Consumers, Producers and the Efficiency of Markets Ratna K. Shrestha Chapter 7 Consumers, Producers and the Efficiency of Markets Ratna K. Shrestha 1 1 1 1 1

Overview Welfare Economics Consumer Surplus Producer Surplus Market Efficiency 2 8 15 15 8 2 2 2 2 8

Market Equilibrium Revisited P S D PE Does the equilibrium price and quantity result in the maximum total welfare of buyer and seller? QE Q 2 3 3 3 3

Market Equilibrium Revisited Market equilibrium illustrates the way markets allocate scarce resources. But does it answer whether that market allocation is desirable? Welfare Economics answers this question. The question is whether this allocation maximizes the combined welfare of both the consumers and producers. 4 3 4 4 4

Welfare Economics… ….Is the study of how the allocation of resources affects economic well being, the well being of the consumers and the sellers. Both buyers and sellers receive benefits from taking part in the market. A consumer’s benefits is … the satisfaction that he/she expects to receive from consuming a good or service. A producer’s benefit is usually its profits or surplus (defined later). 5 4 5 5 5

Marginal Benefit/Utility is ……the amount of benefit (satisfaction) that one more or one less unit of consumption adds to or subtracts from total benefits. A rational consumer tries to obtain the largest possible total benefits (utility) from the mix of goods and services they buy with their incomes. 10 8 10 10 10

Consumer Surplus Consumers buy goods because it makes them better off (or provide utility). Consumer Surplus measures how much better off they are. Consumer Surplus from each unit: The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.

Consumer Surplus - Example Assume a student wants to buy concert tickets. Demand curve tells us the student’s willingness to pay for each concert ticket 1st ticket worth $20 but price is $14 so student generates $6 worth of surplus. We can measure this for each ticket. Total surplus is sum of surplus from each ticket purchased.

Consumer Surplus - Example Price ($ per ticket) The consumer surplus of purchasing 6 concert tickets is the sum of the surplus derived from each one individually. 20 19 18 17 16 Consumer Surplus 6 + 5 + 4 + 3 + 2 + 1 = 21 15 14 Market Price 13 Will not buy more than 7 because surplus from additional ticket is negative 1 2 3 4 5 6 Rock Concert Tickets

Consumer Surplus The stepladder demand curve can be converted into a straight-line demand curve by making the units of the good smaller. Consumer surplus measures the total net benefit to consumers = total benefits from consumption minus the total expenses. Thus, consumer surplus is area under the demand curve and above the price. Note that the area under the demand curve up to the level of consumption measures the total benefits.

Consumer Surplus 20 Consumer Surplus 14 Market Price Actual ($ per ticket) 20 Demand Curve Consumer Surplus 14 Market Price Actual Expenditure 1 2 3 4 5 6 Rock Concert Tickets

Consumer Surplus: Graphical Pmax S Consumer Surplus PE D QE 14 16 16 16 16

$10 Total Consumer Benefits $9 $8 $7 $6 D 1 2 3 4 5 6 P Q 18 20 20 20

P $10 $9 $8 Consumer’s Expense $7 $6 D Q 1 2 3 4 5 6 19 21 21 21 21

P $10 Consumer Benefit - Consumer Expense CONSUMER SURPLUS! $9 $8 $51 - $36 = $15 $7 $6 D Q 1 2 3 4 5 6 20 22 22 22 22

Consumer Surplus and Market Price A lower market price will usually increase consumer surplus. A higher market price will usually reduce consumer surplus. Consumer surplus will be smaller when the demand curve is more elastic and larger when the demand curve is inelastic. 17 15 17 17 17

How the Price Affects Consumer Surplus? B C Consumer Surplus at Price P2 vs. at Price P1 Demand Initial consumer surplus Consumer surplus to new consumers P1 Q1 D E F P2 Q2 Additional consumer surplus to initial consumers Quantity Copyright©2003 Southwestern/Thomson Learning

Producer Surplus Market Supply depicts the various quantities that suppliers would be willing to sell at different prices. Supply curve can also be viewed as a measure of the marginal (opportunity) cost to the seller of supplying various quantities of the good. Assumption: The marginal (opportunity) cost of production increases as market output expands. Producer’s marginal cost of production is the lowest price he/she would accept. 25 22 25 25 25

