Lecture 7 Consumers, producers, and the efficiency of markets
Revisiting the Market Equilibrium Do the equilibrium price and quantity maximize the total welfare of buyers and sellers? Market equilibrium reflects the way markets allocate scarce resources. Whether the market allocation is desirable can be addressed by welfare economics. Consumers, Producers and the Efficiency of Markets
Welfare Economics Welfare economics is the study of how the allocation of resources affects economic wellbeing. Buyers and sellers receive benefits from taking part in the market. The equilibrium in a market maximizes the total welfare of buyers and sellers. Consumers, Producers and the Efficiency of Markets
Welfare Economics Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product. Consumers, Producers and the Efficiency of Markets
Welfare Economics Consumer surplus measures economic welfare from the buyer s side. Producer surplus measures economic welfare from the seller s side. Consumers, Producers and the Efficiency of Markets
Willingness to pay is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good or service. CONSUMER SURPLUS
Consumer surplus is the buyer s willingness to pay for a good minus the amount the buyer actually pays for it. CONSUMER SURPLUS
Table 1: Four Possible Buyers Willingness to Pay
The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. Using the Demand Curve to Measure Consumer Surplus
The Demand Schedule and the Demand Curve
Figure 1 The Demand Schedule and the Demand Curve Price of Album $100 John s willingness to pay 80 Paul s willingness to pay 70 George s willingness to pay 50 Ringo s willingness to pay Demand 0 1 2 3 4 Quantity of Albums 10
At any given quantity, the price given by the demand curve reflects the willingness to pay of the marginal buyer Because the demand curve shows the buyers willingness to pay, we can use the demand curve to measure consumer surplus. Using the Demand Curve to Measure Consumer Surplus CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
Figure 2 Measuring Consumer Surplus with the Demand Curve Price of Album (a) Price = $80 $100 John s consumer surplus ($20) 80 70 50 Demand 0 1 2 3 4 Quantity of Albums 12
Figure 2 Measuring Consumer Surplus with the Demand Curve Price of Album $100 (b) Price = $70 John s consumer surplus ($30) 80 70 Paul s consumer surplus ($10) 50 Total consumer surplus ($40) Demand 0 1 2 3 4 Quantity of Albums 13
The area below the demand curve and above the price measures the consumer surplus in the market. Using the Demand Curve to Measure Consumer Surplus
Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it. What Does Consumer Surplus Measure?
Figure 3 How the Price Affects Consumer Surplus Price A (a) Consumer Surplus at Price P 1 Consumer surplus P 1 B C Demand 0 Q 1 Quantity 16
Figure 3 How the Price Affects Consumer Surplus Price A (b) Consumer Surplus at Price P 2 P 1 Initial consumer surplus B C Consumer surplus to new consumers P 2 D E Additional consumer surplus to initial consumers F Demand 0 Q 1 Q 2 Quantity 17
As price falls, consumer surplus increases for two reasons. a. Those already buying the product will receive additional consumer surplus because they are paying less for the product than before. b. Because the price is now lower, some new buyers will enter the market and receive consumer surplus on these additional units of output purchased. Changes in price and consumer surplus CHAPTER 1 TEN PRINCIPLES OF ECONOMICS
Producer surplus is the amount a seller is paid for a good minus the seller s cost. It measures the benefit to sellers participating in a market. NB: cost is the value of everything a seller must give up to produce a good. PRODUCER SURPLUS
Table 2: The Costs of Four Possible Sellers
Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve. Using the Supply Curve to Measure Producer Surplus
The Supply Schedule and the Supply Curve
Figure 4 The Supply Schedule and the Supply Curve 23
At any given quantity, the price given by the supply curve represents the cost of the marginal seller. Because the supply curve shows the sellers cost (willingness to sell), we can use the supply curve to measure producer surplus. The area below the price and above the supply curve measures the producer surplus in a market. Using the Supply Curve to Measure Producer Surplus
Figure 5 Measuring Producer Surplus with the Supply Curve (a) Price = $600 Price of House Painting Supply $900 800 600 500 Grandma s producer surplus ($100) 0 1 2 3 4 Quantity of Houses Painted 25
