Consumers, Producers, and the Efficiency of Markets Outline:  Positive economics: Allocation of scarce resources using forces of demand and supply  Normative economics: Whether these allocations are desirable leads to the study of welfare economics  Welfare economics is the study of how the allocation of resources affects economic wellbeing  Examine the benefits that buyers and sellers receive from participating in the market  Willingness to pay is the maximum amount that a buyer will pay for a good

Consumer Surplus and Demand Curve  Consumer surplus is a buyer’s willingness to pay minus the amount the buyer actually pays  Using the willingness to pay of the buyers one can derive the demand schedule and the demand curve  The height of the demand curve shows the willingness to pay of the marginal buyer  Consumer surplus in a market is measured as the area below the demand curve and above the market price Consumer Surplus P Q DD

Consumer Surplus and Demand Curve  A lower price raises consumer surplus –Existing buyers see an increase in their consumer surplus due to a reduction in price –New buyers enjoy consumer surplus as they can now enter the market  Consumer surplus is a good measure of economic well-being and respects preferences of consumers. Is it always a good measure?  Important assumption in economics- consumers are rational

Producer Surplus and Supply Curve  Cost is the value of everything a seller must give up to produce. It includes the cost of raw materials and the opportunity cost (value of her time). Cost is a measure of the seller’s willingness to sell.  Producer surplus is the amount a seller is paid for a good minus the seller’s cost. It measures the benefit to the sellers for participating in a market.  The willingness to sell or cost is used to derive the supply schedule and graph the supply curve.

Producer Surplus and Supply Curve  The height of the supply curve measures the sellers’ costs. The price on the supply curve denotes the cost of the marginal seller  Producer surplus in a market is the area below the price and above the supply curve  A higher price raises producers surplus by –Existing producers receive a higher price –New producers enter the market at a higher price

Market Efficiency  Consumer surplus= value to buyers- amount paid by buyers  Producer surplus= amount received by sellers- cost to sellers  Therefore, market surplus= value to buyers- cost to sellers  If the allocation of resources maximizes total surplus then that allocation is efficient  Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society  Equity is the fairness of the distribution of well- being among the members of society

Market Efficiency  Free markets allocate the supply of goods to the buyers who value them most  Free markets allocate the demand for goods to the sellers who produce them at least cost  Free markets produce the quantity of goods that maximizes total surplus in the market  Conclusion: Free markets result in efficient market outcomes but are the market outcomes equitable?

Market Failure  Efficiency of markets is based on two major assumptions: –Markets are perfectly competitive –Market outcomes matter only to the buyers and sellers in the market  Assumptions are invalid in some cases and result in market failure- the inability of some unregulated markets to allocate resources efficiently  Causes for market failure –Existence of market power –Presence of externalities  Free markets produce the quantity of goods that maximizes total surplus in the market  Conclusion: Free markets result in efficient market outcomes but are the market outcomes equitable?