1. SUPPLY AND DEMAND II: MARKETS AND WELFARE3
SUPPLY AND DEMAND II: MARKETS AND WELFARE

2. Consumers, Producers, and the Efficiency of Markets7
Consumers, Producers, and the Efficiency of Markets

3. Revisiting The Market Equilibrium
The theory of supply and demand shows how markets allocate scarce resources among competing needs.
But are the equilibrium price and quantity the right price and the right quantity from society’s point of view?
Do they maximize the total welfare of buyers and sellers?
Whether or not the market outcome makes good use of our limited resources is the topic of welfare economics.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

4. Welfare Economics
Welfare economics is the study of how the allocation of resources affects economic well-being
It shows that:
Both buyers and sellers receive benefits from taking part in the market
The equilibrium outcome, which we saw in Chapter 4, maximizes the total welfare of buyers and sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

5. Welfare Economics: two main concepts
Consumer surplus measures economic welfare of the buyer.
Producer surplus measures economic welfare of the seller.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

6. Consumer Surplus How much does the buyer gain from a purchase?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

7. Willingness to pay
The buyer’s gain from a purchase is what he/she was willing to pay minus what he/she actually pays
Willingness to pay is the maximum amount that a buyer will pay for a good.
It measures how much the buyer values the good.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

8. Willingness to pay
Assume there is a commodity such that every additional unit of it increases a consumer’s happiness by an unchanging amount
In other words, the consumption of additional units of this commodity induces neither boredom nor addiction
Possible examples: Potato chips? Candy?
Then the consumer’s willingness to pay for a product is an accurate measure of the happiness that he or she gets from it
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

9. Willingness to pay continuation from previous slide
If a bag of potato chips provides an unchanging amount of happiness, and
if your willingness to pay is
4 bags of potato chips for a shirt and
2 bags for a cup of coffee, then
one can safely say that the shirt makes you twice as happy as the cup of coffee
In other words, your willingness to pay for a commodity is an accurate measure of how much you like that thing
For a given dollar price of a bag of potato chips, your willingness to pay can also be expressed in dollars
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

10. Willingness to pay continuation from previous slide For example,
if you are willing to pay $15 for a particular shirt, and
if a bag of potato chips always gives you 3 “haps” of happiness, and sells at the price of $0.50 each, then it must be that
the shirt gives you 90 “haps” of happiness.
In other words, your willingness to pay for the shirt is
a monetary measure of the happiness you get from the shirt, which is
proportional to the happiness you get from the shirt, as measured in “haps”
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

11. Table 1 Four Possible Buyers’ Willingness to Pay
For a mint-condition recording of Elvis Presley’s first album

12. Consumer Surplus
Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it.
Example: If the Elvis album’s price is $75…
Buyer
Willingness to Pay
Consumer Surplus
Buy?
John
100 25
Yes
Paul 80 5
George 70 No
Ringo 50

13. Willingness to Pay → Market Demand
The market demand schedule/curve shows the various quantities that buyers would be willing and able to purchase at different prices.
Chapter 4
We can use the willingness-to-pay numbers to calculate the quantities demanded at every price
That is, we can calculate the market demand (schedule/curve) from the willingness-to-pay numbers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

14. The Demand Schedule Buyer Willingness to Pay John 100 Paul 80 George70
Ringo 50
The Demand Schedule
Price ($)
Quantity Demanded
100 1 80 2 70 3 50 4

15. Figure 1 The Demand Curve
Buyer
Willingness to Pay
John
100
Paul 80
George 70
Ringo 50
Figure 1 The Demand Curve
Price of
Demand
Album
$100
John ’
s willingness to pay 80
Paul ’
s willingness to pay 70
George ’
s willingness to pay 50
Ringo ’
s willingness to pay
The height of the demand curve at any quantity shows the willingness to pay of whoever bought the last unit. 1 2 3 4
Quantity of
Albums
Copyright©2003 Southwestern/Thomson Learning

16. Area of a Rectangle Area = Width × Height Height Width
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

17. Figure 2 Measuring Consumer Surplus with the Demand Curve
Buyer
Willingness to Pay
Consumer Surplus
Buy?
John
100 20
Yes
Paul 80 No
George 70
Ringo 50
(a) Price = $80.01
Price of
Demand
Album
$100 80
1. The area under the demand curve measures the total willingness to pay for the quantity demanded. 70 50
2. It is also the maximum willingness to pay that could be generated from that quantity.
John’s willingness to pay ($100) 1 2 3 4
Quantity of
Albums