Figure 5 Measuring Producer Surplus with the Supply Curve Price of House Painting $900 800 Total producer surplus ($500) (b) Price = $800 Supply 600 500 Georgia s producer surplus ($200) Grandma s producer surplus ($300) 0 1 2 3 4 Quantity of Houses Painted 26
Figure 6 How the Price Affects Producer Surplus Price (a) Producer Surplus at Price P 1 Supply P 1 B Producer surplus C A 0 Q 1 Quantity 27
Figure 6 How the Price Affects Producer Surplus Price (b) Producer Surplus at Price P 2 Additional producer surplus to initial producers Supply P 2 D E F P 1 B Initial producer surplus C Producer surplus to new producers A 0 Q 1 Q 2 Quantity 28
As price rises, producer surplus increases for two reasons: a. Those already selling the product will receive additional producer surplus because they are receiving more for the product than before b. Because the price is now higher, some new sellers will enter the market and receive producer surplus on these additional units of output sold How the price affect producer surplus
Consumer surplus and producer surplus may be used to address the following question: Is the allocation of resources determined by free markets in any way desirable? MARKET EFFICIENCY
Consumer Surplus = Value to buyers Amount paid by buyers and Producer Surplus = Amount received by sellers Cost to sellers The Benevolent Social Planner
Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers Cost to sellers NB: amount paid by buyers is the same as the amount received by sellers The Benevolent Social Planner
Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society. The Benevolent Social Planner
In addition to market efficiency, a social planner might also care about equity the fairness of the distribution of well-being among the various buyers and sellers. The Benevolent Social Planner
Figure 7 Consumer and Producer Surplus in the Market Equilibrium Price A D Supply Consumer surplus Equilibrium price Producer surplus E Demand B C 0 Equilibrium Quantity quantity 35
Three Insights Concerning Market Outcomes Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. Free markets allocate the demand for goods to the sellers who can produce them at least cost. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. Evaluating the Market Equilibrium
Figure 8 The Efficiency of the Equilibrium Quantity Price Supply Value to buyers Cost to sellers Cost to sellers Value to buyers Demand 0 Equilibrium quantity Quantity Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. 37
At the equilibrium price, the sum of the consumer and producer surplus is maximum Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it. This policy of leaving well enough alone goes by the French expression laissez faire. Evaluating the Market Equilibrium
Market Power If a market system is not perfectly competitive, market power may result. Market power is the ability to influence prices. Market power can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand. Evaluating the Market Equilibrium
Externalities created when a market outcome affects individuals other than buyers and sellers in that market. cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers. When buyers and sellers do not take externalities into account when deciding how much to consume and produce, the equilibrium in the market can be inefficient. Evaluating the Market Equilibrium
Consumer surplus equals buyers willingness to pay for a good minus the amount they actually pay for it. Consumer surplus measures the benefit buyers get from participating in a market. Consumer surplus can be computed by finding the area below the demand curve and above the price. Evaluating the Market Equilibrium
Producer surplus equals the amount sellers receive for their goods minus their costs of production. Producer surplus measures the benefit sellers get from participating in a market. Producer surplus can be computed by finding the area below the price and above the supply curve. Evaluating the Market Equilibrium
An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes. Consumers, Producers, and the Efficiency of Markets: summary
The equilibrium of demand and supply maximizes the sum of consumer and producer surplus. This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. Markets do not allocate resources efficiently in the presence of market failures. Consumers, Producers, and the Efficiency of Markets: summary
Explain how buyers willingness to pay, consumer surplus and the demand curve are related Explain how sellers costs, producer surplus and the supply curve are related What is efficiency? Is it the only goal of economic policy makers? What does the invisible hand do? Name two types of market failure. Explain why each may cause market outcomes to be inefficient Quick Review Questions