Harcourt Brace & Company Chapter 7 Consumers, Producers and the Efficiency of Markets

Harcourt Brace & Company Market Equilibrium Revisited Does the equilibrium price and quantity result in the maximum total welfare of buyer and seller? S D PEPE QEQE

Harcourt Brace & Company Market Equilibrium Revisited Does the equilibrium price and quantity result in the maximum total welfare of buyer and seller? u Market equilibrium illustrates the way markets allocate scarce resources. But does it answer whether that market allocation is desirable? We can turn to Welfare Economics to answer the question.

Harcourt Brace & Company Welfare Economics u Welfare economics is the study of how the allocation of resources affects economic well being. –Buyers and sellers receive benefits from taking part in the market. –The equilibrium in a market makes the sum of these benefits as large as possible.

Harcourt Brace & Company Welfare Economics u Equilibrium in the market results in maximum benefits, and therefore total welfare for both the buyer and the seller. u Welfare Economics from the Buyer Side and the Seller Side: –Consumer Surplus –Producer Surplus

Harcourt Brace & Company Welfare Economics: Consumer Surplus u Market Demand Curve: depicts the various quantities that buyers would want to purchase at different prices. u What determines how much a consumer would be willing to pay (the maximum price) for a good or service? –Answer: The expected benefits received or Utility.

Harcourt Brace & Company Utility is... … the satisfaction (benefit) that a consumer expects to receive from consuming a good or service. …the power to satisfy a want.

Harcourt Brace & Company Marginal Utility (MU) is... …the amount of utility (satisfaction) that one more unit of consumption adds to total utility. –Consumers try to obtain the largest possible total satisfaction (utility) from the mix of goods and services they buy with their incomes.

Harcourt Brace & Company Consumer Surplus is... …the maximum amount a consumer will be willing to pay for a good depends upon the expected utility (benefits) of that good. –Willingness to Pay: v The maximum price that a buyer is willing and able to pay for a good. v Measures how much the buyer values the good or service.

Harcourt Brace & Company Consumer Surplus: Verbal Definition u The amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. D

Harcourt Brace & Company Consumer Surplus: Graphical S D P max PEPE QEQE

Harcourt Brace & Company Consumer Surplus: Graphical S D P max PEPE QEQE Consumer Surplus

Harcourt Brace & Company Consumer Surplus and Market Price u The area below the demand curve and above the market price measures the consumer surplus in a market. Hence, –A lower market price will increase consumer surplus –A higher market price will reduce consumer surplus

Harcourt Brace & Company D $11 6 $10 $9 $8 $7 $ CONSUMER SURPLUS Consumers Expense

Harcourt Brace & Company Producer Surplus u Market Supply Revisited: –Depicts the various quantities that suppliers would be willing to sell at different prices. –May be viewed as a measure of supplier costs, i.e.. the opportunity cost to the seller of supplying various quantities of the good.

Harcourt Brace & Company Producer Surplus: Verbal Definition u The amount a seller is paid minus the cost of production. u Producer surplus measures the benefit to sellers of participating in a market. S

Harcourt Brace & Company Producer Surplus: Graphical S D PEPE QEQE

Harcourt Brace & Company Producer Surplus: Graphical S D PEPE QEQE Producer Surplus

Harcourt Brace & Company S $6 6 $5 $4 $3 $2 $ Producer Surplus Producer Costs

Harcourt Brace & Company Market Efficiency u Under the assumptions of perfect competition and no externalities, the economic well-being of a society is measured as the sum of consumer surplus and producer surplus. u Market Efficiency is attained when total surplus is maximized, a point where resource allocation is efficient.

Harcourt Brace & Company Market Efficiency S D PEPE

Harcourt Brace & Company Market Efficiency S D PEPE Consumer Surplus Producer Surplus

Harcourt Brace & Company Market Efficiency: Three observations 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 can produce them at least cost. u Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

Harcourt Brace & Company Market Efficiency: Invisible Hand u In a free market system the many buyers and sellers are interested in their own well-being, self-interest. u 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. u As if by an Invisible Hand, the free market system reaches efficiency.

Harcourt Brace & Company Market Failure u If a market system affects individuals other than buyers and sellers of that market, side-effects are created and called Externalities. –Benefits or costs imposed on a third party who is not the consumer or the producer. u Externalities cause markets to be inefficient, and thus fail.