Basic Economics Chapter 7

Size: px
Start display at page:

Download "Basic Economics Chapter 7"

Transcription

1 1 Basic Economics Chapter 7 Consumers, Producers, Efficiency of Markets Welfare economics = how the allocation of resources affects economic well-being Willingness to pay = maximum amount that a buyer will pay for a good Consumer Surplus Note that the height of the demand curve reflects buyers willingness to pay. Consumer surplus = amount a buyer is willing to pay for a good minus amount the buyer actually pays for it. It

2 measures the benefit the buyer receives from participating in the market. It is closely related to the demand curve Demand schedule = is derived from the willingness to pay of the possible buyers At any quantity, the price given (indicated) by the demand curve shows the willingness to pay of the marginal buyer. The demand curve, therefore, reflects a buyer s willingness to pay. It measures the consumer surplus of that buyer. The consumer surplus in a market is the area below the demand curve and above the price 2 Note that the height of the demand curve reflects buyers willingness to pay.

3 Measuring Consumer Surplus with the Demand Curve 3 In panel (a) above, the price of the good is $80, and consumer surplus is $20. In panel (b), the price of the good is $70, and consumer surplus is $40. A lower price raises consumer surplus (more savings, benefits). Buyers always want to pay less, right? How the Price Affects Consumer Surplus In Panel (a) above given a market demand, at the initial price, P 1, quantity demanded of the good is Q 1, creating a consumer surplus defined by the area ABC. When the price

4 falls from P 1 to P 2, as in panel (b), quantity demanded rises from Q 1 to Q 2, and total consumer surplus now increases to the area of the triangle ADF. The increase in total consumer surplus (area BCFD) occurs in part because (i) existing (or initial) consumers now pay less (creating the area BCED) and in part because (ii) new consumers enter the market at the lower price (area CEF). Consumer surplus is the benefit that buyers receive from a good as the buyers themselves perceive it. It s a good measure of economic well-being. - Exception: Illegal drugs Drug addicts are willing to pay a high price for heroin. But from society s standpoint, drug addicts don t get a large benefit from being able to buy heroin at a low price. Producer Surplus Cost = the value of everything a seller must give up to produce a good (examples: ). Cost is a measure of a seller s willingness to sell. Producer surplus = is the amount a seller is actually paid for a good minus the seller s cost of providing it. The cost of four possible sellers: 4 Producer surplus is closely related to the supply curve. A supply schedule is derived from the costs of the suppliers. At

5 5 any quantity, the price indicated by the supply curve shows the cost of the marginal seller. Note that the height of the supply curve reflects sellers costs. The supply curve reflects the seller s costs; it helps measure producer surplus. Producer surplus in a market is the area bounded from below by the price and above by the supply curve.

6 6 In panel (a), the price of the good is $600, and the producer surplus is $100. In panel (b), the price of the good is $800, and the producer surplus is $500. A higher price raises producer surplus; sellers want to receive a higher price, right? Initial price, P1 Quantity supplied, Q1 Producer surplus, area ABC (a) Producer Surplus At Price P 1 Price Supply P 1 B Producer surplus C A Q 1 0 Quantity In panel (a), the initial price is P 1, quantity supplied is Q 1, and producer surplus equals the area of the triangle ABC. When the price rises from P 1 to P 2, as in panel (b), quantity supplied rises from Q 1, to Q 2, and producer surplus rises to the area of the triangle ADF. The increase in total producer surplus (area BCFD) occurs in part because (i) existing (or initial) producers/suppliers now receive more (area BCED) and in part because (ii) new producers enter the market at the higher price (area CEF).