18. The market and the planner
Suppose the government has one copy of the Elvis album. The government’s goal is to give it to one of the four guys so as to generate the maximum happiness.
Who will get the government’s copy?
Obviously, John.
Lesson: The market does the best that the government could have done
Price = $80
Buyer
Willingness to Pay
John
100
Paul 80
George 70
Ringo 50
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

19. Figure 2 Measuring Consumer Surplus with the Demand Curve
Buyer
Willingness to Pay
Consumer Surplus
Buy?
John
100 30
Yes
Paul 80 10
George 70 No
Ringo 50
(b) Price = $70.01
Price of
Demand
Album
$100
1. The area under the demand curve measures the total willingness to pay for any quantity demanded. 80 70 50
2. It is also the maximum willingness to pay that could be generated from that quantity.
John’s willingness to pay
Paul’s willingness to pay 1 2 3 4
Quantity of
Albums

20. The market and the planner
Suppose the government has two copies of the Elvis album. The government’s goal is to give them to two of the four guys so as to generate the maximum happiness.
Who will get the government’s copies?
Obviously, John and Paul, same as in the market outcome.
Lesson: The market does the best that the government could have done
Buyer
Willingness to Pay
John
100
Paul 80
George 70
Ringo 50
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

21. Using the demand curve to measure willingness to pay
In general, the area under the demand curve up to the quantity demanded is a graphical measure of the total willingness to pay of the buyers.
It is also the maximum willingness to pay that can be obtained from that quantity
That is, the government could not give away that quantity in a way that generates higher willingness to pay.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

22. Willingness to Pay from the Demand Curve
Price A
Demand
1. The area under the demand curve measures the total willingness to pay for any quantity demanded. P1 Q1 B C
2. It is also the maximum willingness to pay that could be generated from that quantity.
Quantity

23. Interpersonal comparability
We just saw
that the total area under the demand curve is $180, and
that is also the total willingness to pay of John and Paul
But can we say it is the total happiness of John and Paul?
Yes,
if there is a commodity—say, a bag of potato chips—that provides an unchanging amount of happiness to the consumer, and
if John’s happiness and Paul’s happiness are comparable, and
if both John and Paul get the same happiness from a bag of potato chips
That’s a lot of if’s!
But we will make these simplifying assumption anyway
Not just for John and Paul, but for everybody
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

24. Utilitarianism The idea that
the happiness of an individual can be measured numerically,
the happiness of a group of people can be measured numerically,
the happiness of a group of people is simply the sum of the numbers representing the happiness of the individual members of the group, and that
social policy should seek to maximize the total happiness of society,
is called utilitarianism
The welfare analysis in this chapter takes utilitarianism as its guiding philosophy
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

25. Figure 3 How the Price Affects Consumer Surplus
(a) Consumer Surplus at Price P
Price A
Consumer
surplus
Demand
Consumer Surplus (ABC) + Total Payment (OBCQ1) = Willingness to Pay (OACQ1) P1 Q1 B C
Total Payment
Quantity

26. Using the Demand Curve to Measure Consumer Surplus
In general, the area below the demand curve and above the price measures the consumer surplus.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

27. Figure 3 How the Price Affects Consumer Surplus
(b) Consumer Surplus at Price P
Price A B C
Initial
consumer
surplus
Demand
Consumer surplus
to new consumers P1 Q1 D E F P2 Q2
Additional consumer
surplus to initial
consumers
Quantity

28. Producer surplus How much does a seller gain from a sale?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

29. Producer Surplus
Producer surplus is the amount a seller is paid for a good minus the seller’s cost.
It measures the net benefit to sellers
It is almost, but not quite, the same as profit.
We’ll discuss the minor distinction between producer surplus and profit later
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

30. Cost of production
The cost of production is the market value of all resources used in production
By all, I do mean all. Even if some resources used in production were obtained for free, their market value must be included in cost.
This will be discussed further in Chapter 13 (The Costs of Production)
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

31. Table 2 The Cost of Painting a Standard House for Four House Painters

32. Costs → Market Supply Seller Cost ($) Mary 900 Frida 800 Georgia 600
Grandma
500
Price ($)
Quantity Supplied
900 4
800 3
600 2
500 1
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

33. Figure 4 The Supply Schedule and the Supply Curve
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma
500
The height of the supply curve at any quantity shows the production cost to whoever supplies the last unit.

