Consumer & producer surplusslide 1 Analysis of Competitive Markets In this section, we examine the social welfare implications of competitive markets. The approach taken here (and not the only one possible), is to use the devices of Producer and Consumer Surplus. The social welfare from the production and consumption of a particular amount of a good is assumed to be the sum of the producer and consumer surplus.

Consumer & producer surplusslide 2 Optimality of competitive markets The principal claim is that social welfare (the sum of producer and consumer surplus) is maximized at the competitive price and quantity for a good. A series of examples are worked to show that a variety of policies and regulations, such as price fixing, taxes, and subsidies, will, in general, reduce social welfare from its maximum.

Consumer & producer surplusslide 3 Key terms Willingness to pay: The maximum amount a buyer will pay for an amount of a good. Consumer surplus: A buyer's willingness to pay minus the amount actually paid. Cost: The value of everything a seller must give up to produce an amount of a good. Producer surplus: The amount the seller receives for the good minus the cost.

Consumer & producer surplusslide 4 Consumer surplus can be measured using the demand curve for a product. Demand for tacos D Q* Q P P*

Consumer & producer surplusslide 5 When Q* is sold, willingness to pay is the shaded area. Demand for tacos D Q* Q P P*

Consumer & producer surplusslide 6 When Q* is sold at a price P*, consumers pay P* times Q*. Click to see the cost to consumers. Click again to see the shaded area that is consumer surplus. Demand for tacos D Q* Q P P* Cost to consumers Consumer surplus

Consumer & producer surplusslide 7 Producer surplus can be measured using the supply curve for a product. Supply of tacos S Q' Q P P'

Consumer & producer surplusslide 8 The shaded area is the cost of producing Q' of tacos. If the firm can sell at P', the total receipts are P' times Q'. Supply of tacos Q' Q P P' Click to see the area that equals firms' revenues. Total revenue equals P' times Q'.

Consumer & producer surplusslide 9 Producer surplus is the shaded area. Supply of tacos S Q' Q P P'

Consumer & producer surplusslide 10 S D Q P QEQE PEPE When Q E is sold at a price of P E, consumer surplus is A, and producer surplus is B. A B

Consumer & producer surplusslide 11 Notice on the previous slide that at the market equilibrium the sum of producer and consumer surplus (welfare) is maximized.

Consumer & producer surplusslide 12 S D Q P Q* P* Suppose Q' is sold at a price P'. What's the effect on welfare compared to the market? Q' P"

Consumer & producer surplusslide 13 S D Q P QEQE PEPE Consumer surplus is A. Producer surplus is B plus C. Compared to the market, there is a loss of D plus E. (Note that producers gain B, while consumers lose B.) Q' P' A B E D C

The next (hidden) slide shows the effects on welfare of producing less than the market amount. Hidden slide

Consumer & producer surplusslide 15 What happens to welfare when less than the free market amount is produced? D Q0 S D S PP Q Q Q1 P' Starting consumer surplus Starting producer surplus New output New consumer surplusNew producer surplus

Consumer & producer surplusslide 16 What if MORE than the market equilibrium quantity is produced? S D Q P QEQE PEPE Q' P'

Consumer & producer surplusslide 17 What if MORE than the market equilibrium quantity is produced? S D Q P Q' P' F E C B A

Consumer & producer surplusslide 18 When Q' is sold at P': CS is A + E PS is (B + C) - (C + E + F) = B - E - F Therefore: CS +PS is A + B - F This is less than CS + PS in the market (= A + B).

Consumer & producer surplusslide 19 Conclusion If the demand curve (willingness to pay) is a good measure of the value of a good, and if the supply curve (the firm's cost) is a good measure of the cost to society to produce a good, then the best amount of the good to produce is where supply and demand are equal.