7 Market Efficiency Assume the existence of a benevolent social planner who is an all-knowing, all-powerful, well-intentioned strongman who wants to maximize the economic well-being (or welfare) of everyone in society. What should this planner do leave mkt. participants alone or intervene? The economic well-being of a society may be measured as: 7 Total surplus = consumer surplus + producer surplus Consumer surplus = Value to buyers Amt. paid by buyers Producer surplus = Amt. received by sellers Cost to sellers Amount paid by buyers = Amount received by sellers Alternatively, Total surplus = Value to buyers Cost to sellers Efficiency: - the property of a resource allocation of maximizing the total surplus received by all members of society Equality: - the property of distributing economic prosperity uniformly among the members of society If an allocation of resources maximizes total surplus, then we can say that it exhibits efficiency. Gains from trade in a market: - Like a pie to be shared among the market participants

8 The question of efficiency: whether the pie is as big as possible The question of equality: - How the pie is sliced - How the portions are distributed among members of society If an allocation is not efficient, then some of the potential gains from trade (among buyers and sellers) are not being realized. For example, an allocation is not efficient if a good is not produced by the sellers with the least cost. Similarly, an allocation is not efficient if a good is not being consumed (or bought) by buyers who value it most highly (willing to pay a higher price). Insights on Market outcomes: (1) Free markets allocate the supply of goods to the buyers who value them most highly; measured by their willingness to pay (2) Free markets allocate the demand for goods to the sellers who can produce them at the least cost Consumer and Producer Surplus in a Market Equilibrium Total surplus the sum of consumer and producer surplus is the area between the supply and demand curves up to the equilibrium quantity. 8

9 In an unregulated or free mkt. equilibrium, a social planner cannot increase economic well-being by changing the allocation of consumption among buyers or the allocation of production among sellers. The social planner cannot also raise total economic well-being by increasing or decreasing the quantity of the good. (3) Free markets produce the quantity of goods that maximize the sum of consumer and producer surplus 9 Price Supply Value to buyers Cost to sellers Cost to sellers Value to buyers Demand 0 Q 1 Equilibrium Q 2 Quantity quantity Value to buyers is greater than cost to sellers Value to buyers is less than cost to sellers At quantities less than the equilibrium quantity, such as Q 1, the value to buyers exceeds the cost to sellers (an unsustainable situation). At quantities greater than the equilibrium quantity, such as Q 2, the cost to sellers exceeds the value to buyers. Therefore, the market equilibrium maximizes the sum of producer and consumer surplus. Thus, market equilibrium represents an efficient allocation of resources. It is, therefore, best for the benevolent social planner to let people do as they will which is equivalent to

10 adopting a Laissez faire policy. Much like the idea of Adam Smith s invisible hand which takes into account all available information about buyers and sellers and guides everyone in the market to the best outcome. Thus, free markets are best way to organize economic activity. Market Efficiency & Failure The forces of supply and demand allocate resources efficiently. Even though each buyer and seller in a free market is concerned only about her own welfare, together they are led by an invisible hand to equilibrium that maximizes the total benefits to buyers and sellers. Assumptions about how markets work are in order: (i) Markets are perfectly competitive. In actual economies, competition is far from perfect. In some markets, a single buyer or seller (or a group of them) may be able to control market prices, i.e., they have market power. Market power can cause markets to be inefficient because it keeps the price and quantity away from levels determined by the equilibrium of demand and supply. (ii) Outcome in a market matters only to the buyers and sellers participating in that market. Sometimes the decisions of buyers and seller affect people who are not participants in the market at all. For example, the use of agricultural pesticides affects not only manufacturers and the farmers who use them but also others who breathe air or drink water polluted with these pesticides. When a market exhibits such 10

11 side effects, called externalities, the welfare implications of market activity depend on more than just the value obtained by the buyers and the cost incurred by the sellers. If buyers and sellers ignore these side effects in their decision how much to buy and sell, the equilibrium in a market can be inefficient from society s standpoint. Market power and externalities are examples of what is known as market failure the inability of some unregulated markets to allocate resources inefficiently. When markets fail, public policy can potentially remedy the problem and increase economic efficiency. 11