Welfare economicsslide 1 Analysis of Competitive Markets In this section, we examine the social welfare implications of competitive markets. The approach taken here (and not the only one possible), is to use the devices of Producer and Consumer Surplus. The social welfare from the production and consumption of a particular amount of a good is assumed to be the sum of the producer and consumer surplus.

Welfare economicsslide 2 Optimality of competitive markets The principal claim is that social welfare (the sum of producer and consumer surplus) is maximized at the competitive price and quantity for a good. A series of examples are worked to show that a variety of policies and regulations, such as price fixing, taxes, and subsidies, will, in general, reduce social welfare from its maximum.

Welfare economicsslide 3 Key terms Willingness to pay: The maximum amount a buyer will pay for an amount of a good. Consumer surplus: A buyer's willingness to pay minus the amount actually paid. Cost: The value of everything a seller must give up to produce an amount of a good. Producer surplus: The amount the seller receives for the good minus the cost.

Welfare economicsslide 4 Consumer surplus can be measured using the demand curve for a product. Demand for tacos D Q* Q P P*

Welfare economicsslide 5 When Q* is sold, willingness to pay is the shaded area. Demand for tacos D Q* Q P P*

Welfare economicsslide 6 When Q* is sold at a price P*, consumers pay P* times Q*. Demand for tacos D Q* Q P P* Cost to consumers Consumer surplus 1) Click to see the cost to consumers. 2) Click again to see the shaded area that is consumer surplus.

Welfare economicsslide 7 Producer surplus can be measured using the supply curve for a product. Supply of tacos S Q' Q P P'

Welfare economicsslide 8 The shaded area is the cost of producing Q' of tacos. If the firm can sell at P', the total receipts are P' times Q'. Supply of tacos Q' Q P P' 1)Click to see the total revenue. 2) Click again to see the costs. Total revenue Costs

Welfare economicsslide 9 So producer surplus is the shaded area. Supply of tacos S Q' Q P P'

Welfare economicsslide 10 S D Q P QEQE PEPE When Q E is sold at a price of P E, consumer surplus is A, and producer surplus is B. A B

Welfare economicsslide 11 Notice on the previous slide that at the market equilibrium the sum of producer and consumer surplus (welfare) is maximized.

Welfare economicsslide 12 S D Q P Q* P* Suppose Q' is sold at a price P'. What's the effect on welfare compared to the market? Q' P"

Welfare economicsslide 13 S D Q P QEQE PEPE Consumer surplus is A. Producer surplus is B plus C. Compared to the market, there is a loss of D plus E. (Note that producers gain B, while consumers lose B.) Q' P' A B E D C

The next (hidden) slide shows the effects on welfare of producing less than the market amount. Click for hidden slide

Welfare economicsslide 15 What happens to welfare when less than the free market amount is produced? D Q0Q0 S D Q0Q0 S PP Q Q Q1Q1 P' Starting consumer surplus Starting producer surplus New output New consumer surplusNew producer surplus

Welfare economicsslide 16 What if MORE than the market equilibrium quantity is produced? S D Q P QEQE PEPE Q' P'

Welfare economicsslide 17 What if MORE than the market equilibrium quantity is produced? S D Q P Q' P' F E C B A

Welfare economicsslide 18 When Q' is sold at P': CS is A + E PS is (B + C) - (C + E + F) = B - E - F Therefore: CS +PS is A + B - F This is less than CS + PS in the market (= A + B).

Welfare economicsslide 19 What happens to welfare when more than the free market amount is produced? D Q0Q0 S D Q0Q0 S PP Q Q Q1Q1 P' Starting consumer surplus Starting producer surplus New output New producer surplus (2 parts, + and –. minus New consumer surplus. Wipes out only part of the loss Welfare loss

Welfare economicsslide 20 Conclusion If the demand curve (willingness to pay) is a good measure of the value of a good, and if the supply curve (the firm's cost) is a good measure of the cost to society to produce a good, then the best amount of the good to produce is where supply and demand are equal.