1. © 2010 Pearson Addison-Wesley

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

3. © 2010 Pearson Addison-Wesley Welfare Economics 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 maximizes the total welfare of buyers and sellers. Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product.

4. © 2010 Pearson Addison-Wesley Welfare Economics Consumer surplus measures economic welfare from the buyer’s side. Producer surplus measures economic welfare from the seller’s side.

5. © 2010 Pearson Addison-Wesley Resource Allocation Methods Scare resources might be allocated by  Market price  Command  Majority rule  Contest  First-come, first-served  Sharing equally  Lottery  Personal characteristics  Force How does each method work?

6. © 2010 Pearson Addison-Wesley Market Price When a market allocates a scarce resource, the people who get the resource are those who are willing to pay the market price. Most of the scarce resources that you supply get allocated by market price. You sell your labor services in a market, and you buy most of what you consume in markets. For most goods and services, the market turns out to do a good job. Resource Allocation Methods

7. © 2010 Pearson Addison-Wesley Command Command system allocates resources by the order (command) of someone in authority. For example, if you have a job, most likely someone tells you what to do. Your labor time is allocated to specific tasks by command. A command system works well in organizations with clear lines of authority but badly in an entire economy. Resource Allocation Methods

8. © 2010 Pearson Addison-Wesley Majority Rule Majority rule allocates resources in the way the majority of voters choose. Societies use majority rule for some of their biggest decisions. For example, tax rates that allocate resources between private and public use and tax dollars between competing uses such as defense and health care. Majority rule works well when the decision affects lots of people and self-interest must be suppressed to use resources efficiently. Resource Allocation Methods

9. © 2010 Pearson Addison-Wesley Contest A contest allocates resources to a winner (or group of winners). The most obvious contests are sporting events but they occur in other arenas: For example, The Oscars are a type of contest. Contest works well when the efforts of the “players” are hard to monitor and reward directly. Resource Allocation Methods

10. © 2010 Pearson Addison-Wesley First-Come, First-Served A first-come, first-served allocates resources to those who are first in line. Casual restaurants use first-come, first served to allocate tables. Supermarkets also uses first-come, first- served at checkout. First-come, first-served works best when scarce resources can serves just one person at a time in a sequence. Resource Allocation Methods

11. © 2010 Pearson Addison-Wesley Sharing Equally When a resource is shared equally, everyone gets the same amount of it. You might use this method to share a dessert in a restaurant. To make sharing equally work, people must be in agreement about its use and implementation. It works best for small groups who share common goals and ideals. Resource Allocation Methods

12. © 2010 Pearson Addison-Wesley Lottery Lotteries allocate resources to those with the winning number, draw the lucky cards, or come up lucky on some other gaming system. State lotteries and casinos reallocate millions of dollars worth of goods and services each year. But lotteries are more widespread. For example, they are used to allocate landing slots at some airports. Lotteries work well when there is no effective way to distinguish among potential users of a scarce resource. Resource Allocation Methods

13. © 2010 Pearson Addison-Wesley Personal Characteristics Personal characteristics allocate resources to those with the “right” characteristics. For example, people choose marriage partners on the basis of personal characteristics. But this method gets used in unacceptable ways: allocating the best jobs to white males and discriminating against minorities and women. Resource Allocation Methods

14. © 2010 Pearson Addison-Wesley Force Force plays a role in allocating resources. For example, war has played an enormous role historically in allocating resources. Theft, taking property of others without their consent, also plays a large role. But force provides an effective way of allocating resources—for the state to transfer wealth from the rich to the poor and establish the legal framework in which voluntary exchange can take place in markets. Resource Allocation Methods

15. © 2010 Pearson Addison-Wesley Demand and Marginal benefit Demand and Willingness to Pay Willingness to pay is the maximum amount that a buyer will pay for a good. It measures how much the buyer values the good or service. The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices.

