Principles of Micro Chapter 7: “Consumers, Producers, and the Efficiency of Markets” by Tanya Molodtsova, Fall 2005

We Will Learn: the link between buyers’ willingness to pay for a good and the demand curve the link between buyers’ willingness to pay for a good and the demand curve how to define and measure consumer surplus how to define and measure consumer surplus the link between sellers’ costs of producing a good and the supply curve the link between sellers’ costs of producing a good and the supply curve how to define and measure producer surplus how to define and measure producer surplus that the equilibrium of supply and demand maximizes total surplus in a market that the equilibrium of supply and demand maximizes total surplus in a market

Revisiting the Market Equilibrium Do the equilibrium price and quantity maximize the total welfare of buyers and sellers? Do the equilibrium price and quantity maximize the total welfare of buyers and sellers? Market equilibrium reflects the way markets allocate scarce resources. Market equilibrium reflects the way markets allocate scarce resources. Whether the market allocation is desirable can be addressed by welfare economics. Whether the market allocation is desirable can be addressed by welfare economics.

Welfare Economics welfare economics: the study of how the allocation of resources affects economic well-being. welfare economics: the study of how the allocation of resources affects economic well-being. Buyers and sellers receive benefits from taking part in the market. Buyers and sellers receive benefits from taking part in the market. The equilibrium in a market maximizes the total welfare of buyers and sellers The equilibrium in a market maximizes the total welfare of buyers and sellers

Welfare Economics Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product. Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product. Consumer surplus measures economic welfare from the buyer’s side. Consumer surplus measures economic welfare from the buyer’s side. Producer surplus measures economic welfare from the seller’s side. Producer surplus measures economic welfare from the seller’s side.

Consumer Surplus willingness to pay: the maximum amount that a buyer will pay for a good. willingness to pay: the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good or service. It measures how much the buyer values the good or service. consumer surplus: a buyer’s willingness to pay minus the amount the buyer actually pays. consumer surplus: a buyer’s willingness to pay minus the amount the buyer actually pays.

Four Possible Buyers’ Willingness to Pay

Consumer Surplus The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices.

The Demand Schedule and the Demand Curve

Price of Album 0Quantity of Albums Demand 1234 $100 John’s willingness to pay 80 Paul’s willingness to pay 70 George’s willingness to pay 50 Ringo’s willingness to pay

Measuring Consumer Surplus with the Demand Curve (a) Price = $80 Price of Album $100 Demand 1234 Quantity of Albums John’s consumer surplus ($20)

Measuring Consumer Surplus with the Demand Curve (b) Price = $70 Price of Album $100 Demand 1234 Total consumer surplus ($40) Quantity of Albums John’s consumer surplus ($30) Paul’s consumer surplus ($10)

Using Demand Curve to Measure Consumer Surplus The area below the demand curve and above the price measures the consumer surplus in the market. The area below the demand curve and above the price measures the consumer surplus in the market.

How the Price Affects Consumer Surplus Consumer surplus Quantity (a) Consumer Surplus at Price P Price 0 Demand P1P1 Q1Q1 B A C

How the Price Affects Consumer Surplus Copyright©2003 Southwestern/Thomson Learning Initial consumer surplus Quantity (b) Consumer Surplus at Price P Price 0 Demand A B C DE F P1P1 Q1Q1 P2P2 Q2Q2 Consumer surplus to new consumers Additional consumer surplus to initial consumers

What Does Consumer Surplus Measure? Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it. Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it.

Producer Surplus Producer surplus is the amount a seller is paid for a good minus the seller’s cost. Producer surplus is the amount a seller is paid for a good minus the seller’s cost. It measures the benefit to sellers participating in a market. It measures the benefit to sellers participating in a market. cost: the value of everything a seller must give up to produce a good. cost: the value of everything a seller must give up to produce a good.

The Cost of Four Possible Sellers

Using Supply Curve to Measure Producer Surplus Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve. Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve.

The Supply Schedule and the Supply Curve

Using Supply Curve to Measure Producer Surplus The area below the price and above the supply curve measures the producer surplus in a market. The area below the price and above the supply curve measures the producer surplus in a market.

Measuring Producer Surplus with the Supply Curve Quantity of Houses Painted Price of House Painting $ (a) Price = $600 Supply Grandma’s producer surplus ($100)

Measuring Producer Surplus with the Supply Curve Quantity of Houses Painted Price of House Painting $ (b) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Grandma’s producer surplus ($300) Supply

How a Higher Price Raises Producer Surplus As price rises, producer surplus increases for two reasons : As price rises, producer surplus increases for two reasons : 1. Those already selling the product will receive additional producer surplus because they are receiving more for the product than before 2. Since the price is now higher, some new sellers will enter the market and receive producer surplus on these additional units of output sold

How the Price Affects Producer Surplus Producer surplus Quantity (a) Producer Surplus at Price P Price 0 Supply B A C Q1Q1 P1P1

How the Price Affects Producer Surplus Quantity (b) Producer Surplus at Price P Price 0 P1P1 B C Supply A Initial producer surplus Q1Q1 P2P2 Q2Q2 Producer surplus to new producers Additional producer surplus to initial producers D E F

