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Chapter 5
Efficiency
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
What will you learn in this chapter? •  How to use willingness to pay and sell to determine supply and demand at a given price.
•  How to define and calculate surpluses.
•  How to define and iden=fy efficiency.
•  What distribu=on of benefits results from a policy decision.
•  How to define and calculate deadweight loss.
•  Why correc=ng a missing market can make everyone beBer off.
5-2
Willingness to pay and sell •  Consumers many =mes are willing to pay more than the market price.
–  A consumer is willing to purchase a good if the price is below their maximum willingness to pay. •  Producers likewise are willing to sell for less than the market price.
–  A producer is willing to sell a good if the price is above their minimum willingness to sell. •  Voluntary exchanges create value and can make everyone involved beBer off.
5-3
Willingness to pay and the demand curve Maximum willingness to pay shapes the demand curve.
Price ($)
Price ($)
600
600
500
500
Bird watcher
Each step represents a camera
bought by the additional buyer who
becomes interested at that price.
400
300
400
300
Amateur photographer
200
200
Real estate agent
Journalist
100
Teacher
100
Demand
0
1
2
3
4
5
Potential buyers
Five poten=al buyers’ willingness to pay forms demand curve.
0
10
20 30 40 50 60
Quantity of cameras (millions)
Many buyers’ willingness to pay forms demand curve.
5-4
Willingness to sell and the supply curve Minimum willingness to sell shapes the supply curve.
Price ($)
Price ($)
600
600
500
400
Each step represents
the additional camera
sold by a seller who
becomes interested as
the price increases.
300
400
Sales rep (small
company)
300
Sales rep (big company)
100
Collector
1
2
Supply
Art
teacher
Nature photographer
200
0
500
3
4
5
Potential sellers
Five poten=al sellers’ willingness to sell forms demand curve.
200
100
0
10
20
30
40
50
60
70
Quantity of cameras (millions)
Many sellers’ willingness to sell forms supply curve.
5-5
Measuring surplus •  When a consumer buys a good below the market price, this creates value.
–  Known as consumer surplus, a measure of consumers’ benefit from the purchase.
•  When a producer sells a good above the market price, this creates value.
–  Known as producer surplus, a measure of producers’ benefit from the sale.
•  Surplus is measured as the difference between the price at which at which a buyer or seller would be willing to trade and the actual price.
5-6
Consumer surplus The consumer surplus can be calculated by summing up individuals’ consumer surplus.
Price ($)
600
1. Bird watcher’s
surplus
500
Price ($)
600
1. Total consumer surplus
at a price of $160
500
400
400
300
2. Amateur
photographer’s surplus
1
2
200
160
3
3. Real estate
agent’s surplus
100
0
300
1
2. Additional surplus for buyers
who would have bought at $160
3. Consumer surplus
for the new buyers
200
2
100
1
2
3
4
Potential buyers
5
At a price of $160, the consumer surplus equals
($500-­‐$160) + ($250-­‐$160) + ($200-­‐$160) = $470.
0
1
3
2
3
4
Potential buyers
5
At a price of $100, the consumer surplus equals
$470 + $60*3 + $50*1 = $700.
5-7
Ac:ve Learning: Calcula:ng consumer surplus Use the following demand schedule to calculate consumer surplus if the market price is $5.
Price
Quan=ty
1
280
2
260
3
240
4
220
5
200
6
180
7
160
8
140
Consumer Surplus
5-8
Ac:ve Learning: Calcula:ng consumer surplus Use the following demand schedule to calculate consumer surplus if the market price is $5.
Price
Quan=ty
Consumer Surplus
1
280
$0
2
260
$0
3
240
$0
4
220
$0
5
200
($5 -­‐ $5)*20 = $0
6
180
($6 -­‐ $5)*20 = $20
7
160
($7 -­‐ $5)*20 = $40
8
140
($8 -­‐ $5)*140 = $420
•  Those with a maximum willingness to pay below market price do not buy the good.
•  Those with a maximum willingness to pay equal to market price do not receive consumer surplus.
•  Those with a maximum willingness to pay above the market price receive consumer surplus.
•  Consumer surplus = $20 + $40 + $420 = $480.
5-9
Producer surplus The producer surplus can be calculated by summing up individuals’ producer surplus.
Price ($)
600
Price ($)
600
500
500
400
400
300
300
200
160
100
1. Collector’s
surplus
200
2. Big-company
rep’s surplus
2
1
100
50
0
1
2
3
4
5
Potential sellers
At a price of $160, the producer surplus equals
($160-­‐$50) + ($160-­‐$5) = $170
2. Surplus lost by
collector and bigcompany rep
2
0
1
1. Collector’s surplus
1
2
3
4
5
Potential sellers
At a price of $100, the producer surplus equals
$110.
5-10
Ac:ve Learning: Calcula:ng producer surplus Use the following supply schedule to calculate producer surplus if the market price is $5.
Price
Quan=ty
1
130
2
260
3
390
4
520
5
650
6
780
7
910
8
1040
Producer Surplus
5-11
Ac:ve Learning: Calcula:ng producer surplus Use the following supply schedule to calculate producer surplus if the market price is $5.
Price
Quan=ty
Producer Surplus
1
130
($5 -­‐ $1)*130 = $520
2
260
($5 -­‐ $2)*130 = $390
3
390
($5 -­‐ $3)*130 = $260
4
520
($5 -­‐ $4)*130 = $130
5
650
($5 -­‐ $5)*130 = $0
6
780
$0
7
910
$0
8
1040
$0
•  Those with a minimum willingness to sell below the market price receive producer surplus.
