1. Copyright © 2004 South-Western 7 Consumers, Producers, and the Efficiency of Markets

2. Copyright © 2004 South-Western REVISITING EQUILIBRIUM Equilibrium is most efficient, but is the what’s best for society? Welfare economics is the study of how the allocation of resources affects economic well- being. Equilibrium in a market does indeed maximize the total welfare of buyers and sellers

3. Copyright © 2004 South-Western CONSUMER SURPLUS Measures economic welfare from the buyer’s side Willingness to pay = maximum amount buyer will pay for a g/s (measures how much buyer values g/s) CS = buyer’s willingness to pay – amount buyer actually pays Area below the demand curve and above the price measures CS in a market

4. Table 1 Four Possible Buyers’ Willingness to Pay Copyright©2004 South-Western Example: The market for a rare Elvis Presley album. Each buyer will purchase the album if the price is less than their willingness to pay.

5. Copyright © 2004 South-Western The Demand Schedule and the Demand Curve

6. Figure 1 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

7. Figure 2 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)

8. Figure 2 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)

9. Figure 3 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

10. Figure 3 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

11. Copyright © 2004 South-Western Quick Quiz: Are you picking up what has been put down? Thanksgiving is just around the corner… Draw a demand curve for turkey. In your diagram, show a price of turkey and the consumer surplus at that price. Explain in words what this consumer surplus measures.

12. Copyright © 2004 South-Western PRODUCER SURPLUS Producer surplus measures economic welfare from the seller’s side is the amount a seller is paid for a good minus the seller’s cost Area below the price and above the supply curve measures PS in a market

13. Table 2 The Costs of Four Possible Sellers Copyright©2004 South-Western Example: You want to hire someone to paint your house and accept bids for the work from four sellers. Each worker is willing to work if the price you pay exceeds her opportunity cost.

14. Copyright © 2004 South-Western The Supply Schedule and the Supply Curve

15. Figure 4 The Supply Schedule and the Supply Curve

16. Figure 5 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)

17. Figure 5 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

18. Figure 6 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

19. Figure 6 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

20. Copyright © 2004 South-Western Quick Quiz 2: Are you picking up what has been put down? Thanksgiving is just around the corner… Draw a supply curve for turkey. In your diagram, show a price of turkey and the producer surplus at that price. Explain in words what this producer surplus measures.

21. Copyright © 2004 South-Western MARKET EFFICIENCY Efficiency maximizes the total surplus received by all members of society TS = Consumer surplus + Producer surplus BUT, what about Equity?

22. Figure 7 Consumer and Producer Surplus in the Market Equilibrium Copyright©2003 Southwestern/Thomson Learning Producer surplus Consumer surplus Price 0 Quantity Equilibrium price Equilibrium quantity Supply Demand A C B D E

23. Copyright © 2004 South-Western MARKET EFFICIENCY Free Markets: allocate supply of g/s to buyers who value them most highly allocate the demand for g/s to sellers who can produce them at least cost produce the quantity of g/s that maximizes the total surplus

24. Figure 8 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

25. Copyright © 2004 South-Western Evaluating the Market Equilibrium Because 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

26. Copyright © 2004 South-Western Evaluating the Market Equilibrium If a market system is not perfectly competitive, market power may result. the ability to influence prices can cause markets to be inefficient; keeps P & Q from the equilibrium of supply and demand

27. Copyright © 2004 South-Western Evaluating the Market Equilibrium Externalities 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.

28. Copyright © 2004 South-Western 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.

29. Copyright © 2004 South-Western Quick Quiz How do you think a PRICE FLOOR impacts consumer surplus? Demonstrate your answer with a graph. How do you think a PRICE CEILING impacts consumer surplus? Demonstrate your answer with a graph.