Market Efficiency Consumer surplus and producer surplus may be used to address the following question: Consumer surplus and producer surplus may be used to address the following question: Is the allocation of resources determined by free markets in any way desirable? Is the allocation of resources determined by free markets in any way desirable? Consumer Surplus = Value to Buyers – Amount Paid by Buyers Producer Surplus = Amount Received by Sellers - Cost to Sellers

Market Efficiency The economic well-being of everyone in society can be measured by total surplus The economic well-being of everyone in society can be measured by total surplus Total Surplus = Consumer Surplus + Producer Surplus Total Surplus = Consumer Surplus + Producer Surplus Total Surplus = (Value to Buyers – Amount Paid by Buyers) + Total Surplus = (Value to Buyers – Amount Paid by Buyers) + (Amount Received by Sellers – Costs of Sellers) (Amount Received by Sellers – Costs of Sellers) Because Amount Paid By Buyers = Amount Received By Sellers, Because Amount Paid By Buyers = Amount Received By Sellers, Total Surplus = Value to Buyers - Costs of Sellers Total Surplus = Value to Buyers - Costs of Sellers

Market Efficiency efficiency: the property of a resource allocation of maximizing the total surplus received by all members of society efficiency: the property of a resource allocation of maximizing the total surplus received by all members of society In addition to market efficiency, a social planner might also care about equity: the fairness of the distribution of well-being among the members of society. In addition to market efficiency, a social planner might also care about equity: the fairness of the distribution of well-being among the members of society.

Consumer and Producer Surplus in the Market Equilibrium Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E

Evaluating the Market Equilibrium At the market equilibrium price: At the market equilibrium price: Buyers who value the product more than the equilibrium price will purchase the product. In other words, the free market allocates the supply of a good to the buyers who value it most highly. Buyers who value the product more than the equilibrium price will purchase the product. In other words, the free market allocates the supply of a good to the buyers who value it most highly. 1. Sellers whose costs are less than the equilibrium price will produce the product. In other words, the free market allocates the demand for goods to the sellers who can produce it at the lowest cost.

Evaluating the Market Equilibrium Total surplus is maximized at the market equilibrium Total surplus is maximized at the market equilibrium Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

Total surplus is maximized at the market equilibrium Quantity Price 0 Supply Demand Cost to sellers Cost to sellers Value to buyers Value to buyers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. Equilibrium quantity

Total surplus is maximized at the market equilibrium At any quantity of output smaller than the equilibrium quantity, the value of the product to buyers is greater than the cost to sellers so total surplus would rise if output increases At any quantity of output smaller than the equilibrium quantity, the value of the product to buyers is greater than the cost to sellers so total surplus would rise if output increases At any quantity of output greater than the equilibrium quantity, the value of the product to buyers is less than the cost to sellers so total surplus would rise if output decreases. At any quantity of output greater than the equilibrium quantity, the value of the product to buyers is less than the cost to sellers so total surplus would rise if output decreases.

Evaluating the Market Equilibrium Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it. Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it. This policy of leaving well enough alone goes by the French expression laissez faire. This policy of leaving well enough alone goes by the French expression laissez faire.

Evaluating the Market Equilibrium To conclude that markets are efficient, we made several assumptions about how markets worked: To conclude that markets are efficient, we made several assumptions about how markets worked: 1. Perfectly competitive markets. 2. No externalities.

Evaluating the Market Equilibrium Market Power Market Power If a market system is not perfectly competitive, market power may result. If a market system is not perfectly competitive, market power may result. Market power is the ability to influence prices. Market power is the ability to influence prices. Market power can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand. Market power can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand.

Evaluating the Market Equilibrium Externalities Externalities created when a market outcome affects individuals other than buyers and sellers in that market. created when a market outcome affects individuals other than buyers and sellers in that market. cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers. cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers. When buyers and sellers do not take externalities into account when deciding how much to consume and produce, the equilibrium in the market can be inefficient. When buyers and sellers do not take externalities into account when deciding how much to consume and produce, the equilibrium in the market can be inefficient.

Summary Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it. Consumer surplus equals buyers’ willingness to pay for a good minus the amount they actually pay for it. Consumer surplus measures the benefit buyers get from participating in a market. Consumer surplus measures the benefit buyers get from participating in a market. Consumer surplus can be computed by finding the area below the demand curve and above the price. Consumer surplus can be computed by finding the area below the demand curve and above the price.

Summary Producer surplus equals the amount sellers receive for their goods minus their costs of production. Producer surplus equals the amount sellers receive for their goods minus their costs of production. Producer surplus measures the benefit sellers get from participating in a market. Producer surplus measures the benefit sellers get from participating in a market. Producer surplus can be computed by finding the area below the price and above the supply curve. Producer surplus can be computed by finding the area below the price and above the supply curve.

Summary An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes. Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes.

Summary The equilibrium of demand and supply maximizes the sum of consumer and producer surplus. The equilibrium of demand and supply maximizes the sum of consumer and producer surplus. This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. Markets do not allocate resources efficiently in the presence of market failures. Markets do not allocate resources efficiently in the presence of market failures.