16. © 2010 Pearson Addison-Wesley Individual Demand and Market Demand The relationship between the price of a good and the quantity demanded by one person is called individual demand. The relationship between the price of a good and the quantity demanded by all buyers in the market is called market demand. Figure 5.1 on the next slide shows the connection between individual demand and market demand. Demand and Marginal benefit

17. © 2010 Pearson Addison-Wesley Lisa and Nick are the only buyers in the market for pizza. At $1 a slice, the quantity demanded by Lisa is 30 slices. At $1 a slice, the quantity demanded by Nick is 10 slices. Demand and Marginal benefit

18. © 2010 Pearson Addison-Wesley At $1 a slice, the quantity demanded by Lisa is 30 slices and by Nick is 10 slices. The quantity demanded by all buyers in the market is 40 slices. Demand and Marginal benefit

19. © 2010 Pearson Addison-Wesley The market demand curve is the horizontal sum of the individual demand curves. Consumer Surplus

20. © 2010 Pearson Addison-Wesley Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. It is measured by the area under the demand curve and above the price paid, up to the quantity bought. Consumer Surplus

21. © 2010 Pearson Addison-Wesley Example: Four Possible Buyers’ Willingness to Pay Copyright©2004 South-Western

22. © 2010 Pearson Addison-Wesley The Demand Schedule and the Demand Curve

23. © 2010 Pearson Addison-Wesley The Demand Schedule and the Demand Curve Copyright©2003 Southwestern/Thomson Learning 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

24. © 2010 Pearson Addison-Wesley Measuring Consumer Surplus with the Demand Curve Copyright©2003 Southwestern/Thomson Learning (a) Price = $80 Price of Album 50 70 80 0 $100 Demand 1234 Quantity of Albums John’s consumer surplus ($20)

25. © 2010 Pearson Addison-Wesley Measuring Consumer Surplus with the Demand Curve Copyright©2003 Southwestern/Thomson Learning (b) Price = $70 Price of Album 50 70 80 0 $100 Demand 1234 Total consumer surplus ($40) Quantity of Albums John’s consumer surplus ($30) Paul’s consumer surplus ($10)

26. © 2010 Pearson Addison-Wesley How the Price Affects Consumer Surplus Copyright©2003 Southwestern/Thomson Learning Consumer surplus Quantity (a) Consumer Surplus at Price P Price 0 Demand P1P1 Q1Q1 B A C

27. © 2010 Pearson Addison-Wesley 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

28. © 2010 Pearson Addison-Wesley Consumer Surplus 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.

29. © 2010 Pearson Addison-Wesley Supply and Marginal Cost Supply, Cost, and Minimum Supply-Price Cost is what the producer gives up, price is what the producer receives. The cost of one more unit of a good or service is its marginal cost. Marginal cost is the minimum price that a firm is willing to accept. But the minimum supply-price determines supply. A supply curve is a marginal cost curve.

30. © 2010 Pearson Addison-Wesley Individual Supply and Market Supply The relationship between the price of a good and the quantity supplied by one producer is called individual supply. The relationship between the price of a good and the quantity supplied by all producers in the market is called market supply. Figure 5.3 on the next slide shows the connection between individual supply and market supply. Supply and Marginal Cost

31. © 2010 Pearson Addison-Wesley Max and Mario are the only producers of pizza. At $15 a pizza, the quantity supplied by Max is 100 pizzas. Supply and Marginal Cost

32. © 2010 Pearson Addison-Wesley Max and Mario are the only producers of pizza. At $15 a pizza, the quantity supplied by Mario is 50 pizzas. Supply and Marginal Cost

33. © 2010 Pearson Addison-Wesley At $15 a pizza, the quantity supplied by Max is 100 pizzas and by Mario is 50 pizzas. The quantity supplied by all producers is 150 pizzas. Supply and Marginal Cost

34. © 2010 Pearson Addison-Wesley The market supply curve is the horizontal sum of the individual supply curves. Supply and Marginal Cost

35. © 2010 Pearson Addison-Wesley Producer Surplus Producer surplus is the price received for a good minus the minimum-supply price (marginal cost), summed over the quantity sold. It is measured by the area below the market price and above the supply curve, summed over the quantity sold. Supply and Marginal Cost

36. © 2010 Pearson Addison-Wesley The Costs of Four Possible Sellers Copyright©2004 South-Western

37. © 2010 Pearson Addison-Wesley Using the 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.

38. © 2010 Pearson Addison-Wesley The Supply Schedule and the Supply Curve

39. © 2010 Pearson Addison-Wesley The Supply Schedule and the Supply Curve

40. © 2010 Pearson Addison-Wesley Using the Supply Curve to Measure Producer Surplus The area below the price and above the supply curve measures the producer surplus in a market.

