER) Q you can calculate post-VER Q. That information is enough to calculate the change in consumer surplus, in dollars. Refer to the graph from part (a) to help you see this.

(c) Based on your answer above, would consumers be better off if imports of automobiles to the United States are restricted? Why or why not? What about workers— would U.S. workers be better off if imports are restricted and international trade is reduced?

Answer 1

a)

Let  Price of a typical U.S.-produced car (pre-VER) = P1 =  $6,000

Price of a typical U.S.-produced car (post-VER) = P2 = $7,000

Number of U.S.-produced cars sold in the United States (pre-VER) = Q1 = 8 million

Number of U.S.-produced cars sold in the United States (post-VER) = Q2

Price elasticity of demand for U.S. autos (pre-VER) = -1.5

The demand line for the cars has been denoted by D in figure 1.

Consumer surplus = area above the price line and below the demand curve

Consumer surplus pre-VER = Area highlighted in red in figure 1+ Area highlighted in green in figure 1

Consumer surplus post-VER = Area highlighted in red in figure 1

Change in consumer surplus = Consumer surplus post-VER - Consumer surplus pre-VER

= - Area highlighted in green in figure 1

B)

By using the formula for Price elasticity of demand, we can find out Q2.

change in consumer surplus = - area highlighted in green = - [ area A + area B]

= -[ (7,000-6,000) * 6 + 1/2 *(7,000-6,000)*(8-6) ]

= - [6,000 + 1,000]

= - 7,000

Therefore, change in consumer surplus = -7,000

c) Consumers are worse off if imports of automobiles to the United States are restricted. As the imports of automobiles to the United States are restricted, the price of automobiles goes up. Along with that, there is a reduction in consumer surplus. Hence, consumers are worse off.

U.S. workers would be better off if imports are restricted and international trade is reduced because now the price of the product which they are selling increases. Worker unions can demand a simultaneous increase in their wages. Also, an increased price would induce the owner of the firm to hire more workers.