1. Consumers, Producers and Market Efficiency Lecture 5 – academic year 2014/15 Introduction to Economics Fabio Landini

2. Where are we… Lecture 1 : Demand and supply model Lecture 2: Elasticity and its application Lecture 4: Demand, Supply and economic policy 2

3. What do we do today? Allocative efficiency: – how do we measure the welfare of both consumers and producers? Consumer surplus Producer surplus THE INVISIBLE HAND THEOREM 3

4. QUICK QUIZ If the equilibrium price on the market for cigarettes is equal to 10 Euro a pack, and Government introduces a MAXIMUM price equal to 12 Euro, we obtain… A) … Excess supply: the quantity supplied is greater than the quantity demanded. B)... Scarcity: the quantity demanded is greater than the quantity supplied. C)... No effect on the market. 4

5. Premise: What’s an auction? 5

6. Two issues 1. Is there a RIGHT price? Consumers: prices are ALWAYS too high; Producers: prices are ALWAYS too low. How do we understand which is the ‘right’ price? 6

7. 2. Is the MARKET EQUILIBRIUM (that is: p & q) right? So far: positive analysis of the market; Now: normative analysis; We ask: Is the resource allocation produced by the market desirable? In which sense? How do we measure welfare? 7 Two issues

8. Welfare measure The consumer surplus measures the benefit that the consumer obtains from participating to the market. The producer surplus measures the same benefit for the producer. 8

9. Consumer surplus Willingness to pay: it is the maximum amount that the consumer is willing to pay to obtain the good. It measures the value that the consumer attaches to the good or service. 9

10. The demand curve describes the quantity that consumers are willing to buy at different prices. 10 Consumer surplus The consumer surplus is the difference between the consumer’s willingness to pay and the price that is effectively paid.

11. Example: willingness to pay for a rare Elvis’s record? ConsumerWillingness to pay John 100 Paul 80 George 70 Ringo 50 11

12. Summary: demand table PriceConsumersQuantity Demanded >100None0 80 -100John1 70 - 80John, Paul2 50 - 70John, Paul, George3 < 50John, Paul, George, Ringo4 12

13. Consumer surplus and demand curve – Price=80 13 Price 50 70 80 0 100 1234 Quantity Consumer surplus John (20 euro)

14. Consumer surplus and demand curve – Price=70 14 Price 50 70 80 0 100 1234 Quantity Consumer surplus John (30 euro) Consumer surplus Paul (10 euro) Total consumer surplus (40 euro)

15. Consumer surplus and demand curve – Price=70 15 Price 50 70 80 0 100 1234 Quantity Consumer surplus John (30 euro) Consumer surplus Paul (10 euro) Total consumer surplus (40 euro) Domanda

16. Consumer surplus and price Consumer surplus = area in between the demand curve and the price level. There exist a negative relationship between price and consumer surplus. 16

17. Effects of price variations on consumer surplus 17 Demand Quantity Price 0 P1P1 Q1Q1 Surplus of initial consumer A B C

18. Effects of price variations on consumer surplus 18 Demand Quantity Price 0 P1P1 Q1Q1 Surplus of initial consumer A B C P2P2 Q2Q2 F D

19. Effects of price variations on consumer surplus 19 Demand Quantity Price 0 P1P1 Q1Q1 Surplus of initial consumer A B C P2P2 Q2Q2 F Surplus for the new consumer D Additional surplus for the initial consumer E

20. Producer surplus Supply curve It describes the quantity that the producers are willing to sell for each price; The willingness to sell is determined by the costs of production (measured as an opportunity cost); As the market price increases, less efficient producers can enter the market 20

21. Producer surplus The producer surplus is the difference between the price paid by the consumer and the cost of production. It measures the benefit that the producer obtains from participating to the market. 21

22. Example: willingness to sell a rare Elvis’s record? ProducerCosts Mick 900 Keith 800 Charli 600 Bill 500 22

23. Summary: Table of supply PriceSellersQuantity supplied P > 900 Bill, Charlie, Keith e Mick 4 800 -900Bill, Charlie, Keith3 600 -800Bill, Charlie2 500 - 600Bill1 P < 500None0 23