34. Producer Surplus
Producer surplus is the amount a seller is paid minus the seller’s cost
Example: If the going price for getting a house painted is $700 we get the following table.
Seller
Cost ($)
Producer Surplus
Sell?
Mary
900 No
Frida
800
Georgia
600
100
Yes
Grandma
500
200
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

35. Using the Supply Curve to Measure Producer Surplus
The area below the price and above the supply curve measures the producer surplus.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

36. Figure 5 Measuring Producer Surplus with the Supply Curve
(a) Price = $599.99
1. The area under the supply curve is the cost of the quantity supplied
Price of
House
Supply
Painting
2. It is also the lowest cost at which that quantity could be produced
$900
800
Seller
Cost ($)
Producer Surplus
Sell?
Mary
900 No
Frida
800
Georgia
600
Grandma
500
100
Yes
600
500
Grandma’s Cost ($500) 1 2 3 4
Quantity of
Houses Painted

37. Is there a better alternative to the market system?
If the government had to get one house painted, who would get the job?
Grandma, of course, if the government had any sense.
And that’s exactly what happens in the market outcome.
Lesson: The market achieves the best that the government could have achieved
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma
500
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

38. Figure 5 Measuring Producer Surplus with the Supply Curve
(b) Price = $799.99
1. The area under the supply curve is the cost of the quantity supplied
Price of
House
Supply
Painting
2. It is also the lowest cost at which that quantity could be produced
$900
800
Seller
Cost ($)
Producer Surplus
Sell?
Mary
900 No
Frida
800
Georgia
600
200
Yes
Grandma
500
300
600
500
Grandma’s cost
Georgia’s cost 1 2 3 4
Quantity of
Houses Painted

39. Is there a better alternative to the market system?
If the government had to get two houses painted, who would get the job?
Grandma and Georgia, of course.
And that’s exactly what happens in the market outcome.
Lesson: The market achieves the best that the government could have achieved
Seller
Cost ($)
Mary
900
Frida
800
Georgia
600
Grandma
500
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

40. The Supply Curve Shows Production Costs
1. The area under the supply curve is the cost of producing the quantity supplied
Price
Supply
2. It is also the lowest cost at which that quantity could be produced B A C Q1 P1
Production Cost
Quantity

41. Figure 5 Measuring Producer Surplus with the Supply Curve
(b) Price = $800
1. The rectangular area under the price and up to the quantity supplied is the Total Revenue.
Price of
House
Supply
Painting
Total
producer
surplus ($500)
2. The area under the price and above the supply is the Producer Surplus.
$900
800
Seller
Cost ($)
Producer Surplus
Sell?
Mary
900 No
Frida
800
Georgia
600
200
Yes
Grandma
500
300
600
Georgia ’
s producer
surplus ($200)
500
Grandma ’
s producer
surplus ($300) 1 2 3 4
Quantity of
Houses Painted

42. Figure 6 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P
Price
Supply B A C Q1 P1
Producer
surplus
Total Revenue (OBCQ1) = Production Cost (OACQ1) + Producer Surplus (ABC)
Production Cost
Quantity

43. Market efficiency
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

44. MARKET EFFICIENCY
Consumer surplus and producer surplus may be used to address the following questions:
Is our free market system a good way of running our economy?
Could we design a better system?
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

45. Consumer and Producer Surplus
Consumer Surplus
= Value to buyers – Amount paid by buyers
and
Producer Surplus
= Amount received by sellers – Cost to sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

46. Total Surplus Total Surplus = Value to Buyers – Cost to Sellers
This measures the net gain to society from the production and consumption of a good or service
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

47. Total Surplus Total surplus = Consumer surplus + Producer surplus
= Value to buyers – Amount paid by buyers
+ Amount received by sellers – Cost to sellers
= Value to buyers – Cost to sellers
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

48. MARKET EFFICIENCY
An economic outcome is efficient if there is no feasible way to make the total surplus any higher.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

