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3 SUPPLY AND DEMAND II: MARKETS AND WELFARE Consumers, Producers, and the Efficiency of Markets Copyright © 2004 South-Western 7 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. Copyright © 2004 South-Western Welfare Economics • Welfare economics is the study of how the allocation of resources affects economic wellbeing. • Buyers and sellers receive benefits from taking part in the market. • The equilibrium in a market maximizes the total welfare of buyers and sellers. Copyright © 2004 South-Western Welfare Economics • Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product. Copyright © 2004 South-Western Welfare Economics • Consumer surplus measures economic welfare from the buyer’s side. • Producer surplus measures economic welfare from the seller’s side. Copyright © 2004 South-Western CONSUMER SURPLUS • 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. Copyright © 2004 South-Western CONSUMER SURPLUS • Consumer surplus is the buyer’s willingness to pay for a good minus the amount the buyer actually pays for it. Copyright © 2004 South-Western Table 1 Four Possible Buyers’ Willingness to Pay Copyright©2004 South-Western CONSUMER SURPLUS • The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. Copyright © 2004 South-Western The Demand Schedule and the Demand Curve Copyright © 2004 South-Western Figure 1 The Demand Schedule and the Demand Curve Price of Album John’s willingness to pay $100 Paul’s willingness to pay 80 George’s willingness to pay 70 Ringo’s willingness to pay 50 Demand 0 1 2 3 4 Quantity of Albums Copyright©2003 Southwestern/Thomson Learning Figure 2 Measuring Consumer Surplus with the Demand Curve (a) Price = $80 Price of Album $100 John’s consumer surplus ($20) 80 70 50 Demand 0 1 2 3 4 Quantity of Albums Copyright©2003 Southwestern/Thomson Learning Figure 2 Measuring Consumer Surplus with the Demand Curve (b) Price = $70 Price of Album $100 John’s consumer surplus ($30) 80 Paul’s consumer surplus ($10) 70 50 Total consumer surplus ($40) Demand 0 1 2 3 4 Quantity of Albums Copyright©2003 Southwestern/Thomson Learning Using the Demand Curve to Measure Consumer Surplus • The area below the demand curve and above the price measures the consumer surplus in the market. Copyright © 2004 South-Western Figure 3 How the Price Affects Consumer Surplus (a) Consumer Surplus at Price P Price A Consumer surplus P1 B C Demand 0 Q1 Quantity Copyright©2003 Southwestern/Thomson Learning Figure 3 How the Price Affects Consumer Surplus (b) Consumer Surplus at Price P Price A Initial consumer surplus P1 P2 0 C B Consumer surplus to new consumers F D E Additional consumer surplus to initial consumers Q1 Demand Q2 Quantity Copyright©2003 Southwestern/Thomson Learning 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. Copyright © 2004 South-Western Midterm Is Thursday, March 2 • Two examples of past midterms are on the website. • The midterm will follow that general pattern. • The makeup exam will be offered in class time, Thursday, March 9. • You must provide an official authorized excuse to have a make-up exam administered. • If you are eligible, please arrange taking the makeup first with your TA. Copyright © 2004 South-Western A Sample Test Answer: Q3 from 2002 Midterm • • • • • Throughout this question, you should assume that (i) demand is neither perfectly elastic nor perfectly inelastic and (ii) supply is neither perfectly elastic nor perfectly inelastic. A) Draw the demand and supply curve for hot dogs. Show the equilibrium price and quantity. B) What will happen to the equilibrium price and quantity of hot dogs if a new study finds that eating hot dogs increases the chances you will have a heart attack? Present and discuss a supply and demand diagram as part of your answer. C) Suppose that, AT THE SAME TIME (i) a new study finds that eating hot dogs increases the chances you will have a heart attack AND (ii) firms find a new way to produce hot dogs at a lower cost. What will happen to the equilibrium price and quantity of hot dogs? Present and discuss a SINGLE supply and demand diagram as part of your answer. D) As in C) Suppose that, AT THE SAME TIME (i) a new study finds that eating hot dogs increases the chances you will have a heart attack AND (ii) firms find a new way to produce hot dogs at a lower cost. What will happen to the equilibrium price and quantity of HAMBURGERS? Present and discuss a SINGLE supply and demand diagram as part of your answer. Copyright © 2004 South-Western A Strategy for Answering. • Read ALL the question first. • Determine any information that may be relevant (eg. Not perfectly inelastic S or D, H and HD are complements.) • For each question develop a strategy for answering using the three step method suggested by Mankiw. • Try to resist the temptation