Producer Surplus: Verbal Definition Producer Surplus is the amount a seller is paid minus the cost of production. Producer surplus measures the benefit to sellers of participating in a market. A producer might be willing to accept $3 (his/her MC of production) to supply the good but in fact gets $5 market price. In this case, producer gains a surplus of $2. 27 24 27 27 27

PS = ($6 x 6) - ($1 +$2 + $3 + $4 + $5 + $6) = $15 Q 1 2 3 4 5 6 29 32 32 32 32

Total Producer Benefits (Revenue) S $6 $5 $4 $3 $2 $1 1 2 3 4 5 6 P Q 30 33 33 33 33

Producer Surplus =$15 S $6 $5 $4 Producer Costs $3 $2 $1 1 2 3 4 5 6 P Q 1 2 3 4 5 6 31 34 34 34 34

Producer Surplus: Graphical PE Producer Surplus D Q QE 27 30 30 30 30

How the Price Affects Producer Surplus? Producer Surplus at Price P2 vs. at P1 Price Additional producer surplus to initial producers Supply D E F P2 Q2 Producer surplus to new producers B P1 C Initial producer surplus A Q1 Quantity Copyright©2003 Southwestern/Thomson Learning

Market Efficiency The economic well-being of a society is measured as the sum of consumer surplus and producer surplus. Market Efficiency is attained when total surplus is maximized, a point where resource allocation is efficient. 36 32 36 36 36

Market Efficiency Consumer Surplus S PE Producer Surplus D Q 38 34 38

Market Efficiency:Three observations 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. However note that free market achieves economic efficiency only under certain conditions (but not all the times). When market does not achieves efficiency, we call it market failure. 39 35 39 39 39

Market Efficiency: Invisible Hand In a free market system, many buyers and sellers are interested in their own self-interest. As market participants are motivated by self-interest 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. 40 36 40 40 40

Efficiency of the Equilibrium Quantity Price Supply Demand If Q < Q*, value to buyers > cost to sellers. So efficiency can be enhanced by increasing Q. Value to buyers Cost to sellers Equilibrium Quantity Q* Cost to sellers Value to buyers Quantity Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. Copyright©2003 Southwestern/Thomson Learning

The Invisible Hand and e-Commerce During the past few years, hundreds of Web sites have been established that are dedicated to facilitating trading in all types of goods, services, and factors of production. These e-commerce innovations are increasing consumer surplus, increasing producer surplus, and achieving yet greater allocative efficiency.

Are Mega-Mergers Efficient? Mergers enable firms to avoid duplication of activities and bring resources into one organization so that they can be used more efficiently. But do mergers result in a more efficient allocation of resources? Do they restrict output and produce less than the efficient quantity? Do mergers need to be scrutinized by the government and sometimes blocked?

Are Mega-Mergers Efficient? Mergers are efficient if they cut costs or if they bring marginal benefit closer to marginal cost. Mergers are inefficient if they raise costs or if they widen the gap between marginal benefit and marginal cost?

Does Ticket Scalping Enhance Efficiency? If we want to allocate scarce resources efficiently, it should get to the hands of those who value them most. Ticket Scalping helps to serve that purpose. Scalpers buy tickets to play, concerts, sports events and sell the tickets at a price above the original price and thus help to allocate the tickets to those who value them most. They may sometimes sell them even at lower than original price (if they happen to have excess tickets) to those who may not willing to pay higher prices.

Ticket Scalping

Market Failure If a market system is not competitive, control over prices leads to Market Power. Market Power refers to the ability by one buyer or seller to control market price. Monopoly. e.g., Microsoft, BC Hydro. Market Power causes markets to be inefficient, and thus fail. For example, monopoly prices are higher than competitive prices, and thus negatively affects consumers. The monopolist gains but by less than what consumers lose. Therefore monopoly reduces total surplus. 42 38 42 42 42

Market Failure If a consumption or production activity affects individuals other than buyers and sellers of that market, side-effects called externalities are created. e.g., pollution from a factory adversely affects people living nearby (third party). In a free market the polluter cares about its profits only and so produces (and hence pollutes) more than socially desirable. Thus free market with externality leads to inefficiency. 43 39 43 43 43

Market Failure Assume that smoking benefits the smoker by $10 but harms nonsmokers by $100. In a free market, the smoker cares about only himself and so will smoke. As a result the total surplus of the society (smoker plus the nonsmokers) reduces by $90. If there is no smoking (and hence externality), this loss in surpluses can be avoided. How can the government avoid this loss? 43 39 43 43 43