49. Figure 7 Consumer and Producer Surplus in the Market Equilibrium
Price A C B D E
Consumer
surplus
Demand
Supply
Equilibrium
price
quantity
Producer
surplus
Quantity

50. Figure 7 Consumer and Producer Surplus in the Market Equilibrium
Price A C B D E
Demand
Consumer
surplus
Total Value (or, willingness to pay)
Supply
Total Surplus
Equilibrium
price
quantity
Cost
Producer
surplus
Quantity

51. The best feasible outcome
Price A C B D E
Consumer
surplus
Demand
Total Value (also, Maximum Value)
Supply
As long as we produce the equilibrium quantity, it would be impossible to increase the Total Surplus by reallocating production among producers and consumption among consumers.
Maximum Total Surplus
Equilibrium
price
quantity
Cost (also, Minimum Cost)
Producer
surplus
But is the equilibrium output the right output to produce?
Quantity

52. What if we produced less than the equilibrium amount?
Price A C B D E
Demand
Minimum WTP lost
Supply
If we produce less than the equilibrium quantity, the consumption benefits lost will exceed the cost savings gained. Therefore, society would be worse off if it produces less than the equilibrium quantity
Equilibrium
price
quantity
Maximum Cost savings gained
Alternative
Quantity

53. What if we produced more than the equilibrium amount?
Price A C B D E
Demand
Supply
If we produce more than the equilibrium quantity, the consumption benefits of the additional output will be less than the cost of producing the additional output. Therefore, society would be worse off if it produces more than the equilibrium quantity.
Minimum Cost of extra output
Equilibrium
price
quantity
Maximum Value of extra output
Alternative
Quantity

54. MARKET EFFICIENCY Three Insights Concerning Market Outcomes
Free markets allocate the goods produced to the buyers who value them most highly, as measured by their willingness to pay.
Free markets allocate production of goods to those who can produce them at least cost.
Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

55. The Invisible Hand
We pursue our self-interest, not the social interest
It is, therefore, natural to think that the free market would lead to chaos
And yet, as we just saw, the free market outcome is unimprovable
This idea was most famously proposed by Adam Smith (1723 – 1790), the father of modern economics.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

56. The Invisible Hand
...[E]very individual … neither intends to promote the public interest, nor knows how much he is promoting it. … [H]e intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.
The Wealth of Nations, Adam Smith, 1776
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

57. Ticket Scalping
Ticket scalping is often frowned upon and sometimes considered illegal
See
But a typical view among economists is that “consenting adults should be able to make economic trades when they think it is to their mutual advantage”
Scalping increases the economy’s efficiency
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

58. Market for organs
Should people be allowed to sell, say, their kidneys?
The efficiency of the economy will increase.
What about fairness?
Rich will buy the kidneys; the poor will not. But
Right now healthy people have extra kidneys while the sick have none.
The sale of organs may be more acceptable if organ purchases by the poor were paid for with taxpayers’ money so that rich and poor had equal access
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

59. but markets do fail
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

60. However, markets can go wrong
Market Power
Externalities
Fairness
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

61. MONOPOLY
If a market system is not perfectly competitive, firms may have market power.
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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

62. EXTERNALITIES Externalities
are 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.
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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

63. FAIRNESS
In addition to market efficiency, a social planner might also care about equity – the fairness of the distribution of well-being among the various buyers and sellers.
The free market economic system is efficient but not necessarily fair
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

64. Health Care: Riddled with Market Failure
In most advanced countries, government policies regarding health care routinely disregard the idea that free markets are best
In the United Kingdom, the government builds hospitals, hires doctors and nurses, buys pharmaceutical drugs, and provides medical care to all residents
Patients get no bills; tax revenues are used to pay all costs
Fees of private doctors are paid by the government
Performance indicators are high
Costs are low
There is virtually no clamor for privatization
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

65. Video: Scroogenomics
Heard the one about the economist who gave cash as a Valentine’s Day gift?
Scrooge alert: Your holiday spending may result in an economic loss by Paul Solman, PBS Newshour, December 23, 2013.
Video: .
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

66. Summary
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 can be computed by finding the area below the demand curve and above the price.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

67. Summary
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 can be computed by finding the area below the price and above the supply curve.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

68. Summary
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.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

69. Summary
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.
Markets do not allocate resources efficiently in the presence of market failures.
CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS