Consumers, Producers, and the Efficiency of Markets Chapter 7 Copyright 21 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. 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. Interesting question: is this equilibrium allocation desirable? Welfare Economics Consumer Consumer surplus measures economic welfare from the buyer s side. Producer surplus measures economic welfare from the seller s side. Willingness to pay is the maximum price that a buyer is willing and able to pay for a given amount of a good, when the alternatives are all or nothing. It measures how much the buyer values the good or service. 1
Consumer Consumer surplus is the amount a buyer is willing to pay for a given amount of a good minus the amount the buyer actually pays for it. Four Possible Buyers Willingness to Pay... Buyer Willingness to Pay John $1 Paul 8 George 7 Ringo 5 Consumer The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. Four Possible Buyers Willingness to Pay... Buyer ed More than $1 None $8 to $1 John 1 $7 to $8 John, Paul 2 $5 to $7 John, Paul, George 3 $5 or less Ringo 4 2
Measuring Consumer with the Curve... Measuring Consumer with the Curve... = $8 $1 8 7 John s willingness to pay Paul s willingness to pay George s willingness to pay $1 8 7 John s consumer surplus ($2) 5 Ringo s willingness to pay 5 Measuring Consumer with the Curve... There are 2 available. Who should get them? $1 8 7 = $7 John s consumer surplus ($3) Paul s consumer surplus ($1) $1 8 7 5 Total consumer surplus ($4) 5 3
Competitive equilibrium: price will be between 7 and 8 ISU method: price = 5 and lottery $1 John s consumer surplus ($3) $1 8 7 5 Paul s consumer surplus ($1) p=7 ISU s surplus ($14) 8 7 5 Paul s consumer surplus ($3) George s consumer surplus ($2) P=5 ISU s surplus ($1) Measuring Consumer with the Curve How the Affects Consumer... A Copyright 21 by Harcourt, Inc. All rights reserved The area below the demand curve and above the price measures the consumer surplus in the market. Initial consumer surplus P 1 B C Consumer surplus to new consumers P 2 D Additional consumer surplus to initial consumers E Q 1 Q 2 F 4
Consumer and Economic Well-Being 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. Producer Producer surplus is the amount a seller is paid minus the cost of production. It measures the benefit to sellers participating in a market. The Costs of Four Possible Sellers... Seller Cost Mary $9 Frida 8 Georgia 6 Grandma 5 Producer and the Curve Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve. At any quantity, the price given by the supply curve shows the cost of the marginal seller, the seller who would leave the market first if the price were any lower. 5
Schedule for the Four Possible Sellers... Producer and the Curve... Sellers $9 or more Mary, Frida, Georgia, Grandma Supplied $8 to $9 Frida, Georgia, Grandma 3 $6 to $8 Georgia, Grandma 2 $5 to $6 Grandma 1 Less than $5 None 4 House Painting $9 8 6 5 Grandma s cost 1 2 3 4 Frida s cost Georgia s cost Mary s cost of Houses Painted Producer and the Curve The area below the price and above the supply curve measures the producer surplus in a market. Measuring Producer with the Curve... House Painting $9 8 6 5 = $6 Grandma s producer surplus ($1) 1 2 3 4 of Houses Painted 6
Measuring Producer with the Curve... How Affects Producer... House Painting $9 8 = $8 Total producer surplus ($5) P 2 D Additional producer surplus to initial producers E F 6 5 Grandma s producer surplus ($3) Georgia s producer surplus ($2) 1 2 3 4 of Houses Painted P 1 B Initial Producer surplus A C Q 1 Q 2 Producer surplus to new producers Market Efficiency Economic Well-Being and Total Consumer surplus and producer surplus may be used to address the following question: Consumer = Value to buyers _ Amount paid by buyers Is the allocation of resources determined by free markets in any way desirable? Producer = and Amount received by sellers _ Cost to sellers 7
Economic Well-Being and Total Market Efficiency Total Total = Consumer = or Value to buyers Producer + _ Cost to sellers Market efficiency is achieved when the allocation of resources maximizes total surplus. Evaluating the Market Equilibrium... A D Consumer and Producer in the Market Equilibrium... A D Equilibrium price E Equilibrium price Consumer surplus Producer surplus E B B Equilibrium quantity C Equilibrium quantity C 8
Three Insights Concerning Market Outcomes Free markets allocate the supply of goods to the buyers who value them most highly. 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. The Efficiency of the Equilibrium Value to buyers Cost to sellers Equilibrium quantity Value to buyers is greater than cost to sellers. Cost to sellers Value to buyers Value to buyers is less than cost to sellers. Measuring Consumer with the Curve... Measuring Consumer with the Curve... $1 8 7 6 5 price p s $1 p d 8 7 6 5 Tax revenue Deadweight loss 3 3 9