CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS A.S.Akat EC101- Chapter 7 PART THREE SUPPLY AND DEMAND – II MARKETS AND WELFARE CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS Chapter 7 1 1

A.S.Akat EC101- Chapter 7 What did we learn so far? Part One introduced us to some basic concepts as well as tools of economics as a science Ten principles (Ch.1) Thinking like an economist (Ch.2) Exchange and trade (Ch.3) Part Two introduced us to markets and how they work through the forces of supply and demand Supply and Demand (Ch.4) Elasticities (Ch.5) Markets and government policies (Ch.6) Part Three looks on the welfare implications of the market system

What do we learn in this part? A.S.Akat EC101- Chapter 7 What do we learn in this part? We search for an answer to the following question Are markets a good way to organise the social process of production? To answer it we develop the concepts of consumer surplus, producer surplus and total surplus They allow us to explain market efficiency We then apply our new tools to understand the costs of taxation and the benefits of international trade Part Three is made of Ch.7 : Consumers, producers and market efficiency Ch.8 : Application: Costs of taxation Ch.9 : Application: International trade

Market equilibrium revisited A.S.Akat EC101- Chapter 7 Market equilibrium revisited Market equilibrium reflects the way markets allocate scarce resources Supply and demand determines the equilibrium price and quantity for each good Thus the resources that goes into its production as well as who shall benefit from its consumption The next question is to find out if the equilibrium price and quantity maximize the total welfare of buyers and sellers? Welfare economics answers this question And determines whether the market allocation is desirable or not from the perspective of society 3 2

A.S.Akat EC101- Chapter 7 Welfare economics Welfare economics study how the allocation of resources affects economic well-being in society It uses a new concept called “surplus” And shows that buyers and sellers both receive benefits from taking part in the market Therefore the equilibrium in a market maximizes the total welfare of buyers and sellers Consumer surplus measures economic welfare from the buyer side Producer surplus measures economic welfare from the seller side Together they allow us to evaluate the allocation of scarce resources by markets 4 3

A.S.Akat EC101- Chapter 7 Willingness to pay Willingness to pay is the maximum price that a buyer is willing and able to pay for a good or service It corresponds to the value attributed by the buyer to the good or service demanded The willingness to pay cannot always be directly measured in the market but it is still there How much a buyer will be willing to pay for a good or service is the maximum price at which he/she will purchase that good or service What determines the maximum price? The benefits that the buyer expect to receive from the consumption of that good or service 9 6

A.S.Akat EC101- Chapter 7 Consumer surplus Consumer surplus is the key concept of welfare economics The market demand curve shows the various quantities that buyers would be willing and able to purchase at different prices As the price goes down, the quantity bought goes up Consumer surplus is the difference between the willingness to pay for the good or service and the actual spending for it Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it 6 8

Willingness to pay with four possible buyers A.S.Akat EC101- Chapter 7 Willingness to pay with four possible buyers 11 10

Willingness to pay with four possible buyers A.S.Akat EC101- Chapter 7 Willingness to pay with four possible buyers 11 11

Measuring consumer surplus with the demand curve A.S.Akat EC101- Chapter 7 Measuring consumer surplus with the demand curve Price of Album $100 John’s consumer surplus ($30) 80 Paul’s consumer surplus ($10) 70 Total consumer surplus ($40) 50 Demand 1 2 3 4 Quantity of Albums 13 18

Consumer surplus, demand and price A.S.Akat EC101- Chapter 7 Consumer surplus, demand and price Consumer surplus is the area that lies below the demand curve and above the market price Consumer surplus depends on the demand curve, which represents the willingness to pay And the market price which represents market equilibrium Ceteris paribus, changes in price and demand affect consumer surplus Lower market price increases consumer surplus Higher market price reduces consumer surplus Higher demand increases consumer surplus Lower demand reduces consumer surplus 15 19

How the price affects consumer surplus Initial consumer surplus C Consumer surplus P1 B to new consumers F P2 D E Additional consumer surplus to initial Demand consumers Q1 Q2 Quantity 17 28

A.S.Akat EC101- Chapter 7 Willingness to sell We can now apply the concept of surplus to the producers Market supply curve shows the various quantities that producers would be willing and able to sell at different prices It may be seen as a measure of supplier costs, that is, the opportunity cost of supplying various quantities of the good. The marginal opportunity cost of production increases as market output expands Because a producer’s cost is the lowest price he/she will accept, cost is a measure of his/her willingness to sell 22 32

A.S.Akat EC101- Chapter 7 Producer surplus Producer surplus is the symetric image of consumer surplus on the supply curve It is measured by the difference between the willingness to sell of the producers for a good or service and the actual revenue they receive from it Producer surplus is therefore the amount a seller is paid minus the cost of production of the good or service It is the area that lies above the supply curve and below the price line Producer surplus measures the benefit to sellers of participating in a market 24 34

The costs of four possible sellers A.S.Akat EC101- Chapter 7 The costs of four possible sellers 11 35

Supply schedule with four possible sellers A.S.Akat EC101- Chapter 7 Supply schedule with four possible sellers 11 36

Measuring producer surplus with the supply curve A.S.Akat EC101- Chapter 7 Measuring producer surplus with the supply curve Price of House Painting Supply Total producer surplus ($500) $900 800 Georgia’s producer surplus ($200) 600 500 Grandma’s producer surplus ($300) 1 2 3 Quantity of Houses Painted 26 43

How price affects producer surplus A.S.Akat EC101- Chapter 7 How price affects producer surplus Price Additional producer surplus to initial producers Supply D E P2 F B P1 C Initial producer surplus Producer surplus to new producers A Q1 Q2 Quantity 26 52

A.S.Akat EC101- Chapter 7 Market efficiency The sum of consumer surplus and producer surplus is a good measure of the well-being of society A market with perfect competition and without externatilities maximises society’s well-being Consumer surplus = value to buyers – amount paid by buyers Produces surplus = amount received by sellers – cost to sellers Total surplus = value to buyers – cost to sellers Market efficiency is attained when the allocation of resources maximizes total surplus Competitive markets are therefore efficient 32 53

Efficiency versus equity A.S.Akat EC101- Chapter 7 Efficiency versus equity It is very important to understand the limitations of the word “efficiency” In an efficient solution, nobody can be better off without someone else becoming worse off If it possible to increase one person’s well-being without reducing that of the others the solution is clearly inefficient But efficiency does not mean equity nor equality Our sense of fairness may not be satisfied with an efficient situation which corresponds to a very unequal distribution of well-being among members of society Equity is also very important for society 32 53

Consumer and producer surplus in the market equilibrium A.S.Akat EC101- Chapter 7 Consumer and producer surplus in the market equilibrium Price Equilibrium price Quantity quantity A Supply C B Demand D Producer surplus Consumer E 33 58

Efficiency of equilibrium A.S.Akat EC101- Chapter 7 Efficiency of equilibrium Quantity Price Equilibrium quantity Supply Demand Cost to sellers Value buyers Value to buyers is greater than cost to sellers. Value to buyers is less

Market efficiency: three observations A.S.Akat EC101- Chapter 7 Market efficiency: three observations Welfare economics allow us to evaluate the meaning and benefits of a market economy for the society We highlight three aspects that makes the market economy desirable for society Free and competitive markets allocate the supply of goods to the buyers who value them most highly Free and competitive markets allocate the demand for goods to the sellers who can produce them at least cost Free and competitive markets produce the quantity of goods that maximizes the sum of consumer and producer surplus 35 59

Market as an “invisible hand” A.S.Akat EC101- Chapter 7 Market as an “invisible hand” In a free market there is no centralised social authority to allocate scarce resources The many buyers and sellers in a market economy are motivated by self-interest, not by altruism A process of coordination and communication takes place so that buyers and sellers are directed to the most efficient outcome As if by an invisible hand, the free market system reaches efficiency Scottish economist Adam Smith first coined the term “invisible hand” in his book The Wealth of Nations, published in 1776 36 62

Tickets on the sidewalk A.S.Akat EC101- Chapter 7 Tickets on the sidewalk Let us look at an interesting example Assume you decide to go to a show or a football game at the last minute? Your only chance is to go to the theater or the stadium with the hope that someone will be selling tickets But you have to pay a higher price Is it “black market”? Or is it a service? For the economist the enterpreneurs who buy tickets in advance to sell them with profit at the door take risks which explain their profits The economist will be worried about whether they pay or not income tax on this income

Market failure: market power and externalities A.S.Akat EC101- Chapter 7 Market failure: market power and externalities Market power is the ability of one buyer or seller to control market price Market power reduces total surplus It is called market failure because it causes markets to be inefficient Externalities are the benefits or costs imposed on a third party who is not the consumer or the producer Such as the cost of pollution to the society which is not included in the price of the good Externalities result in lower total surplus Causing markets to be inefficient, and thus fail 38 67

A.S.Akat EC101- Chapter 7 Conclusion Welfare economics evaluate the market from the perspective of society Consumer and producer surplus measures the benefits of buyers and sellers from participating in the market An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient Policymakers are concerned with efficiency and also equity Market power and externalities can cause markets to be inefficient and to fail