Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Welfare Economics u Buyers and sellers gain from the market. u The total welfare of buyers and sellers is maximized at market equilibrium.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Welfare Economics u Consumer surplus measures economic welfare from the buyer’s side. u Producer surplus measures economic welfare from the seller’s side.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Consumer Surplus Consumer surplus is what a buyer is willing to pay for a good minus the amount she actually pays for it … the market price.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Four Possible Buyers’ Willingness to Pay...

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album $ Quantity of Albums John’s willingness to pay Paul’s willingness to pay George’s willingness to pay Ringo’s willingness to pay Demand

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album $ Quantity of Albums Demand John’s consumer surplus ($20) Price = $80

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album $ Quantity of Albums Demand John’s consumer surplus ($30) Total consumer surplus ($40) Price = $70 Paul’s consumer surplus ($10)

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve The area below the demand curve and above the price measures the consumer surplus in the market.

Q2Q2 P2P2 How the Price Affects Consumer Surplus... Quantity Price 0 Demand Copyright © 2001 by Harcourt, Inc. All rights reserved Initial consumer surplus Additional consumer surplus to initial consumers Consumer surplus to “new” consumers Q1Q1 P1P1 DE F B C A

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Producer Surplus u Producer surplus is the amount a seller is paid … the market price … minus the cost of production. u Producer surplus measures the benefit to sellers participating in a market.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Costs of Four Possible Sellers...

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Producer Surplus and the Supply Curve... Quantity of Houses Painted Price of House Painting $ Grandma’s cost Georgia’s cost Frida’s cost Mary’s cost Supply

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting $ Supply Grandma’s producer surplus ($100) Price = $600

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting $ Supply Grandma’s producer surplus ($300) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500)

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. P2P2 Q2Q2 How Price Affects Producer Surplus... Quantity Price 0 Supply Q1Q1 P1P1 A B C Initial Producer surplus Additional producer surplus to initial producers D E F Producer surplus to new producers

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Well-Being and Total Surplus and Consumer Surplus = Value to buyers _ Amount paid by buyers Producer Surplus = Amount received by sellers _ Cost to sellers

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economic Well-Being and Total Surplus or Total Surplus = Value to buyers _ Cost to sellers Total Surplus = Consumer Surplus Producer Surplus +

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Consumer and Producer Surplus in the Market Equilibrium... Price Equilibrium price 0Quantity Equilibrium quantity A Supply C B Demand D E Producer surplus Consumer surplus

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Price 0 Quantity Equilibrium quantity Supply Demand Cost to sellers Value to buyers Cost to sellers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. The Efficiency of the Equilibrium Quantity

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Insights About Market Outcomes u Free markets allocate the supply of goods to the buyers who value them most highly. u Free markets allocate the demand for goods to the sellers who produce them at least cost. u Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Market Power Market power is the ability to influence prices. Monopoly firms and unions have market power. Market power can cause markets to be inefficient. uIt keeps price and quantity from the competitive equilibrium of supply and demand.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Externalities Externalities occur when a market outcome affects individuals other than buyers and sellers. u When buyers and sellers do not take external costs or benefits of their actions into account, the equilibrium in the market can be inefficient.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Consumer surplus measures the benefit buyers get from participating in a market. u Consumer surplus can be computed by finding the area below the demand curve and above the price.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Producer surplus measures the benefit sellers get from participating in a market. u Producer surplus can be computed by finding the area below the price and above the supply curve.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u The equilibrium of demand and supply maximizes the sum of consumer and producer surplus. u This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. u Markets do not allocate resources efficiently in the presence of market failures.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. u Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Graphical Review

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album $ Quantity of Albums John’s willingness to pay Paul’s willingness to pay George’s willingness to pay Ringo’s willingness to pay Demand

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album $ Quantity of Albums Demand John’s consumer surplus ($20) Price = $80

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album $ Quantity of Albums Demand John’s consumer surplus ($30) Total consumer surplus ($40) Price = $70 Paul’s consumer surplus ($10)

How the Price Affects Consumer Surplus... Q2Q2 P2P2 Quantity Price 0 Demand Copyright © 2001 by Harcourt, Inc. All rights reserved Initial consumer surplus Additional consumer surplus to initial consumers Consumer surplus to new consumers Q1Q1 P1P1 B C A DE F

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Producer Surplus and the Supply Curve... Quantity of Houses Painted Price of House Painting $ Grandma’s cost Georgia’s cost Frida’s cost Mary’s cost Supply

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting $ Supply Grandma’s producer surplus ($100) Price = $600

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting $ Supply Grandma’s producer surplus ($300) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500)

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How Price Affects Producer Surplus... P2P2 Q2Q2 Quantity Price 0 Supply Q1Q1 P1P1 A B C Initial Producer surplus Additional producer surplus to initial producers D E F Producer surplus to new producers

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Evaluating the Market Equilibrium... Price Equilibrium price 0Quantity Equilibrium quantity A Supply C B Demand D E

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Consumer and Producer Surplus in the Market Equilibrium... Price Equilibrium price 0Quantity Equilibrium quantity A Supply C B Demand D E Producer surplus Consumer surplus

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Price 0 Quantity Equilibrium quantity Supply Demand Cost to sellers Value to buyers Cost to sellers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. The Efficiency of the Equilibrium Quantity