41. © 2010 Pearson Addison-Wesley Measuring Producer Surplus with the Supply Curve Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (a) Price = $600 Supply Grandma’s producer surplus ($100)

42. © 2010 Pearson Addison-Wesley Measuring Producer Surplus with the Supply Curve Copyright©2003 Southwestern/Thomson Learning Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 (b) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Grandma’s producer surplus ($300) Supply

43. © 2010 Pearson Addison-Wesley How the Price Affects Producer Surplus Copyright©2003 Southwestern/Thomson Learning Producer surplus Quantity (a) Producer Surplus at Price P Price 0 Supply B A C Q1Q1 P1P1

44. © 2010 Pearson Addison-Wesley How the Price Affects Producer Surplus Copyright©2003 Southwestern/Thomson Learning 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

45. © 2010 Pearson Addison-Wesley MARKET EFFICIENCY 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?

46. © 2010 Pearson Addison-Wesley MARKET EFFICIENCY Consumer Surplus = Value to buyers – Amount paid by buyers Producer Surplus = Amount received by sellers – Cost to sellers

47. © 2010 Pearson Addison-Wesley MARKET EFFICIENCY Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers – Cost to sellers

48. © 2010 Pearson Addison-Wesley MARKET EFFICIENCY Efficiency is 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 various buyers and sellers.

49. © 2010 Pearson Addison-Wesley Is the Competitive Market Efficient? Efficiency of Competitive Equilibrium Figure 5.5 shows that a competitive market creates an efficient allocation of resources at equilibrium. In equilibrium, the quantity demanded equals the quantity supplied.

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51. At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity. When the efficient quantity is produced, total surplus (the sum of consumer surplus and producer surplus) is maximized. Is the Competitive Market Efficient?

52. © 2010 Pearson Addison-Wesley MARKET EFFICIENCY Three Insights Concerning Market Outcomes Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay. Free markets allocate the demand for goods to the sellers who can produce them at least cost. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

53. © 2010 Pearson Addison-Wesley The Efficiency of the Equilibrium Quantity Copyright©2003 Southwestern/Thomson Learning 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

54. © 2010 Pearson Addison-Wesley 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. This policy of leaving well enough alone goes by the French expression laissez faire.

55. © 2010 Pearson Addison-Wesley The Invisible Hand Adam Smith’s “invisible hand” idea in the Wealth of Nations implied that competitive markets send resources to their highest valued use in society. Consumers and producers pursue their own self-interest and interact in markets. Market transactions generate an efficient—highest valued—use of resources. Is the Competitive Market Efficient?

56. © 2010 Pearson Addison-Wesley Underproduction and Overproduction Inefficiency can occur because too little of an item is produced—underproduction—or too much of an item is produced—overproduction. Is the Competitive Market Efficient?

57. © 2010 Pearson Addison-Wesley Underproduction If production is restricted to 5,000 pizzas a day, there is underproduction and the quantity is inefficient. A deadweight loss equals the decrease in total surplus—the gray triangle. This loss is a social loss. The efficient quantity is 10,000 pizzas a day. Is the Competitive Market Efficient?

58. © 2010 Pearson Addison-Wesley Overproduction If production is expanded to 15,000 pizzas a day, a deadweight loss arises from overproduction. Again, the efficient quantity is 10,000 pizzas a day. This loss is a social loss. Is the Competitive Market Efficient?

59. © 2010 Pearson Addison-Wesley Obstacles to Efficiency In competitive markets, underproduction or overproduction arise when there are  Price and quantity regulations  Taxes and subsidies  Externalities  Public goods and common resources  Monopoly  High transactions costs Is the Competitive Market Efficient?

60. © 2010 Pearson Addison-Wesley Price and Quantity Regulations Price regulations sometimes put a block of the price adjustments and lead to underproduction. Quantity regulations that limit the amount that a farm is permitted to produce also leads to underproduction. Is the Competitive Market Efficient?

61. © 2010 Pearson Addison-Wesley Taxes and Subsidies Taxes increase the prices paid by buyers and lower the prices received by sellers. So taxes decrease the quantity produced and lead to underproduction. Subsidies lower the prices paid by buyers and increase the prices received by sellers. So subsidies increase the quantity produced and lead to overproduction. Is the Competitive Market Efficient?

