# Consumers, Producers, and the Efficiency of Markets

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1 Consumers, Producers, and the Efficiency of Markets PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 Welfare economics Consumer Surplus How the allocation of resources affects economic well-being Willingness to pay Maximum amount that a buyer will pay for a good 2 1

2 Table 1 Four Possible Buyers Willingness to Pay 3 Consumer Surplus Consumer surplus Amount a buyer is willing to pay for a good minus amount the buyer actually pays for it Measures the benefit buyers receive from participating in a market Closely related to the demand curve Demand schedule Derived from the willingness to pay of the possible buyers 4 2

3 Figure 1 The Demand Schedule and the Demand Curve Price of Albums \$ Demand John s willingness to pay Paul s willingness to pay George s willingness to pay Ringo s willingness to pay Quantity of Albums The table shows the demand schedule for the buyers in Table 1. The graph shows the corresponding demand curve. Note that the height of the demand curve reflects buyers willingness to pay. 5 At any quantity Consumer Surplus Price given by the demand curve Willingness to pay of the marginal buyer Demand curve Reflects buyers willingness to pay Measure consumer surplus Consumer surplus in a market Is the area below the demand curve and above the price 6 3

4 Figure 2 Measuring Consumer Surplus with the Demand Curve Price of Albums \$ (a) Price = \$80 John s consumer surplus (\$20) Price of Albums \$ (b) Price = \$70 John s consumer surplus (\$30) Paul s consumer surplus (\$10) 50 Demand 50 Total consumer surplus (\$40) Demand Quantity of Albums Quantity of Albums In panel (a), the price of the good is \$80, and the consumer surplus is \$20. In panel (b), the price of the good is \$70, and the consumer surplus is \$40. 7 Consumer Surplus A lower price raises consumer surplus (more savings, benefits) Buyers always want to pay less, right? Initial price, P 1 Quantity demanded Q 1 Consumer surplus: area ABC 8 4

5 Figure 3 How the Price Affects Consumer Surplus (a) Consumer Surplus at Price P 1 (b) Consumer Surplus at Price P 2 Price Price A A Additional consumer surplus to initial consumers P 1 Consumer surplus B C Demand P 1 P 2 Initial consumer surplus B D C E Consumer surplus to new consumers F Demand Q 1 0 Quantity 0 Quantity In panel (a), the price is P 1, the quantity demanded is Q 1, and consumer surplus equals the area of the triangle ABC. When the price falls from P 1 to P 2, as in panel (b), the quantity demanded rises from Q 1 to Q 2, and the consumer surplus rises to the area of the triangle ADF. The increase in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area BCED) and in part because new consumers enter the market at the lower price (area CEF). Q 1 Q 2 9 Consumer Surplus A lower price raises consumer surplus New, lower price, P 2 Greater quantity demanded, Q 2 New buyers Increase in consumer surplus from area ABC From initial buyers, add area BCDE From new buyers, add area CEF 10 5

6 Consumer surplus Consumer Surplus Benefit that buyers receive from a good As the buyers themselves perceive it Good measure of economic well-being Exception: Illegal drugs Drug addicts Willing to pay a high price for heroin Society s standpoint Drug addicts don t get a large benefit from being able to buy heroin at a low price 11 Cost Producer Surplus Value of everything a seller must give up to produce a good (examples: ) Measure of willingness to sell Producer surplus Amount a seller is actually paid for a good minus the seller s cost of providing it 12 6

7 Table 2 The Costs of Four Possible Sellers 13 Producer surplus Producer Surplus Closely related to the supply curve Supply schedule Derived from the costs of the suppliers At any quantity Price given by the supply curve shows the cost of the marginal seller 14 7

8 Figure 4 The Supply Schedule and the Supply Curve Price of House Painting Mary s cost \$900 Frida s cost 800 Supply Georgia s cost Grandma s cost Quantity of Houses Painted The table shows the supply schedule for the sellers in Table 2. The graph shows the corresponding supply curve. Note that the height of the supply curve reflects sellers costs. 15 Supply curve Reflects sellers costs Producer Surplus Measures producer surplus Producer surplus in a market Area below the price and above the supply curve 16 8

9 Figure 5 Measuring Producer Surplus with the Supply Curve \$ (a) Price = \$600 (b) Price = \$800 Price of House Painting Supply Price of House Painting \$ Total producer surplus (\$500) Supply Grandma s producer surplus (\$100) Georgia s producer surplus (\$200) Grandma s producer surplus (\$300) Quantity of Houses Painted Quantity of Houses Painted 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 \$ Producer Surplus A higher price raises producer surplus Sellers want to receive a higher price, right? Initial price, P1 Quantity supplied, Q1 Producer surplus, area ABC 18 9