•  Those with a minimum willingness to sell equal to market price do not receive producer surplus.
•  Those with a minimum willingness to sell above market price do not sell the good.
•  Producer surplus = $520 + $390 + $260 + $130 = $1300.
5-12
Total surplus Total surplus is the combined benefits that everyone receives from par=cipa=ng in an exchange of goods or services.
• 
Price ($)
600
Producer surplus
500
Consumer surplus
–  CS=½*30M*($500-­‐$200) =$4.5B
400
S
300
Total consumer surplus is equal to the area underneath the demand curve and above the equilibrium price.
• 
$ 4.5 billion
200
Total producer surplus is equal to the area above the supply curve and below the equilibrium price.
–  PS=½*30M * ($200-­‐$0) = $3B
$ 3 billion
100
• 
Total surplus = CS + PS.
D
0
5
10 15 20 25 30 35 40 45 50 55 60 65
Quantity of cameras (millions)
5-13
Market equilibrium and efficiency The market equilibrium is the point that maximizes total well-­‐being (total surplus) of all par=cipants in the market.
• 
Price ($)
600
Producer surplus
500
Consumer surplus
400
1
Prices above market
equilibrium reduce
total surplus.
S
300
2
200
5
• 
• 
100
D
5
–  Reduces consumer surplus.
–  Reduces producer surplus.
4
3
0
• 
Suppose the price increases from the equilibrium price of $200 to $300.
Reduc=on in cameras sold by 10 million.
Buyers pay a higher price, decreasing consumer surplus from areas 1, 2, & 4 to area 1.
Sellers sell at a higher price, increasing producer surplus from areas 3 & 5 to 2 & 3.
10 15 20 25 30 35 40 45 50 55 60 65
Quantity of cameras (millions)
5-14
Ac:ve Learning: Calcula:ng total surplus Use the following graph to calculate the difference in total surplus if the price increases from $200 to $300.
Price ($)
600
500
400
1
S
300
2
200
4
5
3
100
D
0
5
10 15 20 25 30 35 40 45 50 55 60 65
Quantity of cameras (millions)
5-15
Ac:ve Learning: Calcula:ng total surplus Use the following graph to calculate the difference in total surplus if the price increases from $200 to $300.
Price ($)
600
• 
When price is $200
–  CS =$4.5 B and PS = $3B
–  Total surplus = $7.5B
500
• 
400
1
–  CS = ½*20M*($500-­‐$300) = $2B
–  PS = $3B – ½*10M*($200 -­‐$133.33) + 20M*($300 -­‐ $200) = $4.33B
–  Total surplus = $2B + $4.33B = $6.33B
S
300
2
200
4
• 
5
When price is $300
3
100
The change in total surplus is equal to $6.33B -­‐ $7.5B = -­‐$1.17B
D
0
5
10 15 20 25 30 35 40 45 50 55 60 65
Quantity of cameras (millions)
5-16
Market equilibrium and efficiency Lowering the price from the market equilibrium price decreases total surplus.
• 
Price ($)
Producer surplus
600
Consumer surplus
500
Prices below market
equilibrium reduce
total surplus.
300
S
• 
1
4
200
2
• 
5
3
D
0
–  Reduces consumer and producer surplus.
–  Dead weight loss is areas 4 & 5.
Deadweight loss
400
100
• 
5
Suppose the price decreases from the equilibrium price of $200 to $100.
Reduc=on in cameras sold by 15 million.
• 
10 15 20 25 30 35 40 45 50 55 60 65
Quantity of cameras (millions)
Buyers pay a lower price, changing consumer surplus from areas 1 & 4 to areas 1 & 2.
Sellers sell at a lower price, decreasing producer surplus from areas 2, 3 & 5 to area 3.
A market is efficient when it is at equilibrium.
5-17
Changing the distribu:on of total surplus When an ar=ficial price is imposed on a market, surplus is transferred between consumers and producers.
Price ($)
600
Price ($)
600
500
500
400
400
1
S
S
300
300
2
200
1
4
4
200
5
2
3
100
100
5
3
D
0
5
10 15 20 25 30 35 40 45 50
Quantity of cameras (millions)
When the price is raised above $200, consumer surplus area 2 is transferred to producers.
D
0
5
10 15 20 25 30 35 40 45 50
Quantity of cameras (millions)
When the price is lowered below $200, producer surplus area 2 is transferred to consumers.
5-18
Deadweight loss When an ar=ficial price is imposed on a market, a deadweight loss occurs.
Price ($)
600
500
400
Deadweight loss
S
300
Transactions
that no longer
take place at the
new price
200
100
The deadweight loss is the loss of total surplus that results when the quan=ty of a good that is bought and sold is below the market equilibrium quan=ty.
•  Reduc=on in cameras sold by 10 million.
•  Reduces consumer and producer surplus.
•  Deadweight loss is the gray triangle.
D
0
5
10 15 20 25 30 35 40 45 50 55 60 65
Quantity of cameras (millions)
5-19
Missing markets •  A market is missing when there are people who would like to make exchanges but cannot, for one reason or another, and opportuni=es for mutual benefit do not occur.
•  This occurs due to:
–  Public policy.
–  Lack of accurate informa=on or communica=on.
–  Lack of technology to facilitate exchange.
5-20
Summary •  The concept of willingness to pay and willingness to sell are analyzed.
–  Rela=onship to demand and supply.
•  Consumer and producer surplus are introduced.
•  Total surplus is maximized at the market equilibrium price and quan=ty.
5-21