24. To measure the producer surplus with the supply curve 24 Quantity Price 500 800 900 0 600 123 Bill’s surplus (100 euro) if p=600

25. To measure the producer surplus with the supply curve 25 Quantity Price 500 800 900 0 600 123 Bill’s surplus (300 euro) if p=800 Charlie’s surplus (200 euro) if p=800 Total producer surplus (500 euro)

26. To measure the producer surplus with the supply curve 26 Quantity Price 500 800 900 0 600 123 Bill’s surplus (300 euro) if p=800 Charlie’s surplus (200 euro) if p=800 Total producer surplus (500 euro) Supply

27. Effects of price variations on producer surplus 27 Quantity Price 0 P1P1 B C Supply A Surplus of initial producer Q1Q1 Q2Q2

28. Effects of price variations on producer surplus 28 Quantity Price 0 P1P1 B C Supply A Surplus of initial producer Q1Q1 Q2Q2 P2P2 Q2Q2

29. Effects of price variations on producer surplus 29 Quantity Price 0 P1P1 B C Supply A Surplus of initial producer Q1Q1 Q2Q2 P2P2 Q2Q2 B C A D F Surplus for the new producer Additional surplus for initial producer

30. Market efficiency In a market with perfect competition and no externalities: Social welfare = consumer surplus + producer surplus 30

31. Consumer surplus and producer surplus in equilibrium 31 Price Equilibrium price 0Quantity Equilibrium quantity A Supply C B Demand D E

32. Consumer surplus and producer surplus in equilibrium 32 Price Equilibrium price 0Quantity Equilibrium quantity A Supply C B Demand D E Producer surplus

33. Consumer surplus and producer surplus in equilibrium 33 Price Equilibrium price 0Quantity Equilibrium quantity A Supply C B Demand D E Producer surplus Consumer surplus

34. Allocative efficiency Allocative efficiency obtains when the allocation of resources maximizes total surplus. Does a perfectly competitive market achieve allocative efficiency? 34

35. Market equilibrium and allocative efficiency In a free market: The supply of a good goes to those consumers that evaluate the good the most. The demand of a good is satisfied by the sellers that con produce the good at the lowest cost. The quantity of good that maximizes the sum of consumer surplus and producer surplus is finally produced. 35

36. Graphical demonstration 36 Quantity Price 0Equilibrium quantity Supply Demand Cost for the producer Value for the consum er The value for the consumer is greater than the cost for the producer. The value for the consumer is lower than the cost for the producer. Cost for the producer Value for the consum er

37. The invisible hand In a free market there exist several producers and consumers, each motivated by her own self- interest. Thanks to the price system (= impersonal coordination and communication device): Individual decisions of producers and consumers leads to an efficient allocation of resources. This is the INVISIBLE HAND THEOREM. 37

38. Does the invisible hand theorem always hold? No, in two cases at least: 1.Market power; 2.Externalities. In these cases we usually talk about MARKET FAILURES. 38

39. Market power Market power= when consumers or producers have some control over market prices – we talk about “imperfect competition ” (monopoly, oligopoly). Market power generates inefficiencies (= “ market failures ” ), because market prices do not reflect social cost of resources. 39

40. Externalities Externalities: when the decisions of consumers and producers have “external effects”, i.e. effects (both costs and benefits) on individuals that do not participate to the market. Externalities generate inefficiencies (= “market failures”), because market prices do not reflect the social cost of resources. 40

41. Welfare Consumer surplus and producer surplus measure the benefits that consumers and producers can derive from participating to the market 41

42. Efficiency An allocation of resources that maximizes the total surplus (= consumer surplus + producer surplus) is called “efficient” The existence of market power and externalities can lead to inefficient results and market failures 42

43. Conclusions Keep in mind: social welfare is not only efficiency, but also equity! We will talk about that later in the course…. 43

44. Next week Economic policy and efficiency: exercises and applications 44