62. © 2010 Pearson Addison-Wesley Externalities An externality is a cost or benefit that affects someone other than the seller or the buyer of a good. An electric utility creates an external cost by burning coal that creates acid rain. The utility doesn’t consider this cost when it chooses the quantity of power to produce. Overproduction results. Is the Competitive Market Efficient?

63. © 2010 Pearson Addison-Wesley Public Goods and Common Resources A public good benefits everyone and no one can be excluded from its benefits. It is in everyone’s self-interest to avoid paying for a public good (called the free-rider problem), which leads to underproduction. Is the Competitive Market Efficient?

64. © 2010 Pearson Addison-Wesley A common resource is owned by no one but can be used by everyone. It is in everyone’s self interest to ignore the costs of their own use of a common resource that fall on others (called tragedy of the commons). The tragedy of the commons leads to overproduction. Is the Competitive Market Efficient?

65. © 2010 Pearson Addison-Wesley Monopoly A monopoly is a firm that has sole provider of a good or service. The self-interest of a monopoly is to maximize its profit. To do so, a monopoly sets a price to achieve its self- interested goal. As a result, a monopoly produces too little and underproduction results. Is the Competitive Market Efficient?

66. © 2010 Pearson Addison-Wesley High Transactions Costs Transactions costs are the opportunity cost of making trades in a market. To use the market price as the allocator of scarce resources, it must be worth bearing the opportunity cost of establishing a market. Some markets are just too costly to operate. When transactions costs are high, the market might underproduce. Is the Competitive Market Efficient?

67. © 2010 Pearson Addison-Wesley Alternatives to the Market When a market is inefficient, can one of the non-market methods of allocation do a better job? Often, majority rule might be used. But majority rule has its own shortcomings. A group that pursues the self-interest of its members can become the majority. Also, with majority rule, votes must be translated into actions by bureaucrats who have their own agendas. Is the Competitive Market Efficient?

68. © 2010 Pearson Addison-Wesley There is no one efficient mechanism for allocating resources efficiently. But supplemented majority rule, bypassed inside firms by command systems, and occasionally using first- come, first-served, markets do an amazingly good job. Is the Competitive Market Efficient?

69. © 2010 Pearson Addison-Wesley Is the Competitive Market Fair? Ideas about fairness can be divided into two groups:  It’s not fair if the result isn’t fair.  It’s not fair if the rules aren’t fair.

70. © 2010 Pearson Addison-Wesley It’s Not Fair if the Result Isn’t Fair The idea that only equality brings efficiency is called utilitarianism. Utilitarianism is the principle that states that we should strive to achieve “the greatest happiness for the greatest number.” Is the Competitive Market Fair?

71. © 2010 Pearson Addison-Wesley If everyone gets the same marginal utility from a given amount of income, and if the marginal benefit of income decreases as income increases, then taking a dollar from a richer person and giving it to a poorer person increases the total benefit. Only when income is equally distributed has the greatest happiness been achieved. Is the Competitive Market Fair?

72. © 2010 Pearson Addison-Wesley Figure 5.7 shows how redistribution increases efficiency. Tom is poor and has a high marginal benefit of income. Jerry is rich and has a low marginal benefit of income. Taking dollars from Jerry and giving them to Tom until they have equal incomes increases total benefit. Is the Competitive Market Fair?

73. © 2010 Pearson Addison-Wesley Utilitarianism ignores the cost of making income transfers. Recognizing these costs leads to the big tradeoff between efficiency and fairness. Because of the big tradeoff, John Rawls proposed that income should be redistributed to point at which the poorest person is as well off as possible. Is the Competitive Market Fair?

74. © 2010 Pearson Addison-Wesley It’s Not Fair If the Rules Aren’t Fair The idea that “it’s not fair if the rules aren’t fair” is based on the symmetry principle. Symmetry principle is the requirement that people in similar situations be treated similarly. Is the Competitive Market Fair?

75. © 2010 Pearson Addison-Wesley In economics, this principle means equality of opportunity, not equality of income. Robert Nozick suggested that fairness is based on two rules:  The state must create and enforce laws that establish and protect private property.  Private property may be transferred from one person to another only by voluntary exchange. This means that if resources are allocated efficiently, they may also be allocated fairly. Is the Competitive Market Fair?

76. © 2010 Pearson Addison-Wesley 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.

77. © 2010 Pearson Addison-Wesley 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.

78. © 2010 Pearson Addison-Wesley 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.

79. © 2010 Pearson Addison-Wesley 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.