Download Chapter 7 Welfare Economics Willingness to Pay Consumer Surplus

Welfare Economics
Chapter 7
n
The study of how the allocation of
resources affects economic well-being.
Consumers, Producers, and the
Efficiency of Markets
Willingness to Pay
n
n
The maximum amount that a buyer is
willing to pay.
Measures how much the buyer values
the good.
Consumer Surplus
n
A buyers’ willingness to pay minus the
amount the buyer actually pays.
Example
Demand schedule
Elvis Presley Album at an action
n
Buyer
John
Paul
George
Ringo
Willingness to pay
$100
$80
$70
$50
n
Can use willingness to pay to obtain a
demand schedule
As long as the price is less than or
equal to the buyer’s willingness to pay,
the consumer wishes to buy the good.
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Demand schedule (continued)
Demand Curve
Using the previous example,
n
Price
Buyers
>$100
$81-$100
$71-$80
$51-$70
$50 or less
None
John
John, Paul
John, Paul, George
John, Paul, George,
Ringo
Quantity
Demanded
0
1
2
3
4
n
Demand curve (continued)
Consumer Surplus - example
120
n
John’s willing to pay
100
Paul’s willingness to pay
George’s willingness to pay
80
60
n
Ringo’s
willingness to
pay
40
20
Using the demand schedule, we can
plot a demand curve.
At any quantity, price given shows the
willingness to pay of the marginal
buyer, the buyer who would leave the
market first if the price were any
higher.
Suppose John is able to buy the Elvis
album for $80.
Since he was willing to pay up to $100
for the album, he receives consumer
surplus of
$100 - $80 = $20.
0
0
2
4
6
8
Area below the demand curve and above
the price measures the consumer surplus
in the market
Consumer Surplus - example
n
n
n
Suppose instead that there are two
copies of the album on sale at a flea
market for $80 each.
John receives consumer surplus of
$100-$80=$20 and Paul receives
consumer surplus of $80-$80=$0.
Total consumer surplus is $20.
A
P
Consumer surplus (CS) = area of
triangle ABC.
CS
P1
C
B
D
Q1
Q
2
Consumer Surplus and the Market for
Elvis Albums
A Price Decrease Raises Consumer
Surplus
120
John’s willing to pay
100
CS
80
A
P
Paul’s willingness to pay
George’s willingness to pay
60
Decreasing price from P 1 to P 2
increases CS by area BCGE.
Ringo’s
willingness to
pay
40
20
P1
P2
0
0
Consumer surplus (CS) = area of
triangle AEG.
2
4
6
C
BB
E
8
Decreasing price…
…increases the consumer surplus of consumers
that were already in the market, since they
now pay a lower price (this increase is area
BCFE).
…results in consumer surplus for new buyers
that were unwilling to buy the good at the old
price but are willing to buy at the new price
(this increase is area CFG).
Producer Surplus
Cost - the value of everything a seller
must give up to produce a good (i.e.
the opportunity cost of producing)
- includes cost of inputs and value of
time.
Producer Surplus - amount a seller is
paid minus the seller’s cost.
G
F
Q1
D
Q2
Q
Consumer surplus
n
n
Measures the benefit that buyers
receive from a good as the buyers
themselves perceive it.
Used as a criteria to make normative
judgments about the desirability of
market outcomes.
Example
n
Suppose there are four people that are willing
to paint your house:
Seller
Mary
Frida
Georgia
Grandma
Cost
$900
$800
$600
$500
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Example - continued
n
n
Example - continued
Each seller will only provide the service
if the amount that they are paid is at
least equal to their cost.
For any given price, we can find out
how many sellers are willing to provide
the service. The resulting schedule is
the supply schedule.
Example - continued
n
Sellers
Quantity
Mary, Frida,
4
Georgia, Grandma
Frida, Georgia,
3
Grandma
Georgia, Grandma
2
Grandma
1
None
800-900
600-800
500-600
<500
Producer surplus is the area…
We can plot the supply schedule to get
a supply curve.
…below the market price and above the
supply curve.
S
P
S
P
Price
900+
P
$900
$800
$600
$500
PS
1
2
3
Q
Q
4
Increasing price…
An increase in the price…
…increases the producer surplus available
in the market.
P P1
P0
E
D
S
C
F
B
PS
A
Q
Q
…increases the producer surplus of producers
that were already in the market, since they
now receive a higher price (this increase is
area BDEF).
…results in producer surplus for new sellers that
were unwilling to sell the good at the old
price but are willing to sell at the new price
(this increase is area BCD).
Q
4
Can the social planner improve on
the market outcome?
Market Efficiency
Imagine a benevolent social planner –
an all-knowing, all-powerful, wellintentioned dictator.
The social planner wants to maximize
economic well-being.
n
n
Can the market outcome be altered so
as to improve economic well-being?
We will use total surplus as a measure
of economic well-being.
total surplus = consumer surplus +
producer surplus
Efficiency
Equity
Definition – the property of a resource
allocation of maximizing the total
surplus received by all members of
society
Defintion – the fairness of the distribution
of well-being among the members of
society.
Equity is an alternative criteria for
evaluating the outcome of the market.
Total Surplus and the Market Equilibrium
Evaluating the Market Equilibrium
n
P
CS
n
P*
PS
n
Q*
Q
Markets allocate supply of goods to buyers
who value them most highly, as measured by
willingness to pay.
Free markets allocate demand for goods to
the sellers who can produce them at lowest
cost.
Social planner cannot increase total surplus
by changing allocation of consumption
between buyers or allocation of production
between sellers.
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Can Planner Increase Welfare by
Increasing/Reducing Quantity?
Below equilibrium quantity, the value of output
to buyers exceeds cost to sells
⇒ Can increase surplus by increasing output.
The Market Outcome is Efficient
n
From the market outcome, the social
planner cannot increase economic wellbeing.
Above equilibrium quantity, the value of output
to output to sellers exceeds value to buyer.
⇒ Can increase surplus by decreasing output.
Markets fail to maximize surplus (achieve
efficiency) when…
n
Producers have market power (can
influence price). In this case, market
will not reach equilibrium
price/quantity.
Markets fail to maximize surplus (achieve
efficiency) when…
n
When externalities are involved. In such
cases, decisions of buyers and sellers affect
individuals not involved in transaction (e.g.
pollution) and total surplus depends on more
than the value of good to the buyer and cost
to the seller. In particular, there are values
and costs to non-participants that are not
accounted for in the market.
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