to say TOO much. False statements will cause a point deduction. • Then start... Copyright © 2004 South-Western Part A) Price S PE D QE Quantity Copyright © 2004 South-Western Part B) • The news causes the demand curve to shift in. • The new equilibrium price and quantity are both lower. S Price PE P’ D Q’ QE Quantity Copyright © 2004 South-Western Part C) • The part ii) news causes the supply curve to shift out. • The new equilibrium price is both lower than P and P’. • The new equilibrium quantity is higher than Q’ but may be S higher or lower than Q Price PE P’ P’’ D Q’ Q’’ Quantity Copyright © 2004 South-Western Part D) • Start with the original D and S curve for Hamburgers. • How does the health news affect D and S in the Hamburger market? i) Presumably it increases H demand. • This raises H price and quantity. Price S D QHamburger Copyright © 2004 South-Western Part D) • Since Hamburgers and Hot Dogs are substitutes, though, the technology driven fall in price in HD (ii) should cause a second, leftward shift in demand for Hamburgers. How far the shift is cannot be determined from the information. • Therefore, the final price and quantity may be higher or lower. S Price D QHamburger Copyright © 2004 South-Western PRODUCER SURPLUS • Producer surplus is the amount a seller is paid for a good minus the seller’s cost. • It measures the benefit to sellers participating in a market. Copyright © 2004 South-Western Table 2 The Costs of Four Possible Sellers Copyright©2004 South-Western 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. Copyright © 2004 South-Western The Supply Schedule and the Supply Curve Copyright © 2004 South-Western Figure 4 The Supply Schedule and the Supply Curve 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. Copyright © 2004 South-Western Figure 5 Measuring Producer Surplus with the Supply Curve (a) Price = $600 Price of House Painting Supply $900 800 600 500 Grandma’s producer surplus ($100) 0 1 2 3 4 Quantity of Houses Painted Copyright©2003 Southwestern/Thomson Learning Figure 5 Measuring Producer Surplus with the Supply Curve (b) Price = $800 Price of House Painting $900 Supply Total producer surplus ($500) 800 600 Georgia’s producer surplus ($200) 500 Grandma’s producer surplus ($300) 0 1 2 3 4 Quantity of Houses Painted Copyright©2003 Southwestern/Thomson Learning Figure 6 How the Price Affects Producer Surplus (a) Producer Surplus at Price P Price Supply P1 B Producer surplus C A 0 Q1 Quantity Copyright©2003 Southwestern/Thomson Learning Figure 6 How the Price Affects Producer Surplus (b) Producer Surplus at Price P Price Supply Additional producer surplus to initial producers P2 P1 D E F B Initial producer surplus C Producer surplus to new producers A 0 Q1 Q2 Quantity Copyright©2003 Southwestern/Thomson Learning 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? Copyright © 2004 South-Western MARKET EFFICIENCY Consumer Surplus = Value to buyers – Amount paid by buyers and Producer Surplus = Amount received by sellers – Cost to sellers Copyright © 2004 South-Western MARKET EFFICIENCY Total surplus = Consumer surplus + Producer surplus or Total surplus = Value to buyers – Cost to sellers Copyright © 2004 South-Western MARKET EFFICIENCY • Efficiency is the property of a resource allocation of maximizing the total surplus received by all members of society. Copyright © 2004 South-Western MARKET EFFICIENCY • 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. Copyright © 2004 South-Western Figure 7 Consumer and Producer Surplus in the Market Equilibrium Price A D Supply Consumer surplus Equilibrium price E Producer surplus B Demand C 0 Equilibrium quantity Quantity Copyright©2003 Southwestern/Thomson Learning 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. Copyright © 2004 South-Western Figure 8 The Efficiency of the Equilibrium Quantity Price Supply Value to buyers Cost to sellers Cost to sellers 0 Value to buyers Equilibrium quantity Value to buyers is greater than cost to sellers. Demand Quantity Value to buyers is less than cost to sellers. Copyright©2003 Southwestern/Thomson Learning 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. Copyright © 2004 South-Western Evaluating the Market Equilibrium • Market Power • If a market system is not perfectly competitive, market power may result. • Market power is the ability to influence prices. • Market power can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand. 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. Copyright © 2004 South-Western 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. Copyright © 2004 South-Western 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. Copyright © 2004 South-Western 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. 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. Copyright © 2004 South-Western