10 Figure 6 How the Price Affects Producer Surplus (a) Producer Surplus At Price P 1 (b) Producer Surplus At Price P 2 Price Supply Price P 2 Additional producer surplus to initial producers D E F Supply P 1 B Producer surplus C P 1 B Initial producer surplus C Producer surplus to new producers A Q 1 0 Quantity 0 Quantity In panel (a), the price is P 1, the quantity supplied is Q1, and producer surplus equals the area of the triangle ABC. When the price rises from P 1 to P 2, as in panel (b), the quantity supplied rises from Q 1 to Q 2, and the producer surplus rises to the area of the triangle ADF. The increase in producer surplus (area BCFD) occurs in part because existing producers now receive more(area BCED) and in part because new producers enter the market at the higher price (area CEF). A Q 1 Q 2 19 Producer Surplus A higher price raises producer surplus New, higher price, P2 Greater quantity supplied, Q2 New producers Increase in producer surplus from area ABC From initial suppliers, add area BCDE From new suppliers, add area CEF 20 10

11 Market Efficiency The benevolent social planner All-knowing, all-powerful, well-intentioned dictator Wants to maximize the economic wellbeing of everyone in society Economic well-being of a society Total surplus = consumer surplus + producer surplus 21 Market Efficiency Total surplus = Consumer surplus + Producer surplus Consumer surplus = Value to buyers Amount paid by buyers Producer surplus = Amount received by sellers Cost to sellers Amount paid by buyers = Amount received by sellers Total surplus = Value to buyers Cost to sellers 22 11

12 Efficiency Market Efficiency Property of a resource allocation Maximizing the total surplus received by all members of society Equality Property of distributing economic prosperity uniformly among the members of society 23 Market Efficiency Gains from trade in a market Like a pie to be shared among the market participants 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 24 12

13 Market outcomes Market Efficiency 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 25 Figure 7 Consumer and Producer Surplus in the Market Equilibrium Price A Supply Equilibrium price Consumer surplus Producer surplus C E Demand 0 Equilibrium quantity Quantity Total surplus the sum of consumer and producer surplus is the area between the supply and demand curves up to the equilibrium quantity D B 26 13

14 Market outcomes Social planner Market Efficiency Cannot increase economic well-being by Changing the allocation of consumption among buyers Changing the allocation of production among sellers Cannot raise total economic well-being by Increasing or decreasing the quantity of the good 27 Market outcomes Market Efficiency 3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus Market equilibrium Efficient allocation of resources The benevolent social planner Laissez faire = allow them to do 28 14

15 Exhibit 8 The Efficiency of the Equilibrium Quantity 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. 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. 29 Market Efficiency Adam Smith s invisible hand Takes all the information about buyers and sellers into account Guides everyone in the market to the best outcome Economic efficiency Free markets = best way to organize economic activity 30 15

16 Should there be a market in organs? How a mother s love helped save two lives Ms. Stevens - her son needed a kidney transplant The mother s kidney was not compatible Donated one of her kidneys to a stranger Her son was moved to the top of the kidney waiting list 31 Questions Should there be a market in organs? Trade a kidney for a kidney? Trade a kidney for an expensive, experimental cancer treatment? Exchange her kidney for free tuition for her son? Sell her kidney for cash? 32 16

17 Public policy Should there be a market in organs? Illegal for people to sell their organs Market for organs Government has imposed a price ceiling of zero - Shortage of the good Large benefits to allowing a free market in organs People are born with two kidneys Usually need only one Few people no working kidney 33 Should there be a market in organs? Current situation Typical patient - wait several years for a kidney transplant Every year - thousands of people die because a kidney cannot be found Current system: is it fair? Some people - extra kidney they don t really need Others - dying to get one 34 17

18 Should there be a market in organs? Allow for kidney market Balance supply and demand Sellers extra cash in their pockets Buyers live No more shortage of kidneys Efficient allocation of resources Critics: worry about fairness Benefit the rich at the expense of the poor 35 Market Efficiency & Failure Forces of supply and demand Allocate resources efficiently Several assumptions about how markets work 1. Markets are perfectly competitive 2. Outcome in a market matters only to the buyers and sellers in that market 36 18

19 Market Efficiency & Failure When these assumptions do not hold Market equilibrium is efficient may no longer be true In the world, competition is far from perfect Market power A single buyer or seller (small group) Control market prices Markets are inefficient 37 Market failure Market Efficiency & Failure E.g.: market power and externalities The inability of some unregulated markets to allocate resources efficiently Public policy Can potentially remedy the problem and increase economic efficiency 38 19

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